Alternative fees (Part 1): What’s wrong with billing by the hour?

In discussing the economic outlook for 2009, Business Week (January 5, 2009, p. 39) says that most companies are “scrambling to protect their bottom lines” and “costs cannot be cut fast enough.”  For law firms, that will mean more pressure from clients for alternative fees. 

But there is no clear consensus on how lawyers should use alternative fees, or even on exactly what the term means.  Is a blended rate an alternative fee?  Some experts would say yes, some no.  And there is even less agreement about the risks and benefits of all the variations, including flat fees, contingency fees, retainers, capped fees, safety valves, and other alternative approaches.

 

This series of posts is designed to help lawyers put alternative fees into perspective, and to provide step by step advice on when to use them.  It will apply a broad definition of the term “alternative fees,” including both discounting tactics which are widely used and fixed fee structures which are less common.

Any big picture overview of alternative fees must start with the system that it is an alternative to:  billing by the hour.  A few years ago, the American Bar Association established a Commission on Billable Hours to study the pros and cons.  Their final report in 2002 highlighted many disadvantages of hourly billing, including (p. 5):

“Simply put, the overreliance on billable hours by the legal profession:
• results in a decline of the collegiality of law firm culture and an increase in associate departures
• discourages taking on pro bono work
• does not encourage project or case planning
• provides no predictability of cost for client
• may not reflect value to the client
• penalizes the efficient and productive lawyer
• discourages communication between lawyer and client
• encourages skipping steps
• fails to discourage excessive layering and duplication of effort
• fails to promote a risk/benefit analysis
• does not reward the lawyer for productive use of technology
• puts client’s interests in conflict with lawyer’s interests
• client runs the risk of paying for:
— the lawyer’s incompetency or inefficiency
— associate training
— associate turnover
— padding of timesheets
• results in itemized bills that tend to report mechanical functions, not value of progress
• results in lawyers competing based on hourly rates”

Later in the final report (p.8), the Commission focused on the most critical problem:

“Hourly billing allows, indeed may encourage, profligate work habits. A cost-plus contract can degenerate into disregard for basic market discipline. So too can the obvious benefit of being paid for working more hours lead, directly or indirectly, to inflating the number of hours worked. Cost-plus can also override scruples about quarter-hour billing increments, which are never marked down, only up.”

In a recent interview with Business Week,  Evan Chesler, the Chairman of Cravath, noted that these problems are especially troubling in litigation:

“‘The billable hour can be a terrible thing,’ says Chesler. In litigation, he explains, ‘it creates all the wrong incentives,’ feeding a system ‘where it's more profitable to lose than it is to win.’ That's because when a corporate defendant loses a case, the process generally drags on with mounting legal fees.”

If the billable hour has all these inherent problems, why does it continue to dominate the legal profession?  In part, because it is simple and straightforward, and everyone is used to it.  But most of all, in the words of the ABA Commission (p. 8), because it “lets law firms make more money.”

The seductive appeal of hourly billing is a problem not just in legal circles, but in every profession.  In my experience as the owner of a training and consulting company, hourly contracts are an addictive habit. 

Before we started working with lawyers, we earned over $15 million on contracts developing and delivering training programs on an hourly basis for the US Government.  From the government’s point of view, the job we did was good enough to win an award from the US Small Business Administration as the best small business government contractor in New England.  But from our point of view, the business model of billing by the hour created a disturbing conflict of interest.

The only way to make more money was to hire more people.  The more efficient we became, the less money we made.  Our needs were fundamentally opposed to our clients’ needs.  It was bad for business relationships, bad for work habits, and bad for employee morale.

Nevertheless, we became addicted to hourly billing.  Every time we had some success, we hired more people.  That increased the number of hours we needed to bill the next month to break even.   

When signing new business, sometimes we had a choice between a fixed price contract and an hourly approach.  In those days, I always chose hourly.  Because I hate risk, and the hourly approach minimized my risk.

A few years after our government contracts peaked, we switched our focus to helping lawyers develop new business, and renamed the company LegalBizDev.  Since then, all of our work has been fixed price.  The reason is ironic.  Lawyers love to bill by the hour, but they hate to pay that way.  When we consult with lawyers about how to bring in new business, we want to maximize our chances of success by being able to help and support lawyers whenever a new opportunity for more legal work comes up.  But if we billed by the hour, lawyers would be reluctant to call us, because they would know that the meter is always running.

These same fundamental business realities apply to every law firm.  As David Sump, now at Troutman & Sanders, wrote in the Newsletter of the Virginia Bar Association a few years ago (as quoted in a book review on Amazon):

“The billable hour dies hard, like a cockroach that refuses to check into its own special motel or a rodent that scoffs at the spring-loaded cheese morsel... I must confess that as much as I detest the billable hour, I know that if we bill enough of them each month, there will be money left over at the end of the month to pay my partners.”

This explains why the transition from hourly billing to alternative fees has been so slow.  Most lawyers will seriously consider alternative billing only when they are pressured to do so by clients and competitors.  Next week’s post will describe the evidence that this pressure is going up.

For a summary of all of the posts in this series, see the LegalBizDev Guide to Alternative Fees, in the free resources section of our web page.

Comments

[Susan Ennis]

As a consultant in marketing communications and public relations, I've only had one client push back on being billed by the hour - an attorney.

Several months ago I launched my own firm with the intent to break away from the billable hour. http://www.enspirecommunication.com/EnSpireThought.aspx

I believe that value and efficiency will rule in the end. Thanks for your post - even though it's specifically targeted to the legal community, I found most of the concepts to be relevent.