Alternative fee strategies (Part 3 of 3): Transparency and shadow billing

This three-part series is reproduced from the LegalBizDev Survey of Alternative Fees, a research report based on in-depth interviews with chairmen, senior partners and C-level executives at 37 of the largest law firms in the US.

One of the most fundamental issues that separates aggressive firms from more conservative ones is their attitude toward transparency, and especially towards “shadow billing,” in which law firms provide information about actual hourly costs on fixed price projects.  They believe that this openness and transparency will serve as the basis of a partnership.  If both parties see where things really stand, they can renegotiate in good faith if costs are either far higher or far lower than what both parties expected.

Meanwhile, more conservative firms think that shadow billing is inappropriate.  A fixed price deal is a fixed price deal, and the client should not get to look behind the curtain to see whether the firm has won or lost.  Below are comments from nine firms that subscribe to the conservative view:

When we agree to a fixed fee, we should not be submitting backup and time records and then having it run through some legal audit shop and reviewed through an e-billing system and so forth.

We don’t want our client to come back and ask what it will cost on an hourly basis. We don’t want the lower of one or the other, hourly versus alternative.

If we really want to get alternative fees into the psyche of both clients and lawyers, we need to stop clients from measuring how much more the firm made than their hourly rate, and we need to get lawyers away from thinking about how much they earned less than their hourly rate. Someone’s got to say “Look, I did a job for you. I collected five million dollars. Was it worth it?” Yes or no? “I did a job for you and I collected $50,000. That’s what you paid me. Was that worth it?” Yes or no?

After we’ve submitted an RFP, the discussion often turns to, “Well, we’d still like to see hours and rates for people who are going to be employed on this matter, even though we’ve agreed to a fixed fee. I know what’s behind that, [because] I used to be a huge consumer of legal services as a client.  [Sometimes] a million five [will] sound right for a piece of litigation, but if [the firm does] it for a million one, [the client doesn’t] want to give [the firm] a windfall. [The client] wants some of that benefit.

To the extent [that] GCs want to use shadow billing and other techniques to eliminate the ability of the law firm to cover its costs and earn a margin, fixed fees will not work.

I understand it from the general counsel’s perspective. There’s internal accountability.  Did they get a good deal out of the firm?  How do they know they got a good deal if it’s a flat fee or a fixed fee, unless they have some benchmarks against which to measure that from other providers who do the work on an hourly basis? From the client’s perspective, the marketplace hasn’t evolved as far as a lot of the hype we have been hearing in the trade press. I don’t think it’s evolved as far as it needs to in terms of making this a potential for a win-win.

If a firm agrees to a fixed fee to provide predictability to the client, the firm is taking a risk that it may cost more to do the work than the agreed fee. In return, the fixed fee should be paid promptly, and backup time records shouldn’t be reviewed in a time-consuming process which delays payment and requires large administrative overhead.

We have talked with some clients about doing deals on the defense side, where we would get a percentage of the amount that we saved below a target verdict or a target settlement.  We’ve done a couple of those arrangements over the years. But if you tell clients at the end of the process that you earned 200% of your hourly rate, they want to come back and renegotiate that.  Clients really don’t like you to do that.

And what happens is, that’s not being allowed.  In some cases, what’s happening is that even when there’s an agreement that the fixed fee is going to be allowed, the client wants to reconcile the time that’s put into it and see if they got a good deal or a bad deal. And as long as that’s the kind of relationship it is, it really isn’t an alternative billing arrangement. “Did I do better or worse than under the old system?” If general counsel really want to get rid of the billable hour system for billing, then you can’t have all these post-audit questions about it. If you agree on something, and there’s value, and we found a way to staff it differently, we should benefit from those efforts.

Aggressive firms see it differently.  Many of the deals they described included shadow billing, and some argued that it is absolutely necessary:

If we hide things like [hours], it’s not going to work.  We’re interested in this from a partnership perspective.  There has to be mutual trust.  If [clients] think we’re just doing this and reaping in additional money, it’s not going to work. So what we actually had in that situation was an annual in which we went through all the cases and looked at where we were in the numbers.

Several aggressive firms also used the informal accounting term “true-up” to refer to a process in which they compared actual hourly costs with fixed prices from time to time, in order to bring the two in line:

[In one deal, clients] pay us [a certain] amount a month, and then after an agreed amount of time, there’s a true-up based on actual internal costs, perceived value, [and other variables].

Finding a meaningful true-up, with objective benchmarks that are fair and predictable, is the Holy Grail.  With true-ups you can have a second chance in case something goes haywire.