Pricing Legal Services: the alternative fee arrangement tipping point

As in-house law departments deal with budgeting pressures, demand for alternative fee arrangements may have reached a tipping point

Alternative fee arrangements were bound to be a conundrum for the legal profession. Historically, lawyers have focused on assessing risk for clients but until recently they’ve rarely had to do it for themselves, let alone manage it. But in the end, that’s what alternative fee arrangements (AFAs) are really all about, at least from a law firm’s perspective.

There was a time when the only real risk for lawyers was whether or not or how quickly they would get paid. So in days of yore, managing accounts receivable got a lot of time and attention as the primary focus of law firms’ risk management efforts.

With the arrival of contingency fees and class actions, good risk management for law firms began to embrace considered judgment about the merits of a lawsuit. On the corporate side, the arrival of success fees meant that lawyers might not get paid if a deal fell through or if their client wasn’t the winning bidder on a transaction.

For the most part, however, the hourly rate ruled at business law firms. And unless the client objected to the rate or the time spent, the risk to the law firm was non-existent. There are those who argue that the hourly rate is a relatively recent invention of the last 50 years or so, and that earlier on lawyers simply “set a fair fee.” But even that fee tended to be set when a matter was completed, and consultation with the client was certainly not de rigueur.

Increasingly, however, fees are not “set” by the lawyers; nowadays, they tend to be the product of negotiation and consultation. To be sure, these negotiations and consultations can focus on or include discussions about hourly rates and their allocation. But that doesn’t make them any less consensual.

The upshot is that regardless of the terminology, the core of the debate about “alternative billing” is found in clients’ insistence on having more say in how their external lawyers arrive at the fees they charge and how much that fee will be.

“We’d like to change the language in this arena from ‘alternative fees’ or ‘alternative billing’ to ‘fee arrangements’ or ‘appropriate fee arrangements,’” says Rick Kathuria, National Director, Project Management and Legal Logistics at Gowling Lafleur Henderson LLP in Toronto. “Clients want to understand how their costs will be determined so they can do effective budgeting with certainty and predictability for legal services that offer good value. It’s not all about cost-cutting.”

That being said, it becomes apparent that an alternative or appropriate fee arrangement can be based at least partly on hourly rates. If that’s correct, it flies – at least at first blush – in the face of the commonly held view that the hourly rate approach faces extinction.

On closer examination, however, that is not correct: what clients object to is not the concept of hourly rates in and of themselves, but what has been called the “billable rate model” in which time spent is not limited. Altman Weil’s 2014 Chief Legal Officer Survey indicates that 43 per cent of CLOs couldn’t care less how their external lawyers arrive at their fees, so long as “they get the results they want at a competitive price.” But efficiency and competitiveness occupy much of the same space. That’s why discounted rates and blended rates are not alternative fee arrangements in a real sense: they provide no incentive for efficiency because they put no limit on the number of hours for which a firm can bill.

That doesn’t mean, however, that hourly rates will become irrelevant from law firms’ perspective. In order to come up with an appropriate estimate of cost that will satisfy the client’s need for predictability, law firms will have to resort to sophisticated project management to ascertain in advance what resources they must commit to get the job done to the client’s satisfaction. But time is one of the important resources they will have to measure, and they will have to assign a value to that resource by estimating the number of hours required at a projected rate to do the work in a profitable way.

At the moment that total time is circumscribed, however, the incentive shifts from billing as many hours as possible to achieving the result in as few hours as possible. Put another way, billable hours and hourly returns are different animals. Law firms will continue to measure their profitability at least partly in terms of the dollars each hour of work generates, expressed as the hourly return. What they will no longer have is the option of simply adding hours and raising rates to maximize returns. Therein lies the risk: fee projections that are off base or hours inflated by inefficiency or unforeseen circumstances will impact profitability. Accurate estimates and efficiency become the baseline.

