The Billable Hour: Putting a Wedge Between Client and Counsel

Like most corporate law departments, DuPont Legal is charged with managing the legal exposure of the company. As part of that task, DuPont Legal assures that the cost of the legal service is proportional to the overall corporate objective for which the legal service is deployed.

To a large degree, corporate law departments, like DuPont Legal, discharge that overall responsibility by retaining outside law firms to represent the corporations. In that context and to meet the expectations of corporate management, the in-house lawyers must review the legal fees charged by those law firms and assure themselves and corporate management that those fees bear an appropriate relationship to the work involved.

That determination continues to bedevil in-house counsel. The hourly rate, by which we mean any time-based amount that is used to calculate an overall fee, even so-called “blended rates” and “discounted hourly rates,” long has been the predominant method by which corporate clients compensate their outside law firms. That subject is closely related to other subjects that often dominate surveys of in-house counsel: value and budget pressures. For example, “[w]hen asked about their biggest management challenges, [respondent general counsel] are not shy about mentioning budgets…. ‘We’re all under relentless cost pressure’”

Of the top five pressing issues that they face, 81.96% of in-house counsel who responded to a survey listed “[r]educing outside legal costs” as among the most pressing. The response achieved a weighted average score of 2.55, the lowest weighted average score of any of the responses. (The lower the score, the higher that response ranked in terms of its pressing nature.)

In addition to the need to control the costs of legal service while relying more than they might prefer on the hourly rate, in-house attorneys face the prospect of periodic increases (often annual) in the hourly rates that law firms charge. More often than not, law firms simply “announce” such increases with little advance notice to the in-house attorney. In some instances, firms even send invoices to clients without mentioning that the fees evidenced in those invoices reflect higher hourly rates.

In-house lawyers find the practice of hourly rate increases particularly problematic and irritating since they face increased budgetary pressures from year to year. It all seems to come down to value: do the law firms’ billed fees reflect value commensurate with the amounts in question? Can a firm’s annual increase in the hourly rates that it charges represent sufficient additional value?

The Value Imperative

The question of how outside counsel fees compare to the value that in-house counsel place on outside counsel’s performance has plagued in-house attorneys for some time. In 1997, in-house counsel graded their outside counsel at 3.4 (out of a highest possible score of 5) as to whether the charges for legal service were commensurate with the value of those services, while the outside counsel gave themselves a grade of 4.3. In 1998, in-house counsel responding to the same survey gave outside counsel a C, while outside counsel awarded themselves a B+ that same year. The gap between the scores awarded to outside counsel by in-house counsel and those that outside counsel awarded to themselves on that measure persisted in annual surveys by that same organization.

For quite some time, authors have explored the idea of using fee structures to create incentives for outside counsel to provide legal service more cost effectively and with a greater direct correlation to the value of the legal service that those fees represent. The actual use of alternative fee arrangements (AFAs), however, has been much less common than one might expect from the extent of its treatment by consultants and others. In a survey conducted in 2001, 78.2% of the respondents reported that during the year 2000, a median of 80% of the total amount of their companies’ outside legal work was covered by standard hourly rates. Discounts from standard hourly rates covered a median of 40% of their companies’ outside legal work for 55.2% of the respondents. For no other type of fee structure did more than 25.5% of the respondents respond favorably and no specific alternative fee arrangement covered more than 10% of the work (median) of those respondents who used that type of arrangement. Thus, despite the interest of in-house counsel, the hourly rate persists. A review of the history of the hourly rate and the interest in AFAs might illuminate the changing role of the corporate law department and how that change might affect how corporate clients identify, select and retain outside law firms.

The hourly rate was virtually unknown, in respect of how law firms billed their clients for legal work, until approximately the middle of the twentieth century. Until at least the late 1950s, clients’ bills did not reflect itemized time records, though the firms were beginning to keep records of how their attorneys spent their time. Law firms’ bills contained no detail and merely charged a single amount “for professional services rendered.” Gradually, management consultants promoted time keeping to law firms, at least in part as a means by which the firms could increase their revenue. By the 1970s, bills increasingly reflected the amount of time spent on clients’ matters and the fees were calculated on that basis alone.

