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5 posts from December 2015

December 30, 2015

Alternative fee arrangements: The state of the art (Part 4 of 4)

Whether one uses a narrow definition of AFAs or a broad one, from a law firm’s business perspective, one of the most important questions about AFAs is whether they are profitable.

In 2002, the ABA Commission on Billable Hours Report (American Bar Association, 2002) predicted that the non-hourly approach would be a financial boon to law firms: “Alternatives that encourage efficiency and improve processes… increase profits.” 

Many consultants love to spread this good news message, and when law firms and law departments talk publicly about the topic, they too often focus on the upbeat side. For example, James D. Shomper and Gardner G. Courson argue that “if properly structured, an alternative fee arrangement should result in a win-win scenario for client and law firm.”

To cite another example, a New York Times article about alternative fees quoted Carl A. Leonard, a former chairman of Morrison & Foerster, about AFA profit potential:

In one case... Morrison & Foerster negotiated a fixed fee for defending a company in court, covering work up to the point of a motion for summary judgment.

On top of the fee, if the case settled for less than what the company feared having to pay if it lost in court, the law firm got a percentage of the amount saved. The arrangement made sense when the goal was to resolve the dispute quickly....

Lawyers on the case negotiated a settlement for much less than the client’s worst-case number, Mr. Leonard said. “The effective hourly rate was something like 150 percent of our hourly rates,” he added. “We made money, the client was happy.” 

However, the data suggests that such happy outcomes are not the norm. It can be very hard to turn fixed prices into win-wins, especially in a highly competitive market.

Lawyers have been rewarded for their entire careers for putting in extra hours to analyze every risk from every possible angle. Many will have a hard time learning to deliver the quality they are comfortable with when they must work within strict funding limits. And law firm managers will have an even greater challenge when they try to juggle staff on dozens or hundreds of projects with constantly shifting deadlines. If a firm expects lawyers to bill 1,800 hours per year or more and shifts a significant portion of their work to a fixed price basis, many will find that goal unreachable.

One of the biggest pressures on AFA profitability is the fact that in many firms, lawyers are paid more if they bill more hours. Several participants in the LegalBizDev Survey of Alternative Fees noted that without proper management, AFAs can be seen as a giant loophole, a place where lawyers who have too little to do can bill as many hours as they like without risking client complaints:

It takes a lot of discipline to manage a contingent matter. When lawyers track hours on a traditional hourly project, they know that clients will review the results, and that creates a certain discipline. On contingent matters, lawyers may think no one will look at the hourly record for years.

One of the lessons [we’ve] learned is that somebody has to be the point for cost control. It often happens that alternative fee matters, particularly large ones, [end up being] a dumping ground for individuals who may not be fully employed because you are reportable to the client for the result, not the cost. [When lawyers work unnecessarily on a project] your profitability looks bad, so in order to really determine the profitability, we need to deal with that issue.

Some relationship partners we’ve worked with encourage associates to put in extra hours on AFA matters. Associate salaries are a sunk cost, the partners reason, so they might as well put in extra time to assure quality and client satisfaction on fixed fee matters. It’s more productive than Googling or staring out the window.

In the short term, they have a point. But in the long term, this type of thinking is highly counter-productive. It reinforces the bad habits created by decades of hourly billing and substantially increases the chances that AFAs will be unprofitable.

It is not surprising that systematic data on AFA profitability is hard to come by. Law firms are notoriously secretive about their finances, sometimes even with their own partners. And nobody likes to talk about their losses.

The best available data on the topic of AFA profitability comes from Altman Weil’s annual Law Firms in Transition Surveys. When the most recent survey asked, “Compared to projects billed at an hourly rate, are your firm’s non-hourly projects more profitable or less profitable?” the results were 16% more profitable, 38% the same, 32% less profitable, and 15% not sure.

Even more interesting were Altman Weil’s findings about which firms profited the most. When Altman Weil asked, “Is your firm’s use of alternative fee arrangements primarily reactive (in response to client requests) or primarily proactive (arising from your belief in the competitive advantage of alternative fees)?” about one-third said they were proactive (32%) and two-thirds classified themselves as reactive.

