Your Law Firm Does Not Have Your Incentives

If you hire a law firm, as an individual or the owner of a small business, there is a pretty good chance they will bill you by the hour. So if the work performed takes 100 hours rather than 50, you will pay them twice as much. From the law firm’s perspective, this is reasonable, because each one of their work hours is about as valuable to them as every other one (holding the specific employees on the project constant). However, if we are justified in assuming that law firms are entities that can reasonably be modeled as profit maximizers, this arrangement can be problematic.

A law firm using hourly billing has a profit incentive to exaggerate how long work takes. And, unless the firm is already right at capacity in terms of the workload they are able to manage, it is advantageous for the firm to stretch out the time that your work takes so that it fills the otherwise free hours of their employees. It is easy to make a project take longer in ways that don’t feel very unethical: for example, spending extra time on formatting documents nicely, double and triple checking work, compiling cases that are unlikely to be all that relevant, or meeting unnecessarily to further discuss the case. Parkinson’s Law may also be at play here: if a project must be completed in two weeks, there may be a tendency to work on it for two weeks, regardless of how many hours optimally would be spent.

Two obvious incentives law firms also have are to avoid getting sued and to avoid looking incompetent. If they provide you with inaccurate information, or make obvious mistakes in their work, they are putting themselves at risk. You, of course, also don’t want inaccurate information or large mistakes in the work they hand you. But it is not necessarily the case that you care about these mistakes to the same degree as the firm. For instance, some errors affect them much more than you, such as irrelevant spelling errors in work that is merely intended for you to read. Such errors make the firm look bad but don’t impact the quality of the legal work. Yet a law firm may spend extra hours scrutinizing documents to eradicate such unimportant mistakes. On the other hand, other errors are far more likely to harm you than to harm the law firm, such as terms in a contract that are not what you intended, but which you would not have a strong legal case to sue the firm over.

The profit incentive of a law firm will tend to impact how its employees act, as it will incentivize upper management to put structures in place to promote this profit generation. But we can also consider the incentives of the individual lawyers assigned to work with you. They too have a reason to exaggerate how long work has taken. More recorded billable hours make employees look good to bosses, and make them appear to be more valuable employees (which, for associates, may increase their chance of making partner). Some associates at top law firms don’t even bother to use timers to keep track of time billed. In such cases, you can imagine how easy it can be for them to fudge the numbers, or conveniently round up. Even workers with no intention of dishonesty may rationalize over billing, or simply have an exaggerated sense of their own productivity. When we simultaneously have a strong incentive to do X, and also to believe that X is not immoral, we humans are remarkably good at coming up with reasons why X is a fine thing to do (conveniently not searching for reasons why it wouldn’t be fine). And, of course, nobody can verify how many hours were actually worked by any particular lawyer.

Whereas firms as a whole have a profit incentive to do work slowly when the firm is operating below maximum work capacity, individual lawyers have mixed incentives when it comes to doing work slowly. On the one hand, slow work increases billable hours, which makes the lawyer look good. On the other hand, being able to turn around work quickly is viewed as a virtue by bosses, and in some cases, the faster a lawyer gets her work done, the sooner she can go home at night. [Note: it has also been reported to me that sometimes new lawyers will under report their hours worked, so their bosses don’t realize how much they struggled with the work they had been assigned.]

Incentives aside, another challenge of hourly billing is that it can make it difficult for a client to know whether the service for which they are hiring a law firm is worth the cost, since they don’t even know what the cost is going to be. Some firms will produce estimates of the time that a project will take, but these can be quite unreliable (I personally know of at least one case where a firm was off by a factor of more than five) and while there is little incentive to overestimate the time a project will take, underestimating it will encourage a client to work with your firm rather than another. Even without such financial incentives, it is well-known that people tend to underestimate the time that projects will take. Remarkably, this often still holds even when people are aware that project completion times are usually underestimated (perhaps an instance of Hofstadter’s law).

