The U.S. legal market appears poised to end 2011 with a fairly sluggish overall performance and with mounting pressures on law firm profitability. Although showing signs of recovery during the first half of the year, demand for legal services collapsed in the second half of 2011, particularly in corporate and transactional practices. Indeed, Hildebrandt Peer Monitor data indicate that the legal industry will likely end the year with negative demand growth as compared to 2010. And that will translate into negative growth in productivity as well – with productivity declining by more than 3 percent when compared to the prior year.

Although the decline in demand and productivity has hit the AmLaw 100 firms the hardest, the same negative pattern can be seen across the entire market. The drop in demand was particularly severe in the transactional areas with M&A, general corporate, capital markets, tax, and real estate practices all experiencing sharp declines. The bankruptcy area continued to see negative demand growth in 2011 as well, though at a somewhat slower rate than in 2010. Only labor and employment, litigation, and IP litigation practices showed positive demand growth in 2011, but of those only IP litigation had demand growth equal to the prior year.

Despite the sluggish demand picture, firms continued to raise their rates (at least modestly) during 2011, but the gap between standard billing rates and collected rates continued to widen, as it has over the past few years. As a result, realization rates remain at historic lows, with collected realization hovering between 84 and 85 percent.

At the same time, firm expenses – which dropped precipitously from 2008 to mid-2010 (in some firms by as much as 20 or 25 percent) – began increasing again in late 2010 and continued growing in 2011. By year end, law firm expenses (both direct and indirect) will be in positive growth territory for the first time since the economic downturn began. This reflects the fact that much of the expense savings experienced in 2009 and 2010 resulted from extensive layoffs of associates and administrative staff, actions that could not be repeated in 2011. It also reflects the reality that many of the expense “cuts” in the last couple of years were achieved by postponing projects not by cancelling them. To cite but one obvious example, you can delay replacing key components of your IT system, but only for a limited time. Sooner or later the projects have to move forward and the expenses have to be incurred.

The combination of continuing sluggish demand growth, depressed productivity, low realization rates, and rising expenses creates a highly challenging environment for law firms as they try to maintain acceptable levels of profitability. Many firms are ending 2011 quite concerned about their profit performance this year, some with fears of year-end demands from clients for further discounts as a result of “busted deals.” But perhaps more serious are the prospects for 2012.

If, as appears likely at the moment, the economic recovery continues to be slow – resulting in continuing sluggishness in the growth of demand for legal services – firms could be faced with some stark choices for maintaining profitability in the year ahead. For some, further headcount reductions might be required (more than likely among partners rather than in the already depleted associate ranks). Others might institute transformational changes in management and support structures (such as WilmerHale’s decision last year to open a firm-wide administrative and support center in Dayton, Ohio). Still others might look to various outsourcing solutions to reduce administrative staff or overall costs. And all of this will be occurring at the same time that many firms need to be making new investments to respond to client demands that legal services be delivered more efficiently and cost effectively.

All in all, it might be said that the legal market has stabilized from the downward slide we saw at the beginning of the recent recession. But the stabilization has occurred at a much lower performance level than in 2008, and there remain many challenges on the horizon.

James W. Jones is Senior Fellow at Georgetown Law’s Center for the Study of the Legal Profession. He is the former chairman of the Hildebrandt Institute.