Okay, We Swallowed the Kool-Aid and We Are Using Alternative Fee Arrangements, but Do We Still Need to Have Our Lawyers Submit Time Sheets?

In This Brave New World of Alternative Fee Arrangements, What Role Does Hourly Timekeeping Play?


                                                                             Jerome Kowalski

                                                                             Kowalski & Associates

                                                                             September, 2010           

A Lawyer’s time and advice are his stock in trade

                                                                                                            Abraham Lincoln

 In the revolutionary world of AFA’s is there a role and reason for recording time devoted to a matter?


             I’ve received a surprising number of inquiries from law firm clients who are now working on Alternative Fee Arrangements whether they should continue to require lawyers in the firm to record time.  The short answer is a resounding “absolutely.”  Some clients have put it to me rather simply:  What’s the point, after all hourly billing is virtually dead?  Others postulated that eliminating time keeping would result in the elimination of some costs. 

 Tracking lawyers’ times in AFA engagements is absolutely essential.  It provides a number of vital tools.  I assume that you have by now obtained some greater familiarity with the essence of AFA’s from some of our literature, the growing body of literature generally available, and from clients and professional peers.  

But, too often, when speaking of Alternative Fee Arrangements, law firms simply erroneously equate the arrangement as simply doing work on a fixed fee basis or, simply a flat percentage discount.  Wrong.  Most AFA’s do take in to account and utilize for billing purposes, a component of time actually and accurately recorded.  Thus, actual time expended and such time is an essential ingredient in calculating the ultimate fee.  But it is only one of the ingredients.

 First, accurate time keeping and analysis of the time records provides legal project managers with a tool to measure timeliness and compliance with the project’s timeline.  Second, it provides law firm management with a means by which to measure productivity, in connection with (a) any particular matter, (b) identifying individual lawyer’s demonstrated efficiency when assembling a team for a subsequent matter and (c) annual associate and partner reviews.  Third, astute and well-informed clients are more frequently requiring their outside counsel to provide real-time access to the firm’s time accounting system and monitoring since it provides clients with a method to timely monitor and check on both efficiency and timely compliance with the timeline presumably incorporated within the terms of the scope of the engagement agreement.  Clients of some degree of sophistication, advised by their own inside corporate counsel, project managers and contract compliance officers are more routinely including this provision in their retainer agreements.

 The well-managed AFA engagement also requires regular discussions between client and the firm’s client relations manager regarding the progress of the matter.  Maintenance of accurately reported timekeeping provides client and law firm to have well-informed discussions on the progress of the matter.  Recall, if you will, that the ACC value index reports on the fact that the area in which law firms uniformly score poorly is in connection with budgeting, not merely with respect to matters billed on an hourly basis but also in a firm’s projections regarding the duration of a matter.  These, incidentally are among the matters I cover in my book, “Navigating the Perfect Storm: Recruiting, Training and Retaining Lawyers in the Coming Decade” (Ark Press, 2010) and in my blog Surprisingly (at least to me), I have not received many invitations from late night talk shows, Oprah and the like to plug the book  — which is selling nicely, thank you, thus, I am relegated to using this medium to add a plug. 

 It certainly hasn’t escaped me that the irony is that in the former model of hourly billing, lawyers were incentivized to keep their pedals to the metal and bill large amounts of time.  In the new AFA paradigm, lawyers will be incentivized to go light on the pedal to demonstrate efficiency. The issue of accuracy in reported time exists in large measure because the overwhelming number of lawyers reconstruct time at the end of a day, week, month, or whenever a supervising lawyer demands submission of time records or when a payroll department tells a lawyer that it has been instructed not to issue the next paycheck or partner draw until the time is put in to the system.  The use of the equivalent of an abacus in time recording when a variety of computer based real-time and accurate programs (even an I-Phone App) are available is just one of those enigmas of the profession. Using the reconstruction method (the abacus), has created much well-recognized diverted time n analyzing time when billing and inevitably creating write downs, affecting the former metric of “realization.”