When Altman Weil compared AFA profitability for the two groups, they found that it pays to be proactive. For proactive firms, 29% of AFAs were more profitable, compared to 10% for reactive firms.

But if firms are not making more money with AFAs, why are they offering them? Because in today’s competitive environment, many feel they have to.

The perspective of law firms vs. law departments

When both inside and outside counsel talk about alternative fee arrangements, they will probably continue to accentuate the positive and focus on win-wins. People will speak most freely about the matters that make them feel good and look good. But in fixed price deals one side often wins a revenue concession and the other side does less well.

Consultant Jordan Furlong summed it up like this:

It may come down to how we define “winning.” I think a win-win alternative billing scenario right now might look like this: the client wins because it reduces its outside legal spend, or at least improves its legal cost certainty, and the law firm wins because it gets to keep the client for one more day. That’s not the kind of victory lawyers are accustomed to settling for, but I think they ought to get used to it.

In the ALM Legal Intelligence survey, when law departments were asked, “What role did receptivity to AFA pricing play in any changes your legal department has made to its

roster of outside counsel?” 49% said it had indeed played a significant role.

And when the same survey asked law firms to name the top benefits of AFAs, number one on the list was “Attracting or maintaining clients” (49%). (For law departments, the top benefit was “Cost predictability/transparency” at 44%.)

So it is not surprising that twice as many law departments (40%) as law firms (19%) said they were very satisfied with AFAs.

And when asked to predict the growth rate of AFAs by the year 2019, law departments predicted a greater increase in AFAs (34%) than law firms did (24%). They should know. The client is always right.

This post was adapted from the fourth edition of the Legal Project Management Quick Reference Guide, which will be published in October 2016. 

December 23, 2015

Alternative fee arrangements: The state of the art (Part 3 of 4)

Before leaving the discussion of types of AFAs, it is important to note that the ALM Legal Intelligence survey also included the category of blended rate, which was reported by 39% of firms. These are 100% hourly arrangements in which a single middle rate is charged for senior lawyers who normally charge more and junior lawyers who normally charge less. Whether the client or the firm benefits from this arrangement depends on the actual numbers in a particular situation.

For example, consider a case that is expected to require 100 hours of senior time at an average of $500 per hour ($50,000) and 100 hours of junior time at $300 per hour ($30,000), for a total of $80,000. A firm might offer a blended rate of $350 per hour, which reduces the predicted cost of the matter to $70,000 ($350 times 200 hours).

But now suppose that once the matter is underway, the firm discovers that almost all the work could actually be performed by more junior lawyers. If the senior lawyers only need to spend 20 hours supervising the matter (which would have cost $10,000 at the original rate of $500 times 20 hours), and junior lawyers put in the other 180 hours (which would have cost $54,000 at $300 times 180 hours), the client who pays the blended rate will actually pay more ($70,000) at the blended rate than they would have at the non-discounted rate ($64,000).

Now you could argue that it’s still a win-win, because if the firm had not offered blended rates, senior lawyers would have delivered 100 hours out of the 200. The client won by paying $70,000 instead of $80,000, and the firm won by charging $70,000 instead of $64,000.

From a marketing perspective, that is a terrible argument. In essence, it implies that senior people never should have been doing the work in the first place and the client must agree to be overcharged a little in order to avoid being overcharged a lot.

Blended rates invite gamesmanship, as individual lawyers may be tempted to manipulate predictions to maximize profit. And they encourage the use of more junior level lawyers, even when it may not be to the client’s benefit. Here’s how the general counsel at Marriott International described his unhappiness with his blended rate experience: “The law firm only assigned to the matter those lawyers whose regular hourly rate was at or below the blended rate, and more senior lawyers were unwilling to engage in significant supervision.”

We will leave it to others to argue about whether blended rates are a good thing or a bad thing. In this context, what is important is that there is a philosophical difference between two types of AFA definitions: narrow and broad. These days most people use the narrow definition, which reserves the term “alternative fee arrangements” for fees that are fully or partly non-hourly. The broad definition used by the ALM survey and others also includes blended rates which are 100% hourly, but offer a single hourly rate that applies to all lawyers on a matter.

