Monday, March 29, 2010

Harnessing Complexity - Contractual Building Blocks

When it comes to contract automation, most lawyers think the solution is document assembly. It can, indeed, quickly and accurately generate a document based on user-selected variables.

But is hasn’t become widely adopted outside of areas such as estate planning. Why? I think there are at least three main reasons:

· It's very expensive to build and maintain
· It's a black-box that inhibits lawyerly interaction and judgment
· It works only for first draft situations; it doesn’t help with the more common task of document review

But this is not to say that document assembly is flawed in any way. It is absolutely the right tool for formulaic document generation of frequently used documents, especially where the user can benefit from guidance in selecting contract alternatives.

For all the other circumstances, are there other approaches to contract analysis and automation? I've drawn heavily on the work of Herbert Simon. His parable of the Two Watchmakers is particularly instructive to the challenges facing lawyers today.

"There once were two watchmakers, named Hora and Tempus, who manufactured very fine watches. Both of them were highly regarded, and the phones in their workshops rang frequently - new customers were constantly calling them. However, Hora prospered, while Tempus became poorer and poorer and finally lost his shop. What was the reason?

The watches the men made consisted of about 1,000 parts each. Tempus had so constructed his that if he had one partly assembled and had to put it down - to answer the phone, say - it immediately fell to pieces and had to be reassembled from the elements. The better the customers liked his watches, the more they phoned him and the more difficult it became for him to find enough uninterrupted time to finish a watch.

The watches that Hora made were no less complex than those of Tempus. But he had designed them so that he could put together subassemblies of about ten elements each. Ten of these subassemblies, again, could be put together into a larger subassembly; and a system of ten of the latter subassemblies constituted the whole watch. Hence, when Hora had to put down a partly assembled watch to answer the phone, he lost only a small part of his work, and he assembled his watches in only a fraction of the man-hours it took Tempus."

The Architecture of Complexity: Hierarchic Systems, Proceedings of the American Philosophical Society, 106, Dec 1962, 467-482.

How would this apply to legal agreements? Law firms and corporate legal departments can adopt the approach of Hora and create standard building blocks of the core contract blocks, such as Representations and Warranties, Covenants and Miscellaneous articles. These may be varied by deal type, nature of the asset and parties.

Analyzing current document sets for very similar deals reveal a remarkable varied range of clauses and specific clause language, much like the watches made by Tempus. Moreover, much of the variation in clause language is more semantic, rather than substantive.

Hierarchical modularity does not preclude rich variation. But it does avoid inefficiency. Not all clients want to buy a handmade Patek Philippe Sky Moon Tourbillon for more than One Million Euro; many would be very satisfied with equally functional, thoughtfully crafted watch for a fraction of the price.

Empirical Analysis: What's Market?

In negotiating contracts, lawyers will often assert that certain terms are "market." On what basis can such a claim be made? How many documents are needed for a statistically relevant sample set? There is, in fact, only a limited amount of empirical analysis that is publically available. This post examines three academic studies.

An Empirical Analysis of CEO Employment Contracts: What Do Top Executives Bargain For?

Stewart Schwab and Randall Thomas of
Cornell and Vanderbilt examine a set of 375 employment contracts, focusing on four primary data points: (a) cause, (b) good reason, (c) noncompete, (d) arbitration, and (e) stock option restrictions. The authors conclude that CEO employment agreements are weighted in favor of the CEO's. They "found evidence that CEOs have significant bargaining power in their negotiations over the terms of their employment contracts and change-of-control agreements. Furthermore, the differences between these CEO contracts and these of other corporate workers seem stark."

An Empirical Examination of Business Outsourcing Transactions

George S. Geis of
University of Virginia School of Law analyzes 60 onshore and offshore outsourcing transactions in pursuit of two foundational questions: (1) how do parties write these deals; and (2) why do we observe major differences in governance terms? He concludes that outsourcing transactions are extremely diverse determining that the contracts are "[h]ighly variable, making it difficulty to draw any solid conclusions."

What’s in a Standard Form Contract? An Empirical Analysis of Software License Agreements

The most extensive study is an analysis by Florencia Marotta-Wurgler of
New York University School of Law. She and her team analyzed 647 End User License Agreements (EULAs) from 598 companies. The study analyzes "23 common and important standard terms that allocate rights and risks between buyers and sellers." The study shows a significant bias in favor of the seller as shown in a Bias Distribution chart.

"An immediate conclusion is that the vast majority of the contracts in our sample are more pro-seller relative to the default rules of Article 2 of the UCC. Although EULA terms vary greatly across software markets, I find that larger and (controlling for size) younger firms tend to have more pro-seller terms than smaller and older companies. I find no evidence that firms offer worse terms with software targeted to the general public versus software targeted to larger business or corporate users."

