In Part I of this article, I identified some popular misconceptions about fee arrangements, and cautioned that clients and law firms must be cautious in implementing any fee arrangement, whether hourly rates or fixed fees. Here in Part II, I outline an approach to weighing the pros and cons of fixed fees and hourly billing in light of the circumstances of the case, the client, and the law firm. The touchstone for any fee arrangement should be to provide legal services in a way that generates the most value and satisfaction for the client.
Advantages And Disadvantages
Anyone considering hourly billing versus fixed fees should be well versed in two dimensions along which these fee arrangements differ most dramatically. First, hourly billing and fixed fees create different incentives for effort on the part of outside counsel. Second, they offer clients and counsel different doses of risk.
Incentives for effort
Fixed fees and hourly billing have almost opposite effects on the incentives for outside counsel to devote time to a matter. With hourly billing, the risk is that outside counsel will spend too many hours on the matter. Hourly fees can also mean that law firms have a disincentive to develop time-saving innovations, such as document management and knowledge-sharing tools.1
With fixed fees, the risk is that outside counsel will spend too few hours on the matter. A low number of hours, of course, is not necessarily a problem in itself. The danger is that fewer hours means lower quality. Whether it is legal research, due diligence, document review, brief writing, deposition preparation, or negotiations, legal work is time intensive. More hours worked usually means a better product in the end.
Less obviously, fixed fees also affect the incentives of the client. When negotiating a fixed fee, the client has an incentive to understate the complexity of the case.2This allows the client to obtain the legal services for a lower fixed fee, while placing all of the risk of increased complexity on outside counsel. Outside counsel may also fear that in-house counsel will "overextend" their fixed-fee arrangements by interpreting them to cover more work than originally intended. According to a survey conducted by LexisNexis, one in five attorneys in private practice reported that their corporate clients overextended their flat-fee agreements.3
These concerns can best be addressed if there is a strong relationship of trust and communication between the client and outside counsel. Outside counsel who has a client's trust can be relied upon not to work excessive or insufficient hours. And when in-house counsel carefully communicates information about the matter at the outset, it protects outside counsel against overextension of the fixed fee.
Communication and transparency should be established from the outset. This is very important for fixed-fee arrangements, because developing the engagement letter for a fixed-fee arrangement requires a greater amount of planning by client and outside counsel.4The scope of what is and is not covered by the fixed fee must be clear, in order to avoid later misunderstandings. Client and counsel should think about the contingencies or possible complications that would lead them to revisit the amount of fees - for example, outside counsel will need the assurance that if a case grows significantly in complexity, there is a "safety valve" in the engagement letter.5And when outside counsel can trust the client to be flexible when the circumstances warrant, then the client can trust the law firm to offer a lower fixed fee up front.6
Effect on risk
In every matter, there is a risk that it will either be much faster and simpler than anticipated, or much more time-consuming and complex than estimated. Both hourly fees and flat fees allocate this risk between the client and outside counsel, but they do so in very different ways. Hourly fees place most of the risk on the client. If a matter ends quickly, the client reaps the savings. If it drags on, the client bears the costs. The risk that the law firm bears is uncertainty about its total remuneration for the matter.
Flat fees, on the other hand, provide greater cost certainty to clients. But while fixed fees lower risk for the client, they raise risk for the law firm. If the law firm overestimates the time required to handle a matter, a fixed fee can be a boon. But if a matter becomes more complex or contentious than expected, the law firm's costs could rise substantially. For this reason, law firms offering fixed fees will demand higher fees, on average, to compensate for the greater risk.
Indeed, fixed-fee arrangements, if not properly designed, can be disastrous not only for the law firm, but for the client as well. Imagine a fixed-fee arrangement that does not allow a higher fee if the case turns out to be unexpectedly complex. When the case becomes unexpectedly complex, the law firm must bear all of the unexpected costs. This might seem like a windfall for the client, but what will the law firm do when its bottom line is threatened? It will face the Hobson's choice of breaching the fixed-fee contract by withdrawing from the case, or reducing its investment of resources into the case, perhaps by trying to settle the case as fast as possible, on whatever terms necessary.
The best approach involves some sharing of cost risk between the client and outside counsel. An example of this is K&L Gates' experience working on a fixed-fee basis for Brunswick Corp. Following the first year of representation, the fixed-fee contract had to be modified in order to provide more protections for the law firm.7A provision was added that provides a ceiling on fixed fees and switches a case to hourly billing if that ceiling is met.
When Are Fixed Fees A Good Idea?
In considering a fixed-fee arrangement, in-house and outside counsel should consider the three ways in which a fixed-fee arrangement must succeed: it must work for the case, it must work for the client, and it must work for the law firm. This requires a candid conversation between lawyer and client about their respective views of the case and of their own attitudes toward costs and risks.
The Case
Fixed fees aren't right for every case. Certain types of cases are better suited for fixed-fee arrangements. They work best when the client has a large number of similar, but separate, cases. In this situation, it is easier for the client and the law firm to have confidence that while some cases will be straightforward and others will be complex, costs will average out over time. Further, the client can assure itself that its outside counsel are working efficiently by looking at the performance of the law firm over a large number of cases. Fixed fees for routine matters have been utilized for years in some industries, such as insurance.8
On the other hand, unique or high-stakes litigation is rarely, if ever, suited for a fixed-fee arrangement. In unique cases, it will be difficult if not impossible to know at the outset how the case will unfold. Estimating costs at the outset may not be realistic. Further, since the likely outcome of a novel case is unknown, the client cannot simply look at the outcome of the case to judge whether the lawyer vigorously pursued the case. Finally, high-stakes litigation is ill-suited for fixed fees because both certainty and cost-savings must take a backseat to doing everything appropriate to obtain a favorable outcome for the client. Hourly billing is ideal for high-stakes litigation, because there is less concern that the law firm will spend too much effort on the case - the client wants outside counsel to spend as much effort as possible.
