The Basis of the Billable Hour and Why Clients Benefit From a Fixed Price Arrangement

Well I hope you are as happy as I am that the December holidays have ended.  Now some real work can get done.

The dilemma: If you have any of your firms on an hourly fee basis, then you might notice an uptick in associate hours in December as the associates struggle to meet their hourly billing minimums for the year, just one of the many evils of an hourly billing system left unchecked.  On the other hand, if you were paying a fixed fee on a monthly basis you might be feeling like a chump as you write the check for December recognizing that a lot of partying and little litigating actually occurred in December.

So what is a client to do to strike the proper, fair and economical basis between hourly billing and an alternative method? Importantly, if you understand how the billable hour is constructed, you should be able to better evaluate if hourly billing is appropriate for your matter, if the amount billed is fair and whether annual requests for across the board rate increases will be approved or disapproved.

Anatomy of the billable hour: Years ago, law firms wrote a quarterly or annual bill “for services rendered” for a fixed amount and the client paid the bill without question.  Clients thought they were being overbilled so they pushed for the hourly billing system.  The result was that law firm profits rose!  Certainly not the result the clients intended.  But it was the result of lawyers being notoriously bad at estimating how much time they spent in total on a matter.  (I have found from comparing litigation budgets to actual billings that law firms underestimate their actual time spent 50-66% on a frequent basis.)

Nonetheless, the billable hour was born.  Now the law firms had to set a rate per hour per lawyer that encompassed a number of factors.  This blog speaks generally to the factors considered at the outset of a new client engagement and not to any one client, firm or matter.  The rate typically is set first for the highest, most experienced ranking member of the team.  Factors include the senior lawyers experience in the particular matter at hand, the complexity of the matter, whether the senior lawyer will be actively involved or will merely supervise a team of junior partners and associates, whether travel is involved, whether office costs like postage, copying and research are itemized or included in the rate, the economics of time and availability of the senior lawyer and his/her track record in successfully concluding the type of case.  Of course, the rate also allows for reasonable overhead such as salaries, rent and overhead, and a profit factor for the law firm.

The rates of lawyers assigned to a matter in descending order of seniority (junior partners, senior associates, junior associates, contract lawyers, paralegals, clerks) are billed at rates based on the senior lawyer’s rate.  Unfortunately, this system does not mean that the subordinates’ rate structure bears any relationship to experience or fairness.  These younger lawyer rates will fill up most of the legal bill yet they are merely puffed up based on the senior lawyer rate and other factors internal to the firm which the client cares nothing about.  For example, the “overhead” included in the rate may include the summer associate recruiting and entertainment fund, the office renovation, the holiday party, staff bonuses and other expenses that may help the law firm run harmoniously but do nothing to contribute to the advancement of the client’s cause.

So is hourly billing or fixed rate billing better for the client? If you consider that lawyer rates are rising without relationship to the economy or the actual costs of litigation and that lawyers notoriously underestimate the time they will spend on a matter, then the fixed rate alternative is preferred from the client perspective.  The law firm is likely to underestimate its budgeted amount of hours and, therefore, is likely to underestimate the total cost of the matter.  The client then saves money.  However, the lawyer-client relationship is not about taking advantage of one party over the other when it comes to getting paid.  (Although law firms posting 10% plus profits are not known for giving refunds to clients when this occurs.)

What is a client to do? A client can address the billing method issue several ways.  First, always, always, always insist on a budget that explains the tasks to conclude a matter and the time estimated to conclude the matter plus the level of personnel who will be assigned to complete the tasks.  Second, evaluate whether the rates for the team below the senior lawyer are fair given the lawyers’ experience and expected contributions to the outcome.  Third, evaluate whether the number of people is necessary to the matter, for example is it time sensitive such that ten people must be assigned?  Then, multiply the rate times the expected hours and divide over the estimated time that the matter will likely be pending.  Armed with this total cost, the client can then evaluate whether the cost appears appropriate for the matter.  A particular vulnerability is the high rates charged for the lower level personnel that are not supported by experience or effort.  Another vulnerability is the amount of time spent on routine tasks as a result of the training of junior associates or the filing function of paralegals; this is often a black-hole of billing.  Cut out the costs that serve the law firm’s interest and not the client’s interest and the overall cost becomes more fair.

After analyzing the total cost based on the law firm’s given budget and rates, the client can evaluate if fixing the cost of the matter at that price makes economic sense.  If the law firm will not agree to a set rate, one must ask why?

Finally, the client agreed to a rate and budget at the outset.  I have yet to see in 26 years of practice, a budget that includes annual increases in the hourly rate.  Why should the law firm be allowed to annually increase the rate when it didn’t budget for this cost?  The client is well within its rights to hold the law firm to its contract, to bill a set rate for designated lawyers for the matter.  Of course, in certain economic times it is fair to adjust for inflation and cost of living increases related to law firm expenses but short of these reasons, why should a client pay more to the law firm every year just so the partners can take home more profits that year?  Adjustments can always be made during a matter if it is pending longer than predicted or is more complicated than it initially appeared.

Clients, it’s a new year.  Open your files and look at the requests for rate increases.  Don’t automatically grant them.  Look at the engagement letters from your law firms and see if the law firm has built in an “automatic rate increase” clause into the letter and if so, write a letter rejecting that approach.  Look at the budgets on your files and take the start of the New Year as the time to start a new approach to evaluating whether the hourly rate fairly charges your company for the work done or whether it is time for billing on fixed rate cost based on the law firm’s predicted time and rates.

If not now, when are you going to reset the balance between legal services and fees?  It will affect your company’s bottom line.

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One Response to The Basis of the Billable Hour and Why Clients Benefit From a Fixed Price Arrangement

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