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Agency theory part II: adverse selection and law departments

Agency theory (See my post of Jan. 1, 2008.) importantly encompasses the challenges of moral hazard (See my post of Aug. 13, 2006.). “A moral hazard problem arises when the principal [the law department lawyer] cannot perfectly evaluate the effectiveness of the agent’s actions” [law firm’s] because there is a cost to surveillance (See my post of May 1, 2006 about how little time inside lawyers spend on bill review.) and the law firm’s efforts do not completely determine the outcome of the matter, especially a lawsuit.

Another important concern of agency theory is adverse selection (See my post of July 14, 2006.). “An adverse-selection problem appears when the agent possesses information that may prove useful to his decision-making and the principle does not know it” (at 7). For example, a law firm competing for work might know that its star lawyer has bad health, is over-worked, or is shifting the emphasis of her practice. The law department can’t know those possible risks.

Agency theory identifies two mechanisms to reduce adverse selection problems: signaling and screening (See my post of May 1, 2006 on “signaling” functions of billing arrangements.). Screening in the law department context depends in large part on the brand renown of law firms (See my post of Nov. 28, 2007 on branding and references cited.) as well as size of a firm or its specialty practice (See my post of May 3, 2006 on the consequences of firms growing to behemoth size.). Screening also occurs when there is reliance on personal referrals and league tables (See my post of Nov. 11, 2007 on surveys of law-firm use.). Another mechanism is self-selection (at 10). If a law department insists on fixed-fee arrangements, some firms will select themselves into the competition for that work, others will select themselves out.

This two-part foray has hardly done justice to agency theory, a continuously evolving brew of management research and theory. The posts have traced some of the ways the field informs law department managers. Its tenets apply not only to outside-counsel management but also to a department’s own staff.