A frequently asked question by law firm leaders: “Should our firm invest in training  partners to deal with alternative billing proposals, or is this just another ‘flavor of the month?’”   The answer to both parts of the question is yes.

It’s not surprising that alternative billing is on firms’ collective minds.  It is all the rage at the moment as indicated by the current headline on the webpage of American Lawyer: “… Alternative Billing Will Become Rule, Not Exception.”  Firms with RFPs from Fortune 500 corporate clients routinely find themselves required to quote a fixed or contingent fee alternative to the normal hourly rates.  And, Alternative Billing is among the most frequent topics for law practice seminars.

It is the job of corporate general counsels to constantly seek ways of reducing legal costs and the recession has caused boards of directors to put even more pressure on their legal departments to reduce their budgets.  If alternative billing provides a means of cutting legal costs without adversely affecting the services delivered and the results obtained, clients would be crazy to not pursue it.

But I’m not convinced that this apparent acceptance among large legal buyers is the game changer it’s being portrayed as by the media and some consultants.  This is the 20th anniversary of the publication of Beyond the Billable Hour, the ABA book that opened the alternative billing debate. Since its publication, the legal profession has been through unprecedented economic upticks and at least three significant recessions.  Yet, alternative billing has not progressed beyond the level of an emerging trend.  When it comes to the pricing of legal services, there are three motivations affecting both the sellers and buyers of legal services.

1.  Lawyers are risk averse.  Much is made of alternative billing shifting the institutional risk from the client to the lawyer but, in fact, the risk lawyers are most concerned with is their personal risk.  In many law firms’ compensation systems, the greatest risk to the billing lawyer is appearing to lose money on an engagement because the value of the time required exceeded the amount of the fee.  In fact, for most lawyers operating under a large law firm’s compensation system, the risk of losing money outweighs any potential benefit from overestimating the fee and creating a profit.  The same is true on the client side — a general counsel may be far more open to board criticism for agreeing to a fixed or contingent fee that ends up being way too high for the actual amount of work that was required, than for saving money on a matter that requires outside lawyers to do more work than they anticipated.  In short, protecting from the negative is often more valued than achieving the positive.

2.  Lawyers like to be in control.  When billing by the hour, both the lawyer and client have the ability to observe the pricing of activities going into an engagement at the most granular level.  For the client seeking to provide a highly frugal board with evidence of cost cutting efforts, an alternative fee doesn’t clearly demonstrate that the legal department has actually reduced costs.  One could only show an absolute savings if there was a comparable hourly fee.

But when being billed by the hour, a general counsel can demonstrate that he or she negotiated a high percentage discount off of normal hourly rates.  The same is true for the law firm.  Understanding exactly what its rate discount and profit will be going into an engagement permits the firm to, at least theoretically, shave margins more carefully.

3.  But, in the final analysis, the truth is that lawyers are inherently lazy when it comes to administrative activities like preparing and receiving bills.  Developing a fixed fee or contingent pricing requires a great deal of planning and analysis by both the law firm and the client.  Worse, managing engagements to a predetermined budget requires a lot of non-billable work that may or may not be considered in evaluating a lawyer’s performance.  What it comes down to is that we’ve all got billing by the hour down to a science, so it is easier to stay with what we know.

All in all, there will continue to be a lot of talk about the move toward alternative billing but I suspect that when the dust settles sometime late next year, billing by the hour will still be the standard.  However… given all of the disincentives to move toward alternative billing, there is one driving issue that should cause law firms to develop their fixed and contingent fee billing capabilities, regardless of what clients may or may not demand.

Over the past ten years, the profits of the AmLaw firms have increased by a compounded average growth rate of 8.8 percent.  During that period, increases in leverage (largely due to the creation of non-equity partners) have mainly been offset by corresponding drops in margin.  The result is that the primary driver of profits during one of the largest periods of growth in legal history appears to have been increases in hourly billing rates by an annual average approximating 12 percent.

Will everyone who believes that law firms can continue to raise rates at an average of 12 percent please raise their hand?  If your hand isn’t up, you may find that your best option is to find a means of pricing that allows you to better manage the cost of providing services and thereby increase margin (the amount left over to pay the partners when all the expenses have been paid).  I submit that, for law firms that are capping out on their hourly rates, a change in the economic structure for the delivery of legal services may be their best option… and that probably means alternative billing.

There is another option for some firms.  I’ll talk about that next month.

And…

Two other things to consider at year end.

1.  Some firms will be coming off of a very tough 2009.  The leadership of those firms may have to consider whether they are better off attempting to mitigate the damages this year or position the firm for a positive 2010.  Firms that are attempting to look attractive for laterals or position themselves for a possible merger, may be tempted to maximize revenues for 2009 (you know what I mean — keeping the books open until December 35th).  From my perspective, it is rare that the dollars involved are sufficient to justify shifting the revenue.  In the middle of next year it is doubtful that a swing of ten or twenty thousand dollars of profit per equity partner is going to be material to anyone’s thought process.  But being able to show an improvement in 2010 over 2009 — even by a little bit — may be important next December.

2.  Figuring out what to pay non-equity partners for 2009 may be a tough decision for some firms.  As the number of non-equities increased, their compensation often evolved into a fixed salary plus a bonus based on the success of the firm.  If it is a good year, the non-equities benefit.  If it is not a good year, they still get their base without penalty.  Your firm’s magnanimity over recent good years may have vastly exceeded what was originally intended for non-equity partners.  This might be a good year to correct the situation.