Alternative Fees

The desire among senior corporate counsel and management to control costs has pushed consideration of alternative fee arrangements (AFAs) to the forefront. Respected industry press, independent consultants, and law firm client surveys all concur that utilization of AFAs is at a tipping point ' with some estimates suggesting that within five years, as much as half the Am Law 200 revenue might come from AFAs.

In the conventional hourly rate engagement the client assumes the full risk of adverse results and budget overruns, both cost and legal expense. At their core, AFAs seek to transfer some part of those risks to the law firm. Not surprisingly, how much of that risk a firm is willing to accept depends on how much the client allows the firm 'to price' that risk before moving its business elsewhere to a more entrepreneurially minded firm.

The diversity of AFA approaches and objectives can divide consumers and providers of legal services, and magnify the law firm-client communication challenges presented by movement away from an entrenched business model. Jim Hassett, Ph.D., identified in the December release of his national LegalBizDev survey of senior decision-makers at Am Law 100 firms no less than nine different core approaches to AFAs, before accounting for permutations.

Some of the friction and related trust issues that have surfaced can be summed up in the question, “Do AFAs mean lower costs for clients or a mechanism for growth of profits at law firms?” The question's assumption that the aforesaid goals are mutually exclusive underscores the need for careful evaluation of exactly what risks a new approach entails for both client and law firm alike. Otherwise clients may come to echo the remarks of Qwest General Counsel, who during a Dec. 7, 2009 panel discussion in New York on “Evolution or Revolution: The Future of the Law Firm Business Model,” remarked, “Alternative fee arrangements have been a colossal train wreck for us.”

Case Portfolio Approach

Viewed from the risk transfer lens, it is not surprising that the most noteworthy AFA arrangements have come from Fortune 500 companies with over $20 billion in revenue that have sought to apply AFAs on a “portfolio” basis across a substantial portion if not the entirety of their litigation docket.

These companies share not only a case volume and litigation history that makes data mining productive and projections of likely legal costs to handle entire portfolios of matters feasible, but outside counsel legal expense budgets that can run into the tens of millions of dollars giving them considerable purchasing power. That power is magnified when law firms are pressured by the reduction in the number of outside law firms their clients utilize.

Overall Cost Reduction

Although “buying results ' not time” and increasing incentives for outside counsel to be efficient are behind the adoption of alternative billing strategies, overall cost reduction is an equally important if not the topmost objective. United Technology, with approximately $60 billion in revenue, has reported that with half of its legal matters handled under AFAs, spending on outside counsel has declined 30% as a percentage of revenue from .33% to .22%. At Pfizer, substantial double-digit reductions in outside counsel spending occurred despite matter counts increasing two and half times from 2005 to 2007. Cisco claims to have reduced legal spend as a percentage of revenue every year for the past five years, and operates on a fixed-fee basis.

Tyco, a product manufacturer and provider of security and fire protection services, bundled all its product liability work together to get a fixed-fee agreement on an annual basis to get the best service for the right price. Pfizer did the same in negotiating an annual capped fee for its employment-related work including class actions, single-plaintiff discrimination cases, equal employment opportunity matters, and general advice and counsel. Similarly, Microsoft, which now has 45% of its outside counsel paid under AFAs was able to project the number of annual software piracy cases and set up a fixed fee arrangement for their handling.

Annual Fixed Fees: Risks

Committing to perform all necessary legal work over a portfolio of matters for an annual fixed fee requires the law firm take on the risk of creating lean enough project management to control costs without negatively impacting matter results and still earn a profit for the firm. Company representatives negotiating arrangements with their law firms are acutely aware of that risk and the pitfalls that could ensue if a firm makes the wrong calculations. So much so, that United Technologies requires their outside firms not only to work on a flat fee basis but to explain how they will make money from the arrangement.