The hourly rate served the interests of both law firms and corporate law departments. For law firms, it led to a “cost plus” arrangement for billing purposes that removed all outcome-related risk from their shoulders. It provided to corporate law departments a convenient proxy for an accurate measure of whether the clients received value commensurate with what they paid for the work. It fit well into an accounting-based approach to managing legal service and therefore was well accepted in the 1950s and 1960s.

Though it did serve, to some degree, the interests of both in-house and outside counsel, the hourly rate has several negative impacts on the costs of legal service and on the relationships between in-house and outside lawyers. The most significant impact flows from the fact that the fee borne by the client will bear no relationship (other than, perhaps, an entirely fortuitous one) to the value of the legal work delivered because the fee is determined solely by reference to the amount of time devoted to the work. The efficiency or inefficiency of the lawyer(s) whose work is covered by the fee will have a greater impact on the size of the fee than the value that the work bears to the client’s need.

Another significant effect of the hourly rate is that it means that the financial component of the relationship between the client and the outside lawyer is a zero-sum game insofar as the client wishes a lower fee and the lawyer prefers a higher one. A client that tries to control the costs represented by the fee can only do so by reducing the number of hours for which it pays or negotiate a reduced hourly rate. Each of those means of reducing costs leads to less reward for the lawyer without changing the dynamics of how that lawyer works and the effort devoted to the assignment by that lawyer. In short, either the lawyer or the client “pays” for the lawyer’s time.

The hourly rate has had adverse effect on the relationship between the client and the outside lawyer and it is a subject that both in-house and outside counsel have frequently tried to avoid in the past. If a client does not want to grant the lawyer and law firm carte blanche to bill inordinate amounts of fees, that client is oftentimes forced to police counsel by after-the-fact invoice review to insure the accuracy of rates, timekeepers and agreed-upon activity. A more acceptable approach would be a prospective or “forward looking” discussion between the client and counsel to insure alignment as to anticipated activity, rates, resources, and costs for the period in question. Under either approach, however, the hourly rate undermines the relationship between counsel and client.

As corporate law departments became more sophisticated, the negative effects of the hourly rate became clearer. Even as in-house attorneys became accustomed to reviewing invoices based on detailed time records, they began to question whether the hourly rate created incentives for outside counsel that were contrary to their corporate clients’ interest in cost-effective legal service. They began to search for ways to more closely align the interests of the law firm with those of the client, at least as to cost effectiveness. Such a fee arrangement would also reflect a closer alignment between the amount of the fee and the value that the legal work represents in the eyes of the client. In the earlier-cited 2001 survey, when asked to rank the five most important things that outside counsel could do to improve the working relationship between inside and outside counsel, 80.37% of the respondents listed “[b]e more concerned with costs.” (The weighted average score for that response was 2.10. 2001 ACCA Partnering Survey, p. 195.)

This concern for the costs of legal service led to various efforts by in-house lawyers, particularly in the insurance industry, which is the largest single aggregate purchaser of legal services, to control those costs. During the 90s, a cottage industry of legal fee auditors arose, at least in part, to relieve in-house counsel of the tedium of reviewing long, detail-packed fee invoices. The use of third-party auditors introduced other issues, such as ethical questions and mistrust between in-house and outside counsel on account of the activities of those third-party auditors. See, for example, Gurnee, “Do audits spell doom for attorney-client relationships?”, Defense Comment, vol. 13, no. 2, p. 3. See also Brennan, “Driven to Defection,” The National Law Journal (May 18, 1998), pp. A1, A27.

In-house lawyers consider the value of the legal service as a necessary, inherent element of the service that they seek from outside counsel. In order to demonstrate that the value exists in adequate proportion, in-house attorneys express interest in AFAs. That interest likely will continue.

That interest stems from several sources. First, as legal fees continued to escalate, in-house attorneys and corporate management both began to question whether the total cost justified the effort, when considered in the context of the specific assignment. In other words, it is not just the total amount of the fee that raises questions, but its relationship to the business matter from which the need for that legal service arose.

Second, the hourly rate leads to focus on the amount of time that the billing attorneys spend on the matter. In order to manage the work, the in-house attorneys must focus on the billing data to such a degree that it can distract them from more substantive review of the work.

