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Alternative Fee Arrangements — A Primer


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Alternative Fee and Billing Arrangements: A Primer

 

 

Jerome Kowalski

Kowalski & Associates

March, 2010

The most significant current public discourse regarding law firm revenues which will surely continue in the months and years ahead is the increasing popularity of Alternative Fee (or Billing)  Arrangements. The tide of its increasing popularity has even provided a generally accepted acronym of AFA.  These billing arrangements are aimed at destroying or at least seriously maiming the invidious hourly billing process, which economically incentivizes inefficiencies and subordinates a law firm’s economic interests to those of the client.   The hourly rate may be either dead, suffering a lingering death or in a simple state of somnolence, depending only on whether the observer is an optimist, a pragmatist or an ostrich.  Nonetheless, keeping careful track of hours billed will remain a much needed tool to monitor productivity, efficiency and, most significantly, profitability on engagements.

The facts are plain.  We all know about the rising tide of fixed fees, alternative billing, and holdbacks depending on results, success fees, radical convergence and fixed retainers. Let’s be completely clear on what this means:  Clients, particularly those of significant economic clout are passing all or most of the risk on legal engagements to the law firm.

However, the implementation of an AFA that serves the best interests of both law firm and client requires careful planning and implementation so as to maximize revenue production, limit the risk assumed by a law firm and provide the greatest value to the client. Some of the detailed planning and implementation of an AFA are described in detail below.

Added to this new discourse is yet another game changer:  The data base recently announced by a significant group of corporate counsel (the “ACC Value Index”)  under which law firms will be rated by clients on a scale of one to five for six  criteria ( [1] understanding objectives/expectations; [2] legal expertise; [3] efficiency/process management; [4] responsiveness/communications; [5] predictable cost budgeting skills; and [6] results delivered/execution]) and this data base will be available for all corporate counsel.  Thus far, more than 1,800 evaluations have been made of 600 law firms.  Currently these evaluations are being made on a general basis.  Inevitably, I am confident, they will likely be subdivided in to different practice areas.

The one area in which law firms consistently score the lowest in the ACC ratings is in the area of cost budgeting skills.

In late March of this year, Evershed’s, London “Magic Circle” firm released the results of a survey it had undertaken of corporate counsel and leaders of major law firms.  The Evershed report, as reported in the ABA Daily Journal of March 24, 2010, is critically instructive:

“The legal landscape has changed permanently and more quickly than anyone imagined,” the report says. In the new, post-recession legal market, general counsel have more status and influence in their corporations, fee levels will decline or stay the same, and legal work will become more efficient as tasks are outsourced and technology is used.

In this changed world, law firm structures may be vulnerable. Forty-six percent of managing partners said a reduction and change in premium legal work available would change law firms’ shape and size. The larger firms reported long-term cuts in headcount and leverage, and possible changes to the “up and out” pyramid structure of law firms. Only 30 percent of the partners said they were wedded to the traditional partnership model.

In this new legal world, hourly fees are giving way to value billing that is based on the value of work to the client rather than lawyer hours expended, the report found. Two years ago, only 22 percent of in-house clients and 48 percent of partners surveyed saw value billing as a trend for the future. Now, 86 percent of clients and 88 percent of partners say they often or sometimes use value billing. Among the partners surveyed from the United Kingdom, 79 percent said the hourly rate was almost dead.”

In our own surveys, we have heard from a few law firm leaders that the current focus on alternative or premium billing is merely a passing fad, which will inevitably go the way of the hula hoop.  Another small group of large firm leaders continue to press the argument, already proven without factual basis based on significant engagements of the past two years at least, that the nature of legal work is such that so many unknown variables are involved the only reasonable basis to compensate lawyers is based on the hourly rate.  In our view, those who continue to stridently hold that outlook are putting their firms in to extreme jeopardy.

