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Cost Recovery for the Law Firm 101

Daniel Pelc

Editor's Note: This is the first of a pair of posts on understanding and building a cost recovery plan. Be sure to check out the second installment, too.

At a fundamental level, there are several typical go-to-market plans for law firms as it relates to third-party expenses. These expenses include e-discovery, as well as reimbursement for expenses incurred in connection with the representation of a client. Specifically, these reimbursements could cover any hard costs (disbursements to third parties such as providers) or soft costs (overhead expenses and work typically performed in-house).

A large number of firms absorb the cost of litigation and primarily bill for attorney hours as part of their representation. However, given changing pricing models and the evolving landscape of legal practice, many law firms are considering converting from a cost absorption model to a cost recovery or profit model. In the former case, costs reasonably related to the representation are passed through to the client. In the latter, firms are turning expenses like e-discovery into a potential revenue stream and will often create a wholly-owned subsidiary as a profit model.

The conversion process from cost absorption to either cost recovery or profit model can be challenging, but it’s not insurmountable. We’re going to briefly cover the dos and don’ts of a cost recovery or profit model, and look at some of the opening steps toward formulating a conversion plan. There are distinct cultural, financial, and legal implications to the change that must be considered when a change of this magnitude occurs. As with any change, having a well-reasoned plan can provide some direction.

Though the effort may be daunting, this handful of reasonable first steps can help put the reins on your plan and prevent hurdles along the way.

Three Types of Law Firm Representation Expense Plans

In a cost absorption model, a firm absorbs all costs of litigation as the cost of doing business. Many firms see this model as a differentiator in a deeply competitive industry. Some hybridize cost absorption by charging some costs to a client, such as cases with extensive e-discovery—which can be permissible under ABA Model Rules of Professional Conduct 1.5 listed below, provided the fees are defined prior to the engagement and are reasonable within the scope of the representation.

On the other side of the spectrum, a growing number of firms are pursuing cost recovery and consider expenses reasonably related to the representation of the client as recoverable.

Finally, a smaller number of firms are creating wholly owned subsidiaries as revenue sources to recognize the value of new revenue streams.

A Note About the Rules

According to the ABA Model Rules of Professional Conduct 1.5(a), a lawyer may not charge an unreasonable amount for litigation expenses (reasonableness is measured through a number of factors enumerated in Model Rule 1.5(a)). Ethics Opinion 93-379 states that reasonableness standards in 1.5(a) also apply to disbursements to third parties.

For services performed by in-house practice support departments, the ethics committee is clear: the charges must reflect the actual amount paid without tacking on a profit. However, without a written agreement as per ABA Model Rules of Professional Conduct 1.5(b), the ethics committee is clear on another point, as well. The rule requires that any item for cost recovery must be relayed to the client before the representation begins. In Formal Opinion 93-379, the ABA Committee on Ethics and Professional Responsibility stated: “The lawyer’s stock in trade is the sale of legal services, not photocopy paper, tuna fish sandwiches, computer time, or messenger services.”

Tuna fish … I love that one. Who knew the Standing Committee on Ethics and Professional Responsibility had a sense of humor?

Our goal here isn’t to instruct on what’s reasonable and what isn’t, but it’s important to keep those basic rules in mind in a discussion about cost modeling. Reasonableness is a decision you need to make with your accounting department and law firm leadership.

So, once that conversation is wrapped, what do you need to do first if your team has decided to move toward cost recovery?

Steps 1 and 2 Toward a Cost Recovery Plan

Formulating a plan of this type is not easy. There is little guidance on how to create and enact a policy of this type—for good reason. Each plan will differ based on the firm and situation.

Keep in mind that plans like these are subject to detail analysis paralysis. Without the proper support, a plan can easily get stuck in the mud with comments like “our accounting software will not allow for it,” “the partners will never go along with it,” or “we may look at something like this in a few years.” Those concerns may be well-intentioned, but solving them is the path to innovation and more sustainable success.

That’s why an important first step is to construct a cost-benefit analysis. Thoroughly understanding why you are modifying your firm’s representation expense plan in the first place, defining what benefits can be obtained, and identifying what risks threaten to derail you—and planning accordingly—can help sell your proposal. Consider doing some external research on how competitors are setting their own expense policies, or gauging the reactions of clients through a focus group. If you can sell the cost-benefit analysis and gain the support of the law firm’s management or c-suite, the details that may bog you down become less important.

Another good step at this point is to understand your footing politically. There are three ways you can help a plan like this stay on the rails from the start:

1. Understand your support structure. Which groups in the firm will work in favor of a proposal to change to cost recovery? Firm attorneys may see this change as a benefit or a threat. Do what research you can to understand sentiments and be prepared to address concerns as they arise.

2. Understand the approval process. Do you have a champion in the upper ranks who will approve of and oversee the implementation of this conversion? Often, having a CFO or managing partner championing your efforts will mean the difference between success and failure.

3. Understand potential variations from the plan. All rules have exceptions, and you need to prepare to prevent them from unraveling your overarching goals. Will attorneys be able to carve out and eliminate line items? How is that process going to be accomplished and approved?

These are no small tasks, but executing them properly can pave the way for greater success—and a healthier bottom line—down the road.

To help you march toward that goal, subscribe to The Relativity Blog for more on cost recovery and how to introduce and implement it at your firm. Soon, we’ll cover conversations, stakeholders, and commitments, wrapping up with a discussion about carve-outs and how to prevent your new cost recovery policy from being eviscerated from the inside out. 

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Daniel Pelc was a senior manager of industry marketing at Relativity. He is now director of client solutions and integration at NightOwl.