Those who choose to work longer hours may still be rewarded by way of advancement, bonuses and partnership, but their success will have come from taking on more matters rather than overworking files at clients’ expense. As of January 1, 2015, Jackson Lewis P.C., one of the largest workplace law firms in the world on the management side (780 lawyers in 54 United States locations) and a pioneer in AFAs, stopped using billable hour requirements to measure associates’ performance. The firm’s website cites the motivation for the move as a desire to “further incentivize associates to achieve positive results in the most efficient manner.” Seyfarth Shaw LLP, an international AmLaw 100 firm headquartered in Chicago, also recently announced that hours worked will no longer be an internal measure of performance because they constitute the “wrong incentive.”

 

For our purposes, then, alternative fee arrangements are arrangements that promote efficiency, whether they include a billable hour component or not. But because what constitutes an AFA is rarely defined and has no universal definition, it can sometimes be difficult to ascertain the degree to which AFAs are making headway in the Canadian legal market and elsewhere.

What seems fairly certain is that, although its use is declining, the billable hour model remains the primary fee arrangement in Canada. According to the 2014 Canadian Lawyer Corporate Counsel Survey, the billable hour is still the primary arrangement for 47.3 per cent of GCs, albeit down from 55.2 per cent in 2013. The balance of the 320 respondents relied primarily on a combination of billable hours plus flat fees (30.5), AFAs (7, but AFAs are undefined), flat fees 4.4, RFPs (4.4) and other (6.2).

Under our definition of AFAs as any billing arrangement that promotes efficiency, flat fees, some proportion of RFPs and some proportion of the “billable hours plus flat fees” respondents would qualify as AFAs. Of the respondents who specifically cited AFAs, on the other hand, more than half described their arrangements as discounts, meaning they would not fit within our definition of an AFA. The next favourite AFA arrangements were flat fees quoted on a prescribed scoped, phased or bundled portfolio of work; and capped fees, both of which fit within our AFA definition.

The most that can be deduced from the survey, then, is that true AFAs are filling a meaningful part of the gap left by the declining use of the billable hour model. The evidence from in-house counsel and individual law firms supports that conclusion.

“There’s definitely increased receptivity over two or three years ago, and we have seen an increase in AFAs,” says Emily Jelich of Toronto, Vice-president and Associate General Counsel at RBC and a member of the ACC Value Challenge Steering Committee, who agrees that the term AFAs is used most accurately when the arrangement ties billing to value generation. “Many firms are giving AFAs the old college try, but the difficulty is that they’re doing it in so many different ways.”

Jelich’s preferred type of AFA is “fixed fee by phase” where the underlying assumptions are clearly understood. “One of the great benefits of this approach is that it helps external counsel articulate much more accurately what’s included in a particular phase,” she says.

At York University in Toronto, Director of Legal Services Christine Silversides has been running AFA trials. “We take several examples of one type of high-volume file and run them on different AFA models to see whether there is one model that provides better pricing for that type of file,” she says.

From the law firm perspective, Kathuria says that Gowlings used “something other than hourly rates” for about 30 per cent of its matters in 2013. “It’s been ramping up recently,” he said at press time. “We’re definitely above 30 per cent in 2014.”

For its part, Borden Ladner Gervais LLP has won kudos for its medical malpractice litigation AFA with its longstanding client, the Healthcare Insurance Reciprocal of Canada (HIROC). The arrangement is based partly on a creative configuration of business fundamentals. Among them is a volume of work guarantee measured by number of matters in different classes of matter rather than by hours; insourcing to HIROC’s legal department; use of project management for more complex matters; and a fee arrangement consisting of a base fee and a significant performance factor calculated on weighted indicators that could result in as much as a 30 per cent premium if performance standards are met or a 15 per cent deduction from the base fee if they are not.

The six-year deal between BLG and HIROC, which originated and evolved from informal discussions that began in 2006, is projected to reduce legal fees by some 23 per cent.

“Once we started to collaborate, we found efficiencies that we didn’t know existed, including the efficiencies that come from being able to rely on a long-term commitment,” says John Morris in BLG’s Toronto office. “But the greatest benefit has been the predictability the agreement creates for both sides.”

