One of the revolutionary changes occurring in the legal industry in the wake of the 2008 financial crisis has to do with the pricing of legal services. For the entirety of the post-World War II period, legal services have been provided under an hourly rate structure. There have been some limited exceptions, such as personal injury contingent fee cases and fixed-fee municipal bond financings.
However, during the past four years, the percentage of legal work performed by the larger American law firms under an arrangement other than an hourly rate structure has more than doubled, and this trend, I believe, will become a permanent fixture in the legal industry.
Alternative Fee Arrangements (AFAs) is the fashionable label for legal work performed for compensation determined on some basis other than hourly rates, and the different permutations under that umbrella are seemingly limitless (a recent author enumerated something on the order of 25 different AFAs). In order to provide a basic analytic framework for exploring AFAs, we can begin with the following simple description of AFAs, as divided between litigation and transactional practice areas:
Litigation: Contingent/Reverse Contingent Fees
From a plaintiff counsel’s perspective, fees payable are a percentage of damages recovered through trial or settlement. In the context of defense litigation, this is an arrangement where the law firm and the client agree at the outset upon the true exposure for the client from the subject litigation and the firm is awarded a percentage of the difference between that agreed-upon exposure and the eventual outcome (assuming, of course, that the outcome results in payments by the client at trial or through settlement below the agreed-upon exposure).
A hybrid of these arrangements for many large firms is the performance of services on an hourly rate basis, billable monthly, in the traditional manner but at hourly rates substantially below the normal rates, with a success fee premium to the firm in the form of a percentage of any successful result for the client.
Transactional: Fixed Fee
A fixed fee is agreed upon at the outset of the engagement by the firm and the client, and it is payable irrespective of (a) the number of hours spent by the firm’s service providers in fulfilling the engagement and (b) whether the transaction closes.
Success Fee
Either a fixed-dollar amount or a percentage of the value of the subject transaction is agreed to as the prospective fee, which is paid to the firm only in the event that the transaction closes.
So, as they say, what’s in it for you? The immediate catalyst for the explosion of and, in the case of many corporate general counsels, insistence upon AFAs was the imperative in corporate America to reduce operating expenditures of whatever type. CEOs no longer tolerate the traditional exclusion of legal budgets from the dictates of corporate cost-containment and project-management protocols. While reduction in overall legal spending may be a result of AFAs (my expectation is a modest reduction in overall legal expenditures), two other rationale for (and benefits from) AFAs are, in my view, more profound and will result, if not in substantially lower legal costs for corporate America, in a more rational and value-added legal-fee environment.
First, clients welcome the clarity and transparency that result from AFAs as the uncertainty surrounding the cost of any particular legal engagement is reduced (if not eliminated). When the legal fees to be paid in a matter are fixed to a sum certain at the outset of the engagement or relegated to a percentage of damages recovered (or avoided), the client can take comfort that the legal engagement will not drag on forever and generate burgeoning, unquantifiable legal costs.
Apart from clarity, the risk allocation between the law firm and the client is dramatically transformed in AFAs. In the traditional hourly rate environment, not only are there structural disincentives for law-firm efficiency and project management, but the client is shouldering the majority (if not the entirety) of the risk of an unsatisfactory outcome. Where the client’s obligation to pay for legal services is tied to the result (either successful litigation or a transactional closing in our simplistic template outlined above), then the law firm is obviously collaborating with the client in terms of shouldering, to a large degree, the risk attendant to the subject engagement.
While not a panacea for all of the frustrations clients encounter in dealing with legal difficulties, and while in many instances it is actually inertia on the part of clients that impedes the pursuit of AFAs, AFAs do offer clients transformational opportunities to assuage justifiable fears with respect to the management of legal expenditures and attendant risks.
David Smith is a member in Stoll Keenon Ogden’s Lexington office. He serves as co-chair of the business services practice.