Third, the very nature of a review of time records, as reflected in an invoice for legal services, is distasteful to both the in-house and outside attorneys. It suggests that the former will second-guess the work of the latter and it often leads to less-than-pleasant discussions between them.

The electronic submission of invoices for legal services (“e-billing”) can facilitate in-house attorney review of invoices by identifying instances of erroneous billings through arithmetic errors, the use of incorrect hourly rates, the inappropriate addition of timekeepers and even the allocation of time to the wrong matter. Much of the tedium associated with invoice review can be accomplished by the e-billing systems that are now available.

E-billing offers several benefits in addition to the reduction of the tedium that has heretofore accompanied invoice review. It provides in-house counsel greater control of the process by which proposed rate increases of law firms are reviewed and approved. It creates a data-rich environment and allows a far more meaningful and focused analysis of the work completed. Finally, it provides the parties with a platform to advance their dialogue vis-à-vis AFAs.

Can we find an alternative? Clearly a fee arrangement that does not rely solely on the number of billed hours to determine the amount owed the outside counsel (i.e., an AFA) will eliminate or reduce the need to scrutinize those time records. Can we expect inside and outside attorneys to develop AFAs in light of their failure to do so to this point? Yes, with some preparation and a great deal more data than they usually have at hand. To do so successfully, however, they need to understand the importance of approaching the effort in a true “partnering” spirit.

To develop and implement a successful AFA, client and counsel need to share information. What each knows about the assignment and about the most effective means of completing it is very important to the fee arrangement. That information might consist of internal data and prior experience. For example, a client might better understand the firm’s financial needs if it understands the firm’s internal compensation system or the cost structure of the firm on which the firm’s hourly rates are based. Increases in hourly rates are often justified, in a very general, unsubstantiated manner based upon increased costs. Rarely, if ever, do firms substantiate such increased costs or analyze why they are justified in simply passing those increases through to their clients without any meaningful attempt to reduce or ameliorate their impact. Outside counsel should, at a minimum, demonstrate that despite the impact on the client of the increases in his or her costs to provide the legal service needed, he or she has adopted efficiencies or otherwise worked to offset that increase.

Both parties should err on the side of disclosure. Some information that is usually kept secret may not be necessary to designing the fee structure, but disclosing it demonstrates that the disclosing party trusts the other with that information. Such demonstrations of trust can be very effective in establishing the type of relationship the clients and firms want to have.

If outside counsel truly believes that he or she can do the work more effectively than can competitors (and what law firm does not believe that it is the best at what it does) he or she should be willing to put something at risk to demonstrate that. Counsel should also be willing and able to put something on the table that is important to the client, such as certainty as to the fee. The client, as part of the same bargain, should be willing to provide its outside counsel incentive to share the risk of the engagement. This is manifested typically by a willingness to pay a premium to a firm that accepts such a risk and achieves certain agreed-upon goals. If, for example, client and counsel design the AFA to provide the client greater budgetary certainty and that certainty is achieved together with the desired result, does outside counsel deserve a premium in accord with the financial risk that she or he accepted?

Use information about the cost of the service in determining what sort of AFA is appropriate. Don’t simply guess how much work had cost previously and then use that guess as the basis for the new arrangement. To the degree such an estimate fails to achieve the client’s and firm’s aims, it might set them back in their relationship.

Identify benefits and risks for the client and the firm in any proposed AFA. Sometimes risks cannot be avoided (e.g., there is a great deal more work than anticipated, and the firm can’t afford to handle it all for the agreed-on fixed fee). If the client and counsel have acknowledged the existence of those risks and agreed to address them when they (the risks) materialize, client and counsel will be better prepared to do so without rancor or feelings of either one having been undercut by the other.

It is important that both in-house and outside counsel recognize that they might need to review an AFA periodically. Any fee arrangement is premised on certain assumptions and it reflects the circumstances at the time that it is created. Since that context can change over time, sometimes radically, client and counsel must be prepared to revisit the terms of their fee arrangement when circumstances warrant such a step.

As we mentioned, the hourly rate causes the fee arrangement to constitute a zero-sum game between client and counsel. For one to improve its position, the other’s position must be worsened. One step that in-house and outside counsel can take together is to search for creative ways of making the delivery of legal service to the client more efficient. Such a collaborative effort also depends on a mutually supportive or synergistic relationship between them.

