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.