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Large companies are opting for cheaper, more-predictable alternatives to the traditional billable-hours approach.
Russ Banham, CFO Magazine
October 1, 2005
Companies all want law firms to turn over every stone in the quest to win their cases. Paying for all that stone-turning is another matter.
In the past, the desire for a favorable outcome has usually won out over cost concerns. These days, though, many companies are finding a way to shave expenses while still getting the extra effort they need from their outside legal teams. It often starts with replacing the standard billable-hours approach that law firms have used for most of the century in favor of a negotiated-fee-based model that provides financial incentives if external counsel can keep costs down.
The approach puts Houston-based manufacturer FMC Technologies Inc. "on the same side of the line as the law firm," says CFO and senior vice president Bill Schumann. "I want low cost first and cost certainty second, and I'm not sure the traditional billable-hour format provides either." With the fixed-fee approach, lawyers focus on specific targets, like settling cases "for the lowest legal cost and settlement amount where warranted." When they charge for billable hours, he adds, "there are no incentives."
Billing by the hour remains by far the most common compensation model for corporate law practices, and will probably remain so for smaller companies that use their services. "Generally speaking, if you are under $5 million to $10 million in total annual legal spend, it doesn't make sense" to seek an alternative, says Brad Blickstein, a principal at The Blickstein Group, a Skokie, Illinois-based legal consultancy. "You're just not going to get the return on investment."
But as legal expenses have soared, larger companies like DuPont, Tyco International Ltd., and Cisco Systems Inc. have looked for options. Companies "already view their law departments as cost centers. They need to look beyond that and bring predictability to them," says Fred Krebs, president and chief operating officer of the Association of Corporate Counsel. In a benchmarking survey of corporate law departments, the association found that in 2003, for each internal lawyer employed by the department, companies paid an average of $546,960 to external law firms — up from $480,582 in 2002. It also found that billable-hour alternatives are an increasingly popular way of combating that rise.
Convergence at DuPont
DuPont is the granddaddy of novel legal-fee approaches. In 1992, then-CEO Ed Woolard mandated $1 billion in cost cutting across the company, including a reduction in the number of law firms engaged by its legal department. "We wanted to drive different ways of conducting business with external counsel," says Thomas L. Sager, chief litigation counselor at the chemical giant. The goals: longer-term commitment from law firms, better integration between DuPont and outside counsel, greater alignment in resolving cases quickly, and reduced duplication of effort. Fixed fees provided "certainty and predictability in billing, with the proviso that if the firms became more efficient and yielded better results, we would give them a bonus," he says.
In three-and-a-half years, DuPont cut the number of external firms from 450 to 34. Outside firms today agree to set fees based on the docket of cases, types of litigation, and expected workload. DuPont's approach, known as the convergence model, saved the company $13.2 million in a two-and-a-half-year period, says Sager. Now, "when my CFO asks how much we're spending, I can give him a number," he notes. "We're far better able to forecast our legal spend, anticipate large settlements or payouts, and forecast recoveries."
Tyco International — a company that knows something about legal bills — now uses a similar convergence model. Litigation program manager Jim Michalowicz, who worked under Sager at DuPont until the end of 2003, says "Tyco was in a situation where it was looking to develop a litigation portfolio management program." (All of Tyco's legal expenses were managed under the billable-hour system that prevailed before last year.)
Until recently, Tyco had too many "generalist" internal attorneys, while its external law firms numbered close to 500. "Frankly, we didn't know the actual total number of firms or the related costs, because we didn't have a centralized management system" for the external lawyers, explains Michalowicz. "Nevertheless, it was easy for me to go with my experience at DuPont and conclude that too many law firms breed too much cost."
Following the direction of Bill Lytton, general counsel for Tyco, Michalowicz restructured the company's internal law department to focus on specific practice areas, creating teams to work closely with the outside firms. "In product-liability litigation, our first convergence area, we reduced the number of external firms from 167 to 1," he notes. "We then negotiated a fixed fee that best represented the total legal cost — essentially fees plus expenses." Tyco's overarching goal: to reduce that total cost by slashing total case-cycle time, exposure levels, and the number of cases.
Tyco's lone outside product-liability firm, Kansas City, Missouri-based Shook, Hardy & Bacon LLP, inked its agreement in October 2004, with both organizations comparing the result to Tyco's previous billable-hour experience. "We're using an electronic task-based system where timekeepers from the law firm bill time as they normally would, except they send zero-sum invoices," says Michalowicz. Measuring the fixed fee against that, "we're projecting savings of 25 to 30 percent over a two-year period."
Pay for Results, Get Results
While Shook, Hardy & Bacon continues to bill some clients by the hour, chairman John Murphy sees more companies "wanting more certainty about what their litigation book will cost them for the calendar year." Alternative-fee approaches increase the emphasis on strategy, he says. "We ask things like, 'Is this a case that should be settled, or a case that may involve some overriding precedent involving other products made by the company?'"
