Partner profits, client perceptions, and the Litigation Investment Model (Part 1 of 2)

This post was written by Jim Hassett and Matt Hassett.

In the May 2012 issue of ACC Docket, Markus Hartman and Bill Mordan describe a new approach to billing called the Litigation Investment Model.

 “The concept is very simple,” the authors say. “The law firm agrees to deduct a fixed percentage from their invoice — the same amount they would have earned as profit — and treat the deduction as an investment in the litigation. In return for that ongoing investment of their profit, the firm can earn a bonus depending on the total amount invested and the outcome of the case.”

The article includes several examples, all of which “require flat-rate billing across each major segment of the case.” In the simplest, a firm is paid 70% of its normal fee as the case proceeds.  The other 30%, representing the firm’s potential profit, is invested in the outcome.  

Their Figure 2 shows a case with an initial discovery phase that would have been billed at $500,000 if it were performed for a flat fee.  Of this, only $350,000 (70%) would be paid when the work is performed. The other $150,000 (30%) would be held back. At the end of the case, if the firm won, they would be paid double the hold back ($300,000).  If they settled, they would be paid the exact amount that was held back ($150,000).  If they lost, they would be paid nothing.

The actual multipliers are negotiated at the beginning of each case, based on a joint assessment of the facts of the case.  Figure 4 in their article illustrates a more complex case with six possible outcomes, each with a different multiplier ranging from 0 to 2.5 (for an “exceptional case finding and award of attorney fees pursuant to 35 U.S.C 285”).

According to the authors, the key difference from other alternative fee arrangements is that “while standard hold back agreements and success fees focus on the client’s savings, the Litigation Investment Model focuses on something far more relevant: the firm’s profit.”  In essence, they argue that law firms should only make a profit if they succeed in meeting the client’s objectives.

From the in-house client’s point of view, all this sounds quite reasonable. In most businesses, profit is a kind of bonus.  It is what is left over after all expenses have been paid, the revenue a company receives over and above its breakeven point, money they “don’t really need.”  In theory, companies could stay in business if they never made a profit and simply broke even forever. 

The Merriam Webster dictionary defines profit as “the difference between the amount earned and the amount spent in buying, operating, or producing something.”  If that’s the way law firms defined profit, this model might seem not only simple but also fair and reasonable.  But, as we noted in a recent white paper, law firm definitions of profit are far more complex and confusing.

In the 2012 Global Partner Compensation System Survey, Ed Wesemann and Nick Jarrett-Kerr reported an analysis of 263 large law firms in the United States, the United Kingdom, Europe, and Australia.  They classified compensation systems into seven categories:  lockstep, equal distribution, modified lockstep, formula, combination, subjective, and corporate.  The last of these, corporate, would make it easy to calculate profits since “partners receive a salary and bonus based on performance and then are paid dividends based on the profitability of the firm.”  There’s just one problem: This corporate compensation system is “rarely seen in the US or Canada.”

In the six systems which are widely used to compensate partners, the line between cost and profit ranges from fuzzy to non-existent. 

In other businesses, when the finance department considers the price they should charge for a product, they pay special attention to the break-even point, the amount they must charge to cover their expenses before profit.  When lawyers decide what to charge, most are blissfully unaware of their firm’s break-even point.  The CFO, the managing partner and other leaders probably have a good idea of the break-even point, but even that is not as unambiguous as in other businesses, because it is based on assumptions about what partners expect to be paid. 

When Hartmann and Mordan used an estimated profit of 30% in their example, they explained in a footnote that they got this figure from the American Lawyer’s widely publicized concept of “profits per partner,” used in its annual rankings of the AmLaw 200.  “Thanks to law firm bravado and their own published data,” they said,” we have a pretty good idea of how much profit a large firm makes: about 38 percent, based on the published results of the top 200 firms in the United States.” 

Unfortunately, the American Lawyer’s definition of profit -- “net operating income for the firm divided by the number of equity partners” -- differs from both the dictionary definition and the normal usage of the word profit in other businesses.  Net operating income is calculated by subtracting all of a firm’s expenses from revenue excluding partner compensation.  To put it another way, partners may get 100% of their pay from the pool of “profits per partner.” They may also pay taxes and benefits from this pool.  If those “profits” were permanently withheld, partners would be paid little or nothing for their work, and would certainly not consider themselves to be breaking even. 

When Hartman and Mordan describe the Litigation Investment Model, it seems they recognize it is a bit one-sided when they call it “beneficial to the client and more comfortable to the law firm.”  They also note than when in-house lawyers negotiate these agreements, they should “expect an equity partner to be squeamish and uncertain.”

Next week’s post will include the math behind the concept for a hypothetical case at a three lawyer firm.  The numbers will show why some firms have good reason to be squeamish and uncertain about this model.