Are Public Companies Spending Too Little on Law Firms?

Elisabeth de Fontenay is an Associate Professor at Duke University School of Law. This post is based on a recent article authored by Professor de Fontenay.

For at least the past decade, U.S. companies have been keenly focused on reducing their expenditures on outside counsel. Many have taken innovative and drastic actions to that end, such as negotiating alternative fee arrangements or making law firms compete for legal work in electronic auctions. Indeed, the conventional view remains that corporate clients are overpaying for legal services. But is that actually the case? One option for reducing legal expenditures is simply to engage a less expensive law firm. Yet surprisingly, there has been little research on whether corporate clients’ choice of law firms is value-maximizing.

In a recent article, Agency Costs in Law-Firm Selection: Are Companies Under-Spending on Counsel? (forthcoming in the Capital Markets Law Journal), I provide evidence suggesting that U.S. public companies may be selecting lower-quality counsel for their transactional work than is warranted. Specifically, using a large sample of syndicated loans, I find that public-company borrowers tend to engage lower-quality law firms than do private equity firms, for the very same types of financing transactions and controlling for key deal characteristics. Admittedly, some of this discrepancy in law-firm choice is likely attributable to value-maximizing behavior by both private equity firms and public companies. Yet it also raises the possibility that agency and other information problems within public companies are distorting their choice of counsel.

Why might private equity sponsors be more willing to pay for elite law firms than much larger organizations such as Fortune 500 companies, for the very same types of transactions? Conversely, what explains the relative reticence of major corporations to engage top-tier law firms? In considering these questions, we might first observe that private equity firms are relatively well incentivized to select counsel for their portfolio companies that maximizes their expected value from the transaction. Private equity investments are typically highly leveraged, meaning that any improvement in transaction terms that counsel can obtain results in a relatively larger economic return. Further, private equity sponsors benefit more directly from such increased returns than do the public-company agents—typically, general counsels—responsible for selecting outside counsel. Private equity sponsors commonly receive twenty percent of the profits from their portfolio-company transactions (the “carry”), which is then shared among a relatively small number of individuals. Such high-powered incentives to maximize transaction value contrast with the relatively low-powered incentives faced by public-company general counsels.

Not only are private equity firms better incentivized to select counsel optimally, in the transactional context they are arguably better able to do so. As sophisticated, repeat players with respect to leveraged acquisitions, they can benchmark their outside counsel’s performance across a sizable volume of transactions. Thus, overall, private equity firms internalize both the costs (higher legal fees) and the benefits (the expectation of a better economic deal) of hiring top-tier law firms relatively well. From the outset, then, their revealed preference for elite counsel suggests that it is likely to be value-maximizing.

The picture for public companies is murkier. Major public companies face a classic “make-or-buy” decision when it comes to transactional work: they can engage a law firm or rely on in-house counsel. Yet framing the make-or-buy decision as a binary choice is misleading in this context. In practice, the difficulty lies in selecting from a wide range in quality of outside counsel, once the decision to “buy” has been made. This article’s empirical result raises the possibility that public companies are selecting an inefficiently low quality of legal work for their transactions. Stated differently, a general counsel’s bias toward “making” legal work in-house may manifest as a tendency not only to forgo (or under-utilize) outside counsel for certain work, but also to select lower-quality outside counsel than is optimal for the company.

To be sure, in-house counsel at public companies can help monitor outside law firms’ work, thus potentially increasing the value that outside counsel provides once a law firm has been engaged. Yet there are reasons to doubt whether public-company general counsels optimally select among law firms in the first instance. Particularly for one-off transactions, general counsels may not be correctly incentivized to make value-maximizing choices. Information, agency, and influence costs within public companies may drive general counsels to steer transactional work to cheaper firms or to in-house counsel, even when doing so is not in shareholders’ best interests. This raises the surprising possibility that, contrary to the prevailing view, major U.S. public companies may in fact be under-spending on legal services.

The full article is available for download here.

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