Contingency Fees

Much of the pressure for law firms to utilize alternative billing approaches comes from companies of all sizes that increasingly want to control their legal costs by appealing to the individuality of lawyers. That requires rewarding lawyers for having “skin in the game” ' a personal financial stake in the outcome of a matter through compensation that goes up when the results justify it. The risk for the lawyer is in not meeting the client's cost and business goals; the reward is in meeting them or even doing better than what was required.

Lawyers who bill using contingency fees are the classic example of this type of shared risk arrangement. If the client doesn't receive value, there is no charge; if the client does receive value, the lawyer's fee is based on a previously negotiated percentage. Contingency fees are particularly useful for the lawyer skilled in analyzing cases and accepting those with a high likelihood of success. But there are risks as well, summarized in the line used in some law firms' television advertising: “No fee unless we win.”

Who Pays the Costs?

Contingency fees are frequently used as the billing arrangement in such litigation engagements as personal injury and collection matters, structured as a flat percentage to the firm of the value recovered for the client. This creates a difficult dynamic for a firm of any size: Until there is a recovery, the firm is spending money to resolve the matter, but not getting money in. These costs are hard to avoid. First is the cost of labor, the attorneys and staff required to pursue the matter. Also inescapable are costs of operation such as rent, insurance, office expenses and so on. Another cost involves the expert witnesses engaged ' the larger the battle, the more (and better paid) the experts. All these costs are expected. But in large matters, where delay is inevitable, the case can drag on, causing even greater financial strain on the contingency lawyers.

Lawyers charging contingency fees may advance the costs for essential case management activities such as depositions and filing fees. Such costs can add up quickly, and if the lawyer is not successful in the case and no value is recovered, getting the client to pay the out-of-pocket costs can be difficult at best. Certainly from the firm's perspective it is better for the client, rather than the lawyer, to advance the costs. Ideally this should be specified in the engagement agreement, but too many lawyers either don't want to ask this of the client or get clients who can't afford to pay except out of the recovery that the lawyer secures.

It is valid to ask why any lawyer would accept such a client, but there are a variety of reasons for doing so. The lawyer may simply need the work, no matter what the merits of the case, or may be convinced, upon assessing the case, that a substantial recovery is possible. In such situations the important considerations are the size and complexity of the case, the amount that needs to be advanced, and the cash reserves that the lawyer has at hand.

Providing in an engagement agreement that the client is responsible for expenses need not preclude accepting a case from a client who has limited means to pay. While lawyers tend not to enforce such provisions during the representation, on settlement or judgment, they often reduce the client's share by the expenses advanced on behalf of the client when stipulated in the engagement agreement. It is not possible to change an engagement agreement once both parties have signed, so if payment of expenses is not stipulated upfront, it's too late to add such a provision retroactively.

If the client who has promised to pay expenses while the case is ongoing cannot or will not do so, Rule of Professional Conduct 1.16 allows the lawyer to withdraw from the case if the client has been given adequate warning and the withdrawal does not cause material adverse consequences to the client, such as coming too close to the time of trial to arrange for replacement counsel. However, withdrawing without adequate communication on and careful records of the client's conduct may bring a state bar disciplinary action upon the lawyer. The best course remains to choose contingency cases and clients carefully.

What Are the Funding Alternatives?

What alternatives exist for funding contingency arrangements? There have been finance companies interested in lending on contingency cases, but this practice (akin to asset securitization lending on the presumed value of mortgages, which ultimately spurred the mortgage financial mess) is less prevalent in today's tighter financial environment. In the film “Erin Brockovich,” the big screen provided a clear example of the issue: The attorney had to take out a mortgage on his own home to finance the case, and ultimately had to associate with a larger law firm with larger financial resources to continue.

