To make or to buy: in-house lawyering and value creation.

• Author: Schwarcz, Steven L.

In recent years, companies have been shifting much of their transactional legal work from outside law firms to in-house lawyers, and some large companies now staff transactions almost exclusively in-house. Although this transformation redefines the very nature of the business lawyer, scholars have largely ignored it. This Article seeks to remedy that omission, using empirical evidence as well as economic theory to help explain why in-house lawyers are taking over, and whether they are likely to continue to take over, these functions and roles of outside lawyers. The findings are surprising, suggesting that in-house lawyers may now be performing work as high in quality as outside lawyers and that the reputational value of outside lawyers may be significantly diminishing.

1. INTRODUCTION II. METHODOLOGY III. HYPOTHESIS A. Disintermediation B. Reducing Agency Costs C. Economies of Scale D. Economies of Scope E. Responsiveness and Ease of Communications F. Reputational Intermediary G. Client Privilege and Confidentiality H. Dynamic Equilibrium IV. EMPIRICAL FINDINGS A. Disintermediation Hypothesis Compared with Empirical Findings B. Reducing-Agency-Costs Hypothesis Compared with Empirical Findings C. Economies-of-Scale Hypothesis Compared with Empirical Findings D. Economies-of-Scope Hypothesis Compared with Empirical Findings E. Responsiveness-and-Ease-of-Communications Hypothesis Compared with Empirical Findings F. Reputational-Intermediary Hypothesis Compared with Empirical Findings G. Client-Privilege-and-Confidentiality Hypothesis Compared with Empirical Findings H. Dynamic-Equilibrium Hypothesis Compared with Empirical Findings V. COMPARING THE FINDINGS WITH ECONOMIC THEORY VI. CONCLUSIONS ANNEX 1 ANNEX 2 APPENDIX A: DETAILED PRESENTATION OF THE DATA UNDERLYING THIS ARTICLE'S FINDINGS APPENDIX B: VARIATIONS IN RESPONSES BASED ON LAW DEPARTMENT SIZE I. INTRODUCTION

   Improvements in reputation and skill of in-house lawyers and the recent growth of in-house legal departments mark a watershed in legal demographics. (1) Although a need remains for outside law firms, especially in litigation, the relative distribution of work has changed. There has been a substantial shift towards more in-house lawyer transactional work in the past decade, with one survey showing approximately 68% of transactions currently lawyered in-house. (2)

   Some large companies now rely almost exclusively on in-house counsel for their transactional legal work. Sears, for example, began building up its in-house legal department in the late 1990s, adding lawyers in areas like securities, tax, and real estate. (3) In real estate, its goal was to handle transactions from the beginning to the end. (4) Many other companies have legal departments numbering in the hundreds, providing internally many of the same skills available from large outside law firms. (5)

   This Article examines the shift from outside to in-house "transactional lawyering"--meaning the structuring, negotiating, contract drafting, advisory, and opinion-giving process leading to "closing" a commercial, financing, or other business transaction. (6) The shift appears to reflect a transformation in the relative value provided by in-house and outside transactional lawyers. This Article uses empirical research and economic theory to examine that transformation, analyzing why in-house lawyers are taking over, and whether they are likely to continue to take over, the functions and roles of outside transactional lawyers. The findings suggest, among other things, that in-house lawyers may now be performing work as high in quality as outside lawyers and that the reputational value of outside lawyers may be significantly diminishing. At the same time, however, the shift to in-house lawyering may well be starting to slow and approach an equilibrium state.

   Because this Article focuses on transactional lawyering, subsequent references to "lawyer," "counsel," "lawyering," and the like refer to lawyering in a transactional context. (7) This Article does not address such non-transactional lawyering roles as litigation, lobbying, or compliance work because those roles do not normally involve, as does transactional lawyering, head-to-head competition between outside and in-house counsel. (8) Also, this Article assumes that lawyers generally provide value in business transactions, and thus does not address such issues as whether lawyers add value compared to having no lawyers involved in such transactions. Recent research confirms that lawyers do indeed add value. (9)

