AI-driven legal services will cause a reimagination of how legal work is done, how it’s priced, and the relationship between law firms and their corporate clients
Anyone following the developing schools of thought around how artificial intelligence (AI) and generative AI (GenAI) could impact the ways in which legal services are provided has inevitably led to discussions concerning how law firms will bill clients for new AI-enabled legal services.
The Thomson Reuters Institute recently began to wade into this conversation itself, starting the conversation by discussing what AI-enable legal services are not — specifically, they’re not equivalent to a photocopy, a long-distance phone call, or a tuna sandwich. However, the idea that the pricing mechanism for legal services will have to change is basically unavoidable.
The legal market largely operates on a labor theory of value, in which the price of a service depends on the hours and resources put into it rather than the value of the outcome to the client. This theory will lead to problems for law firms if they persist in strict adherence to the billable hour.
I recently attended an event with a few hundred managing partners. In a roundtable discussion, one of the partners shared the story of a client who was considering mandating that the partner’s law firm adopt a specific GenAI-enable technology to replace paralegal hours. The client’s argument was that it would be good for the firm because they could take the paralegals off their payroll, and it would be good for the client because work could be completed much faster.
It doesn’t take much examination, however, to see the warning flags for the law firm. First, the hours billed by the paralegals are the high-volume, low-margin revenue engine that largely supports the broader overhead cost structure of the firm. If that revenue disappears, the firm would be hard pressed to find new revenue streams to support its overall operations.
But surely the AI-enabled work would serve as a swap, right? Most likely not, because of the theory of value applied. When the client is looking for work to be completed faster, under a labor theory of value, that also means cheaper. In theory, something that used to take an hour to complete that now takes 0.2 of an hour would also, under the labor theory of value, carry just 20% of the previous cost to the client, meaning 80% less in revenue for the firm.
And therein lies the flaw in the labor theory of value in an evolving AI-driven market. That theory places the onus on inputs rather than the value of the output — it values time over solutions.
The law firm could, theoretically, leverage its newly acquired tech to ramp up productivity to a point where it would be revenue-neutral; however, overcoming that size of a drop in revenue would mean completely five-times the amount of work. In theory, the firm would have the capacity to do that much work, but without the revenue stream, how could the firm afford to invest enough in new business development to generate that work?
The re-emergence of AFAs
And this is where alternative fee arrangements (AFAs) re-enter the conversation. AFAs burst onto the scene in the era following the Great Financial Crisis and quickly rose to account for roughly 20% of law firm revenue. But AFAs plateaued around 2014 and have stayed largely stagnant since. Now, however, many legal industry experts believe that AFAs are poised for resurgence.
In the Thomson Reuters Institute’s recent 2024 State of the Corporate Law Department Report, we examined how corporate general counsel have been working to control their costs and found that nearly half of GCs surveyed cited an increasing preference for AFAs. At the same time, many law firms have built up robust teams of experienced professionals to support more creative and profitable AFAs that meet the goals of both law firms and their clients.
I recently attended a meeting of many of these experts hosted by the True Value Partnering Institute to ask their cohort a few simple questions. First, there was near universal agreement with my earlier premise that AI is not a cost to be disbursed to clients, but a fundamental change in the technology required to provide legal services. Second, many meeting attendees also agreed that for law firms to remain profitable and protect revenue, a shift to greater use of AFAs for AI-enabled services would be necessary.
That does not mean they’re advocating for a firms-win/clients-lose outcome. There is broad recognition in the legal industry that the marginal price of a particular matter will likely come down somewhat as AI plays a greater role, providing cost savings to the client in addition to the benefits associated with faster matter resolution. However, arriving at a conclusion faster does not mean that the solution is less valuable. Indeed, in some cases it might be more valuable due to time sensitivity or other factors.
The answer for law firms then becomes a shift away from focusing on the number of hours put into a matter and instead toward the value of the solution provided. Clients can realize marginal per-matter savings, and law firms might realize margin per-matter drops in revenue, but ones that are much easier to overcome through increased capacity than the one potentially faced by the client in my earlier scenario. This is precisely the type of outcome envisioned in the first hypothetical discussed in our 2024 Report on the State of the US Legal Market, that rising tides lift all boats (see page 26 of the report).
The need for law firms to pivot
Law firms that persist in the pursuit of billable hours above all are placing themselves in a precarious position as the market is poised to shift to greater reliance on technology. Indeed, as shown in the aforementioned report, we are in the midst of a nearly uninterrupted 15-year decline in productivity as measured by billable hours per lawyer — a trend, as I’ve argued before, that is unlikely to reverse.
While the need to move to greater use of AFAs may not yet be acute, it is a looming likelihood on the horizon. Firms that move proactively to define what the transition to AFAs will look like have an opportunity to set the standard and make that value argument to clients first.
The others risk falling into a world in which their revenues continue to be defined by their inputs, putting them at greater risk. These firms could potentially succumb to dramatically diminished revenues because their new technology stack has cut their time of production dramatically; or, if they refuse to implement new technology in the hopes of avoiding that fate, they could very likely lose work to firms that have improved their tech and can now offer clients higher levels of service than those firms can offer.
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