Citi Private Bank and Hildebrandt Consulting publish an annual client advisory on the legal market. The last two advisories confirm what most lawyers know from their own anecdotal experience: Law is a tough business. Demand has been flat for nearly a decade as alternative service providers crowd the market and more corporate legal departments bring work in house. Firms continue to raise rates, but realization percentages—that is, the percentages of rack rates that firms are actually able to collect—have been dropping since 2010. Today, few clients are willing to pay rack rates, especially for very junior lawyers. And many clients demand discounts of 10 percent or more as a matter of course. Law firms have increased leverage slightly, that is, they have added lawyers without adding equity partners. But the impact on profitability has been minimal because the additional leverage has been offset by losses in productivity and increases in expenses. The loss in productivity should not be surprising. Many young lawyers simply are unwilling to organize their lives around increasing the profits of equity partnerships that they have poor prospects of joining.
If the traditional tools of leverage, rate increases, and significant billable hour requirements for associates are less effective at generating profits than they used to be, what options are available? For litigators, at least, sharing risk with clients is one way to increase profitability. But adding contingent fee cases can be difficult or impossible for firms that are used to billing by the hour. In addition to the obvious cash flow challenges, when deciding on partner compensation, firms often find it hard to weigh the relative contributions of lawyers whose clients pay by the hour versus lawyers who work on contingency cases. (This is a new variation on the old problem of how to measure contributions to stability versus contributions to upside. When times are tough, lawyers in countercyclical practice areas like bankruptcy, and, to a lesser extent, litigation, often complain that they are not being given enough credit for keeping the lights on. And M&A lawyers understandably feel they deserve credit for high profits during boom years.)
Litigation finance can offer a middle path for law firms to recover 50-75 percent of their rack rates on an ongoing basis, while retaining upside in the form of a success fee that often pushes realizations to 125 percent or more of rack rates. Imagine a hypothetical scenario in which a busy lawyer must choose to accept either Case A or Case B. To keep the example simple, assume Cases A and B are identical in strength and complexity. The lawyer expects to resolve each case on favorable terms 60 percent of the time for an average recovery of $100 million when successful. The lawyer estimates that each case will require 5,000 hours of lawyer time at a blended hourly rate of $900/hour.
In Case A, the client proposes to pay by the hour, but only at a discounted blended rate of $800/hr (Option A). In Case B, the client proposes to enter into a financing agreement that will allow it to pay the firm $600/hr, plus a success fee equal to 5 percent of the total recovery. Case A has an expected value to the firm of $4 million (5,000 hours at $800/hr). Case B has an expected value to the firm of $6 million (5,000 hours at $600/hr) plus ($100 million x 60 percent x 5 percent).
On average, the firm would realize 133 percent of its rack rates on Case B compared to just 88 percent of its rack rates for Case A. Over the long haul, then, the firm should take on more Case Bs and fewer Case As. But what about cash flow and volatility? After all, the firm may not have an endless supply of Case Bs and Case As. The relatively modest volatility in Case B is where the value of litigation financing really becomes clear to the law firm. The enterprising lawyer in our example probably would have difficulty convincing her firm’s management committee to let her take a case on a full contingency that had a 40 percent chance of being a total loss. But in our hypothetical Case B, the firm recovers two-thirds of its rack rates even if Case B is a total loss, and far above its rack rates when the case is successful. That is an acceptable tradeoff between risk and reward for all but the most conservative firms, especially in an environment where few clients pay full rack rates by the hour in any case. Note also that Case B allows the client to avoid any litigation expense, just as it would in a traditional contingent fee arrangement. The participation of a litigation funder in Case B effectively converts a traditional contingent fee arrangement from the perspective of the client into a hybrid fee arrangement from the perspective of the law firm.
Not every case is appropriate for litigation funding. In the example above, if the expected recovery were $30 million rather than $100 million, Case A arguably would be a better proposition for the law firm than Case B. But in many cases, lawyers should welcome the participation of a litigation funder and the opportunity to realize more than 100 percent of rack rates with very modest risk.
Ross Wallin is a managing principal and co-founder of Curiam Capital LLC, a private investment firm that provides funding for high-value litigation.