The most strident objectors to changing the hourly fee arrangement are the litigators.  They claim to be in a unique position to explain that the nature of litigation is so complex and the variables so unforeseeable, that only hourly rates provide an appropriate medium for compensating the professional.  They tend to be dismissive of the fact that a transaction may prove more complex than anticipated because of materials reviewed in the due diligence process. They also ignore the fact that a capital or other market transaction requiring regulatory approval may also be more complex than anticipated because of unanticipated government opposition or unanticipated regulatory hurdles.

The consumers of legal services, now emboldened by the excess of supply over demand are more and more seeing the economically anamolous view of legal vendors that services must be paid for on an hourly basis.  They recognize that airlines do not increase the cost of a flight because of a weather delay or technical problem extended the time of the flight. They also reject the idea, as do lawyers, that the Lexus they have under ordered should now be subject to a higher price because Toyota was required to expend additional time in curing engineering defects.  Nor would any purchaser of an apartment or home under construction blindly accept the notion that the purchase price must be raised because construction costs were higher than anticipated because of labor, weather or heightened local zoning or building requirements.  (Actually, the most articulate riff ever created on the anomaly of hourly billing, and well worth seeing, appeared here)

At the same time as demand exceeds supply, as clients make rational demands of their lawyers regarding fee structures,  law firms seem to find the need to announce that they have somehow “beat the system,”  by announcing,  indeed boasting annually, that their profitability has increased, even as their clients are beaten down by a flagging economy.

Those who scoff at the notion of fixed fees, fee caps, reduced fees during the pendency of a matter coupled with a premium at the conclusion of a matter, portfolio representation, straight contingency work and the myriad other AFA’s available (limited only by creative minds), on the grounds that legal representation, whether in litigation or transactional work contain so many unknown variables that only the hourly billing of days of yore make sense, share substantial DNA with those who scoffed at Eli Whitney, Thomas Edison and the Wright Brothers. The same arguments might be made by companies that agree to build a fighter jet for the Defense Department, design a building, provide a software solution, engage in a complex consulting arrangement at a fixed fee (too many unknown variables), yet those industries involved have, for many years, moved far away from hourly billing and entered into their own industry’s versions of alternative fee arrangements.

Again, clients, whose current demands for legal services are significantly lower than the existing supply, are requiring efficient delivery of quality legal services at predictable rates, consistent with the current market and with the law firms themselves, assuming a degree of the risk in such engagements.

Jeffrey W. Carr, Jr., Vice President and General Counsel of FMC Technologies, a company with sales of $4.4 Billion, has in recent months taken a leadership role on behalf of private industry in regard to the need for AFA’s and the insistence that corporate clients should dictate to outside law firms the terms of any engagement and that virtually every engagement demands “performance-based pay”.  Mr. Carr has been a strong advocate of requiring that outside counsel have “a laser like focus on value.”  In a recent interview with Law360, Mr. Carr did not mince his words: “ FMC has advised all of its outside counsel that FMC required that “all existing matters to be handled below current matter budgets. [FMC] also advised that [it expected] new matters to have budgets 10 to 15 percent below historical budgets for similar types of matters.”

Mr. Carr’s advice to outside law firms, as reported by Law360 is direct, succinct and beyond misinterpretation:

“Change and do it now. Learn to focus on delivery of value by reducing your costs to remain profitable as opposed to leveraging the pyramid and focusing only on top line revenue growth. To quote a former U.S. Army chief of Staff, ‘If you dislike change, you’re going to dislike irrelevance even more.’”

Let’s also be clear on what the passing of that risk mandates:  Legal work must be handled efficiently by experienced well trained lawyers.  Mr. Carr is hardly a lone voice in the wilderness making these demands on outside counsel.

