Tuesday, May 25, 2010

Contract Building Blocks—the low hanging fruit of standardization

One of the challenges to creating contract templates as a reference standard is that a yardstick must be built for every document type; just as we need spell checkers for each language. Nevertheless, there are shared characteristics that can be exploited across all document types.

Virtually all contracts follow the same basic structure. While we may give these elements different labels, the basic organization of bi-lateral and multi-lateral contracts can be described as follows:

  • Statement of agreement and identification of the parties
  • Form and mechanics of the transaction
  • Representations and Warranties
  • Conditions Precedent
  • Covenants (ongoing promises)
  • Term and Termination (Events of Default)
  • Limitation on Liability
  • Indemnification
  • General Provisions (Miscellaneous)

With the exception of the form and mechanics of the transaction, legal agreements share many of the same terms and provisions. Furthermore, we can predict the likely degree of similarity of each building block. For example, the General Provisions will likely be more consistent across a wide range of agreements compared to Termination provisions. I would predict that the next most consistent terms can be found in the Representations and Warranties.

Consistency across all documents offers an opportunity to standardize terms "horizontally" or at least across blocks of related agreements. Then applying the wisdom of the 80/20 rule, a relatively simple 3-step approach can realize significant productivity and quality gains.

First, create a list of all clauses in each common contract section (e.g. Miscellaneous, Covenants, or Representations and Warranties).

Second, mark each clause as either standard or deal-specific.

Third, build a library containing the standard and alternative language for each clause.

Simple. However, I should disclose that I've received significant push-back on standard document building blocks. In one case, I was told that is would be impossible to create a standard Miscellaneous section of boiler-plate terms because, for example, the assignment clause requires customization to each deal. Of course, terms must be tailored to the transaction. However, the variations are predictable and can be supplied. Others have warned that clauses are dependent on the terms of other provisions and therefore cannot be read in isolation. It is true that some deal terms are conditional on other provisions, but again such conditionality can be predicted and, where it exists, it should be clearly identified to prevent mistakes in the use of precedent.

As an example, we can apply the approach to the Miscellaneous section of the set of 106 intellectual property security agreements analyzed in a prior post. The complete list contains 32 clauses shown in the chart below where the blue bar shows the commonality (frequency) of each clause and the yellow bar display the language consistency (variance), based on calculation of standard deviation.

If we focus on the 8 most common clauses appearing in at least 1/3 or more the documents, we can see that the language is universally more consistent. For the less common clauses there appears to be more divergence: some highly consistent; others very inconsistent.

In non-mathematical terms, the analysis provides additional support for the 80/20 rule, namely: in the case of frequently appearing clauses there is already broad consensus on the standard language. And, such consensus can hopefully reduce some of the political hurdles associated with contract standardization.

Tuesday, May 18, 2010

Latent Legal Market Revisited—A Rare Win-Win

Law firms want high value "bet-the-business" work, where no effort is spared and legal fees are not questioned. As many commentators have pointed out this market is shrinking and the number of law firm specializing in this type of work is dwindling.

Ever since I picked up a computer and started programming, I've thought about the other end of the market: the low margin business. I've pitched the concept to many firms with very limited success. And, described in terms of "let's go after low value business" lack of interest is hardly surprising.

From the Law Firm's Perspective

First, the desired high margin business is also very low volume. The seemingly less desirable low margin business is high volume. I suspect the total value of low margin business is at least as large as high margin work.

Second, another rationale for avoiding routinized work is that it may be perceived as less intellectually challenging. However, I would point out that what a simple individual representation may lack in challenge is more than supplemented when the goal is to meet the needs of all present and future clients in a systematized and packaged legal service.

Third, standardizing lower value work (NDAs, employment agreements, sales agreements, etc) is an excellent training vehicle for associates, employing underutilized lawyers.

From the Client's Perspective

General Counsel is challenged not only to reduce their outside legal fees—more likely than not comprising the non-standard, high value work—but also their internal costs. And, for every merger agreement executed by a business, they are likely hundreds of employment agreements. In order to reduce costs and increase quality, many, in-house departments, for example Cisco, have invested in standardization projects. But, such efforts still represent a small fraction of the overall volume of work.

Combining Interests

Rather than describe the opportunity as "low value" business, there are better marketing approaches. Employ law firm associates to build standard forms and document assembly systems for their clients, using the expertise of the firm's senior attorneys to ensure adherence to best practices. The law firm bills for its legal services, the client benefits from reduced cost. Moreover, if law firms fail to assist business reduce their day-to-day costs, will in-house lawyers invest in document standardization forever cutting outside counsel out from this line of work?

How large is the low-margin, high volume market? In order to estimate the cost-benefits of document standardization, I've built an ROI calculator to weigh the cost of building standard templates compared to time required to draft documents using the "last draft" method. Here's a link to the calculator. If I'm right then the cost savings to businesses are very significant and scaled up to the entire market, it's a huge opportunity for law firms.

Wednesday, May 12, 2010

Measuring Commonality and Consistency—Do the Numbers Tell a Story?

Those who have read a few posts in the blog know that much of my research is based on pure statistics. And, of course, we know the adage: "lies, damn lies, and statistics." But, can they tell a story? Can they offer some insight into how lawyers use precedent and how precedent evolves over time?

Where clauses are repurposed from an earlier precedent, they remain very consistent. Is that because they are copied but not substantially changed, or is it because the language of a particular contractual provision can only be defined in a relatively limited number of ways?

Early research confirmed that the consistency of legal document can be measured. The results of the analysis uncovered an unexpected conclusion: the more sophisticated the underlying transaction, the more likely the document will be consistent. A merger agreement, for example, is more likely to be consistent than an employment agreement.

In order to further test these propositions, we must distinguish between: (a) the elements of a contract and (b) how each of those elements is defined. Mathematically we can measure these values by commonality and consistency. Commonality is calculated by the frequency of a particular clause. For example, we may find a governing law clause in 90% of the sample agreements, while a severability clause may appear in 50% of the documents. Consistency is calculated by the standard deviation of a factor itself calculated primarily by the commonality of the words in the clause.

I recently ran these statistical measures of commonality and consistency for merger agreements and intellectual property security agreements. The charts display the outline organization of the agreement and for each caption, the bar chart shows the commonality of the clause in the blue bar and its language consistency in the yellow bar. You can click on the images above or the links in this paragraph to see a larger (readable?) image.

In the case of the merger agreement, we see high commonality of clauses and high consistency of language. Indeed, the presence of these two factors indicates a market standard. However, in the case of the intellectual property security agreement we see only two common clauses: grant of security interest and rights and remedies. However, all clauses (whether common or uncommon) display a high degree of language consistency.

What observations can be draw? First, there is great opportunity to standardize (and enjoy the efficiencies thereof) in the reps, covenants and miscellaneous sections. It is truly remarkable the variation in the clause selected. Second, the greatest opportunities for standardization will likely come from building deal checklists, not just clause libraries. It appears that we generally agree as to the language of a given clause, but there is less agreement on what clauses should be included.