 Tracking of time in AFA’s should also require some radical re-thinking by law firms of the metrics used for measurements of profitability. In the hourly billing model,  profitability was measured by an equation under which time recorded was multiplied by a firm’s standard hourly rates, less write downs and write offs (or in some instances, plus a premium added to a bill) yielding a realization rate.  The fact is that under generally accepted accounting principles as well as under well established, long standing principle used by service providers in other industries,   this metric does not provide an accurate measurement of profitability.  AFA’s permit law firms to measure profitability of an engagement using more conventional metrics:  That is, the calculation of the actual cost of labor, namely the compensation of the time-keeper, together with an allocated portion of G&A, measured against the fee received.  Nonetheless, recording of time is still of the essence of both an AFA and a conventional hourly billing model.

 A separate question has also recently arisen: Whether a client not contractually requiring real-time or other access to time records in connection with an AFA engagement should be entitled to review time records is simply not susceptible to an easy answer. Certainly, the law firm might take the view that time actually expended in the engagement should be a matter of indifference to the client.  After all, why would you need to know how long your home building contractor spent on working on your house, provided it was completed on time and the price paid was in accordance with your initial flat price arrangement? However, a client may make the request, or perhaps should even require, disclosure of these records so that it is afforded the opportunity to have some measure of the firm’s actual costs and profits (realizing that the client would be unaware of the actual cost of labor and G&A) in order to negotiate the next AFA on a more informed basis, compare efficiency with other providers of legal services and provide its input in to the selection of professional personnel in subsequent AFA engagements based on a particular lawyer’s proven efficiency.   Law firms’ responses to such requests, in the absence of a prior agreement on the subject, will be driven by issues of maintenance of quality client relationships and of course the knowledge that such disclosure,  may provide the client with an advantage in negotiating your next AFA, assuming, of course, the AFA was well managed and thus handsomely profitable.

 (c) Jerome Kowalski, September, 2010.  All rights reserved.


Should Law Firms Continue to Report Publicly on Profits Per Partner?


Revenue (Photo credit: yourdoku)

Jerome Kowalski

Kowalski & Associates

 May 19, 2010

In March of this year, we questioned the wisdom of law firms continuing to publicly report on its revenues and profits.

While humility precludes our suggesting that we alone initiated a public discourse regarding  the question, since this was an issue that had been quietly discussed and whispered about in many corners of the profession, the  volume of the debate was raised by several material decibel with the public announcement on May 12, 2010 by Ralph Baxter the chairman of Orrick, Herrington & Sutcliff that Orrick would simply no longer publicly report on profits per partner.

The volume of the debate has been raised yet a few more notches in the copyrighted article by noted journalist Leigh Kamping-Carter in a copyrighted article appearing in today’s Law 360.

Ms. Camping Carter reported, in part,

[U]nlike publicly traded companies, law firms are not required to disclose [profits per partner], and naturally, some firms have never reported PPP, either out of a preference for privacy or a sense that disclosing sky-high profits would be unseemly, consultants said.

In a rational world, firms would either keep their financial numbers private or would disclose information according to a uniform and regulated set of accounting guidelines, backed up by an accountant’s certification, said Jerry Kowalski, founder of legal consulting firm Kowalski & Associates.

As it stands, however, the number is open to manipulation. Firms can adjust the number of partners they report, shifting between equity, nonequity and counsel status, and altering counts of staff lawyers or temporary lawyers, experts said.

“1 think one of the most misleading of all public financial figures of law firms is in fact PPP,” said Gary Klein, founder of legal recruiting firm Klein Landau & Romm Inc. “Many firm chairs believe that every other firm fudges the numbers, and they might be correct about that, because it’s too indefinite.”

The weaknesses of the profits per partner model “hit home” during the recession, when law firms in the midst of unprecedented layoffs also posted excellent PPP results, said Toni Whittier of Whittier Legal Consulting. And for lateral hires, the number is now just one of a variety of different ways to size up a firm, she said.

Still, rejecting profits per partner as a standard measure would likely entail coming up with a new, more comprehensive model for measuring a law firm’s progress, which could be light years away, consultants said.

One easy metric that could replace profits per partner would be revenues per lawyer, a figure that would take into account gross revenues, minus expenses, divided by the number of full-time lawyers at a firm, consultants said.

“Revenues per lawyer is the ultimate go-to number when you’re looking at a law firm,” Klein said.