Passing the risk, requiring law firms to have “some skin in the game” will require law firms, for their own survival, to vastly improve their budgeting skills.  The inevitable result of the combination of passing the risk as well as the public data and rankings is that there will emerge a new critical category of either non-lawyer managers or specifically trained lawyers who will function as project managers, of the kind that exist in so many other industries.  In order to further compete effectively in this new transparent world, law firms will require (a) client relationship managers; (b) competent and efficient lawyers; and (c) embedded quality control standards and personnel.   Deployment of resources to fulfill an engagement while taking every reasonable precaution that a matter results in taking on too much water in a rocky sea.  Critical function of these project managers, sometimes dubbed as “client relations managers” involves risk management, monitoring work flow and budgetary issues.  Risk management is essential in assessing the financial risk the firm is undertaking in an alternative fee arrangement.  Budgetary management is critical in monitoring the successful and cost efficient Similarly, budgetary proficiency requires, particularly on an hourly fee engagement, the ability to more accurately provide a fee estimate, monitor and manage the progress of the matter keep the client timely informed of any required changes in the budget, with detailed and informed reasons, while being able to adequately explain why a higher budget was not foreseen.

These client relationship, project and risk managers will need to deploy existing technologies, in use for more than a half of a century, to provide an informed and intelligent assessment of the likely cost and risk involved in any engagement.  These technologies have been used by engineering firms, consulting firms, architects, R&D firms and other service providers who have been delivering services for fixed fees for decades. The application of these skills will permit a law firm to propose an AFA on a more fully informed basis than is currently the vogue:  A partner receiving an RFP for an AFA simply circulates an email to his or her partners and billing department inquiring as to total fees charged in the past on similar engagements aligns the responses on a bulletin board in his or her office and then tosses a dart at the board, with the fee closest to the dart being the suggested AFA total.

This point requires repetition and emphasis. The consequence of the increasing demand for AFA’s is that as the recession subsides, the entire ecology of the law firm/client relationship will radically change.  Leverage is largely irrelevant.  Law firm survival and success will be dependent on the effective deployment of the relationship managers, project managers, efficient lawyers and quality control.

And, speaking of game changers, the most remarkable example of convergence and the complete passing of the risk was the deal announced in November of last year between Orrick and Levi Strauss. Under the terms of that arrangement, Orrick undertook the complete and unfettered legal representation of Levi Strauss on a worldwide basis for a fixed single fee, with the exception of trademark work to be continued by Townsend & Townsend.  The deal requires Orrick to provide all legal services required of Levi Straus, anyplace in the world on every matter (with one small exception in the trademark area).  It is rumored that the annual fee is approximately 20% less than Levi Strauss’ total bill for legal work than it incurred in 2008.  Orrick is taking on the entire risk.  If outside counsel is required in a jurisdiction in which Orrick does not have an office, Orrick is required to engage and pay for that counsel.  A super sub-specialist needed that Orrick does not already have in its ranks?  Orrick’s problem.

Recently, convergence, AFA’s and disdain for hourly rates have jumped across the pond, as these concepts take root in the UK:  http://www.law.com/jsp/article.jsp?id=1202472210613 .

And even more recently, Jeff Carr has added yet a new twist on convergence:  http://kowalskiandassociatesblog.com/2010/09/23/are-100-page-responses-by-law-firms-to-client-rfps-really-efficient-or-necessary-some-radical-and-revolutionary-changes-are-upon-us/

The advantages and risks are obvious.  Orrick obtains predictable and regular payments of significant amounts. Levi Strauss no longer has any risk in exceeding its legal budget for any reason. Levi Strauss no longer has a need to put its counsel’s detailed bills under a microscope.  In fact, Levi Strauss can and probably will reduce its in house staff dramatically.  Win-win situation? Maybe.  But one cannot over-estimate the risk taken by Orrick.  Similarly, one should not under-estimate Orrick’s potential rewards.

However, with proper risk management and assessment, together with excellent project management, this model is beyond intriguing.  Carefully consider your own client base and ponder while you carefully deliberate whether such an arrangement might provide advantage to the client and the firm.   Risk is always measured against reward.  Risk may be tempered with prudent risk assessment and project management.  But, the opportunity may provide the firm with enormous opportunities: expansion in to new practice areas, developing new relationships with firms around the world, and, of course, regular and predictable cash flow. Today’s “new” new thing is Portfolio Representation or sometimes called Portfolio Pricing. , in which a law firm undertakes representation of a client’s entire portfolio of a particular practice area for a fixed annual fee. The risk must be measured against the reward. The risk is mitigated by appropriate project management.

