Billing: Considering Alternatives That Work & Others That Don't
by John W. Toothman
7(4) Accounting for Law Firms (Leader Publ. April 1994)
LAW FIRMS THAT HAVE decided to offer value-billing alternatives to clients should not jump on the first band wagon heading out of town. Not everything labeled as "value-billing" works. Of course, some ideas might look attractive to the firm or to the client, but be so one-sided that they will not build the relationship between client and attorney that will always be the real secret to cost-effective representation.
There are several alternative billing schemes that seem to fulfill the goal of tying the law firm's compensation to the value of the case to the client, thereby giving the firm the incentive to do a cost-effective job.
Alternatives Worth Considering
Contingent fees. A contingent fee encourages counsel to staff a case efficiently, file cost-effective motions, take cost-effective discovery and settle a case as soon as possible. As added bonuses, the client does not need to comb through massive hourly fee bills to manage the case (reducing the client's case-related expenses), the fee is proportional to the value of the result and the firm need not bother with keeping track of time, in most instances.
Purely contingent fees may encourage a firm to settle too quickly, selling the client short to obtain a quick windfall. Stepped contingent fees attempt to overcome this problem by increasing the size of the carrot in proportion to the firm's investment in the case.
The tendency of many firms to avoid contingent fees like the plague -- by citing the uncertainties of litigation -- makes many clients laugh. Clients normally bear not only those uncertainties, which expert counsel should be in the best position to minimize, but also the uncertainty caused by the clients' limited control over their cases and hourly fees. Firms do not need to remind clients about the uncertainty of litigation, but clients are likely to blame that uncertainty, in part, on the firm. Moreover, experienced counsel minimize uncertainty by being able to foresee the likely path of a case and options -- counsel who always seem surprised by litigation are perceived by clients to be inexperienced or incompetent, which is another reason not to emphasize how uncertain litigation can be.
Hybrids of hourly and contingent fees. One variety of value billing combines an hourly component, at discounted hourly rates, with a contingent "kicker," giving the attorney a stake in the outcome of the case (and in getting to that outcome sooner and more cheaply). My experience with this suggests that the discount to hourly rates must be significant; otherwise, the firm's profits are not at stake and they do not have the proper incentive to handle the case cost-effectively. Discounts of 10 to 20 percent probably fail to give the firm the proper incentive -- 50 percent is more like it. 'lie contingent component may also have several steps in it, say 10 percent if the case settles early, rising perhaps to 25 percent after trial to avoid windfalls in the event of early termination or diminished attorney attention if the case takes longer than expected.
Bonuses. A variation on the hybrid theme is the bonus or premium fee situation, in which firms earn a pre-determined reward for accomplishing a particular result, meeting a deadline or whatever. The underlying fee is usually an hourly fee, perhaps discounted (which brings it into the realm of value-billing). Bonuses can be used where there is concern that hourly rates would fail to fully compensate a firm or would encourage inefficient conduct; e.g., where the matter will preclude the firm from obtaining other business due to unusual conflicts, where a firm becomes involved in a short-term emergency or where the client wants to borrow a firm's top gun but not pay for the rest of his or her entourage. Bonuses can be tied to non-economic milestones, making them more flexible than contingent fees, if non-economic forces are important to the client.
Lump sums, fixed fees. Other value-billing alternatives include a negotiated lump sum or fixed fee for the project or case. The client agrees to pay $100,000 for the case to be handled, with the attorney receiving the full amount -- but only that amount -- regardless of when the case terminates. If the fee includes expenses, it also encourages the attorney to economize and to manage the fees of experts, for example. If the case ends early or is handled efficiently, the attorney receives a "bonus" above hourly billing, which provides the firm with an incentive to provide cost-effective quality. However, if the case goes longer than expected and is handled inefficiently or takes an unexpected turn, then the attorney still has a professional duty to fulfill for the client, even if it means the attorney loses money.
Just as firms do not expect, however, to collect 100 percent of their billed fees, a "loss" on a fixed fee does not occur simply because the fee is less than 100 percent of the billed time. Having $100,000 in hand or paid in regular installments is much more preferable than having the opportunity to send a $100,000 bill to an unhappy client, for example.
In theory, fixed fees could be used in any case, but in practice, clients and lawyers are more comfortable doing this with routine matters. There have been exceptions, however, including instances where a client's entire portfolio of business has been turned over to one firm for an annual retainer, effectively a global fixed fee, with the firm responsible for handling all matters that arise for that amount.
Clients want to know what their legal expenses will be so that they can decide whether the expenditure is worthwhile before they are forced to throw good money after bad as their case spirals into a bottomless pit of hourly fees. Fixed fees assume that a client can tell what the legal work is worth to them at the beginning of the representation, which is not always the case. If the client's perception of what the case is "worth" changes, then his or her perception of a reasonable fee may change as well.
Fixed fees emphasize predictability, but may create problems, such as windfalls for the attorney, which cause clients to shy away. Fixed fees can also be a problem where the client is receiving a windfall because the matter becomes more complicated than expected, but then the incentive for the lawyer is also diminished, so the client's apparent wind fall may actually be costly once the result of the matter is taken into account, if the lawyer chooses to cut too many corners. Concern for a firm's reputation and for obtaining repeat business should discourage it from sacrificing quality with a "lowest bidder" mentality in cases where the fee quote turns out to have been inaccurate and the attorney is losing money.