But considering the changes in the legal industry, additional metrics like revenue growth,

operational efficiency, the number of lateral hires, major representations, evaluations of the success of alternative fees and staffing changes and, especially, client satisfaction could all eventually come into play, consultants said.

“Is it as easy as latching on to one number? No,” Whittier said. “Does it give you a better idea of how one firm compares to another firm? Yes.

But how will firms assign numerical values to these “soft” measures? So far, it’s not clear. Whittier sees a lot of firms wrestling with how to measure client satisfaction; others have formed committees to study methods for quantifying efficiency, she said. Even Orrick is still working out a law firm equivalent of “earnings per share.”

“Law firms are used to looking at certain numbers, and obviously there’s going to be adjustments in determining alternatives to what theyve been looking at for a long time,” Whittier said.

Besides, reporting profits per partner serves another function: letting top 100 firms boast about their rankings – much like a couple of golfers talking up their golf games, Kowalski said. It’s questionable whether firms would willingly give up the chance to brag.

“Given the nature of the unique economic entities that law firms are, and the unique egos that drive law firms, its quite unlikely in my view that they will stop doing that,” he said.

If it does nothing else, Orrick’s move will at least generate discussion and push firms forward, Whittier said.

“What’s going to turn the tide is some other strong leaders in the bar to stand up and say, once again, ‘Ralph Baxter is right, we’re going to follow suit,'” Kowalski said of Orrick’s CEO and chairman. “And it will happen.”

             Publicly traded companies, report on revenues and profitability in accordance with SEC regulations, and more significantly, in accordance with standards required by the accounting profession, namely, Generally Accepted Accounting Principles, measured by General Auditing Standards, accompanied by an opinion by a firm of certified public accountants that such standards had been consistently applied.  Other companies report in the same consistent fashion to its lenders and stakeholders. In no public announcement or report by any United States law firm has there been such a certification.  UK law firms do have the obligation to report, in accordance with various regulations and standards information concerning revenues and profitability.

The anomaly of the current pronouncements by law firms is further confounded by the fact that law firm reports on revenues and profitability (as well as headcounts and partnership compositions) are virtually simultaneously issued to different media and to organizations such as the National Association for Legal Placement in completely inconsistent and often contradictory fashions.

The profession should also take note of the very public ruckus created by publicly released information regarding $5,000,000,000 in bonuses recently awarded by Goldman Sachs to various managing directors and officers.  Yet, there is no report issued by Goldman Sachs that of payments to such personnel equaled or averaged any particular amount. The public outcry of this excess in the current economic climate was rather deafening. Yet, in fact, the only actual report of revenues and profitability issued by Goldman Sachs was the one it was required to issue pursuant to SEC requirements, since, among other things, Goldman is a public company and the public report was made in accordance with GAAP, certified by its outside public accounting firm.

Law firms should, among other things, take particular note that the public brouhaha of the publicly released information by Goldman is now occurring in an equivalent fashion by and among the clients of the law firms that feed law firms with revenues.  These same clients,  stung by The Great Recession and dealing with their own concomitant drop in revenues and reduced profits must be completely appalled by the profession’s hubris in recently reporting either non-material declines in profitability or, in too many instances, public boasts of increases in profitability, particularly in light of the fact that a number of surveys conducted by the Association of Corporate Counsel, various law firm consultants, and law firms themselves all consistently report that consumers of legal services share the view that lawyers already “make too much money.”

Accordingly, public boasts of profits per partner and, particularly, reports of increases in PPP only serve to give further credence to that view. Thus, these public pronouncements produce serious collateral damage in the form of increasing client insistence that fee structures be reduced, increasing commoditization of legal services and that pricing of legal services be doled out through the same prism consistently applied by corporate purchasing agents, namely, with the same corporate discipline in which clients seek vendors of other goods and services are procured, namely price being the same primary factor.

In short, public reports of PPP results in a direct shot to the foot — or perhaps to other more vital organs.

Is Ralph Baxter correct?  Should all responsible firms follow suit?  We certainly think so.

[Update:  In a post of August, 2011, we explore some of the smoke and mirrors that sometimes unfortunately finds its way in to some law firms’ financial reports.  And to some public disappointment, Orrick did in fact release its financial information to AmLaw for inclusion in the 2010 rankings.]