The application to large firms opens another can of worms for contingency billing. It is in fact becoming an accepted alternative to give corporate firms a bigger payoff on “bet-the-company” matters for large clients, and to give those clients the assurance that their lawyer has a stake in the outcome in exchange for the predetermined percentage payout. This can apply to litigation defense as well as plaintiff matters. Consider a lawsuit where the plaintiffs “win” by securing a settlement for $35 million after suing for $90 million. This large sum for the plaintiff also meant a large fee for the plaintiff's law firm. However, the defense firm may be just fine with it if the firm had taken on a case that its client knew could cost $90 million, for which it had reserved $50 million ' and ultimately “only” had to pay $35 million. By billing on a reverse contingency basis, the defense firm would receive a bonus for anything it could produce less than the $50 million. In this case, $35 million would mean a very large lawyer's fee!

That is the ideal use of contingency fee incentives in corporate litigation, but the issue of advancing fees is just as problematic here as in our earlier examination. Normally, corporate law firm compensation is based on hours worked and dollars collected. If such firms bill on a contingency basis, they face the dilemma of compensating lawyers who bring no money into the firm, and, in fact, are responsible for many dollars flowing out of the firm in the form of compensation and expenses to sustain the lawsuit. Then, if the firm is successful, and many dollars flow into the law firm, the issue of compensation is raised. The lawyers working on the matter expect their incentive share. But isn't the matter the “property” of the firm, which advanced the costs while the contingency matter was ongoing?

Why Compensation Is Crucial

News reports indicate that such questions were at the heart of the March 2011 dissolution of Howrey LLP. The litigation-focused firm, which once employed as many as 750 lawyers, suffered a massive exodus of talent and had less than half that number when it finally wound up its affairs in recent weeks. Several news stories contained interviews with senior firm lawyers, who blamed the partner defections in part on fluctuating fees from contingency work, which contributed to a substantial two-year drop in partner profits. By the time of its demise, up to 11% of Howrey's billable hours reportedly were devoted to contingency matters, up from 8.5% in 2009, and up from 3% to 4% percent in the 1990s. As the firm's CEO was quoted in The Wall Street Journal and the ABA Journal: “You have to ask your partners to be patient until it [contingency billing] pays off, and not everyone is patient enough.”

In pure contingency law firms, every equity lawyer must wait until the judgment or settlement is paid, while money flows out of the firm to pay lawyer and staff compensation and expenses advanced to sustain the lawsuit. And if the result of the case doesn't benefit the firm, the loss can be substantial. But the lawyers of the firm know that. Why this led to defection at Howrey can only be conjectured, but it appears that many partners wanted pure hourly billing with less contingency work, and were uncomfortable with advancing costs for matters in which they were at risk. The firm seemingly could not determine, to the satisfaction of enough partners, how to divide the compensation pool when revenues arrived out of sequence to the work performed connected with those revenues.

If fees to the firm based on contingency reached 11%, it is almost like having one client exceed the dangerous 10% threshold of dependency. Control of this much money was essentially out of the partners' hands, unless the firm only took on matters that were virtually sure things ' which conversely would lessen the likelihood of a big contingency payout. However, if intake decisions were wise, the firm likely benefited more than it suffered from periodic big revenue bumps; in today's world of “value billing,” the firm would be at the forefront of aligning its interests with those of its clients. With good cash flow management and partners committed to the team concept, contingency and hourly billings are not incompatible.

The lesson may be that the ultimate risk of contingency fees is using them in an environment of solo silos (with some lawyers piling up cost but poised to earn a great deal of money if “their” ship comes in), not an environment where everyone was pulling for the whole, irrespective of how they brought in the revenue. Any firm that encourages and is set up to allow lawyers to maximize their individual compensation may have fast near-term growth. But approaching compensation as an institution makes for greater firm harmony and longevity of the firm as an institution.

Ed Poll, J.D., M.B.A., CMC, Principal, LawBiz Management, helps law firms increase profitability, coaching them on issues of internal operations, practice development, and financial matters. He practiced law for 25 years, has coached lawyers for 20 years, and is the author of 13 books. Poll is a member of this newsletter's Board of Editors, a Fellow of the College of Law Practice Management, a board-certified Coach to the Legal Profession, a charter member of the Million Dollar Consulting' Hall of Fame and Recipient of a Lifetime Achievement Award, State Bar of California (LPMT Section). He can be reached at 800-837-5880, www.lawbiz.com, www.lawbizblog.com, and www.lawbizforum.com.

