Recently, an article in The Atlantic by Heidi Grant Halvorson (link) discussed the psychology of lost causes, making particular reference to Bruno Iksil, the JP Morgan derivatives trader who “doubled down” on bad investments, ultimately leading to the loss of more than six billion dollars. The article goes on to discuss new research into the concept that people often just don’t know when to quit and walk away, cutting their losses by refusing to continue to allocate resources to a failing project.
The article points out that, like many things, it is easy to recognize in others, but not nearly as simple to find in oneself. While many are risk averse, many more seem to be loss averse: “putting in a lot, only to end up with nothing to show for it, is just too awful for most of us to seriously consider.” A recent study by a pair of Northwestern University psychologists finds that it may simply be a matter of focus. Concentrating on what we have to gain by moving on, rather than what we lose by not succeeding, helps to maintain focus on what is really happening.
So how do this article and this research relate to our discussion on Break the Scales? Well, in two ways really. In this post, we will discuss how the fallacy of sunk costs is keeping the legal industry in the same loop it has been in for more than a decade now, largely ignoring the increasing and highly developed competition that is here to stay. In the next post, we’ll take on the topic of maintaining focus in value-based billing arrangements.
First, a little definition is necessary. Sunk cost is an economic term to refer to a retrospective cost that cannot be recovered. It is allocation of company resources, vendor costs, materials, human resource costs, etc. From the beginning of a project, an organization sinks costs in to move the project forward. These costs are different than economic loss or depreciation, in that the value of the cost is not necessarily related to the passage of time. The new car’s value drops in price immediately upon leaving the lot (economic loss) and its resale value diminishes every mile it is driven (depreciation), but the amount paid for the vehicle doesn’t change. That cost is permanent and not recoverable.
The Northwestern study finding that sunk costs can affect future behavior is neither new nor groundbreaking. The value of the study comes in the effects of context on that future behavior. Maintaining a prospective view on the project reduced the likelihood of the participant putting her head down and continuing along the path of certain failure, whereas concentrating on what has been invested in the project caused 80 percent of the participants to see it through to the end.
But the concept of sunk costs is not limited to project based-analysis. Indeed, it may be at least a contributing factor for what is happening in the entire industry. Law firms have spent hundreds of millions, and probably well into the billions of dollars, building a practice that is based largely on the Cravath model. Bill everything in 0.1 or 0.25 hourly increments, continually increase the rate by which the matter is billed, and continue to pay higher and higher premiums for the best talent. As the firm costs increase, increase the rates and bill more hours, and the money will continue to flow. This model is not the exclusive landscape of the AmLaw top 20, either. It is pressed through the entire industry, from very small law firms to the biggest conglomerates. And it is not just firms. The largest consumers of legal services are insurance companies, and they have taken the Cravath model and turned it to their own advantage. Need to reduce costs? Press the firms doing the work to reduce their rates. Simple logic, no? If we pay less per hour, our costs will decrease, or at least stay the same in the face of inflation. Using the simplest of metrics yields the simplest results, but simple results rarely reflect the full story accurately.
The Cravath model worked initially, and it continued to work for decades, when law firms enjoyed “hockey-stick” projections of law firm profits. And so, the industry continued to sink costs into the same model, even as the profits diminished into losses from quarter to quarter, and even as some of the most notable names in the industry: Howrey, Thelen, Dewey; imploded catastrophically. “We’ll see this through to the end,” you can almost hear them say. You sure did.
Some of the evidence I have for this is surely anecdotal. I have spoken to colleagues in in the industry, both lawyers and clients, about why there continues to be resistance to value-based billing, alternative fees, and project based management. The reasons people have come with, whether they are their own or those collected from others, are varied. Some are just hanging on to what they know until they can reach retirement. Others believe the old adage about the old dog and new tricks. But most important to this discussion is the old standard, “this is how we’ve always done it”, which can easily be read to mean “we have too much invested”.
Of course, the concept that there has been no return on that investment is positively laughable. But the other undercurrent is that most people just don’t know how to do it. Clients don’t know how to develop it or measure it, which means that chief legal officers don’t know how they’ll explain it to boards, and chief financial officers don’t know how they’ll explain it to shareholders. Law firm management doesn’t know how to lock it in with a client (or they know they can’t), and it doesn’t know how to increase revenue when it has to.
We all have little mantras to live by, and one of mine is “fear is a liar.” Convincing ourselves that we cannot change something because we don’t know how to work the alternative is succumbing to fear that is baseless. Are firms going to fail if they change the manner in which they operate? Yes. But firms are going to fail regardless, and some of the same firms are going to fail regardless. The real question is whether a firm is going to fail because it changes the way in which it operates. And I believe the answer is “not if it is done right.” The corollary question is whether the firm will fail if it does not change and adapt, and for many firms, the answer to that one is yes too.
Finding new ways to deliver value to your clients is what will allow you to thrive in the upcoming decades. This is not going to be an easy road. If you have clients or friends who run businesses in different industries, they will tell you how difficult it is to operate in more of a free market. Talk to your clients. Build those relationships. Try to find innovative ways to support those clients, and tell them what you’re doing and why. Generate the relationships that will lead you to knowing more about your clients than your competitors, and the brass ring will be within your reach. Then do it again.
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