How does a firm protect its profit under such an arrangement? It is assumed that some profit as well as a contingency for unexpected developments is built into the quoted fixed fee sum for taking on a portfolio of work. One option is to “hedge” the fixed- fee “target number” by agreeing to split with the client any “over” or “under” the targeted amount. Bonuses can also be negotiated for superior results either looking at total settlements/judgments paid across a portfolio compared to historical data if available or performance on individual cases. Regardless of which approach a firm chooses it is absolutely essential to know its cost of delivery of services through data mining of similar cases it has handled across its client base, and then control those costs during execution of the engagement to earn a profit on a fixed fee arrangement.

From the client's standpoint, the combination of having the business leverage to reduce costs across a portfolio of matters and the administrative ease of assigning work without the concomitant task of constantly monitoring attorney hourly billing outweighs the risks that have led the overwhelming majority of senior corporate counsel to avoid fixed fee arrangements for complex litigation on an individual case basis. On a single case basis, fixed fees however attractive from a cost predictability standpoint, were viewed as having too much risk. Typical questions included: How can I compare what I would otherwise pay on an hourly engagement? How do I know the firm is not building in excessive profit and contingency risk into the quote? Will the firm try to settle the case early for too rich an amount to boost profitability of the arrangement? Am I assured that if a firm blows through the fixed fee on a time value basis, the best attorneys will still be assigned to do everything possible to get my case ready for trial and actually try it to the best of their abilities?

Managing the Risks

However, in the context of a longer-term business relationship involving millions of dollars of fees and many cases, senior decision-makers at a select group of large companies have determined that the risks posed by the aforesaid questions can be managed. Similarly, law firm leaders committing to such fixed portfolio engagements have concluded that their litigation acumen and prowess as well as project management skills and risk appetite are a match for an opportunity to earn profits from a fixed fee approach.

Single-Case Approach

Senior legal counsel of companies that are not $20 billion plus revenue enterprises may not have the case volume and historical litigation dockets that makes data mining to develop predictable portfolio costs on a going forward basis a statistically sound exercise. There may be opportunities at some companies to carve out a practice area that generates a predictable stream of litigation for a fixed fee portfolio engagement. Levi-Strauss, an apparel manufacturer with $5 billion in revenue, recently entered into a multi-million-dollar fixed annual fee contract for all legal work, but there were no details made public as to the breakdown between non-litigation transactional and advisory work, and the litigation component. Further, there was a carve out for IP work under the arrangement.

A smaller company may find that the best opportunity to enjoy some of the same benefits of cost reduction, efficiency, and a greater focus on results that their larger brethren are deriving from AFAs is by focusing on a matter by matter single case approach as opposed to trying to fit within the “fixed fee for a entire portfolio” box. AFAs, however, entered into for single matters that may be repeated for similar litigation entail a different set of risks for clients and their law firms.

The Holdback/Bonus Model

The AFA for individual matter engagements that has received the most attention is the holdback/bonus model. FMC Technologies Inc. reports that using this model has enabled them to hold outside legal spend flat despite revenue more than doubling from 2001's $2.2 billion. This model puts 20%-40% of every invoice at risk by holding back payment, whether on a flat monthly fee or an hourly timekeeper submission basis, thereby limiting the law firm's guaranteed income stream. On the back end, the agreement typically calls for the firm to receive a return of some or all of the holdback and possibly a varying multiple of the amount at risk as a “success fee” as a function of factors including final result, budgetary compliance, and time of resolution, as well as how the final results compared to what was originally projected by the firm in its initial litigation management plan.

Under this approach, the risks to the firm are clear: Fail to deliver results and the firm may receive 20%-40% less than it would customarily receive as fee income. The upside reward may be a significant multiple of the hourly fees the firm put at risk. However, the risks for the legal services consumer are considerably more opaque. A reduced “guaranteed” hourly rate accomplished via a holdback is no guarantee that the total legal fees will be controlled. Further, agreeing to a success marker(s) at time of retention that triggers a holdback return and fixed bonus at time of resolution that turn out to be too easily achievable can increase the total legal fee beyond what would have otherwise been paid under a straight hourly engagement, for results that with 20/20 hindsight at the end of the case, hardly qualify as “success.”