(c) Jerome Kowalski, May, 2010, all rights reserved.

Law Firm Reports on Revenues and Profitability: A Radical Proposal

Seattle Transit System 32 Year Net Loss & Prof...

Seattle Transit System 32 Year Net Loss & Profit History (Photo credit: Oran Viriyincy)

Law firms’ profitability and revenue stream which infect the trade press at this time of year is a reflection of the profession’s hubris in boasting about how much money it makes on the backs of their (frequently cash strapped) clients.  The principal creator of this villainy may very well be Steve Brill, the initial publisher of The American Lawyer and who some 30 years ago, invented the AmLaw 100.  A casual observer might wonder why private partnerships publicize their personal financial information.  I doubt that very many law firm partners distribute to the press or otherwise publish their own personal tax returns or post them on their Facebook sites.  But why would law firms  stick it in their clients’ faces that law firm partners or a particular law firm is making oodles of money, when the clients, who fill their coffers, are on austerity budgets?  Who would expect that before engaging a physician, you first asked him or her how much money he or she makes every year.  The result of law firms crowing about the wonderful profitability the firm is realizing, often exaggerated by legerdemain, smoke and mirrors (which those of us who advise law firms can see right through) is just plain pissing  clients off.  Lexis/Nexus recently conducted a survey and found that 58% of in house general corporate counsel believes that their outside lawyers are just making too much money.  And, what is their reaction?  For those firms not willing to assume the financial risk on legal engagements, clients are cutting hourly rates and taking more work in-house.  The demands for reduced hourly rates by clients is only emboldened by the otherwise inexplicable compulsion by law firms to boast about how much money they are already taking out of their clients’ pockets.

A significant parenthetical to some of the examples of the creative dexterity to which firms resort to artificially inflate their profitability is instructive:  First, we have all known for years that the so-called “Profits per Equity Partner,” the purported gold standard, is adroitly manipulated by most reporting firms by simply dubbing some lowered paid partners to “non-equity partners,” without in any way affecting the actual earnings of such partners or their roles or status within the firm.  Rather, by eliminating the lower earning partners from the metric, the PPP number is – poof  — inflated.  Reporting for 2009 provides an added level of prestidigitization. During a difficult year for the profession as a whole, with decreased revenues and wholesale elimination of timekeepers, we have seen so  many firms report that despite such reduced gross revenues, profitability has nonetheless increased.  However, there is no mention made of the fact that the differential is caused by the elimination of salary expenses and personnel, while bills rendered by the firm for work already done by such timekeepers as well as work already in progress (WIP) yet to be billed will yield revenues, the so-called “ramp down effect.”  Yet, long term effects of ramp downs can have staggering negative consequences.

Financial accounting for law firms is governed by applicable generally accepted auditing standards and generally accepted accounting standards, adopted from time to time by the American Institute of Independent Certified Public Accountants.  As we all know, footnotes to income, balance sheet and profit and loss statements are an integral part of any financial statement.  Yet, it is virtually unheard of for any law firm to release its full financials or the required footnotes. In many instances, lawyers are fully aware of the fact that release of partial data, including the failure in particular the integral footnotes may constitute material and actionable omissions.  Despite such knowledge, the release of financial data by law firms with material omissions is pandemic.

There is no federal, state or regulatory requirement that firms boast about their profitability or slink in shame when their numbers are off.  So, just don’t do it.  Let the American Lawyer magazine say what it might, but, in the end, it simply won’t matter if you don’t report to them.  The only people who should see  law firm revenue and profit numbers are partners, their accountants,  the firms’ and partners’ bankers,  potential lateral partners,  the IRS and clients who require such disclosure prior to engaging their services. And each should be held to confidentiality requirements.  For those who suggest that declining to participate in this perp walk might adversely affect recruiting, bear in mind that just like the market for legal services is purely a buyers’ market, so too is the market for lateral partners and young lawyers.

The bottom line and our radical proposal is to simply stop this chicanery and flouting of plumage. Let that which is private remain private and remove revenue and profitability numbers from public discourse until some rule, regulation or governing requirement compel disclosure and if that ever that becomes the case, require uniform reporting consistent with AICPA standards.

© Jerome Kowalski, February 2010, All Rights Reserved.

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