Of course, many cases fall between the extremes of routine litigation and unique, high-stakes lawsuits. In these cases, the twin concerns of cost and performance remain. Counsel and client should ask themselves, "Is this a case where we can reasonably estimate how much work is required?" and "Is this a case where maximum effort is required, or should we incentivize outside counsel to economize on effort?"
The Client
The client must be comfortable with the fee arrangement in the matter. For some clients, the overriding concern is cost certainty, while other clients may be willing to accept some cost uncertainty in exchange for the benefits that hourly fees provide. Different clients also have different amounts of information available to them about their matters.
A client who has a large amount of information about a case at the outset is going to be in a better position to estimate a fair fixed fee than a client who has relatively little information early in the case.
Further, different clients will have different comfort levels with the fact that a fixed- fee arrangement, even for the client, may feel like a gamble. If a complex case ends up settling surprisingly easily, the law firm will make a seemingly big profit. Some clients may feel uneasy about this, even though in reality the big profit on that case simply balances out the losses that the law firm suffers when a fixed-fee case ends up in a long and expensive trial. But if either the client or the law firm is going to seek to re-negotiate a fixed fee if a particular case yields savings for the other, a fixed fee may not be desirable in the first place.
The Law Firm
Just as clients have different degrees of tolerance for unpredictable costs, law firms have varying degrees of tolerance for risk. Fixed fees bring counsel the risk of working longer hours than anticipated, leaving them unable to be profitable in the matter or complete other work.
Firms that offer fixed fees, therefore, must take steps to control that risk. One way that a law firm can control this risk is by taking on a diversified portfolio of fixed-fee matters. The unusually complex cases will be balanced out by the relatively simple cases. But this makes it hard for firms to dabble in fixed fees - it is unlikely that the highs and lows of billing will average out across only a small number of cases.9Some firms, therefore, will decide it is not worth the investment to develop a fixed-fee practice.
Other firms, however, will have to be proactive in developing their fixed-fee practice in order to attain the scale of work needed to control the risks that it presents. This requires ensuring that incentive structures within the firm, such as partner and associate compensation, reward attorneys for working on fixed-fee matters. Firm leadership should also train its partners to communicate effectively with clients about fixed fees and to develop information-sharing systems so that the costs of cases subject to fixed-fee arrangements can be accurately estimated.
Another way in which law firms can both reduce their risks and increase efficiency in fixed-fee matters is by disaggregating their services - breaking them down into discrete units, some of which may be offered on a fixed-fee basis, and some of which may be outsourced rather than provided by the firm at all.10Once the law firm's services are disaggregated in this way, the firm and client can decide which entity will be the most cost-effective provider of the service and what is the appropriate billing arrangement. The rapid growth in both complexity and expense of electronic discovery and document review, in particular, has led many firms to rely on outside vendors and consultants in order to become more efficient.
Conclusion
Fixed-fee arrangements are not right for every case. When they are a sound option, both the client and outside counsel must be willing to make an investment in defining the engagement in a way that protects both the client and the law firm from excessive risk. But experience has shown that fixed fees can be used to achieve efficiency and cost predictability. Successful fixed-fee arrangements require a strong relationship between the client and outside counsel. Communication and trust, which permit open dialogue as the matter evolves, are the essential elements.
1 Judith S. Kaye and Anne C. Reddy, "The Progress of Women Lawyers at Big Firms: Steadied or Simply Studied?" 76 Fordham L. Rev. 1941, 1963 (March 2008).
2 Poonan Puri, "Taking Stock of Taking Stock," 87 Cornell L. Rev. 99, 121 (Nov. 2001).
3 LexisNexis, State of the Legal Industry Survey at 23 (http://www.lexisnexis.com/document/ State_of_the_Legal_Industry_Survey_Findings.pdf).
4 Although written engagement letters are a standard practice with hourly billing, they are essential for fixed fee arrangements. ABA Committee on Lawyer Business Ethics, "Report: Business and Ethics Implications of Alternative Billing Practices: Report on Alternative Billing Arrangements," 54 Bus. Law. 175 (Nov. 1998).
5 See Charles S. McGowan, Jr. and Esteban Herrera, Jr., "Alternative Fee Arrangements: Time for Consideration," 43 La. Bar. J. 466, 467 (Feb. 1996).
6 Amanda Royal, "Orrick-Levi Strauss Deal Underscores Growth of Alternative Billing," Law.com (Nov. 29, 2009) (http://www.law.com/jsp/article.jsp? id=1202435773922) ("One interesting phenomenon when we started asking for bids for fixed fees: The lowest bids we got were from firms that worked with us before and knew us and had a trust relationship - they knew that my policy was to protect the firms' profitability," according to the General Counsel of Cisco Systems Inc.).
7 Ameet Sachdev, "Understanding the flat-fee contract for legal services," Chicago Tribune: Chicago Law Blog (http://newsblogs.chicagotribune.com/ chicago-law/2010/01/understanding-the-flatfee-contract-for-legal-services.html).
8 See Charles Silver, Flat Fees and Staff Attorneys: Unnecessary Casualties in the Continuing Battle over the Law Governing Insurance Defense Lawyers," 4 Conn. Ins. L. J. 205, 217 (1997/1998).
9 Ed Wesemann, "Managing Your Practice: Alternative Pricing: Full Circle," 70 Or. St. B. Bull. 38, 39 (May 2010).
10 Milton C. Regan, Jr., and Palmer T. Heenan, The Disaggregation of Legal Services, 78 Fordham L. Rev. 2137, 2139 (2010).
Published May 2, 2011.
