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In the mid-1990s, the Internal Revenue Service (IRS) stopped allowing lawyers to deduct as a business expense funds advanced for clients, treating their repayment as income. The agency said such advances should be treated as loans. This policy turned the nation’s lawyers into bankers making interest-free loans. Last year, the nation’s 100 highest-earning law firms-as reported by The American Lawyermagazine, an affiliate publication of The National Law Journal, in a list known as the AmLaw 100-alone advanced more than $4.5 billion in interest-free loans in prepaying their clients’ hard disbursement costs-that is, governmental filing fees, litigation and trial support services, expert and consultant fees, travel expenses and other out-of-pocket costs. This is real cash paid by firms on behalf of their clients. Firms eventually add these costs to clients’ regular invoices, and then wait for repayment. Hard disbursements and related capital needs will continue to grow as firms do more global and complex legal work, use more outside resources and build practices in intellectual property and other disbursement-intensive areas. IP practices generate the highest percentage of hard disbursement costs per clients’ invoices-often four times as much as for general practice clients, typically averaging about 28% versus 6.5%. Firms vary widely on how they manage these payments; some may need a noticeable increase in capital to finance disbursements. Clearly, management of hard disbursements merits scrutiny. Improved hard-disbursements management can mean major improvements for firms’ financial performance. Firms typically average about 120 days from the date they pay outside vendors to the date clients repay firms. Most firms lay out the cash and finance these payments on behalf of their clients without charging interest to cover their own cost of funds. Bank borrowings or borrowings from principals as additional capital are needed to pay vendors if firms pay before clients do. In essence, on any given day, hard disbursements for the AmLaw 100 total more than $1.5 billion of outstanding free loans to clients. Over three 120-days cycles each year, this is the annual total of $4.5 billion in interest-free loans from just these firms. That is a potential of $4.5 billion that can be recouped for firms. There’s a better way: conversion to outsourced, client-paid borrowing. It begins with adopting a policy like this: “If the firm advances cash or credit on behalf of any client for more than 30 to 45 days, the cost (or “float”) for that loan must be billed to the applicable client to avoid burdening the firm and our other clients with this cost. Clients have three choices in how they wish to handle their hard disbursement obligations: pay the legal matter’s invoice in full within 30 to 45 days, provide an evergreen retainer per legal matter or use an outsourced third-party vendor to finance these costs.” A matter of fairness The emphasis is on fairness and client choice. If clients are not responsible for the interest charges their work generates, firms have to raise billing rates, charging all clients more in order to defray expenses and stay competitive for talent. Clients respond with understanding to a plea for fairness, and they appreciate competitive pressures and being given choices as to how to pay for disbursements. Letting profits fall is destabilizing to a firm. The overall costs to typical general practice clients that use outsourced third-party vendors is less than 0.25% of their total invoices for the year-less than 1% of the total for IP clients. Yet the benefits to firms are enormous. The practice is easy to adopt, as clients understand that borrowing money has a cost. The vast majority of businesses or professions, other than lawyers, charge interest on unpaid balances of longer than 30 to 45 days. Clients are not being asked to pay interest on legal fees, just out-of-pockets. The financial impact of this change will be felt in three ways for typical clients: profitability, capitalization and cash flow. Profitability per AmLaw 100 firm is reduced by the interest on approximately $45 million per year of free financing. Eliminating interest expenses improves the bottom line on an ongoing basis. Firms may wonder whether conversion to client-paid borrowing requires reducing billing rates or deferring or moderating billing rate increases. Both issues affect profits, but they clearly are separate discussions. Clients use significantly different levels of hard disbursements for each legal matter, and these charges can be kept separate in their minds. It makes sense to unbundle the costs of funding hard disbursements from billing for related services.
THE BUSINESS OF LAW

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