While a lawsuit's course is uncertain and will be affected by opponents and judges over whom a litigator has no control, similar uncertainties have not stopped contractors from bidding on construction projects -- lawyers must learn to manage those uncertainties. As experts in their field, lawyers should know better than anyone how to estimate and minimize risks and costs.
There can also be variations on the lump-sum bid, like bids broken down into sub-parts, interim or progress payments at pre-determined milestones and bonuses for reaching certain goals or meeting deadlines. A firm could, for example, bid $5,000 per deposition, $25,000 for a summary judgment motion, $50,000 for an appeal and $75,000 for trial preparation and trial.
Because fixed fees shift some of the risk to the lawyer, encourage efficiency, provide predictability and reduce the client's management burden, I recommend them to clients in the right situations, but they are far from perfect.
Averaged Fee Billing
My consulting firm has developed its own alternative billing arrangement, which we call "averaged fee billing." Averaged fees are the monthly average of hourly fees and a monthly retainer or fixed fee basis. The fixed fee basis is established as a fixed or lump sum fee would be established, using an estimated or budgeted amount. Normal restrictions on hourly billing, such as staff controls, are also in effect and the client must still manage the hourly component.
For example, assume that a matter is expected to last a year, with a budget of $120,000, or $10,000 per month (the budget could also be refined to take into account spikes and lulls in work). In the first month, the firm's actual hourly fees might have been $12,000, making the averaged fee $11,000. In the second month, the firm would have billed just $5,000, but the averaged fee then becomes $7,500, rewarding the firm for billing less, but not providing the full windfall. The firm is thereby encouraged to be more efficient, but if the exigencies of the case take it over budget, it will not be punished with a total write-down of the time.
Considering Common Problems
Consideration must be given in the retainer agreement to common problems, such as early termination of the case -- a bonus less than the full estimate would encourage the firm to seek early termination without providing the full windfall a fixed fee might provide. The budget benchmark can be revised as time passes, either to take matter history into account or to anticipate the effect of changes since the last budget. Time must still be recorded and billed, so the administrative burden is, if anything, heavier than for pure hourly billing because of the work involved in preparing estimates (which clients should insist upon, however, in all hourly cases anyway).
Averaged fees are designed to smooth out the spikes that occur with hourly billing and remove much of the incentive to overstaff or complicate the case that is inherent in hourly billing. At the same time, averaged fees mitigate the windfalls (for both parties) that a fixed retainer would cause if the work is much more or much less than predicted. With periodic re-examination of the retainer basis, averaged fees are best used in ongoing, busy matters and may be more suitable for complex matters than are fixed fees.
Alternatives to Avoid
In contrast with the foregoing value-billing techniques that have advantages that typically outweigh their disadvantages, the following alternatives are less desirable, in my estimation:
Blended rates. Among the handful of value-billing alternatives that clients are experimenting with is the blended rate, in which one hourly rate, perhaps based on some calculation of the firm's average rate, for example, is used as the hourly rate for all billers. This results in a markup of the rates of junior attorneys but a discount for senior attorneys. According to its proponents, this is designed to push work down to the lowest competent level of attorney -- I'll bet it sure does. I have never understood why this would be attractive to clients. The biggest problem is that there is no limitation on the hours billed, and the client must be vigilant or the "discount" will disappear.
My experience indicates that the more senior attorneys are often the most efficient and valuable, while junior attorneys account for much of the wasted time. Junior attorneys typically feel the most pressure to produce billable hours, even if the firm does not consciously create that pressure. Blended rates seem to worry too much about the attorney's hourly rate, while it is the efficiency of the attorney that is more important.
As a trial lawyer, I was once opposed by a large firm that was charging a blended rate: There were seven or more attorneys billing time on that case, many of them far too inexperienced to handle depositions or arguments, so they often traveled in pairs, or threes or fours. I later heard that their settlement with my client almost covered their legal bill --their client must have been happy. Blended rates may only exacerbate the problems of hourly billing, while failing to make the attorneys interest coincide with the client's.
Hourly billing up to a fixed ceiling. Sometimes a client sets a "limit" to how much it will pay in fees, say $100,000, with the firm billing by the hour up to that point. In theory, this makes the amount the client will pay in fees a known quantity, while encouraging the firm to meet that expectation. If the case ends early, the firm receives no bonus and certainly not the balance up to the limit, which is why this is not a fixed fee. (Budgets or estimates of fees often have the same effect if the number bid Is going to be enforced.) The problem is that, while a client might be lulled by the cap into managing the matter less closely, the cap has little impact on the billing incentives of the firm up to the limit and, as the limit is approached, might actually encourage the firm to cut corners to avoid losing fees -- the firm's incentives are reduced to zero as the limit is reached. Often the limit is then abandoned as the client realizes that, to keep its firm happy, it has no alternative, now that the fixed amount has been spent, but to increase the limit. A fixed fee has the advantage of giving the firm an upside reward for efficient work, while accomplishing the goal of making the fees predictable, although it is really best-suited to "routine" matters, while clients often attempt to use the fee ceiling in complex or unusual matters as well.
Keep an Open Mind
Hourly billing was never perfect, nor is there a perfect alternative billing method. But some may better fit the needs of certain clients. Firms that keep an open mind will have the best chance of finding and retaining clients. While they may have to work harder to keep these clients happy and make a living, they will have one less thing to worry about: competition from the closed-minded firms.
©1994, 1998 John W. Toothman
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