One countervailing force to the incentive alignment problem is that law firms have to worry about reputation and getting repeat business. If they take a long time to do your work, or exaggerate the number of hours that work took, or give you bad estimates of how long future work will take, you will be less likely to hire them in the future, and may speak poorly about them to others. Unfortunately, due to the difficulty of acquiring information, this probably produces less of an incentive than many people assume. It is very hard for an outsider to estimate how long specific legal work should take, or evaluate the quality of the work done. How do you know, for instance, whether the will a law firm produced for you is a good one? Are you, as a non-lawyer, able to evaluate its quality? And if you never get sued, how do you know whether a contract you hired a firm to create truly protects your interests? For that matter, how do you know whether the 30 hours billed was a reasonable amount of time to produce that particular contract? As a non-expert, you most likely would not be able to tell from the contract itself if they had in fact only spent 20 hours working on it. Even in the instance of a case that was won or lost, while it may seem easy to evaluate the firm’s work quality, it is unclear what would have happened with that case if you had gone to competitors. Did you win because of your lawyer’s skill, or despite their lack of it? Did you lose because of weak performance, or because the case was very difficult? Would a competitor have achieved a better settlement, or a better plea bargain, or gotten the same result but at 80% the cost? It is fundamentally difficult for a non-expert, non-lawyer to measure the quality of work produced by lawyers. Of course, many issues similar to these apply to areas outside of law as well, when the person hiring lacks the ability to evaluate the quality of the product that they receive. [As some commenters have noted below, when large corporations hire law firms, they should be capable of holding these firms much more accountable than individuals are, because they have internal legal counsel with expertise in evaluating the quality of worked performed.]

What about reputation? Many people will choose a firm in part based on personal relationships, or what they happened to have heard said about that firm, or based on the firm rankings, or based on how famous the firm is. But if most individuals hiring law firms can’t evaluate the quality of the work that they are hiring firms to produce, it is not clear that firm reputation will be updated very efficiently. Does the fact that a friend of yours had a good experience working with large law firm X imply very much about that firm’s average quality? First of all, he likely only worked with a tiny fraction of their lawyers. Second, it is fairly likely that your friend is basing his assessment largely on softer factors like how attentive the firm was, how closely they matched his expectations of what a good lawyer seems like, and how much he personally liked the people he dealt with there, not on the quality of legal work produced and cost effectiveness (since as we’ve said these can be hard for a non-lawyer to evaluate).

The law firm ranking systems can be problematic as well. For instance, the Vault ranking, which is one of the most commonly used, is based on the opinions of law associates. They rate firms “on a scale of 1 to 10 based on prestige” (not being allowed to rate their own firm, and being asked to not rate firms they are not familiar with). How much does this really correlate with how good or cost-effective the work of a firm is for a typical client? Somewhat, surely, but it is far from an ideal measurement. What’s more, the prestige that an associate assigns to a law firm itself probably depends somewhat on the prior year’s vault rankings, adding circularity to the process.

Fame is a problematic measure as well. Older firms will tend to be more famous, as will those involved in famous cases, or that frequently appear in the news. But again, this may not correlate that well with quality of service and cost effectiveness for a typical client. In fact, famous firms and older firms may have less incentive to provide good service to new clients, since they have long established relationships and so can typically afford to rely less on new business.

There is little question that hourly billing creates misaligned incentives between you and your law firm. Project based billing (where a cost for the project is fixed in advance) fixes some of these problems, but produces new ones. With project based billing you at least know what hiring the firm will cost you, and so may be able to do a better job of estimating whether the project is worth the expense. But, in this case, firms have an incentive to get your work done in the least hours possible, since they get paid the same whether it takes them 100 hours or 200. So they may spend less than an ideal amount of time working on your project in this framework, and produce lower quality work than under the hourly billing paradigm.

When you hire a law firm, their incentives are not very well aligned with yours. You may be able to improve this problem, in some cases, by consulting with an unbiased lawyer about the quality and cost effectiveness of another lawyer’s work  (compared to the available alternatives) before hiring the latter. Of course, the former lawyer would have to be reliable herself and quite familiar with the latter’s work.