The clout of the ACC, which is gelling more and more as a potent force in the buying and selling of legal services is contributing mightily to the new realities; the collateral and long term consequences of the current recession.  Individually and in unified action, they have plainly told law firms that the pockets of hourly billing that remain extant, will be subject to material cuts in hourly rates.  Those decreases, in this buyers’ market are most often a return to 2008 rates or a flat 10% reduction of 2009 rates. Firms that had hoped for a modest 3% or 4% rate increase in 2010 have been knocked down.  Firms that had based budgets on the expectation of a flat 2010 now need to confront a likelihood that 2010 will show less revenue, a fact further exacerbated in the widespread reaction in timekeepers.  Here, the remedies are few:  Further reductions in support personnel, more efficient reliance on technology and the probability of reduced revenue and profitability expectations.  As bad as that news might be, it is far better than becoming a member of the unfortunate trash heap of firms that are no longer. Survival will in some measure require greater transparency within the firms and sharing the news of lowered expectations early on.

Interestingly, Citibank reported on January 21, that its annual survey of the confidence level of managing partners for positive outlooks for 2010 showed that the majority of managing partners felt positive that 2010 would be a positive year and one of growth of stability.  We should note that neither Dan dePetrio, the voluble and extremely well regarded head of the law firm group at Citibank, who always has something wise to add to the public discourse on law firm economics, uncharacteristically had no comment on the survey results.  There may in fact be some reason for optimism, but that optimism must be based on some realistic planning, based on an understanding of the past and careful methodical planning.  Recall vividly that the former heads of each of the dozen or so firms that failed within the last two or so years all voiced optimism that they had weathered the storm and everything would now be fine.  Assuredly, had they had a better view of what lays on the horizon, everything may well have turned out fine.

We have all travelled to some third world country and been approached by a waiting taxi driver who offers to take us to our downtown destination for a fixed fee instead of the amount he would need to charge if he used the meter, assuring us that we will receive a bargain.  Clients today are far too sophisticated to accept that claptrap.

Rather, clients want to limit their risk and have their counsel put some skin in the game by assuming some of the risk. Law firms, at the same time have a natural aversion to avoiding the safe haven of the ticking meter. Add to this formulation that clients are prepared to reward lawyers who assume some risk and at the end of the day, are more than comfortable in awarding a premium to counsel prepared to do so.

Accordingly, while AFA’s may be as diverse as the imagination may allow  — from fixed fee to straight contingency engagements — a more prudent and mutually acceptable approach to an AFA, particularly on more complex engagements, would be one in which the law firm agrees to either undertake a matter for which it will bill a fixed monthly amount is paid, which amount should be the equivalent under which, after careful assessment by an appropriate risk manager of all available data, the law firm makes an informed assessment of  (a) the likelihood of success on the engagement; (b) the amount of personnel, both professional and support staff likely to be required;  (c) the level of professional staff required, from junior to senior associate; (d) the length of the engagement; and (d) any unique or novel reasonable foreseeable issues that may arise.

Once these key ingredients for the AFA recipe are gathered and assessed by the client relations manager teams, the next steps are the most critical:  Preparation of a work flow chart, including time lines and identification of critical path points (time proven PERT or GANTT charts or variations of these tools are probably the best gear for this purpose).  Identification of the professional staff who will proceed along the time line, informed estimates of the time and (at least for internal purposes) the hours and typical hourly rates must be estimated.

The work flow chart, whether using PERT, GANTT or another format, should be reviewed in detail with the client so that there is a shared understanding of expectations, milestones, activities and critical paths. In reviewing the work flow chart, the client must receive assurance and comfort that historical bubbles of unexpected time charges (such as those arising from departure of personnel,  duplicative work, unwarranted legal research, extended conferences among large groups of lawyers, opposition to foreseeable motions to disqualify, extended document review, extraordinary disbursements and the like) will not be chargeable to the client except upon express prior approval. Again, it is the responsibility of the client relation manager to monitor these activities and, where necessary inform the client of a change in circumstance requires an exception and approval.

