The Rise of Alternative Fee Arrangements
By Darren VanPuymbrouck and Joshua Kurtzman – December 11, 2013
Alternative fee arrangements (AFAs) have been debated and used to some extent for decades but have become much more prevalent within the past five years. Earlier use of AFAs saw law firms grant larger institutional clients a volume discount or a smaller firm take a case on contingency. Both of these examples illustrate a mechanism for a client or a corporate legal department to avoid paying the lawyer or law firm’s hourly billing rate. The presence and prevalence of AFAs in the legal marketplace vastly increased during the economic downturn of 2008–2010.
The economic crisis forced legal departments of every size to evaluate their legal costs and look for ways to control these costs. The general counsel of Marriot International stated that AFAs became more widely used as “a reaction to the significant increases in billing rates over the last 10 years . . . and the rise of $1,000 per hour lawyer.” Catherine Ho, “Law Firms Look for an Alternative to the Billable Hour,” Wash. Post (Apr. 15, 2012). Xerox Corporation’s general counsel expressed his agreement and felt that while AFAs may have been a by-product of the economic downturn, they are “no longer a necessity just because of the recession . . . [;] [i]t’s now part of the normal process.” Jennifer Smith, “Watch Out, Billable Hour: Alternative Fee Arrangements Continue to Grow,” Wall St. J. (Apr. 9 2012). These cost-control efforts have led law firms and legal departments to become more and more creative with offering and evaluating alternative fee arrangements. As the economy gradually strengthens, alternative fee arrangements have remained prevalent.
Overview of Alternative Fee Arrangements
Alternative fee arrangements are defined as a “mutual agreement between a law firm and corporate legal department for billing and payment of outside legal services that does not rely on straight hourly billing by the firm.” ALM Legal Intelligence, Speaking Different Languages: Alternative Fee Arrangements for Law Firms and Legal Departments 10 (2012). These agreements come in numerous forms and have varying degrees of use in the industry. They also have variable degrees of success. Legal departments will sometimes negotiate an alternative fee arrangement that actually leads to a higher bill than the hourly rate because the law firm accomplished its client’s objectives in less time than originally predicted. Below is a brief overview of the six most prevalent AFAs in the marketplace.
- Blended-Rate AFAs, which prescribe a set hourly rate for all lawyers working on a matter, regardless of their seniority.
- Contingency AFAs, which provide that a law firm is only paid if it achieves a certain result. Any compensation is usually predetermined as a certain percentage of a client’s recovery. A defendant can also employ this AFA by setting a predicted outcome value of the case and providing the law firm a percentage of any cost savings.
- Partial-Contingency AFAs generally provide a firm with an hourly billing rate plus a bonus if the firm achieves the client’s desired result. This partial contingency can also be combined with other AFAs. For example, a flat fee, as described below, could be set for the initial pleadings stage. If the firm then wins on summary judgment, it would be entitled to an additional bonus above and beyond the flat fee established for the initial pleadings stage.
- Phased-Fee AFAs provide a budgetary constraint for each phase of a matter. In a litigation context, this could consist of a set budget for initial pleadings, discovery, pretrial, trial, and appellate services.
- Flat-Fee AFAs set a fixed amount of money for a particular legal service. This is a strict form of budgeting and places a significant amount of risk on the law firm by forcing the law firm to absorb any cost overruns. This AFA is sometimes coupled with a provision that allows a law firm to also track the matter using its normal hourly billing model. If the hourly billing model would provide a cost savings, the firm and legal department split the cost savings between the flat and hourly fee.
- Holdback AFAs allow a client to reserve a portion of the overall fee if the law firm fails to provide the desired result. This AFA, like flat-fee AFAs, allocates a significant amount of the risk to the law firm. However, this type of AFA provides the client with a merit-based metric to use when evaluating legal services.
Prevalence of Alternative Fee Arrangements
The ALM Legal Intelligence report has provided the most thorough and up-to-date analysis of alternative fee arrangements. The statistics were culled from a survey of 200 corporate legal departments and almost 200 NLJ 250 firms. The figures are incredibly enlightening and provide an ability to forecast the future of billing arrangements for legal services. The two most significant statistics are the opinion of firms and legal departments regarding the staying power of AFAs and the rising frequency of reverse auctions for legal services. In a reverse auction, firms compete, often through packaging AFAs, to receive repeat work from large clients.
First, the statistics regarding the projected future of AFAs are enough to drive any law firm to develop a plan for offering AFAs to its clients. The ALM survey found that 88 percent of legal departments and 92 percent of law firms believe that AFAs will remain a permanent part of legal billing. ALM Legal Intelligence, supra at 18. This super-majority is indicative of a legal marketplace where competition for clients is a critical aspect of every law firm’s business model. This principle is supported by 91 percent of law firms, which report that the major benefit of AFAs is their utility to attract and maintain their client base.