11 thoughts on “Your Law Firm Does Not Have Your Incentives

  1. Ames says:

    Good summary — and the point about spelling errors is clever — but I’ll add two notes. First, the requirement of zealous advocacy, and the importance of reputation, both moot the conflicting incentives to some degree. For example, our firm conducted a major litigation, in all the papers etc., and won it on summary judgment. Which was huge, a real feather in our cap, and the client loved it, but certainly deprived us of the thousands and thousands of hours (and millions and millions of dollars) we would’ve billed had it gone to trial. Anyways, at the end of the day, the guarantee of repeat business, reputational boost, and paper-making/marketable victory matter much, much more than the billables. So we’re damn happy with that win, even though we lost out on a more immediate payday.

    Second, cost overruns (like your factor of five example) happen, but really result from miscommunication on both. The “relationship partner” is usually the one that gets directions from the client, and then passes it on to more junior partners and, ultimately, the associates. How much time the task will take is most often evaluated by the relationship partner, based on his guess of how important a task is to her client. But, clients over-prioritize everything, which results in partners over-prioritizing them too, associates killing themselves to make everything perfect, and huge bills. What I view as the real alternative to hourly billing, then, isn’t project-based billing, which is irresponsible in many ways, as it ends up tying your lawyers’ hands. It’s planned hourly billing.

    Clients should say, on a task-by-task basis, “I’d love it if this could cost less than X, and you’ll have to justify yourself above that level, or face a pay cut.” In this economy, those directions will be followed.

    Probably.

    1. Spencer Spencer says:

      Hi Ames,
      Thanks for the comment! I totally agree that reputation helps reduce the conflicting incentives to an extent (hopefully that was clear in my article). I would also point out that this article is about what happens when a non-expert hires law firms. My guess is that your firm generally works directly with experts: either the legal council of large corporations, or other representatives of large corporations that have tons of experience with working with law firms. These experts are in a much better position to evaluate the quality of work produced than a non-expert would be, which helps incentives be a bit more aligned.

      The story you give is a nice example of a case where (1) there are bigger incentives than the financial ones (in this case, looking great for your client and looking good in the newspaper) and (2) where quality is easily measurable (it sounds like in this case it was obvious to everyone that your firm had done something unusually good). I would say that a more typical case is one in which quality is not nearly as easily measurable (e.g. the production of a contract that will only be tested if someone sues years later) and where reputation related incentives are not nearly as large compared to profit incentives as they were in that case (rarely is there an opportunity to save a client so much money, and do so in such a public way).

      You make a good point about miscommunication, and clients not understanding how valuable different aspects of work really are. That may be an important contributing factor. But none the less, when a company as a whole, and its individual agents, have a monetary motive to do X, I think it is a fair assumption that we will see a lot of X being done. So financial incentives should be a significant factor as well.

  2. Ilya Kipnis says:

    Good post. Interesting in that the two extremes are “extend work as long as possible” or “get it out the door ASAP”. I’m of the belief that anytime there are two extremes, there probably exists a happy medium. I wonder how a “moderate hourly rate and bonus for good completion of project” would work.

  3. Alex says:

    I don’t think that the requirement of zealous advocacy, and the importance of reputation, “moot” the conflicting incentives more than Spencer already acknowledged in the original post, where he mentioned avoiding obvious incompetence, for example. I think the message of the original post is that law firms will tend to tend to inflate costs by any means they can get away with. Clearly, a firm is not going to punt a winnable summary judgment motion for the possibility of going to trial, unless its a very foolhardy firm. That said, probably there are such foolhardy firms.

    The example of one firm winning a summary judgment dismissal doesn’t show that reputation and client appreciation can make a firm behave in a way that’s optimal for the client. Didn’t that client pay the firm to win the dismissal? Was it the firm that won the dismissal, or the facts of the case? I’d bet money that they overpaid for their win compared to the imaginary ideal world where the lawyers did the best work they could do and charged the client less than expected. The reality is that if a team of 10 lawyers working around the clock at $500/hr per lawyer can write a winning brief in 3 weeks, it’s very likely that 3 lawyers working 8 hr days at $250 hrs can write a brief just as good, particularly when 7 of that first group of 10 have about 5 months experience each and are duplicating effort and engaging in shady billing practices as mentioned in the post. Where is it written that law firms must charge to the client when some foolish associate makes profitless busywork for 3 other associates, and they bill $10,000 for something unnecessary. It’s not. Firms write off hours all the time. However, at least as often they choose not to write off needless costs, and then engage in conspicuous needless spending, i.e., everything about summer associate internships. $50/person lunches … $100/person dinners and open bars. Flying hither and thither and staying in fancy hotels.