Upon gathering the ingredients for the recipe and preparation and analysis of the work flow charts, an informed estimate by the firm of the total fees to be charged for the project based on ordinary and customary hourly charges.  The most attractive proposals to the client are ones in which the firm offers to charge a fixed monthly fee equal to a total of 65% of the total fees to be charged (based on the firm’s calculations of the total fees which would customary rates be charged on an engagement of this type) divided equally among the projected number of months estimated necessary to complete the project.  Clients would, of course, be most interested and attracted to a cap of these payments.  Cash flow would thus be predictable and regular, to the benefit of the firm and the client. The ultimate premium would then be a “kicker” of a fixed amount payable upon the (very carefully defined) successful conclusion of the matter, which should be equal to 110% or more of realization rates, had the more customary hourly rates have been charged.

The engagement agreement should also contain carefully defined exceptions for extraordinarily material variances of the particular engagement as well as the ability of the law firm to identify those material variances to the client in a more timely fashion.

The firm’s financial success on AFA engagements would thus be contingent on the two most significant aspects of this process: careful risk assessment during the intake process and regular monitoring of the work flow and the processing thereof, following closely the work flow charts.

Anything short of this detailed process, again, on more complex engagements, would be the equivalent of the firm taking its money and taking a chance in Las Vegas, Atlantic City or their equivalents.

Certainly, these processes are shockingly revolutionary to law firms and the historical billing process.  However, as I noted above, this system or its equivalent has been successfully deployed for more than half a decade by other service providers.

Further, monitoring the quality and efficiency of the professionals involved in the engagement as it proceeds and a post mortem analysis following the conclusion of the engagement provides a clearly objective instrument to measure performance and value of the professionals involved in servicing the client.

Additionally, use of these instrumentalities would give law firms the tools they so sorely lacked in the past, namely, the ability to make an intelligent and well informed AFA proposal and to more accurately and regularly report to the client on the progress of the matter.

These added complexities, acquisition of newly required skills on the part of partners responsible for the matter as well as the use of client relations managers is a direct consequence of the new world of AFA’s which properly deployed add profitability to the law firm, predictability to the client and an informed assessment by the law firm of the degree of risk it is assuming in an AFA engagement.

At the end of the day, the result should be a satisfied client and enhanced profitability to the law firm.

The unintended collateral consequence is the deterioration, if not the destruction of the leveraged, “Cravath” style pyramid.  In the new era, an inverted pyramid may very well be the progeny of AFA’s.

Once you have read this, you may want to move on to:

The Continuing Public Dialogue on Alternative Fee Arrangements at: http://kowalskiandassociatesblog.com/2010/04/08/alternative-fee-arrangements-and-value-billing-the-continuing-public-dialogue/

Then, you will be interested in the question of dealing with the unique genome lawyers have which makes them resistant to change: http://kowalskiandassociatesblog.com/2010/04/08/alternative-fee-arrangements-and-value-billing-the-continuing-public-dialogue/

Obviously, you will want to know how to effectively market AFA’s.  Here’s the scoop:  http://kowalskiandassociatesblog.com/2010/09/06/how-to-effectively-and-efficiently-integrate-your-marketing-with-your-other-marketing-activities/

You are ready for Chapter II of the primer:  http://kowalskiandassociatesblog.com/2010/08/24/alternative-fee-arrangements-lesson-ii-of-the-primer/

And, finally, the basics for drafting an AFA agreement which you can find here: http://kowalskiandassociatesblog.com/2011/03/23/alternative-fee-arrangements-and-value-billing-lesson-iv-%e2%80%93-drafting-the-alternative-fee-arrangement-agreement/

© Jerome Kowalski, March 2010, All Rights Reserved.

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