The latter risk could best be addressed by the purchaser of legal services by treating the “success markers” as guidelines, not triggers, and providing that all (or a substantial part) of any holdback return or success fee is determined at case conclusion in the client's discretion, taking into account how the firm adapted and improvised its strategy as case developments occurred to deliver “success.”

Retaining absolute discretion however, on payout of the holdback and success fee can complicate negotiations with a law firm to transfer even more risk under the holdback/bonus approach by requiring the firm to include and overlay some cost predictability elements onto the basic model.

Incentivizing the law firm to constrain total legal spending within an initial legal budget set forth in a litigation management plan can be accomplished by increasing the holdback once the initial legal budget is exceeded. Some companies have gone so far using an example of a 70/30 holdback, to “flip” the percentages when the budget is exceeded, raising the holdback to 70% from 30%. Others negotiate a corridor above the legal budget within which the firm will track time but waive payment, and bill at a significantly discounted rate for time submissions above the corridor. Companies that insist on tough cost predictability measures while also retaining complete end of case discretion to return the holdback and award success fees are transferring considerable risks to their law firms, and need to build a strong relationship of trust with those providers to sustain an AFA program.

Conclusion

The events over the last year demonstrate that companies are committed to controlling, if not actually reducing, costs ' and insisting on greater efficiencies from their legal services providers without sacrificing results. AFAs whether on a portfolio or single-case model offer a compelling and proven way to meet those goals for large and small companies alike. Law firms committed to building an environment that puts a premium on teamwork where litigation and trial skills as well as project management discipline can flourish will have the confidence to accept some transfer of cost and result risk from clients and an ability to earn profits under AFAs that will allow them to prosper and thrive. Only those firms that cannot adapt to the new environment will view lower client costs and law firm profits as mutually exclusive under an AFA regime.

John F. Brown Jr. is a principal at Brown Law LLC. He can be reached at [email protected].

The desire among senior corporate counsel and management to control costs has pushed consideration of alternative fee arrangements (AFAs) to the forefront. Respected industry press, independent consultants, and law firm client surveys all concur that utilization of AFAs is at a tipping point ' with some estimates suggesting that within five years, as much as half the Am Law 200 revenue might come from AFAs.

In the conventional hourly rate engagement the client assumes the full risk of adverse results and budget overruns, both cost and legal expense. At their core, AFAs seek to transfer some part of those risks to the law firm. Not surprisingly, how much of that risk a firm is willing to accept depends on how much the client allows the firm 'to price' that risk before moving its business elsewhere to a more entrepreneurially minded firm.

The diversity of AFA approaches and objectives can divide consumers and providers of legal services, and magnify the law firm-client communication challenges presented by movement away from an entrenched business model. Jim Hassett, Ph.D., identified in the December release of his national LegalBizDev survey of senior decision-makers at Am Law 100 firms no less than nine different core approaches to AFAs, before accounting for permutations.

Some of the friction and related trust issues that have surfaced can be summed up in the question, “Do AFAs mean lower costs for clients or a mechanism for growth of profits at law firms?” The question's assumption that the aforesaid goals are mutually exclusive underscores the need for careful evaluation of exactly what risks a new approach entails for both client and law firm alike. Otherwise clients may come to echo the remarks of Qwest General Counsel, who during a Dec. 7, 2009 panel discussion in New York on “Evolution or Revolution: The Future of the Law Firm Business Model,” remarked, “Alternative fee arrangements have been a colossal train wreck for us.”

Case Portfolio Approach

Viewed from the risk transfer lens, it is not surprising that the most noteworthy AFA arrangements have come from Fortune 500 companies with over $20 billion in revenue that have sought to apply AFAs on a “portfolio” basis across a substantial portion if not the entirety of their litigation docket.