2. METHODOLOGY

   This Article first utilizes quantitative data, derived from the results of surveys, (10) to test a range of hypotheses about the value or relative value provided by in-house and outside lawyers and to assess any transformation therein. (11) The Article then compares the resulting findings with the predictions of economic theory, using the insight that a decision whether to bring legal work in-house is a subset of the broader question of vertical integration: whether a company should make needed products in-house, or whether it should buy them (the classic "make-or-buy" decision). (12)

   The recipient of value provided by in-house and outside lawyers is always primarily the client-company. The Article therefore focuses on value from the company's standpoint. (13) The company's general counsel (or other chief legal officer), as manager of the legal department, typically is responsible for assigning legal work, including the decision whether to handle a matter in-house or to retain the services of outside counsel. (14) For survey purposes, the Article thus treats the general counsel--or, where applicable, a person to whom the general counsel forwards the survey to respond--as a proxy for the client-company. (15)

   Treating the general counsel as a proxy for the client-company raises potential biases. Where (as often occurs) general counsel also are responsible for hiring in-house attorneys, general counsel may respond to the survey in ways that justify their hiring decisions. That, in turn, may slant some responses towards in-house lawyer value. There also may be a self-reporting bias insofar as general counsel, being in-house lawyers, view the role of in-house lawyers as more important and indispensable than it actually is. (16) To mitigate these biases, as well as to serve as a reality check, this Article additionally surveys a representative sample of outside lawyers. (17)

   The initial surveys were conducted using a ten-page questionnaire for general counsel as proxies for client-companies and a slightly modified, shorter questionnaire for outside lawyers. The forms of these general counsel and outside lawyer questionnaires are attached to this Article as Annexes 1 and 2, respectively. The answers to several questions in the original general counsel questionnaire appeared to vary significantly depending on the number of attorneys in the company law department. To ensure statistical reliability, a subsequent survey was conducted using an abbreviated general counsel questionnaire focusing primarily on those questions. (18)

   Survey methodology is potentially subject to flaws. Although surveys constitute "a primary source of data in ... the social sciences," (19) they are dependent on the precise wording, format, and context of the survey questions. (20) Survey data also indicate what respondents (here, in-house and outside lawyers) say is the case, which may be different from what is actually the case. (21) Additionally, treating the general counsel as a proxy for the client-company may bias some survey responses. (22)

   The surveys also had a low response rate, (23) which can signal potential biases because "nonresponse often is not random." (24) The respondents, for example, may have been more intellectually curious about this project than non-respondents or they may have been, on average, less busy--and therefore perhaps less competent lawyers--than non-respondents. On the other hand, the rates may simply reflect generally declining response rates to unsolicited surveys and the fact that lawyers tend to be extremely busy.

   To help discover flaws or biases as well as to provide a contrasting perspective, this Article compares its empirical findings with the predictions of economic theory. Economic theory is relevant because, as indicated, (25) a company's decision to bring legal work in-house is, in economic terms, one of vertical integration. (26) Significant differences between the theory and empiricism might suggest methodological errors. The results, however, turn out to be remarkably complementary.

3. HYPOTHESIS

   In accordance with the foregoing methodology, this Article first empirically tests the following hypotheses: (A) Disintermediation; (27) (B) Reducing Agency Costs; (28) (C) Economies of Scale; (29) (D) Economies of Scope; (30) (E) Responsiveness and Ease of Communications; (31) (F) Reputational Intermediary; (32) (G) Client Privilege and Confidentiality; (33) (H) Dynamic Equilibrium. (34) These hypotheses--representing what appears to be the universe of plausible hypotheses about the value or relative value provided by in-house and outside counsel--were compiled from scholarly literature, (35) practitioner literature, feedback on draft questionnaires, and the Author's experience as a transactional lawyer. (36) As the discussion below shows, there is some overlap among certain of these hypotheses. (37) Each of these hypotheses is further explained below.

   1. Disintermediation

      This hypothesis predicts that in-house counsel are, other factors being equal, less costly than outside counsel because, by bringing lawyers in-house, companies can achieve a disintermediation of legal services--removing the need for outside lawyers and therefore avoiding the profit component, or markup, (38) charged for their services. (39) This profit component represents the higher average incomes of outside lawyers at comparable...