Much of the pressure for law firms to utilize alternative billing approaches comes from companies of all sizes that increasingly want to control their legal costs by appealing to the individuality of lawyers. That requires rewarding lawyers for having “skin in the game” ' a personal financial stake in the outcome of a matter through compensation that goes up when the results justify it. The risk for the lawyer is in not meeting the client's cost and business goals; the reward is in meeting them or even doing better than what was required.

Lawyers who bill using contingency fees are the classic example of this type of shared risk arrangement. If the client doesn't receive value, there is no charge; if the client does receive value, the lawyer's fee is based on a previously negotiated percentage. Contingency fees are particularly useful for the lawyer skilled in analyzing cases and accepting those with a high likelihood of success. But there are risks as well, summarized in the line used in some law firms' television advertising: “No fee unless we win.”

Who Pays the Costs?

Contingency fees are frequently used as the billing arrangement in such litigation engagements as personal injury and collection matters, structured as a flat percentage to the firm of the value recovered for the client. This creates a difficult dynamic for a firm of any size: Until there is a recovery, the firm is spending money to resolve the matter, but not getting money in. These costs are hard to avoid. First is the cost of labor, the attorneys and staff required to pursue the matter. Also inescapable are costs of operation such as rent, insurance, office expenses and so on. Another cost involves the expert witnesses engaged ' the larger the battle, the more (and better paid) the experts. All these costs are expected. But in large matters, where delay is inevitable, the case can drag on, causing even greater financial strain on the contingency lawyers.

Lawyers charging contingency fees may advance the costs for essential case management activities such as depositions and filing fees. Such costs can add up quickly, and if the lawyer is not successful in the case and no value is recovered, getting the client to pay the out-of-pocket costs can be difficult at best. Certainly from the firm's perspective it is better for the client, rather than the lawyer, to advance the costs. Ideally this should be specified in the engagement agreement, but too many lawyers either don't want to ask this of the client or get clients who can't afford to pay except out of the recovery that the lawyer secures.

It is valid to ask why any lawyer would accept such a client, but there are a variety of reasons for doing so. The lawyer may simply need the work, no matter what the merits of the case, or may be convinced, upon assessing the case, that a substantial recovery is possible. In such situations the important considerations are the size and complexity of the case, the amount that needs to be advanced, and the cash reserves that the lawyer has at hand.

Providing in an engagement agreement that the client is responsible for expenses need not preclude accepting a case from a client who has limited means to pay. While lawyers tend not to enforce such provisions during the representation, on settlement or judgment, they often reduce the client's share by the expenses advanced on behalf of the client when stipulated in the engagement agreement. It is not possible to change an engagement agreement once both parties have signed, so if payment of expenses is not stipulated upfront, it's too late to add such a provision retroactively.

If the client who has promised to pay expenses while the case is ongoing cannot or will not do so, Rule of Professional Conduct 1.16 allows the lawyer to withdraw from the case if the client has been given adequate warning and the withdrawal does not cause material adverse consequences to the client, such as coming too close to the time of trial to arrange for replacement counsel. However, withdrawing without adequate communication on and careful records of the client's conduct may bring a state bar disciplinary action upon the lawyer. The best course remains to choose contingency cases and clients carefully.

What Are the Funding Alternatives?

What alternatives exist for funding contingency arrangements? There have been finance companies interested in lending on contingency cases, but this practice (akin to asset securitization lending on the presumed value of mortgages, which ultimately spurred the mortgage financial mess) is less prevalent in today's tighter financial environment. In the film “Erin Brockovich,” the big screen provided a clear example of the issue: The attorney had to take out a mortgage on his own home to finance the case, and ultimately had to associate with a larger law firm with larger financial resources to continue.