These companies share not only a case volume and litigation history that makes data mining productive and projections of likely legal costs to handle entire portfolios of matters feasible, but outside counsel legal expense budgets that can run into the tens of millions of dollars giving them considerable purchasing power. That power is magnified when law firms are pressured by the reduction in the number of outside law firms their clients utilize.

Overall Cost Reduction

Although “buying results ' not time” and increasing incentives for outside counsel to be efficient are behind the adoption of alternative billing strategies, overall cost reduction is an equally important if not the topmost objective. United Technology, with approximately $60 billion in revenue, has reported that with half of its legal matters handled under AFAs, spending on outside counsel has declined 30% as a percentage of revenue from .33% to .22%. At Pfizer, substantial double-digit reductions in outside counsel spending occurred despite matter counts increasing two and half times from 2005 to 2007. Cisco claims to have reduced legal spend as a percentage of revenue every year for the past five years, and operates on a fixed-fee basis.

Tyco, a product manufacturer and provider of security and fire protection services, bundled all its product liability work together to get a fixed-fee agreement on an annual basis to get the best service for the right price. Pfizer did the same in negotiating an annual capped fee for its employment-related work including class actions, single-plaintiff discrimination cases, equal employment opportunity matters, and general advice and counsel. Similarly, Microsoft, which now has 45% of its outside counsel paid under AFAs was able to project the number of annual software piracy cases and set up a fixed fee arrangement for their handling.

Annual Fixed Fees: Risks

Committing to perform all necessary legal work over a portfolio of matters for an annual fixed fee requires the law firm take on the risk of creating lean enough project management to control costs without negatively impacting matter results and still earn a profit for the firm. Company representatives negotiating arrangements with their law firms are acutely aware of that risk and the pitfalls that could ensue if a firm makes the wrong calculations. So much so, that United Technologies requires their outside firms not only to work on a flat fee basis but to explain how they will make money from the arrangement.

How does a firm protect its profit under such an arrangement? It is assumed that some profit as well as a contingency for unexpected developments is built into the quoted fixed fee sum for taking on a portfolio of work. One option is to “hedge” the fixed- fee “target number” by agreeing to split with the client any “over” or “under” the targeted amount. Bonuses can also be negotiated for superior results either looking at total settlements/judgments paid across a portfolio compared to historical data if available or performance on individual cases. Regardless of which approach a firm chooses it is absolutely essential to know its cost of delivery of services through data mining of similar cases it has handled across its client base, and then control those costs during execution of the engagement to earn a profit on a fixed fee arrangement.

From the client's standpoint, the combination of having the business leverage to reduce costs across a portfolio of matters and the administrative ease of assigning work without the concomitant task of constantly monitoring attorney hourly billing outweighs the risks that have led the overwhelming majority of senior corporate counsel to avoid fixed fee arrangements for complex litigation on an individual case basis. On a single case basis, fixed fees however attractive from a cost predictability standpoint, were viewed as having too much risk. Typical questions included: How can I compare what I would otherwise pay on an hourly engagement? How do I know the firm is not building in excessive profit and contingency risk into the quote? Will the firm try to settle the case early for too rich an amount to boost profitability of the arrangement? Am I assured that if a firm blows through the fixed fee on a time value basis, the best attorneys will still be assigned to do everything possible to get my case ready for trial and actually try it to the best of their abilities?

Managing the Risks

However, in the context of a longer-term business relationship involving millions of dollars of fees and many cases, senior decision-makers at a select group of large companies have determined that the risks posed by the aforesaid questions can be managed. Similarly, law firm leaders committing to such fixed portfolio engagements have concluded that their litigation acumen and prowess as well as project management skills and risk appetite are a match for an opportunity to earn profits from a fixed fee approach.

Single-Case Approach

Senior legal counsel of companies that are not $20 billion plus revenue enterprises may not have the case volume and historical litigation dockets that makes data mining to develop predictable portfolio costs on a going forward basis a statistically sound exercise. There may be opportunities at some companies to carve out a practice area that generates a predictable stream of litigation for a fixed fee portfolio engagement. Levi-Strauss, an apparel manufacturer with $5 billion in revenue, recently entered into a multi-million-dollar fixed annual fee contract for all legal work, but there were no details made public as to the breakdown between non-litigation transactional and advisory work, and the litigation component. Further, there was a carve out for IP work under the arrangement.

