Danger in the Shadows

Topics: Billing & Pricing, Client Relations, Law Firm Profitability, Law Firms

Alternative fee arrangements (AFAs) remain a hot topic for discussion among law firms. A recent ALM report showed that 81% of respondents expected more non-hourly billing of matters to be a permanent trend going forward. Law firms and their clients disagree on several key fronts related to AFAs, including how much their use is expected to grow going forward. But all sides seem to agree that use of AFAs will increase.

I’ve written before on firms’ resistance to leaving the billable hour model. As we all know, lawyers are a risk-averse breed, and the billable hour has been a comfortable metric by which to measure legal work for many years.

But I recently witnessed a discussion that gave me a new perspective on an unappreciated, and perhaps unrealized, obstacle to the transition to AFAs. At this year’s LMA P3 conference in Chicago, there was a panel discussion featuring two law department officers. The differences of opinion were fascinating. But what was perhaps the most troubling to me was the discussion around the practice of “shadow billing.”

For those not familiar with the concept, shadow billing refers to a legal matter that has an agreed-upon flat fee or other non-hourly billing arrangement. However, in order to gauge the effectiveness of the AFA, the client still requires reporting of the billable hour figures for the matter. In essence, the law firm will collect the amount of money specified by the AFA, but must still report all time and metrics as if the matter had been done on a typical hourly arrangement.

I used to think shadow billing was an understandable, albeit tedious, duplication of effort. But after listening to this panel, I became convinced that it may be, in fact, a stark impediment to innovation in how law firms bill for their work.


What troubled me was how shadow bills could be used as a cudgel against the law firm. One of the panelists made the point that not every matter a law firm takes on will be profitable. But this panelist seemed to go a step further to suggest that there would also be resistance if a law firm managed to negotiate a matter that was too profitable for the firm.


My resistance does not come from the fact that hours must still be tracked and reported. Law firms concerned with their efficiency and costs should already be tracking the amount of time spent on a matter so as to watch for potential efficiency gains.

What troubled me was how shadow bills could be used as a cudgel against the law firm. One of the panelists made the point that not every matter a law firm takes on will be profitable. But this panelist seemed to go a step further to suggest that there would also be resistance if a law firm managed to negotiate a matter that was too profitable for the firm. Essentially, it seemed as though the desire to see the shadow bill was driven in part to make sure that the firm wasn’t making too much money off the client, even if the client had agreed to the rates up front on negotiated terms.

I thought of the following hypothetical: law firm and client agree to undertake a given matter for a flat fee of $1 million. Everyone is happy with this rate and the client feels it represents a fair fee for the work to be performed. Now the law firm happens to have a particularly innovative attorney who figures out a new way to complete the task at minimal cost. On a billable hour basis, the firm incurs only $50,000 in costs to quickly produce a top-quality result. The client sees the work product and is thrilled. But when they see the shadow bill they become irate. How could the law firm bill them $1 million for something that took only $50,000 to complete?


And therein lies the potential problem with shadow billing. AFAs are ostensibly designed to help promote efficiency within the law firm. But should a firm become too innovative, efficient or profitable, it would be to the firm’s detriment rather than benefit.


What changed the client’s attitude? Initially, the client thought the rate was fair given the work to be done. They were satisfied with the work product. They got their result quickly. It seems like a win all the way around. Had the firm incurred $950,000 in costs to procure the result, the client would never have objected. But because the law firm was able to innovate and build efficiency, thereby increasing its profit margin, the client is now dissatisfied with the outcome. Nothing about the matter itself or the outcome changed. It simply became a function of the law firm making too much of a profit.

And therein lies the potential problem with shadow billing. AFAs are ostensibly designed to help promote efficiency within the law firm. But should a firm become too innovative, efficient or profitable, it would be to the firm’s detriment rather than benefit.

Granted, the scenario above is an exaggerated hypothetical. It may not be common that law firms are finding themselves in a situation where the client is upset because the firm made too much money on a matter. But the likelihood of the occurrence of such a scenario grows in proportion to the practice of requiring shadow bills. If the market is truly demanding that law firms innovate and become more efficient, then we should also take care to remove any unnecessary sticks that go along with the carrot being offered.

Law firms are taking a risk by transitioning their billing practices away from hourly billing. Part of that risk will almost certainly lead to matters in which the firm loses money. But law firms shouldn’t be penalized by their clients for getting things too right.