A client that has significant economic “clout” may be able to achieve apparent cost reductions simply by demanding that law firms reduce their hourly rates and then monitoring extremely closely the number of hours for which the client pays. That might, however, be a shortsighted approach for at least three reasons. First, that approach exacerbates the “zero sum” aspects of the fee arrangement and it increases the likelihood that the relationship will be adversarial. This cuts against the goal of “partnering” relationships (or even good, old-fashioned client/counsel relationships), in which the client expects its counsel to look out for the client’s interests in more than a very narrow manner. Moreover, a relationship that is premised on a “zero sum” fee arrangement is likely to be a short-lived arrangement.

Second, a firm must remain profitable in order to stay in business. If it charges hourly rates, it can reduce those hourly rates only so far and remain viable. The recent decision by the firm of Brobeck, Phleger & Harrison to disband highlights the financial risks in the legal profession even for firms that, until recently, were thought to be well positioned in the market.

Third, even reduced hourly rates cannot control the overall cost of legal service. Such an arrangement merely puts a premium on the client’s ability to manage the work and thereby minimize the amount of time devoted to its assignments. Cost control via reduced hourly rates therefore has limited utility despite its superficial attraction.

A collaborative search for cost efficiencies by client and counsel is potentially far more effective. It is more consistent with the type of client/counsel relationship that many law departments espouse than is a unilateral approach. Moreover, it enables the parties to explore AFAs that might take advantage of identified efficiencies. If they can successfully eliminate steps or activities previously completed when performing legal service, they can reduce the cost of providing that service. And they do so in a way that does not represent an arbitrary reduction of the fees due counsel. Rather, they can achieve the same legal protection for the client with less expenditure by intelligently streamlining the workload. An example of such efforts might involve a company that, together with two regional employment litigation firms, developed pleadings that were made available to local counsel handling the matters covered by the arrangement. The two regional firms were responsible for the fees charged by local counsel but through the sharing of work product they were able to realize efficiencies in representing that client that allowed them to successfully manage that financial risk. Creative retention, dissemination and re-use of work product constitute an effective cost-control technique.

Further, the discussions about efficiencies may highlight different characteristics of the representation that affect its value to the client. The firm and client should develop a deeper understanding of the work and the value or risk associated with that work, as well as the related challenges. This, in turn, will have implications for the type of alternative fee arrangement that might be appropriate.

By exploring efficiencies, the client and counsel will also investigate possible mutual benefits. How can the client benefit from the fee arrangement? How might counsel benefit? If they can identify different advantages for each of them that do not adversely impact the other, they will have the makings of a workable arrangement that will be self-reinforcing and therefore self-sustaining. Each will have something to gain from the relationship. Neither will have reason to feel unduly disadvantaged.

An effective AFA depends on the ability of the client and counsel to come to terms on a multiplicity of difficult issues. Perhaps even more important, however, is the fact that they may very well have to revisit issues during the course of the relationship as circumstances evolve and change. As a result, it is important that they have a relationship that enables them to address issues that may arise, whether or not anticipated. In other words, they need a healthy, respectful relationship.

DuPont Legal’s efforts to implement AFAs might provide some insights into the difficulties that arise in the course of such an effort as well as some solutions that have enabled us to make some headway in that regard. You should remember that these efforts, despite the success that we may have achieved, are ongoing and evolutionary. We do not believe that our current situation represents the most that we can do and our efforts continue.

The ultimate key to an AFA is to demonstrate an alignment between the incentives available to the outside lawyers and the client’s valuation of the legal matter in question and the resources that will be necessary to its successful resolution. On a tactical level, DuPont Legal relies on the lawyer working on the matter to investigate the possibility of an AFA as well as to design an appropriate one. The in-house attorney must identify those matters as to which our in-house clients would be receptive to a fee arrangement that does not rely on a mechanical multiplication of a number of hours by an hourly rate to determine the final legal fee due the firm. Some of the factors that the in-house attorney will examine include the level of risk that the dispute or litigation represents for DuPont, what the possible return for DuPont might be (this is particularly important in respect of cases in which the company is the plaintiff) and the nature of the exposure that DuPont has on account of the dispute. The last factor might focus on a dispute over a practice that is critical to DuPont’s business, as to which a judicial finding of illegality or liability might be unacceptable.
That in-house attorney, if the matter does qualify for such treatment, then must educate the outside attorney as to the company’s goals for the representation (not relying on simplistic goals like “win”). At the same time, we expect the in-house attorney to educate the outside attorney as to the core values that DuPont Legal wants reflected in the fee arrangement: certainty, efficiency and clear incentives for the outside lawyer.

