Alternative Fee Arrangements: What's Holding Us Back?

Monday, October 4, 2010 - 01:00

Edgar Meza

Fred Loya Insurance (Courtesy of LexisNexis CounselLink)

One might assume from all of the discussion and excitement around Alternative Fee Arrangements (AFAs) that such arrangements have become the norm in the U.S. legal services industry, making the billable hour an endangered species. On the contrary, the billable hour model remains dominant and, while discussion of AFAs is certainly on the rise, they remain little used and poorly understood.

According to data generated from LexisNexis CounselLink, an e-billing and matter management solution that helps corporate counsel manage their legal spend and seamlessly collaborate with outside counsel, just 15.9 percent of law firm fees billed to clients in the first six months of 2010 were invoiced according to rules of AFAs.

It's important to note, however, that there is clearly a directional trend toward AFAs in the marketplace. According to the CounselLink solution, in the first six months of 2008, 3.9 percent of law firm fees were billed according to AFAs, and the number climbed to 10.5 percent in 2009. So although the use of AFAs is smaller than might be expected given the industry hype, it's also true that the use of AFAs has been growing rapidly in the past 24 months.

Still, if more than four out of every five dollars in law firm invoices are being calculated based on the billable hour, the question must be asked: What's holding us back?

The AFAs Revival

As more experts have weighed in on the AFAs model over the past year or two, it's often pointed out that AFAs were actually the standard compensation formula for law firms until about 40 years ago. It turns out that, for decades, pretty much all law firm invoices were calculated in a similar way. The client approached the firm about a specific legal need, the lawyer would deliver the appropriate services, then the firm would write out a bill for services based on the value they believed was delivered. With rare exceptions, the client would pay the bill and the case was closed. The belief was that the marketplace would determine the range of fees that could be charged by law firms, based on the value that clients felt they received from the various firms they used.

Over time, legal services became slightly more commoditized as litigation-weary corporate clients sought a better way to quantify what they might expect to pay for the work and the value they were getting. Many believed the amount of time spent on certain types of cases was fairly predictable based on the same types of matters for which they had sought outside counsel in the past. There was a gradual trend in the 1960s and 1970s for clients to start determining what an hour of time was worth to them and to better quantify what they were buying.

The billable hour then gave rise to a new "de facto" business model for law firms in which the firms assigned an hourly rate based on the experience and expertise of the individual attorneys in their firm. Unfortunately, for the past few decades, law firms have consistently raised their hourly billing rates every year in order to better compensate their partners and fund their own business development initiatives. Clients have seen their rates continue to rise but have often concluded they were receiving the same level of service as the year before.

The result of this unsustainable trend has been the revival of AFAs. AFAs come in various shapes and sizes, with the most common examples including fixed fees, project milestone fees, commodity-priced fees, bonus fees, contingency fees or volume discount fees. The common thread is that AFAs move away from lawyers billing for their time on the clock and instead revolve around how clients and their outside counsel choose to share the risk in an engagement.

Our Commitment To AFAs

Fred Loya Insurance started as a single-office insurance agency in El Paso, Texas, back in 1974. The agency enjoyed steady growth and, in the 1990s, the Loya family decided to expand the business by working with multiple brokers that operated under their ownership. In 2000, sensing that there was a market opportunity in the Southwest for a Hispanic-owned insurer to serve Hispanic clients, the company's management team made the strategic decision to form their own insurance company.

In 2010, Fred Loya Insurance is now licensed as an auto insurance carrier in seven states and writes more than $400 million in premiums. The company employs more than 2,600 people, including the claims department team that I manage, and we also have our own corporate legal department with 50 employees, including 15 in-house attorneys.

Shortly after forming our own insurance company and hiring the senior personnel to run the company, we developed a strategy to help us maximize the value of services we would need to purchase from the various outside law firms we would need to engage to represent Fred Loya Insurance in litigation. The first step in this process was to acquire the right technology to help the claims team better manage the litigation portfolio. Our goal was to find a software system that would provide us with visibility into the litigation we were managing at any given time and help us implement a sound spend management initiative with our outside counsel. After extensive research and testing, we selected LexisNexis CounselLink to be our technology platform.

The next step for us was to limit the number of law firms we would engage in each market where we do business. We made it a policy that we would only send cases to firms where we had strong relationships with the partners, including a very clear understanding about how we expect to be billed for their services. Our company's policy for law firm billing: Every single case we assign must start out with the assumption that we will pay for services under an AFA.

Today, 90 percent of our cases are billed on an AFA, just 10 percent are billed according to the billable hour.

How Do We Do It?

