Legal Commentary

Thoughts on "Risk Sharing"

By Patrick J. Lamb

Someone sent me this slide from a presentation by Hildebrandt, and it got me thinking about risk sharing.  The conventional wisdom is that under the billable hour model, the client bears all the risk.  The conventional wisdom, reflected in this slide, is that law firms bear a substantial amount of risk when using fixed fees.  But imagine this:  a single party breach of contract case with only a handful of documents, not much in the way of injury and no experts.  If the fixed fee is $5 million, how much "risk" is there to the law firm.  And is the "risk" in this scenario the same as the "risk" the client accepts under a billable hour approach?

Let's consider risk in the context of the chart's indication that blended rates create a shared risk between law firm and client, with slightly more risk being borne by the law firm.  In a theoretical sense, this may be true, but in real life, clients bear more risk in a blended rate model than they do using straight hourly fees.  Why?  Many, perhaps most, partners are compensated in part on their realization rates.  Blended rate matters are easy vehicles to push your overall realization rates up.  All you need to do is staff the blended rate matter with young lawyers, the more the better.  Their rate is lower than the blended number, thus creating a realization number greater than 100%.  This offsets discounts or collections problems with other clients.  For the lawyer and the firm, the risk here is very low.  For the client, the risk from the inefficiency and inexperience of younger lawyers is far greater than a normal matter where the partner and senior associates are more involved.

While this outcome may not occur on every blended rate matter, it certainly occurs on some, and the possibility of it happening is certainly significant enough that there must be "risk" to the client.  That risk is greater than that the law firm bears because the law firm controls the risk it incurs by how it staffs the matter.  So control is clearly a relevant factor in determining the degree of risk. 

The holdback is shown as a high risk for both the firm and the client.  Is it?  From an accounting standpoint, most clients likely would book the holdback amount as an expense and would reverse that entry if the holdback was not paid.  The amount is paid only if the engagement is successful, however that is defined, so I am not sure how significant the risk is for the client other than the uncertainty of whether the accrual would be reversed or not.  The risk to the firm seems greater because the ability to gain positively from the uncertainty is not entirely within the firm's control.  To me, the element of uncertainty of gain is part of what makes the holdback concept a greater risk to the firm.  This is clear because the slide distinguishes between a holdback (of a negotiated fee) and an outcome bonus, which is an "add-on" or upside only for the firm.  The "risk," it seems to me is relatively minimal to the law firm.  From the client's standpoint, this "risk" only appears if the outcome is successful, which tends to minimize the risk on that side as well.  Thus, "risk" seems to include "bad things happening" rather than "good things not happening."  That may not be the most artful way of explaining the difference between holdbacks and bonuses, but one is cutting meat and the other is not adding fat.

This idea of cutting meat or not adding fat explains why the risk of contingency fees is allocated to the law firm. 

This blog entry is obviously not intended to be the final word on creating a useful understanding of risk, and I look forward to the thoughts of others.  We do need to move beyond the idea that merely not knowing how much something costs or how much we will be paid is the beginning and end of the discussion of risk.  The concept cannot be viewed so simplistically, especially in the context of providing value.

Full post as published by In Search of Perfect Client Service on June 03, 2010 (boomark / email).