That’s not to say that the AFA approach has worked for everyone at the firm. “All our lawyers are not necessarily on the same page, but at the same time, the HIROC arrangement has been a great example for other practice areas at BLG,” Morris says. “Our leaders’ view is certainly that this is the way the world is heading.”

McCarthy Tétrault LLP, a forerunner in legal project management, is another firm whose name often arises in discussions about AFA pioneers. “I have found McCarthy to be one of the early adopters of AFAs and project management,” Silversides says. “They brought innovative concepts of this kind to us without our having even asked for them.”

 

Sometimes, however, working with an AFA model demands more than just project management.

After hearing from clients that they wanted the firm to service more of their legal needs, Torys LLP set up a Legal Services Centre (LSC) in Halifax that focuses on certain areas of corporate work, such as due diligence, contract review and corporate reorganization implementation, characterized by repetitive elements. None of the work generated at the LSC will be billed at hourly rates; instead, it will be competitively priced through fixed-fee arrangements that will vary depending on clients’ requirements. Christopher Fowles, who moved to Halifax to run the LSC, expects the Centre, which is currently staffed by three lawyers, to grow to as many as 20 legal professionals in the next 18 months.

While Torys’ self-standing LSC is a first in Canada, using low-cost centres to service AFA-friendly work is not a new concept in Canada. Gowlings, for example, has long used its Hamilton, Ontario, office as a low-cost centre for mortgage remedy and related collection work.

But it’s not just the major firms that have embraced AFAs. Mississauga, Ont.’s Speigel Nichols Fox LLP, a commercial litigation boutique with expertise in business law, including commercial transactions and real estate, tax and collections, is likely the first law firm in Canada to offer flat fees across the board on a case, project or phase of a matter basis.

That should surprise no one who has seen the firm’s plucky website, which unabashedly bills itself as “Big Law Alumni Challenging the Status Quo” and as a group of mostly large firm expatriates “who are redefining the traditional legal model.”

The key to Speigel Nichols’ philosophy is merging the flat-fee approach with what the law firm likes to call customization. “Customizing is all about finding out what clients’ expectations are and meeting those expectations,” explains the firm’s Allison Speigel. “It ranges from how services are delivered, includes how often the client expects meetings to be updated and where they want meetings to occur. All these things affect pricing but as a rule nobody talks about it.”

There’s one other twist. The “flat fee” in litigation matters is actually two fees, each depending on the outcome. “What happens when you combine flat fees with results-oriented fees is that you align the financial interests of the client with the financial interests of the law firm,” says Speigel, who returned to Toronto after five years in New York at Shearman & Sterling LLP and McKool Smith. “What we’ve done changes everything about the firm, including how we pay our lawyers.”

But when it comes to fee-based risk, Toronto-based Conduit Law Professional Corporation, an 11-lawyer firm that provides in-house counsel with lawyers “to address your needs as they emerge within your business” has gone furthest with its unique idea of a “Client Value Adjustment Line.”

It’s very simple: the firm provides a space on each invoice that allows clients to adjust their bill to reflect the value they believe they received. “No questions asked,” promises the firm’s website. “We trust our clients that much.”

And why is Conduit doing this? “We have a continuous incentive to do our best work and to deliver the most value to our clients,” states the firm’s website. “After that, we trust our clients to make their assessment and tell us how we did.”

If that’s not alternative billing, it’s certainly alternative thinking. Some may argue that it’s an invention of necessity, albeit a very creative one.

“What is clear is that Canada has too many law firms, and that’s changed the mentality of the marketplace,” says one veteran corporate lawyer at a national firm in Toronto. “No matter what the account is, many clients have taken on the habit of questioning it.”

Not all clients, of course. “We have a longstanding client for whom we provide the usual menu of business law services, but we also create opportunities for them that they themselves haven’t seen,” says Jon Levin in Fasken Martineau DuMoulin LLP’s Toronto office. “We’ve billed them millions of dollars and they’ve never questioned a single invoice.”