The application to large firms opens another can of worms for contingency billing. It is in fact becoming an accepted alternative to give corporate firms a bigger payoff on “bet-the-company” matters for large clients, and to give those clients the assurance that their lawyer has a stake in the outcome in exchange for the predetermined percentage payout. This can apply to litigation defense as well as plaintiff matters. Consider a lawsuit where the plaintiffs “win” by securing a settlement for $35 million after suing for $90 million. This large sum for the plaintiff also meant a large fee for the plaintiff's law firm. However, the defense firm may be just fine with it if the firm had taken on a case that its client knew could cost $90 million, for which it had reserved $50 million ' and ultimately “only” had to pay $35 million. By billing on a reverse contingency basis, the defense firm would receive a bonus for anything it could produce less than the $50 million. In this case, $35 million would mean a very large lawyer's fee!

That is the ideal use of contingency fee incentives in corporate litigation, but the issue of advancing fees is just as problematic here as in our earlier examination. Normally, corporate law firm compensation is based on hours worked and dollars collected. If such firms bill on a contingency basis, they face the dilemma of compensating lawyers who bring no money into the firm, and, in fact, are responsible for many dollars flowing out of the firm in the form of compensation and expenses to sustain the lawsuit. Then, if the firm is successful, and many dollars flow into the law firm, the issue of compensation is raised. The lawyers working on the matter expect their incentive share. But isn't the matter the “property” of the firm, which advanced the costs while the contingency matter was ongoing?

Why Compensation Is Crucial

News reports indicate that such questions were at the heart of the March 2011 dissolution of Howrey LLP. The litigation-focused firm, which once employed as many as 750 lawyers, suffered a massive exodus of talent and had less than half that number when it finally wound up its affairs in recent weeks. Several news stories contained interviews with senior firm lawyers, who blamed the partner defections in part on fluctuating fees from contingency work, which contributed to a substantial two-year drop in partner profits. By the time of its demise, up to 11% of Howrey's billable hours reportedly were devoted to contingency matters, up from 8.5% in 2009, and up from 3% to 4% percent in the 1990s. As the firm's CEO was quoted in The Wall Street Journal and the ABA Journal: “You have to ask your partners to be patient until it [contingency billing] pays off, and not everyone is patient enough.”

In pure contingency law firms, every equity lawyer must wait until the judgment or settlement is paid, while money flows out of the firm to pay lawyer and staff compensation and expenses advanced to sustain the lawsuit. And if the result of the case doesn't benefit the firm, the loss can be substantial. But the lawyers of the firm know that. Why this led to defection at Howrey can only be conjectured, but it appears that many partners wanted pure hourly billing with less contingency work, and were uncomfortable with advancing costs for matters in which they were at risk. The firm seemingly could not determine, to the satisfaction of enough partners, how to divide the compensation pool when revenues arrived out of sequence to the work performed connected with those revenues.

If fees to the firm based on contingency reached 11%, it is almost like having one client exceed the dangerous 10% threshold of dependency. Control of this much money was essentially out of the partners' hands, unless the firm only took on matters that were virtually sure things ' which conversely would lessen the likelihood of a big contingency payout. However, if intake decisions were wise, the firm likely benefited more than it suffered from periodic big revenue bumps; in today's world of “value billing,” the firm would be at the forefront of aligning its interests with those of its clients. With good cash flow management and partners committed to the team concept, contingency and hourly billings are not incompatible.

The lesson may be that the ultimate risk of contingency fees is using them in an environment of solo silos (with some lawyers piling up cost but poised to earn a great deal of money if “their” ship comes in), not an environment where everyone was pulling for the whole, irrespective of how they brought in the revenue. Any firm that encourages and is set up to allow lawyers to maximize their individual compensation may have fast near-term growth. But approaching compensation as an institution makes for greater firm harmony and longevity of the firm as an institution.

Ed Poll, J.D., M.B.A., CMC, Principal, LawBiz Management, helps law firms increase profitability, coaching them on issues of internal operations, practice development, and financial matters. He practiced law for 25 years, has coached lawyers for 20 years, and is the author of 13 books. Poll is a member of this newsletter's Board of Editors, a Fellow of the College of Law Practice Management, a board-certified Coach to the Legal Profession, a charter member of the Million Dollar Consulting' Hall of Fame and Recipient of a Lifetime Achievement Award, State Bar of California (LPMT Section). He can be reached at 800-837-5880, www.lawbiz.com, www.lawbizblog.com, and www.lawbizforum.com.