When we meet with a prospective outside law firm, we discuss billing arrangements as part of a larger conversation about law firm compensation. The message from us is that we are culturally oriented toward the simple premise that we will pay them a fair fee in exchange for their work on a specific project.

When we are confronted with a new lawsuit, we do a comprehensive analysis of the case and assign a 1-4 rating based on what we believe to be our risk exposure in the case. The least risky cases are handled by our in-house attorneys and the most risky cases are referred to outside counsel.

We have eight different types of cases within our law firm compensation model. When a new matter is assigned out to a law firm, we send them the details, let them know how we have assessed the case ourselves within our rubric and then ask them for an estimate of how much they would charge us to handle the case. Some of these cases are low-cost small claims matters, some of them are property damage cases, but 85 percent of the cases we litigate with the assistance of outside counsel are bodily injury cases. Over time, with the assistance of LexisNexis CounselLink, we have established a fairly predictable sense of how much these cases will cost us in law firm fees.

However, we are acutely sensitive to the fact that the practice of law is not a scientific experiment that can always be precisely measured. We invite our law firms to make a formal request to us if they need to bill us on an hourly basis for a specific activity within a case they're litigating on our behalf. We're always fair about those requests and, if it makes good business sense for both parties, we give the green light to the billable hour. These special requests account for the 10 percent of our law firm spending that does not conform to the terms of an AFA.

Lessons Learned

Our experience with making AFAs work at Fred Loya Insurance produces some lessons that can be applied to other corporations and other lessons that are clearly unique to our own culture. Namely, we had the good fortune of starting our corporate culture with the premise that we would only do business with law firms willing to work under AFAs; there was nothing for us to unwind and no law firm relationships at risk because of a shift in thinking. With respect to law firm spending, we're all about AFAs and that's how it's always been.

But I do think there are a few important takeaways that could be applied to other organizations seeking to move that needle above the 16 percent of law firm invoices currently represented by AFAs.

The key to the success of AFAs is creating an open dialogue between in-house and outside counsel. If there is a level of trust there and open lines of communication, then it really just becomes a function of finding a way of making a good business deal for both parties. That is what we all do for a living!

Making AFAs work requires a commitment at every level of the client's organization. The executive team and the appropriate department heads (Claims, Legal, etc.) need to be fully convinced that AFAs are an essential ingredient of how they will effectively manage litigation costs. Otherwise, they will be unwilling to stand by those convictions when the pressure cranks up on a high-risk case that requires the engagement of specific outside counsel.

The onus is on the clients to establish trust with their law firms by taking seriously their financial investment in the relationship. For example, corporate counsel can make sure that law firm invoices are paid quickly as soon as the relevant work is completed. By turning law firm bills into immediate cash flow, the client can powerfully illustrate the benefit of AFAs to law firms, not to mention incentivize them to get work done quickly and successfully. A related example is to stay in communication with law firms about the volume of work they can realistically expect from the company down the road. This level of dialogue takes the relationship beyond a good-natured chat and reassures the law firm that you are committed to a stable, predictable business relationship with your organization.

In spite of all the talk about collaboration and partnership between in-house and outside counsel, there is a fundamental understanding that must be in place for AFAs to work for any corporation. The fact is that clients are the buyers of legal services and they need to be consistent about laying down the terms of the business relationship with their outside counsel from the very beginning. If AFAs are understood to be a non-negotiable compensation arrangement, then there will be less difficulty with working out the dollars and cents each time a new matter is assigned.

In Closing

As I travel around the country and meet with colleagues of mine at other companies, it's clear to me that the AFAs buzz is still a lot of talk and not a lot of action - the results of the LexisNexis CounselLink study seem to back this up with empirical data. Clients are saying that we need a new model from our law firms, law firms are saying that they get the message and want to come up with a better model, but we just aren't seeing a lot of concrete changes taking place in the legal services industry.

In the end, my view is that AFAs have failed to gain ground faster because of a fundamental lack of trust between clients and law firms. This lack of trust, which may indeed be justified due to tension in the relationship in the past, must be overcome before we see real progress in the use of AFAs.

The needle is clearly moving in the direction of AFAs, but in order for the culture to change enough so that AFAs replace the billable hour as the standard law firm compensation model, the conversation needs to start from scratch. Instead of exploring how we can remake the U.S. law firm business landscape, perhaps the best place to start is with the next case you need to assign to one of your trusted outside law firms.

Edgar Meza is Vice President of Claims at Fred Loya Insurance, a Texas-based automotive insurance company with a 50-person corporate law department and more than $400 million in annual premiums.

Please email the author at emeza@fredloya.com with questions or for more information about this article.