The silver lining for law firms in the recession may just turn out to be alternative pricing.  For years, sophisticated managing partners have realized that changing the basis for pricing legal services could enhance profits more than any other available action.  The only problem was that neither their lawyers nor their clients were willing to move away from the billable hour.  In large measure that problem still exists but now everyone appears willing to at least discuss the concept.  So if alternative pricing is such a good idea, how do we go about selling it to all the parties involved and using it without losing profits?

A Short History of Legal Pricing
If, for the sake of discussion, we consider alternative pricing to be anything other than billing by the hour, then the hourly rate has enjoyed a rather short and ignoble rein as the standard for the legal profession.  Traditionally, lawyers charged clients on a fixed fee or retainer basis.

Typically, the lawyer would charge a retainer at the beginning of an engagement and then make a subjective judgment as to the appropriate fee upon completion.  While lawyers would joke about the fee being based on the weight of the file times the wealth of the client, in reality it was a judgment of fair compensation for the value of services provided.

Then, in the 1960’s and 70’s the size of law firms increased rapidly with the growth of the complexity of matters.  As everything got bigger, it became more difficult for billing partners to accurately assess the activities of a large number of lawyers involved.  As firms moved to a quantitative standard of charging by the time expended, they found that their revenues increased dramatically and law firm leaders fought with their partners about keeping accurate records of their time expended.  The popularity of billing by the hour was supported by technology, first through “one-write” record books, then electronic accounting machines and, eventually, computers until it became the pricing standard for the legal profession.  But in the 1980’s the shift to the billable hour came under attack on several fronts.  Legal ethicists became concerned about what they saw as an inherent conflict of interest in hourly based fees that could drive lawyers to being purposefully inefficient in the pursuit of profit.  Consultants warned firms that charging by the hour was akin to butchers charging by the pound and it gave way to viewing professional services as commodities.  Worse, it made it more difficult to tailor a bill to effectively reflect the aggregate of complexity, unique legal issues, time constraints and the myriad issues that the Code of Professional Conduct allowed lawyers to consider in setting their fee.  By the time the ABA Section on Legal Economics (the predecessor to the Section on Law Practice Management) published the book Beyond the Billable Hour in 1989, it was generally agreed that the use of time expended as the primary consideration is setting price would be dead in the near future.

Fast forward to 2009 — 20 years have gone by and the swing to alternative billing methods has been nowhere close to the immensity predicted.  The reasons are quite basic.  Lawyers are lazy when it comes to administrative matters.  If billing decisions can be made by a computer based on objective factors, it makes their life easier.  Further, clients, especially general counsels at institutions and large corporations, have themselves been reluctant to embrace alternative billing because it makes their efforts to control costs less demonstrable than a negotiated discount from an hourly rate.  But perhaps the most significant barrier to alternative billing has been law firms’ resistance to change.  Hourly rates are the norm and we are comfortable with what is considered normal.

A Shift to Alternative Billing?
It will take a couple of years for the legal profession to clearly observe whether the current interest in moving away from billable hours is just window dressing by all parties involved in the legal billing process or if there is a true shift in the pricing of legal services.  We are, in fact, seeing some movement.  In last Friday’s Wall Street Journal, K&L Gates said that 30 percent of their revenues come from alternative fees (although that may be somewhat effected by a significant overseas practice where fixed fees are more widely used).  But, at the same time, some general counsels who advocate fixed fee billing want the best of both worlds by demanding approval of staffing and access to lawyer time sheets.

After setting all of the arguments aside, the greatest profitability tool that law firms have available to them may well turn out to be the ability to separate revenue from operating costs.  That is, use efficiency and productivity to increase profit — and that is the primary benefit of alternative billing.

However, as many firms have experienced, using alternative billing methods requires law firm leaders to do more than just encourage their use.  Intent and desire are important, but to make alternative billing work it takes implementation, which, for management, translates into five specific actions:

1.  Benefit from the law of large numbers.   To assure profitability, any form of alternative billing must involve enough cases to balance out the potential for losses and unique situations.  Both fixed fee and contingent fee cases (the two basic forms of alternative billing) present the risk that the cost of providing legal services will exceed the revenue from a matter.  Unfortunately, the tendency of most firms is to stick their toe in the water and experiment with a limited number of alternative fee matters.  This almost guarantees that a firm will lose money on its investment. The balancing factor is that, over a large number of cases, there will also be at least an even number of situations where the matter is completed with less of a time investment than estimated.  Therefore, alternative fees don’t work for one-off or unique matters.  The more cases involved, the more proficient the firm becomes in estimating cost, managing resources and hedging risk.

2.  Active leadership support.  It is the job of law firm leaders to get their partners to do what they don’t want to do on their own and nowhere is that more true than in trying to institute a program of alternative billing.  To make alternative fees work, leaders must be active and aggressive supporters and not allow passive support to come off as damning with faint praise.  In leading lawyers, it is not sufficient to simply say what is expected of them.  To accept and support firm objectives, lawyers must know the reasons for support and how it will benefit the firm.  In the case of alternative fees, it is the job of firm leadership to articulate how moving away from hourly rates will help the long term success of the law firm.

One firm that is particularly committed to moving away from hourly billing requires that partners discuss pricing alternative with clients for every engagement.  The purpose is to demonstrate the importance of the issue to their lawyers while helping clients become comfortable with the options of fixed and contingent fees.

3.  Skills training.  Lawyers are very good at quickly acquiring information.  But working with alternative fees requires the ability to effectively discuss fees with clients, create cost estimates and evaluate contingent fee cases.  These are skills that are developed through hands-on experience, practice and coaching.  If a firm is going to be serious about alternative fees, it must permit its lawyers to hone these skills without putting large amounts of firm revenues at risk while they attempt to learn on the job.

4.  Share the risk.  While compensation systems may not be able to motivate partners to take specific actions, they can certainly de-motivate them by presenting a disproportionate risk/reward situation.  Lawyers make judgments on what the firm values based on the compensation system.  If the partner remuneration plan puts a greater penalty on revenue losses in alternative billing situations than the rewards for wins, it quickly becomes clear what the firm values and lawyers will act accordingly.   The focus must be on the reward for the positive result even though there may be a counterbalancing penalty for negative results.

5.  Institutional learning.  The culture of many law firms is to not dwell on failures so as to not embarrass the partners involved.  However, in dealing with contingent and fixed fees, having an affective feedback system that allows all partners to learn from prior experience is integral to building the ability to management a profitable alternative billing practice.  The firm must use its technology to measure actual time compared to estimated time — not to punish people for being inefficient but to constantly refine the ability to create accurate estimates.  And the firm’s performance on all forms of cases must be openly available for analysis and learning.

Take Away
Firms can react to alternative fees in two ways.  They can view them as something that their clients are demanding and go about compliance without enthusiasm or creativity.  The result, predictably, will be a loss of revenue, a decline in profitability and, in all likelihood, the loss of clients.  The alternative is to recognize that fees based on factors other than hours represent the opportunity for greater profitability than could be achieved through attempts to increase billable hourly performance and raise rates.  The ability to manage the balance of productivity and legal outcome allows the best managed firms to enhance client satisfaction and build sustainable profitability, even in the most competitive environment.

This time, are alternative fees here to stay?  Yeah, I think they are and you probably want to get out in front of this.