The fact that two conflicting definitions of AFAs are in wide use adds considerable confusion to an area that was already confusing enough. If a firm claims that 50% of its work is performed on an alternative fee basis, that could mean that they are moving away from the billable hour (under the narrow definition), or it could mean that they are engaging in some creative hourly rate discounting (under the broad definition).

Some have a vested interest in maintaining this confusion. Announcing that a firm offers 50% of its work on an alternative fee basis sounds much more thoughtful and less desperate than saying, “Half the time, we have to slash our hourly rates because we need the business.”

This post was adapted from the fourth edition of the Legal Project Management Quick Reference Guide, which will be published in October 2016.

December 16, 2015

Alternative fee arrangements: The state of the art (Part 2 of 4)

There is no universally accepted taxonomy for classifying all the possible types of AFAs, but there is good data on which types are most common. The graph below is based on a recent ALM Legal Intelligence survey and includes the seven most common types of arrangements:

Percent_of_firms_using_AFAs

The most common arrangement (reported by 60% of firms) is a fixed fee, which is a mutually agreed sum for a set of well-defined services. It could apply to a single matter or a portfolio of matters, such as a single fee for handling all of a Fortune 100 company’s US labor and employment litigations in a single year. In order to succeed with this approach over the long run, defining scope clearly at the start is absolutely critical. It also helps if firms have many fixed price deals, since they will surely win some and lose some. This arrangement can be risky with new clients until mutual trust and understanding has been established.

Next most common are contingent fees (43% of firms) which are paid only if the firm succeeds in producing a financial recovery or other mutually agreed result. This approach has long been used by plaintiffs’ lawyers, but it is now becoming more common for the defense to use as well.

With partial contingencies or success fees (37% of firms), a law firm typically receives part of an hourly fee or fixed fee, and a lump sum—or success fee—at the end of the matter, but only if it achieves a result desired by the client. Criteria for success fees are sometimes spelled out at length and sometimes left entirely to the client’s discretion. Clearly this can have the benefit of aligning the interests of clients and their law firms.

With capped fees (36% of firms), hourly rates are charged up to an agreed maximum amount for a particular matter. Beyond that, if additional work is required to complete the matter, the law firm pays for it. Of course, this is really just hourly billing with a twist: a hard limit on the maximum. Some lawyers see fee caps as the worst of both worlds—you can do worse than hourly, but you can’t do better—and refuse to do business this way. While this arrangement does clearly benefit the client more than the law firm, other firms see fee caps as an inevitable element of the changing legal landscape, and an important way to get new work.

Next most common are phased fees (30% of firms), in which firms have a separate fee—whether hourly or AFA—for each phase of a matter. This can be especially useful in situations where it is relatively easy to predict the amount of work required in the short term but where the long term need is uncertain. In essence, both the client and the firm agree on one predictable phase at a time.

Risk collars, the sixth most common type on this list (17% of firms), are in my judgment the most interesting, because they can truly align the interests of clients and law firms by offering incentives to both. The term generally refers to a billing arrangement built around an estimated budget for a particular matter in which the client pays a bonus if work is completed under budget and/or gets a discount if the work goes over the budget. The ways risk collars can be structured are limited only by the imagination of the lawyers involved. The table below provides six examples reported by interviewees in the LegalBizDev Survey of Alternative Fees. Example 1 is the “best” for clients and firms that want to share risk equally and fully align their interests.

Table

However, it must be pointed out that many clients want the law firms to take more risk. Indeed, in the ALM survey they did not ask about the familiar term “risk collar” and instead used the term “flat fee with shared savings,” which is a particular kind of risk collar in which client and firm share any savings if the hourly fees turn out to be less than a fixed fee. In this arrangement, if the hours exceed the fixed fee, only the law firm is at risk. Presumably this definition was selected by ALM because more firms are taking risks these days than clients are, since it is a buyers’ market. If they had used the more neutral and more common term “risk collar,” the total would have been greater than 17%.