Next, the emergence of reverse auctions in the post-economic-crisis legal market illustrates the prevalence of AFAs and will likely drive the creative use of AFAs in the future. A reverse auction is a competitive bidding process that pits multiple law firms against one another and has been employed by Fortune 500 companies like GlaxoSmithKline, eBay, and Toyota Motor Corporation. Patrick G. Lee, “Pricing Tactic Spooks Lawyers,” Wall St. J. (Aug. 2, 2011).The ALM survey found that three-quarters of law firms approached by a legal department to compete in reverse auctions elected to do so. ALM Legal Intelligence, at 24. These reverse auctions focus more on the overall value the law firm can provide through a package of alternative fee arrangements and less on the per-hour billing rate of each firm. These reverse auctions are also one example of the rise of the procurement process in today’s legal market.
Legal Procurement as a Catalyst for AFAs
What is largely unspoken by both law firms and law departments in the discussion of AFAs is that these changes are not being driven from inside the legal community. Law firms and legal practitioners have customarily espoused the view that their services are unique. Before the economic crisis, these views led to general counsels internally managing their legal department’s budget. However, because the economic crisis demanded cost-cutting measures throughout all segments of a business, legal departments have increasingly seen their sourcing methodology challenged by procurement professionals.
Procurement professionals and the procurement process traditionally “focused on the purchasing of raw materials, production items as well as maintenance, repair and operations supplies.” Dr. Silvia Hodges, “Legal Procurement: Sourcing Is a Team Sport,” Bloomberg Law (2012). Procurement professionals are typically tasked with “[t]he identification, acquisition, access, positioning, management of resources and related capabilities the organization needs or potentially needs in the attainment of its strategic objectives.” Dr. Silvia Hodges, “You Better Know Their Names and Understand Their Metrics: Corporate Procurement Influences the Law Firm Selection,” 14 Strategies: J. Legal Marketing, No. 2, Mar./Apr. 2012. Additionally, procurement professionals’ influence in obtaining legal services is usually triggered by cost-cutting directives from senior management. This direction and support from senior management provides the procurement professionals with a broad and powerful mandate.
Given this broad mandate, it is not surprising that AFAs are increasingly sought out in the legal procurement process. A procurement mindset can aid a legal department in “defining the scope of the project, selecting the right supplier, negotiating and structuring compensation, evaluating supplier performance, and leveraging business with preferred suppliers.” Lynn D. Krauss, “I Bought the Law: Purchasing Legal and Other Professional Services,” 14 Strategies: J. Legal Marketing, No. 2 (Mar./Apr. 2012. Indeed, 87 percent of law departments surveyed reported that AFAs were valuable due to their ability to provide cost predictability and transparency. ALM Legal Intelligence, at 12.
When coupling the current prevalence of alternative fee arrangements with the rise of a procurement mindset in legal services, three things become clear. First, law firms and legal departments have already begun to reshape their business relationships to adapt to the methodologies of the non-legal corporate world. The influence of procurement and the competition among firms for clients will very likely make AFAs the predominant legal pricing model. While the prevalence of AFAs should not be seen as the demise of the billable hour, legal departments and senior management will more frequently question why the billable hour is the market standard for legal services. To non-lawyer business professionals, the billable hour appears to be an inefficient mechanism for measuring the value added. Hence, they have increasingly challenged that financial arrangement.
Next, these trends will drive general counsels to reassess some long-standing relationships with their outside legal-service providers. While personal relationships between general counsels and their chosen law firms will remain vitally important, they will no longer be the paramount concern. The search for value will lead general counsels and the procurement professionals they work with to assess relationships for value. Presumably, general counsels will initially seek AFAs from their preferred legal-service providers. If the AFAs acquiesced to, or offered by, their chosen law firms are insufficient to control costs, these general counsels will likely be forced by their management to seek other outside counsel.
Finally, these trends send a clear message to law firms. The edict is that the firms that are the most innovative, creative, and resourceful in designing and offering AFAs will be more successful. Legal-procurement processes will reward those firms that innovate and provide superior client service coupled with value. As the past few years have evidenced, the legal industry is one where those who adapt will thrive, and those that do not will perish. This maxim will likely become increasingly evident in the context of alternative fee arrangements.
Keywords: litigation, corporate counsel, AFA, billable hour, blended rate, contingency, partial contingency, phased fee, flat fee, holdback