Do you regret not running certain cases on contingency?

With Kirkland and Ellis confirming the launch of its plaintiff contingency fees plans, we look at some firms that made the transition and discuss how they managed the risk and revenue recognition issues.

Constraints and frustrations

It’s an interesting time for disputes lawyers. With the continued expansion of the litigation finance market, coupled with client demand for alternatives to traditional billing models and an increasing willingness to tender their cases to multiple firms, it’s no wonder that many firms are in a spin over pricing.

Kirkland and Ellis recently reported its plan to significantly grow its plaintiff practice with a pro-contingency fee model to drive earnings. As one of the largest global law firms, it’s a significant development, as it’s probably one of the first times a firm of that size has raised its head above the parapet to positively promote its intentions with regards contingency fee retainers. Historically, it’s been a dirty word, something only discussed when really pushed by a prospective client. To change stance and proactively seek such opportunities is something we’ve long since predicted many larger practices would ultimately have to do in order to achieve significant growth in profitability.

Over recent months we have spoken to several global top 20 law firms, many of whom cited examples of how they’ve recently had to offer alarmingly high discounts in their rates to compete in tenders. It seems counter-intuitive to increase charge-out rates, only to then need to discount even more aggressively than before to stay competitive in tenders, yet this appears to be the case for some.

Fee earner frustration is increasingly palpable given the internal friction that can be generated between those at the coal face trying to win pitches and those responsible for the firm’s financial management. Some firms now routinely have pricing managers involved in all bids, but even here we’ve witnessed some alarming shortcomings in some managers’ knowledge of how external funding/insurance plays a key role for their direct competitors. In fairness, pricing managers are also often constrained with little wriggle room, particularly those within practices still wedded to a billable model for almost all matters, despite the pressure brought to bear by market forces.

Are we on the cusp of an industry shake-up?

Clearly law firms are not insurance companies or funding companies. “Law firms are not in the business of taking risk” was a common expression we heard cited by several partners at the early onset of the funding market (as funders were encouraging firms to risk share), but such comments are far less frequent in today’s competitive market. At the end of the day, law firms are in the business of making money. Any threat to income should not be overlooked. Whether that threat is partners jumping ship to set up boutiques, aggressive firms shooting up the rankings and knocking on the door of loyal clients offering increasingly flexible alternative fee arrangements, or even litigation funders evolving from $100m funds to multiple billion-dollar funds. If these threats alone are not enough to raise alarm bells, then Kirkland & Ellis’ announcement should be. Other large practices will follow suit; indeed, we know from our own discussions that’s the case.

Is the real risk in not evolving models?

Even the most risk averse partner in a firm’s management would struggle not to grimace at the thought that they could have legitimately and comfortably collected many multiples the sum billed on a successful result, had they just run the case on contingency. Generating the income of three or four normal billable cases from one case is clearly attractive in principle but one might justify the decision as a bird in hand at a point the outcome was unknown.

However, some might argue that not adapting to the changing market and being forced to cut fees by 30%, 40% or even 50% to win tenders, is just a different type of risk, but a risk nonetheless – particularly in the medium to long term.

Of course, the benefit of the hindsight analogy above assumes the law firm still won a tender based on a billable model; they may well have lost out completely to a rival firm offering a contingency or other alternative fee arrangement.

Perhaps the above partner would say having a funder pay their fees is preferable to the firm offering a contingency fee arrangement. A discount in the billable rate would probably still have been applied, as many funders will understandably look to to maximum their return and seek as much certainty over the budget as they can achieve.

Flash forward three years, the funded case prevails, and the law firm witnesses first-hand the sizeable return now being paid out to the litigation funder. The bracing reality of the funder’s risk versus reward profile is made manifest. No longer theoretical, but actual money changing hands. In that 3-year period the litigation funder may have grown 200-300% in size, whereas the firm’s litigation team revenue may have seen single digit growth. It’s perhaps somewhat simplistic to say, but the rapid rise in the volume of funders is in part due to the opportunity being missed by so many law firms – funders are capitalizing on the gap in the market between clients changing needs and demands and law firms’ slower pace of response to meet the changing attitude.

Notwithstanding the above, the partner might still have preferred the ‘bird in hand’ on the basis that law firms provide legal services and are not in the business of taking risk. But here’s a further stark reality check.

A reality check based on actual case studies

The following are three real examples of cases, each handled by a leading international law. The law firm ran all three cases on a contingency fee basis. Risky strategy? Well no, actually. We arranged contingency fee insurance for the law firm that covered 50% of it’s incurred WIP. This meant that if a case were to lose, the firm is reimbursed for 50% of its time incurred (at full rack rate against an agreed budget). The certainty provided by the policy was sufficient for internal revenue recognition within the firm’s finance team, which mitigated tensions over the team’s year end billables. In each case the cost of the insurance was a zero-dollar upfront cost – the insurers’ entire premium was contingent upon the case prevailing and the firm recovering its fees.

All three cases ultimately succeeded. The cases themselves were not stratospheric in value, but each succeeded with a $40-70m award. In case 1, after reimbursement of the firm’s actual time cost and after reimbursement of the premium due to the insurer, the firm’s success fee uplift was 2.8 times their incurred fees. In case 2, the firm made a multiple of circa 3.6 on their incurred fees (after reimbursement of their fees/insurer premium) and in case 3 the firm made just over a 4 times return.

At this point even the most stubborn of partners still wedded to the billable model would doubtless have pause for thought. Many probably didn’t realise such insurance options are available – litigation funders tend to grab the limelight. Yet there are several very large insurance companies willing to risk-share with law firms. We’ve said it before in other articles, but several litigation funders mitigate their own risk via such insurance models.

Contingency fee insurance isn’t the only model that facilitates such alternative thinking. Litigation funders can likewise sit behind a law firm. However, two key distinguishing features exist.

Firstly, the insurer provides an indemnity against loss and so reimburses the firm if the case loses or if damages can’t ultimately be recovered through enforcement, whereas a funder provides cash flow as the case progresses.

The second distinguishing feature is cost. The cost of the insurers’ premium will likely be significantly lower than the success fee charged by a funder. The greater the cost, the less profit remains for the law firm.

So, with these features in mind, the question becomes one of the time-value of money for the firm. Would it rather take the cash as the case progresses, but achieve a much smaller success fee, or accept that the cash payment will be deferred until the end of the case, but with the potential for a much greater uplift? In the case examples above, the firm chose the latter, which in hindsight has proven a very wise, commercial decision.

In truth, both models have their place. For example, a large law firm with a strong balance sheet might be comfortable to use contingency fee insurance for some cases where the timeframe is likely to be 2-4 years, but may opt for a funding-based model where the likely longevity will exceed 4 or 5 years.

The above are just two basic examples. There are further options available that could potentially achieve an even better all-round position for a law firm, particularly for larger practices (e.g. keeping the cost down, maintaining cash-flow and still achieving a larger upside) – please contact one of our team if you’d like to learn more.

A change in strategy for law firms?

Of course, the above is just focusing on situations where the client has expressed a desire for an alternative fee structure. Some clients, for a variety of reasons, will still have demand for a traditional billable model, particularly where they can secure significant discounts in the hourly rates. Indeed, the client could look to insure their own outlay directly with insurers, meaning they are reimbursed if the case loses. However, it might be that the heavily discounted billable option ultimately becomes an unsustainable model for many law firms, and as such it might well be that the firm takes the initiative, as Kirkland & Ellis appear to now be doing, to proactively promote an alternative fee arrangement as a means to boost its profitability, rather than putting the traditional billable model front and centre in all retainer discussions.