We have negotiated with the law firms that represent DuPont (the Primary Law Firms, or PLFs, that constitute the membership of the network of firms and service providers that work with DuPont Legal on the company’s litigation) several AFAs. One AFA relates to litigation that involves the drug Coumadin. More recently, we crafted an AFA for some intellectual property litigation.
In every case, we make sure to involve the internal client in the decision to investigate whether an AFA would make sense and, if it would, the final terms of the arrangement. We also revisit the terms of the AFA periodically because the nature of legal work is not static but it changes over time due to many factors, many of which are outside the control of DuPont Legal and the PLFs. Those practices result from our belief in openness, candor and trust, not only between DuPont Legal and the PLFs but also between the lawyers (within DuPont Legal and the PLFs) on the one hand and our mutual clients on the other.

We also try to reward those firms that agree to effective AFAs by honoring them within the PLF Network. This positive reinforcement serves to provide competitive incentives for the other PLFs to attempt to emulate those so honored. We believe that positive reinforcement serves to advance our interest in AFAs much more effectively than would many other ways of pushing the firms in that direction.

Outside lawyers have expressed some frustration at the apparent unwillingness or resistance of some in-house attorneys to AFAs. That unwillingness or resistance might result from any of several factors, like inertia (even in-house attorneys are more comfortable with a known quantity like the hourly rate than an unknown one, such as a to-be-designed AFA) or unfamiliarity. Even in the face of that reaction, however, we believe that outside attorneys will profit from an effort to engage their clients in discussions about possible AFAs for several reasons. Most importantly, they will demonstrate to those clients, simply by raising the idea of an AFA and attempting to initiate a discussion of the issue, an alignment of their own interests with those of their clients. They will also exemplify a concern for the resources that the matter will require, resources for which the client will ultimately pay. Even if, after discussing with a client the possibility of an AFA for the client’s work, the firm bills that client on an hourly rate, the firm and the client likely will discover that their discussion led to a more effective and more efficient representation of the latter by the former on account of the enhanced understanding that the firm realizes about the client's goals for the matter and as to what is most important to the client in the course of the representation.

Increases in the hourly rate

In the context of the need for such a healthy, respectful relationship, law firms’ routine of increasing their hourly rates periodically, whether annually or on some other timetable, can be extremely counterproductive. This results from several attributes of such increases.

First, increases in the hourly rates that law firms charge their clients eliminate any incentive for the firms to be more efficient. Law firms typically justify increases as necessary to allow them to pay higher salaries to their associates. If a firm imposes (or attempts to impose) an increase automatically, it obviates the need for the firm to justify the increases without identifying any efficiency gains that may offset the proposed fee increase. The market for legal services for corporate clients has not relied on competitive pressures to keep charges down.

A good relationship between a firm and a corporate client, which we often refer to as “partnering” and which we at DuPont strive to establish with the members of our Primary Law Firm Network, should be characterized by communication, collaboration, and information sharing. Circulating redacted AFAs is but one example of the type of information that our network partners track and share with one another. Accordingly, DuPont Legal’s Network of Primary Law Firms provides a platform that serves to identify best practices that its members can share for their and DuPont’s benefit.

For a healthier exchange to occur, both client and counsel need clearer communication with respect to issues such as productivity, technology utilization, resource leveraging, increased experience, efficiency and cost considerations that impact their economic health. By clearly addressing such issues, they will establish the basis for the open communication and collaboration that will serve them well over the course of the relationship. In short, greater alignment between the parties will result as to all facets of the litigation.

An AFA should be dynamic, like any good relationship. The unilateral adoption of fee increases by law firms undermines that relationship. AFAs, as opposed to the hourly rate “zero sum” game, underscore the importance of candor, communication and a greater understanding by the parties of each other’s financial interests.