    I think the big enabler here is these rich clients’ ability to pay. Big, publicly traded companies have budgets that dwarf firms’ ability to charge fees. Even in these “hard times” corporations are still able to conjure money up in ways that individuals and small organizations just cannot. No matter what way you cut it, with regard to for-profit clients, firms are purely self-interested organisms. They’re not working for charity or for the joy of lawyering. Even the glory of the win is just a manifestation of financial self-interest. Law firms are never friends, they are tools. That said, probably these rich fat cat clients are finding creative ways to pay the bills, maybe even finding some sort of tax shelter to protect themselves from the costs of litigation. I’m sure they expect to be be billed ridiculous amounts, and for the most part don’t really care. Google is not going to go under because of its legal bills. Google understands that only Google has Google’s incentives.

  4. Nanno says:

    How many professionals do we trust to do their work “as should be” without knowing to the full extent how or why? Doctors? Construction workers? Lawyers?

    Secondly, as with most bills/invoices we all want/need a specification. Same goes for lawyers. I currently work at a law firm and everything (from 6 minutes and more) must be accounted for.

    Third, the goal is to get the most out of a case for your client, not to get as many billable hours as you can. I know a lot of firms judge their associates on billable hours but every employee in every job is is judged on his job-performance

  5. AFL says:

    Spoken like a non-lawyer.

    Most regular people that need lawyers hire lawyers on flat fees. It’s usually at the consumer level that unscrupolous lawyers will rip off clients, particularly in Wills and Estates.

    But Lawyers that charge by the billable hour usually only serve very sophisticated clients, i.e. corporations and other high net worth entities. These mega clients typically have their own legal departments – staffed by former “Biglaw” associates. If a top law school student doesn’t end up becoming a partner (or aspire to it) @ big law, they often end up working decent hours (and much less pay) as corporate counsel.

    The legal department at your typical fortune 500 firm farms out its transactions and lawsuits to many different Big Law firms depending on the matter. Very few corporations are captive to one firm, and very few big law firm are captive to one corporation.

    And believe me, at this level of the game, there are plenty of attorney/accountants, former partners, former senior associates who can review the quality of the work as well as go line by line on any invoice sent. There’s more than enough oversight.

    When you look @ the size of the matters that law firms typically handle (transactions in the tens/hundreds of millions, lawsuits in the hundred millions/billions), the legal fees often don’t amount to more than 1-2% of what is at stake.

    Furthermore, the community of fortune 500 companies and big firm lawyers that can handle their work is very small. At any particular Vault 100 firm, there are probably a handful of rain maker partners that bring in the business. With a community that small, attorneys/firms that pad the bill will be quickly outed.

    What’s actually more prevalent is Fortune 500 companies nickle and dime-ing their legal counsel to the point of stretched capacity. Corporate legal departments will specify vendors that the firm must use, limit which attorneys can work on which matters, so on and so forth. At the same time they do that, the business people at the corporations will insist on being overly aggressive (which means more people on the case to do more running around in crisis mode).

    Is there some slack in law firm billing of major clients? Probably.

    But if you expand your vision and look at the ecosystem, you’ll find that the situation is not defined by waste, fraud, and abuse.

    1. Spencer Spencer says:

      Thanks for the comment. Your thoughts are interesting, but mostly don’t apply to this post, as it specifically is about the case of a non-expert, non-lawyer hiring a law firm (for example, an individual or small business owner). I thought that was clear from the mention of “you” and “non-expert”, but went ahead and tried to clarify that point a bit more in the post. When large corporations hire law firms, the situation is, as you point out, quite a bit different.

      I believe that hourly billing when individuals are hiring lawyers is quite a lot more common than you imply. If you can provide evidence to the contrary though, that would be helpful to see. Certainly, small businesses are often charged by the hour when they would like to have a legal question answered, and they generally are not experts in the law or what might be reasonably deemed “sophisticated clients”.

  6. Lyndon Vesey says:

    Do you have a Facebook page or Twitter? Would love to follow you there, I’m on my iPhone and love reading your stuff!

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