I’ve been having a lot of conversations lately about alternative fee arrangements (AFAs).
In a earlier column, I wrote that the death of the billable hour has been one of the most consistently overhyped nonevents in the history of Big Law. Indeed, despite the move to AFAs having been heralded for decades, the majority of high-value mandates are still handled on-the-clock.
Part of the problem seems to be that clients and law firms can’t decide who should be actually driving this reform.
It seems clear that taking a proactive and innovative approach to pricing would be a good way for law firms to differentiate themselves in an increasingly competitive marketplace. The common refrain among partners is that clients don’t actually want AFAs, but when pushed further, it’s amazing how few have actually gone to their in-house counterparts with a detailed proposal, rather than just discussing the subject in general terms.)
But it is equally clear that if clients are frustrated by the pace of change, they ultimately have the power to force things through.
There are signs that more in-house legal departments are waking up to that fact. Microsoft recently announced plans for 90 percent of its external legal work to be handled via AFAs within two years, with deputy general counsel David Howard calling for a “new type of relationship” with law firms.
GlaxoSmithKline is already there. Since former Sidley Austin partner Dan Troy joined the British pharmaceutical giant as general counsel in 2008, the company has taken an increasingly hard line with external advisers in a move to ditch the billable hour entirely.
Justin Ergler, GSK’s director of alternative fee intelligence and analytics, helped spearhead the initiative. He said the company’s outside counsel now work “almost exclusively” for flat fees. “And I don’t mean caps or some other kind of hourly-based AFA—I mean literally flat fees,” he said. “No hourly billing, no shadow invoices, no nothing.”
Even more remarkably, the company has a strict policy that any matter with an anticipated legal cost of more than $250,000 not only has to be handled on a fixed fee, just like everything else, but also has to be offered to law firms via a reverse auction—without exception.
So, when the company entered into a consumer health care joint venture with Novartis in a big-ticket deal that saw more than $23 billion of assets change hands, all of the law firms acting for GSK—including Cleary Gottlieb Steen & Hamilton and Slaughter and May—worked on a flat fee basis.
“Some companies are hesitant to introduce flat fee AFAs on their largest, most important matters,” Ergler said. “When we first started our transition, we were the exact opposite: We started with the biggest stuff.”
A Formula for Firms
It’s fair to say that law firms generally aren’t big fans of competitive auctions. Ergler accepts that there is a “negative connotation” attached to the process, but insists that this is because many firms have had bad experiences of clients running such auctions “improperly”—by simply using them to drive down costs, for example. (Clients: See below for Ergler’s tips on how to avoid screwing it up.)
At GSK, the lowest-price pitch only wins the mandate around half of the time, with Ergler describing the fee quote as “just one piece of a firm’s overall value proposition.”
Each pitch is judged according to three distinct aspects, with price only accounting for 30 percent of the overall score.
The most important factor, with a 60 percent weighting, is what Ergler refers to as “substantives,” which includes everything from the team’s experience of handling the relevant type of work, to the firm’s geographic coverage and the overall quality of its lawyers. (The assessment of this category will vary depending on the specific matter under consideration. In some instances, access to a particular international market may be a pre-requisite, for example.)
The final 10 percent of the firm’s rating is based on the gender and ethnic diversity of its lawyers. “If you’re not promoting a diverse team when pitching for a matter at GSK, you are putting yourself at a huge disadvantage in our selection process,” Ergler said.
Once the three scores have been totted up and weighted appropriately, the firm with the biggest number next to its name gets the work. Simple.
Ergler said that the system is designed to be fair to both the company and its external legal advisers. He refers to the relationship GSK has with its preferred law firms as “strategic partnerships” and said fairness is “the guiding principle” in its approach to pricing. “At the end of the day, trying to find a pricing mechanism that leaves one side unhappy isn’t a healthy thing to do,” he added.
That also means that the law firms participating in the auctions share a degree of responsibility in making sure that they function effectively. Ergler said that it is important for firms to have in-house pricing specialists and project managers to ensure that the matter is comprehensively planned and appropriate priced at the outset, and then run efficiently once it is underway. After all, when working for a fixed fee, a firm’s profit is directly proportional to its own efficiency.
“As soon as we agree on a flat fee that both sides feel is fair for the value that will be provided by the firm, the ball is in their court,” Ergler said. “If a firm is not utilizing things like project management and the other business resources they have at their disposal, they are potentially not being as efficient as they could be and therefore damaging their own margin.”
In the space of just a few years, GSK has managed to do what the wider legal profession has struggled with for decades: End its obsession with the billable hour. Perhaps unsurprisingly, not all of its historic legal advisers have been able to keep pace with such radical reform. “The list of firms that we consider has been somewhat whittled down over the years,” Ergler said. “Some firms have embraced the competition and thrived. Others, quite frankly, have fallen flat and not been willing or able to adapt.”
Some lawyers still see pricing pressure as a temporary phenomenon; a hangover from the recession that will ultimately subside once the balance of power returns from clients to law firms and things go back to normal—whatever “normal” means. But Ergler has a message for them: Better get used to it.
“Guess what—the market crashed nine years ago, things aren’t going back to the good ol’ days,” he said. “I do not see the CEO of a large company calling up the general counsel and saying ‘Hey, I know I’ve been really hard on you about how much we’re spending on legal fees since the crash, but I’ve got some good news: The company is now doing really well so go spend whatever you want.’ Firms are starting to understand that in this current economic climate, clients want to be able to peel back the curtain and see exactly what they’re paying for.”
It isn’t hard to see GSK and Microsoft as just the tip of the spear, and to foresee a time when AFAs are the norm, rather than the exception. Change won’t come overnight—this is the legal industry after all. But it does now seem inevitable. Smart firms will embrace it and lead from the front. Stragglers may find they are left behind.
How Not to Run a Competitive Auction: Ergler’s Tips for Clients
1) Always selecting the firm with the lowest fee quote. “That’s the stereotypical race to the bottom. We’d never sacrifice excellent legal representation just to save on fees.”