A smaller company may find that the best opportunity to enjoy some of the same benefits of cost reduction, efficiency, and a greater focus on results that their larger brethren are deriving from AFAs is by focusing on a matter by matter single case approach as opposed to trying to fit within the “fixed fee for a entire portfolio” box. AFAs, however, entered into for single matters that may be repeated for similar litigation entail a different set of risks for clients and their law firms.

The Holdback/Bonus Model

The AFA for individual matter engagements that has received the most attention is the holdback/bonus model. FMC Technologies Inc. reports that using this model has enabled them to hold outside legal spend flat despite revenue more than doubling from 2001's $2.2 billion. This model puts 20%-40% of every invoice at risk by holding back payment, whether on a flat monthly fee or an hourly timekeeper submission basis, thereby limiting the law firm's guaranteed income stream. On the back end, the agreement typically calls for the firm to receive a return of some or all of the holdback and possibly a varying multiple of the amount at risk as a “success fee” as a function of factors including final result, budgetary compliance, and time of resolution, as well as how the final results compared to what was originally projected by the firm in its initial litigation management plan.

Under this approach, the risks to the firm are clear: Fail to deliver results and the firm may receive 20%-40% less than it would customarily receive as fee income. The upside reward may be a significant multiple of the hourly fees the firm put at risk. However, the risks for the legal services consumer are considerably more opaque. A reduced “guaranteed” hourly rate accomplished via a holdback is no guarantee that the total legal fees will be controlled. Further, agreeing to a success marker(s) at time of retention that triggers a holdback return and fixed bonus at time of resolution that turn out to be too easily achievable can increase the total legal fee beyond what would have otherwise been paid under a straight hourly engagement, for results that with 20/20 hindsight at the end of the case, hardly qualify as “success.”

The latter risk could best be addressed by the purchaser of legal services by treating the “success markers” as guidelines, not triggers, and providing that all (or a substantial part) of any holdback return or success fee is determined at case conclusion in the client's discretion, taking into account how the firm adapted and improvised its strategy as case developments occurred to deliver “success.”

Retaining absolute discretion however, on payout of the holdback and success fee can complicate negotiations with a law firm to transfer even more risk under the holdback/bonus approach by requiring the firm to include and overlay some cost predictability elements onto the basic model.

Incentivizing the law firm to constrain total legal spending within an initial legal budget set forth in a litigation management plan can be accomplished by increasing the holdback once the initial legal budget is exceeded. Some companies have gone so far using an example of a 70/30 holdback, to “flip” the percentages when the budget is exceeded, raising the holdback to 70% from 30%. Others negotiate a corridor above the legal budget within which the firm will track time but waive payment, and bill at a significantly discounted rate for time submissions above the corridor. Companies that insist on tough cost predictability measures while also retaining complete end of case discretion to return the holdback and award success fees are transferring considerable risks to their law firms, and need to build a strong relationship of trust with those providers to sustain an AFA program.

Conclusion

The events over the last year demonstrate that companies are committed to controlling, if not actually reducing, costs ' and insisting on greater efficiencies from their legal services providers without sacrificing results. AFAs whether on a portfolio or single-case model offer a compelling and proven way to meet those goals for large and small companies alike. Law firms committed to building an environment that puts a premium on teamwork where litigation and trial skills as well as project management discipline can flourish will have the confidence to accept some transfer of cost and result risk from clients and an ability to earn profits under AFAs that will allow them to prosper and thrive. Only those firms that cannot adapt to the new environment will view lower client costs and law firm profits as mutually exclusive under an AFA regime.

John F. Brown Jr. is a principal at Brown Law LLC. He can be reached at [email protected].