Statistical Significance and Statistical Range

There are a number of tools on the
web to calculate sample sizes. The key inputs are the size of the population (or total collection) size; sample size and answer range or spread. Using these calculators and assuming collection sizes ranging from 10,000 to 50,000 then sample size ranging from 250 to 500, as two of the studies used, give a margin of error of less than 5%.

I can confirm that when analyzing publicly available documents from
EDGAR, typically drawn from a wide range of authors, a sample set of 250 to 500 documents appears to yield satisfactory levels of confidence. Much smaller sample sizes are needed, however, when analyzing documents from a single organization or documents that exhibit high consistency. In these cases, the sample size can be as few as 20 documents. It turns out that you need fewer merger agreements than employment contracts, because merger agreements are much more consistent. See, Measuring the Consistency of Transactional Documents; Ron Friedmann; It's Time To Rethink The Lawyer's Role In Dealmaking: Start By Facing Up To The New Realities, Robert A. Profusek and Lyle G. Ganske, Jones Day

Tuesday, March 23, 2010

Why Standardize?

This blog focuses on empirical contract analysis and the identification of contract standards. The main themes will be: change; economics and metrics.

This is my first foray into the blogosphere. I plan to write at least weekly on the forces driving change in the legal industry and how lawyers can best respond and adapt.

I'm speaking on the
Future of KM at ABA TechShow this week with Toby Brown from Fulbright & Jaworski. Many of you will know Toby through his well known 3 Geeks and a Law Blog. As I get ready for TechShow, it seems appropriate to start this blog on the topic of the economic factors driving change.

Paul Lippe of the
Legal OnRamp in "Embracing the New Normal" highlights the power of the current economic forces. Paul reports:

"• The general counsel of a major company explained that he had shifted his legal spending from 50 percent internal and 50 percent external to 70-30, thus reducing outside spending by 40 percent.

• The General Counsel Roundtable presented data showing that outside legal spending by the S&P 500 was dropping from $16.7B in 2007 to an estimated $13.8BB in 2010, a 17 percent decline."

These numbers are astounding. When working for larger companies, I began to get a sense of the degree of change needed to meet changing circumstances. Where for example, the corporation was challenged to reduce expenses by less than 10%, it could typically meet its goal by active expense control. When the business was challenged to reduce expenses by 10 to 15%, then expense control was not enough, and it would be forced to lay people off. In this circumstance, staff reductions would likely come from lower paid categories. However, when the goal ranged from 15-20%, then staff reductions would have to include senior staff. Each level of cost control has escalating impacts on the ability of the organization to meet its client's needs. But, where the expense goals rose to 20% or more, trimming expenses probably would not suffice. The business model would need to change.

Those of us involved in legal technology for many years have long debated what will it take for lawyers to fully embrace technology—not just generic technology for communication and word processing—but technology that automates the practice of law? If Paul's numbers are correct and this approach is widely adopted by US businesses, then change is not nigh: its here. And the change is not just incremental: it's a sea change.

The impacts and appropriate responses can be illustrated by a sliding bar chart—an idea I've adapted from Jeff Rovner. In this example, I pose the example of a law firm engaged to draft and negotiate an outsourcing agreement in each of the last three years.

In 2008, the firm bills 71.5 hours at a blended rate of $350 per hour. The total bill is $25,000. The firm, like many successful law firms in the pre-recessionary period enjoyed a profit margin of 40% and so we can calculate the cost of services was $15,000 and the firm's profit was $10,000.

In 2009, due to soft demand for legal services, the firm agreed to a discount of 20%. Nothing changed at the firm; the work was still performed in the traditional manner and it still took 71.5 hours. The cost of services therefore remained $15,000 and the discount "comes off the top" reducing profit by 50% to $5,000.

As the economy slowly comes out of recession, many hope to return to the good 'ole days. But this appears unlikely. Why would clients pay $25,000 this year for the same service for which they paid $20,000 last year?

The bottom line is that it is now easy to see how law firms can quickly bankrupt themselves through discounting because profit margins are quickly eroding. For this reason, law firms are seeing the importance and value of Alternative Fee Arrangements (AFA's).

In 2010 and beyond, firms may agree to a fixed price of $20,000 and adjust the internal cost lever "to the left." While it may take some investment, if firm's can reduce their costs by 20% and take 57 hours to draft and negotiate the agreement, their profit margin would be restored to 40%.

The chart shows there are two key determinates of profit: market price and internal costs. This is, of course, no different from any other business.

The market price is primarily set by macroeconomic trends and firm brand. Firm's have little control over macro trends. They can control their brand. It can take years to establish or improve brand quality. But, as Toyota has shown, a business can quickly tarnish its image.

Internal costs are entirely in the control of the firm. However, I get the sense from law firm leaders that they do not see the cost slider as being so fluid. For most lawyers, shifting the cost slider left is fraught with danger and uncertainty. This is where the legal technologists and knowledge management experts can help.

The better approach is maintain (or improve quality) while reducing costs. And, this will be the topic of the next post.