We do not mean to say that law firms, if they bill their clients on the basis of hourly rates, must forever live with present rates. Such an artificial constraint on law firms’ billing practices could result in adverse and unintended consequences for the firms and their clients. Increases in those rates should, however, reflect something other than a reflexive price increase to offset a firm’s inability to control its own costs. Almost every business in America must consider the competitive impact of an increase in its prices for customers before putting such an increase into effect. Unlike most other businesses, law firms profess to look after the interests of their clients almost in a paternalistic sense, yet they often impose rate increases without any apparent regard for the effect that the increases will have on their clients’ finances.

We make the point that law firms should expect to, and their clients should expect them to, justify increases in their hourly rates. A simple statement by a firm that an increase is warranted to keep up with the market is or should meet skepticism at least. Instead, a firm should provide clients sufficient data to establish that the firm has settled on the increase as a last resort and that it has attempted, at least, to avoid the need for an increase through efforts to more efficiently achieve the client’s goals. A firm should make a measured, disciplined, articulated case for any rate increase that it proposes to impose on its clients.

At the same time, it is only fair that clients share information with the law firms about their (the clients’) financial and budgetary goals. If the costs of legal service consume a greater portion of a company’s expenses each year, the firms should know that and work with that client to ameliorate that situation. In short, give careful consideration to each client and the uniqueness of that client. The ability and willingness of the client to assist the firms in various ways should be taken into account as well when approaching the subject of fee increases and AFAs. That assistance could take the form of assisting firms in their own marketing, making referrals to other law departments, for example, or even advertising its success with the firms, as DuPont Legal has done in respect of its Network of Primary Law Firms. Law departments of whatever size can do such things.

Greater transparency between clients and law firms about finances and billing, in both directions, would enable them to achieve firmer, more supportive relationships. Together, they would be able to explore how to more efficiently and effectively deploy the talents of the lawyers (inside and outside) so as to reach the client’s business goals most expeditiously.

Conclusion

The hourly rate is still very much alive. Corporate law departments have a love/hate relationship with it, however, and long for a viable alternative. They think that AFAs are more appropriate for much of the work they assign to outside law firms.

While the hourly rate is still the predominant method of calculating legal fees, law firms should pay attention to its effects on their relationships with their corporate clients. This advice pertains even more strongly to increases in hourly rates. Their impact on the relationship between a firm and its corporate clients can be particularly insidious.

Given the necessity of the hourly rate, however, at least in the near future, it is important that law firms and corporate clients approach it with greater understanding and appreciation for its strengths and its weaknesses. Greater transparency between client and counsel and a higher level of information sharing between them should at least ameliorate the worst impacts of the current reliance on the hourly rate.

AFAs provide a challenge and an opportunity to both law firms and law departments. If those parties can overcome their internal resistance to experimenting with AFAs, they will both discover marketing and other opportunities that will redound to their mutual benefit.

Thomas L. Sager serves as Vice President and Assistant General Counsel of the DuPont Company and also serves as the Chief Litigation Counsel. Mr. Sager helped pioneer DuPont’s Convergence and Law Firm Partnering Program and continues to have oversight responsibility. Through his leadership, this program has become a benchmark in the industry and has received national acclaim for its innovative approach to the business of practicing law. In addition, his responsibilities include oversight for all litigation and IT support. He received his J.D. from Wake Forest University School of Law in 1976 and began his career with DuPont in August of the same year.

Steven A. Lauer is a consultant based in Maplewood, New Jersey. He spent thirteen-and-one-half years as an in-house counsel for four organizations, including one of the largest law departments in the country. He was responsible for litigation management for several business units and associated issues, including counsel selection and management. He was project director for the effort of the Law Department of The Prudential Insurance Company of America to use requests for proposals in its counsel selection process. As a result of that effort, approximately 60 percent of the company’s outside legal service was awarded to eighty law firms. He is Managing Director of Managed Compliance eLearning Services, a joint venture of PLI and Corpedia Education, and he now consults with corporations regarding compliance-related issues, including corporate governance. His telephone number is (973) 763-6340 and he can be reached by e-mail at steven.a.lauer@comcast.net. Until recently, he was Executive Vice President, Deputy Editor and Publisher of The Metropolitan Corporate Counsel, a monthly journal for in-house counsel.

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