High-stakes-litigation specialist Bartlit Beck Herman Palenchar & Scott LLP is one firm that has given up the billable-hour format entirely. Managing partner Sidney N. "Skip" Herman says that accepting the fixed-fee structure offers "the opportunity for an upside: if we win the case, we get a big bonus." Besides, he sees "a risk of inherent abuse" by firms measuring billable hours. "When you pay for hours, you get hours; when you pay for results, you get results," he says. "Perhaps as much as 20 percent of billed hours in the billable-hour model are inflated. You end up rewarding inefficiency."
With Cisco Systems's adoption of fixed-fee arrangements for "the vast majority" of its business with outside firms, says general counsel Mark Chandler, "one effect has been a new focus on technology." In the 1990s, the San Jose, California-based company began managing lots of its legal work — things like tracking subsidiaries' records, contract creation, and patents — with Internet tools, then joined with other big companies "to help select law firms that could move HR counseling onto online functions," says Chandler. Cisco's technological advances and legal benchmarking, which it credits with $100 million of cost savings, "consistently puts us in the bottom quartile [in our industry] when it comes to legal expenses," he says.
Money in a Bucket
FMC Technologies may boast the most sophisticated alternative-fee strategy. In 1993, says vice president and general counsel Jeffrey Carr, there were "48 attorneys in the department and more than 100 outside law firms billing us by the hour," he recalls. The company began cutting its inside legal staff, and reduced that number to 8 attorneys. "Meanwhile, 12 external firms account for 85 percent of our spend," says Carr, "with the remainder local domestic firms and indigenous firms overseas," and each firm applies fees. FMC Technologies tells firms it "will pay 80 cents on the dollar of the budgeted amount, putting 20 cents at risk," according to Carr. "If you come in on budget and achieve the set goal, you get what is in that risk bucket, plus a multiplier as a bonus." The first phase of a case may offer a 100 percent multiplier of the at-risk amount — a substantial incentive. The second phase offers 75 percent, the third 50 percent, and the fourth and fifth 25 percent.
"Since I don't want the firm to stop work if it goes over budget, we've created another fee arrangement covering work in excess of the budgeted amount," says Carr. "We flip the at-risk number, paying the firm 20 cents on the dollar and putting 80 cents in the bucket." This "unleashes the firm's entrepreneurial spirit" and provides "a very tidy bonus through the multiplier."
The success of the strategy is measured in part by how long cases remain open. "Cycle time used to be 48 months in the mid-1990s, and we're down to less than a year now," says Carr. "We also measure deviations from expected values. For example, if we estimate that a case ought to be worth $1.2 million in exposure, plus $300,000 in fees, that's a $1.5 million estimate of total cost." If cases cost $1 million below target, "we count that as a win. Since we've been doing this, we've resolved 40 cases and had only 3 in which we paid more than the expected value."
The approach, and the result, sit well with CFO Schumann. "When we win, they win," he says. "From where I sit, that's a pretty good deal."
Russ Banham is a contributing editor of CFO.
How FMC Technologies Laid Down the Law
Tips for reducing the cost of outside counsel.
• Terms for "success" are defined and agreed upon.
• A target legal expense budget is established for each phase of the litigation.
• Within each phase, up to the target amount, a firm gets 80 cents on the dollar, putting 20 cents at risk.
• If the firm exceeds the target for the phase, the firm gets 20 cents on the dollar, with 80 cents at risk.
• Achieving success in the case's first phase wins the firm the at-risk amount, plus a bonus of 100 percent of at-risk dollars.
• Achieving success in the second, third, fourth, or fifth phases wins the firm the at-risk amount, plus a bonus of 75 percent, 50 percent, 25 percent, and 25 percent, respectively, of the at-risk dollars.
• The success multiplier is adjusted upward or downward by the percentage of total expense budget saved or overrun and by the percentage difference between the actual recovery or settlement and expectations.
Source: FMC Technologies Inc.
The Law of Partnerships
Companies also form alliances with law firms to cut costs.
Not every company chooses fixed fees as the way to reduce external legal costs. Shell Oil Co., the Houston-based unit of Royal Dutch Shell Plc., has developed strategic partnerships with 28 law firms that still pay by the hour. The volume of work the firms get, though, provides Shell with leverage to reap volume-based discounts.
"We used to contract with more than 500 law firms in 2002, and we contract with less than 350 today," says Kennetta Joseph, manager of the strategic-partnership program in Shell's law department, "but our goal is to have our 28 strategic partners handle the majority of our legal work." Partners share documents and other knowledge on a Web-based system, "so we are not repeatedly paying for the same work," she says. Shell's program is predicated on reducing billable rates as well as cutting duplication of effort, and Joseph says the program is resulting in cost savings but that it's too early to calculate the actual dollar amount of the savings.
Microsoft adopted a similar legal strategy in July 2004, instituting "a preferred-provider program" for external law firms, according to Kevin Harrang, deputy general counsel, Law & Corporate Affairs, Internal Operations, at the software giant. He says Microsoft managers have cut the number of law firms used to a core group of 30 from more than 500, and that "the company's goal this year is to concentrate its legal spend on a group of about 20 'premier' firms."
Microsoft continues to pay the majority of firms it contracts with by the hour, but the preferred-provider strategy saved the company millions of dollars in fees alone through year one. "As we further strengthen our relationship with providers," says Harrang, "we anticipate more savings." — R.B.