Finally, the seventh and last type of AFA used by more than 5% of firms was the holdback (9%), an arrangement in which the law firm is guaranteed to receive part of its fees but where the other part is paid only upon achievement of a certain milestone or result. For example, a firm may receive 80% of its negotiated hourly rates while a matter is underway. At the end of the matter, the firm may be awarded the remaining 20%, or less, depending on the client’s satisfaction with the result.

This post was adapted from the fourth edition of the Legal Project Management Quick Reference Guide, which will be published in October 2016.

December 09, 2015

Alternative fee arrangements: The state of the art (Part 1 of 4)

One of the main forces driving interest in LPM has been the growth of non-hourly alternative fee arrangements (AFAs), especially fixed fees. Nothing gets a lawyer thinking about efficiency faster than knowing that if they go over budget, they will have to use their own money to pay for the cost overrun.

In 2008, when the AFA buzz was first building, we interviewed senior decision makers at 37 AmLaw 100 firms for the LegalBizDev Survey of Alternative Fees. Those interviews revealed a significant split of opinion about the future of AFAs. At one extreme, some chairs and managing partners said AFAs could rapidly replace the billable hour in many practice areas. At the other extreme, some felt AFAs were just another fad that would soon fade away.

Since then, surveys have consistently shown that both extremes were wrong. AFAs have neither exploded in popularity nor disappeared. Instead, there has been slow and steady growth, year after year.

In its annual Law Firms in Transition Surveys for the last several years, Altman Weil has asked firms to estimate the change in non-hourly billing revenue. Since 2011, the percentage of firms who reported an increase in AFA revenue over the previous year has ranged from 43% to 58%, while only 1% to 5% have reported that AFA revenues went down.

Similarly, in the 2015 survey Who Really Drives AFA Use—and Why? ALM Legal Intelligence found that 40% of firms and 48% of law departments reported an increase in “AFA volume” the preceding year.

While most surveys in this area have been limited to the perspective of either law departments or law firms, this particular survey took the unusual step of interviewing both: senior managers at 197 law departments and partners at 114 law firms that use AFAs.  The complete survey includes data on such topics as reverse auctions, whether clients limit billing by first and second year associates, how often do they discuss an AFA but then decide to do hourly, who approves AFAs, what are the perceived benefits by firms and departments (quite different, not surprisingly), obstacles to growth, the use of software, task coding, ratings of law firm profitability and law department savings, and predictions for the future.

In the context of this post, the most important finding is that it is crystal clear that the use of AFAs is growing.  However, it is almost impossible to precisely determine the percent of law firm revenue they represent. There are many reasons this question is difficult to answer, including law firm secrecy about finances, disagreements over the definition of the term “alternative fee arrangements,” and the fact that some firms simply do not know. In the Law Firms in Transition Surveys, 6% to 13% of firms said they did not even know whether their firm’s AFA revenue had gone up or down the preceding year, much less exactly what the percentage was.

While we may never know the average percentage of AFA revenue for all firms, we do know that there are wide differences between firms. In Altman Weil’s most recent survey, about one quarter of firms reported 5% or less of their revenue came from AFAs, one quarter said 16% or more, and the remaining half fell between 6% and 15%. The median value of AFA revenue—that is, the mid-point, with half the firms above it and half below—was 10%.

While in some ways that may not sound like much, if you apply 10% to the $100 billion of annual revenue for the AmLaw 200, it implies that about $10 billion worth of legal work was performed on a non-hourly basis. And the figure is going up.

This post was adapted from the fourth edition of the Legal Project Management Quick Reference Guide, which will be published in October 2016.

December 02, 2015

Tip of the month: Develop a defensive marketing plan for 2016

As legal competition continues to get tougher, it’s more important than ever to focus on protecting relationships with the clients you already have.  What have you done for your best clients lately?  What could you do to further strengthen your position next year?  If you’re not sure, just ask your clients.  But only if you are committed to following up, and actually doing what they ask.

 

The first Wednesday of every month is devoted to a short and simple tip like this to help lawyers increase efficiency, provide greater value to their clients and/or develop new business.