What that demonstrates is that value goes a long way to justifying accounts, whatever their form. Increasingly, however, clients are demanding not just more value but insisting on value delivered in a transparent format, one that allows them to deal with the budgeting pressures that characterize in-house law departments today and that certainty and predictability go a long way to resolve.

“We’re getting to the point where we are requiring that law firms work closely with us to find creative ways to reduce our overall legal spend for the long term,” Christine Silversides says.

 

Nonetheless, many commentators say the process is going too slowly. There is some empirical evidence to support this contention, at least inferentially.

Most telling, perhaps, are several statistics from the Canadian Lawyer survey. The first is that more than one in four GCs “came to a new fee arrangement with their outside counsel” in the last 12 months. But while this statistic suggests that in-house departments are pushing change, another suggests that law firms – despite the innovation that is undoubtedly taking place – are resisting it: of the in-house counsel who are using AFAs, 73 per cent introduced the idea to their external counsel, 21 per cent credited the introduction of AFAs to mutual discussions, and law firms were the protagonists with only 6 per cent of respondents.

Where the divide between client and lawyer becomes most ominous, however, is in this final statistic: 75.6 per cent of respondents said they would be “receptive” if a firm with whom they had not been working proposed an AFA.

Indeed, Michael Roster, Co-chair of the ACC Value Challenge Committee, says lawyers who continue to resist will be bucking what appears to be a decided trend on an international scale.

“Many of the commentators who are complaining that the move to AFAs is really slow are working with averages and in so doing are missing what’s really happening,” says Roster, whose distinguished career has included pursuing the legal marketplace from three separate perspectives as managing partner of Morrison & Foerster LLP’s Los Angeles office, as general counsel to Stanford University and Stanford Medical Center, and as a lay client while vice-chair of Silicon Valley Bank. “There’s a difference between equilibrium and normative truth, and the truth is that many law firms are already doing 20 to 40 per cent of their billings on an AFA basis.”

They appear to have little choice. “Both large and small companies are making significant changes and virtually all of them report that their costs have dropped about 25 per cent as a result of these changes,” Roster says.

Among the recognizable names that have made the most impactful changes is Bank of America, which has moved from no fixed pricing at all to a system in which 85 per cent of litigation costs on matters ranging from individual slip-and-fall cases to class actions are based on AFAs. United Technologies Corporation now requires that each in-house lawyer deliver 70 per cent of the external spend the lawyer supervises by way of fixed cost.

Things are moving even more quickly in the UK. A recent Legal Week survey of 1,400 in-house counsel found that clients “are increasingly rejecting the chargeable hours model and instead demanding fixed pricing for work.” The number of respondents who listed fixed fees as their preferred billing option rose to 69 per cent from 47 per cent the previous year. Hourly capped rates were the second most popular billing method, and fixed fees with a success premium rose from 9 per cent to 17 per cent. Just 12 per cent of in-house counsel preferred chargeable hours.

“It’s important to appreciate that pricing pressures in the UK, which are much greater than in the US, have led to a much wider adoption of the fixed-price model,” says London, UK-based Tony Williams, principal of Jomati Consultants LLP.

To be sure, the heightened pricing pressures in the UK are to some degree a reflection of the enactment of the Legal Services Act and more particularly the advent of alternative business structures (ABSs), which has forced many law firms to reconsider their business models as a whole.

“In the US, law firms are constrained to be law firms, so innovation may not be happening quite as quickly,” says Malcolm Mercer, a partner in McCarthy Tétrault’s Toronto office.

But ABSs may well be making their way to Canada. Mercer heads the Law Society of Upper Canada’s legal task force that examined Ontario’s legal market. The group’s initial report made it clear that the status quo is not a viable option and recommended several ABS models as a basis for further consultation with the Bar. In February 2014, LSUC voted to proceed with such consultation.

Mercer is also a member of the Canadian Bar Association’s Legal Futures Task Force, whose August 2014 report mimicked the LSUC report in its insistence that the status quo is not a viable option for the profession.

There is, of course, no certainty when or whether ABSs will become a reality in Canada. Regardless, all the evidence suggests that AFAs are already here — and here in force.