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BigLaw: Flat Fees and the Internal Hedge Fund: A Next-Generation Business Model for Large Law Firms

By Liz Kurtz | Monday, December 19, 2011

Originally published on September 21, 2011 in our free BigLaw newsletter. Instead of reading BigLaw here after the fact, sign up now to receive future issues in realtime.

Partners and associates alike hate the drudgery of tracking their billable hours. Clients hate paying exorbitant hourly rates, always wondering whether that associate really spent 1.6 hours composing a letter, or 23 hours reviewing documents. We all agree that hourly billing stinks — except that all other pricing models (known as "alternative fee arrangements") seem to stink more — at least from the perspective of large law firms.

As some industry insiders have pointed out, fixed or flat fees present two concerns — whether the fee is too high, and whether the fee is too low. And, of course, the risk of the latter "concern" makes the thought of fixed fees a source of terror for partners. No one wants to become the next Brobeck or Howrey. Lawyers hate risk so despite its flaws, the billable hour is a soft, fluffy guarantee that in the unfortunate event a CD of documents ends up taking 200 hours to review instead of 100, the client will assume most of the cost of the extra time.

Enter the Internal Hedge Fund …

Fear not! Some of the great minds here at BigLaw have developed a way to make flat fee billing work for your firm, giving you a devastating competitive advantage over your rivals in an increasingly zero sum game.

We call it the "Internal Hedge Fund" (although, technically, it's more like "My Law Firm's Proprietary Trading Desk"). This new though admittedly not rocket science business model kills two birds with one stone.

The First Bird: Offsetting the Risk of Flat Fee Arrangements

Let's start with a few basics — what exactly is a hedge fund? I asked Michael Nelson who practiced law at Willkie Farr & Gallagher, moved in-house, switched gears and worked at a proprietary trading desk, and now manages hedge fund Thea Capital.

"The definition of a hedge fund has become very broad," says Nelson. "Traditionally, a hedge fund employed a strategy that literally 'hedged' investments so that, for example, if you were short on one position, you would be long on another. Nowadays, the term is used to describe a huge variety of funds, trading in just about anything, that are very actively managed."

Nelson contrasts the various hedge fund strategies with the "buy and hold" position usually taken by mutual funds. In addition, he says, hedge funds are characterized by a certain fee structure, which is usually "2 and 20," or a formula that compensates managers 2% of the assets under management and 20% of the fund's profits for the year.

As you may have gathered from news coverage of our current economic climate, a certain degree of mystique surrounds hedge funds. One reason could be their history of opaqueness. According to Nelson, hedge funds were once subject to very little oversight, although the regulatory environment is changing. In addition, hedge funds can be very risky, but also extremely financially rewarding.

But the sexiest facet of the hedge fund, perhaps, is its exclusivity. "The hardest thing about starting a hedge fund is raising the money," says Nelson. Traditionally, this meant that the hedge fund was the province of the uber-wealthy, or anyone talented enough to drum up the capital required to play high-stakes investment poker.

Enter the Internal Hedge Fund for large law firms. In our model, clients pay fees for litigation and other hard-to-price legal services up front, thereby supplying your firm with lots of cash. Maybe you price to perfection, maybe you underprice, maybe you overprice. No matter. Your money (i.e., the fees that your clients pay up front) is already hard at work being actively invested by the small team of experienced hedge fund managers with a proven track record working full-time at your firm or if you prefer at their own hedge fund with your firm as the sole or principal investor.

Given the potential returns, the risk — or reality — of offering legal services a little more cheaply than you would have liked is offset by the benefit of having all that paid-up-front "straw" to spin into hedge fund gold.

What About Ethics Rules?

But wait, you say — is this model ethical? Can you collect an up-front fee for deposit directly into your firm's internal hedge fund trading account before having performed a single legal service? The ethical ramifications of alternative fee arrangements have certainly been (and continue to be) explored, but our model contains an added wrinkle in that it contemplates completely bypassing retainers and client trust accounting.

According to legal ethics maven Eric Cooperstein, the answer is a definitive "maybe." "It depends on the jurisdiction," explains Cooperstein. For the most part, he says, lawyers can take a flat fee for certain kinds of defined services. In fact, it's routine in practice areas like bankruptcy and criminal defense. Charging up front for a specific service or a "package" of services should not be problematic Cooperstein adds, as long as the fees are "reasonable" under the factors defined in the ABA's Model Rules governing billing arrangements.

Hedge fund manager Nelson points out a few additional ethical pitfalls for adopters of the the internal hedge fund model to avoid — don't allow clients to direct investments, don't forget to thoroughly vet your internal hedge fund managers … and so forth. In fact, says Nelson, having the law firm vouch for the sterling credentials of its fund managers might greatly benefit the "branding" of the fund if you decide to invite others to invest.

The Second Bird: Put Underemployed Associates to Better Use

Nelson ends our interview with a clever idea. Your firm could make use of some of those underemployed associates, thereby killing the second bird.

"Lots of associates sit around at times twiddling their thumbs," Nelson notes. "Instead, they could conduct equity research." Think of it as the large firm equivalent of timesharing a jet. Your firm has lots of talent, some of which simply lies fallow in a down economy. Why not put it to good use? The downside — could these assignments result in higher attrition as associates given a taste of Wall Street leave the law to pursue a career in finance? It's hard to say, but we're hedging our bets.

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Topics: Accounting/Billing/Time Capture | BiglawWorld | Law Office Management
 
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