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Top Five Reasons Cost Recovery Plans Fail

Daniel Pelc

Editor’s Note: Recently, we explored some foundational concepts in law firm cost recovery. Here, we’re going to look at some of the “gotchas” that may trip up firms attempting to engage in cost recovery efforts.

“The best-laid plans of mice and men often go awry.” - Robert Burns

After a considerable effort, you have a newly minted cost recovery policy. Your firm will now be able to pass on costs to clients and fund the freedom to innovate. However, your efforts are not over yet.

Cost recovery touches law firm revenue, client relationships, and the firm’s competitive strategy—all of which are near and dear to an attorney’s heart. There are five common reasons your cost recovery plan can be derailed before it even leaves the station. Planning for these eventualities during the construction of your policy will increase its efficacy.

Attorney Carve-Outs and the Missing Champion

“There is no way we can charge this client for e-discovery. They are our biggest client. They will just take their business elsewhere. Remove e-discovery from the invoice.”

This scenario plays out every day in firms nationwide. However, much like a small crack in a dam, failure and flood will invariably follow this initially small wound to a policy's integrity. If e-discovery is removed for Client A, why not Client B or Client C?

What has resulted from this demand is a carve-out, or removal of the line item from the client’s invoice. To prevent your cost recovery plan’s destruction by a thousand cuts, two things need to happen.

First, billing attorneys must understand and appreciate the value of the services being offered to their clients. The expertise required in analysis and review is extensive. Quite possibly, the value of the needle of data uncovered from the virtual haystack may mean winning or losing a matter.

Second, for cost recovery to be successful, a carve-out must require both process adherence and a champion. Requests for carve-outs are going to occur frequently. To account for this eventuality, a firm should create a process around such requests.

For example, when an attorney seeks to remove a billable item, the request must follow an approval path where objective decisions are made by comparing costs and future revenue potential. This analysis must be conducted identically for both hard costs (costs paid out to third parties for services performed) and soft costs (costs incurred by work performed in-house on a client’s behalf). An individual who is able to examine the impact of the carve-out objectively can evaluate the financial effect on the firm. Approval by this champion is built into the carve-out process based on their objective perspective and knowledge of the financial inner workings of the firm.

In my experience, where this approval is a set process, carve-outs become very rare. If a carve-out does occur, it would benefit the firm to list the carved-out expense on the invoice and show that the amount was removed from the bill. By doing so, the firm is still able to demonstrate value to the client.

Client Pushback

“The client’s in-house counsel just called. There is no way they’re paying for e-discovery. This is a policy with all of their law firms. If we want to keep them as a client, we have to remove it from the invoice.”

There is no doubt that the legal market is becoming more competitive. Corporate clients are in the driver’s seat and they regularly place restrictions on what they will or will not pay for.

Formal Opinion 93-379 from the ABA Committee on Ethics and Professional Responsibility states that expenses related to the client’s representation must be discussed with the client prior to or within a reasonable time after the beginning of the representation. If this process is followed, the firm would begin representation with eyes wide open as to what the client will or will not pay for when e-discovery occurs in the matter lifecycle.

Additionally, the expertise required for defensible e-discovery analysis is often a core competency for many firms. If done well, a law firm may be able to save clients millions of dollars from the cost of a review by applying technology-assisted review or analytics. The way to defuse client pushback on the e-discovery line item is to clearly demonstrate the value of the services performed and the positive effect on the total cost of the review.

Incompatible Systems

“Our accounting software is set up to allow us to bill by the hour only. We can’t bill for any line item other than an hourly rate. It has always been this way.”

Policy begets process. Law firm structures have been built and maintained around the principle of cost absorption. It can be frustrating to alter these processes to match a new cost recovery strategy.

Billable items under a cost recovery policy are often unfamiliar to both the law firm accounting team and the invoicing team. During the creation of the cost recovery plan, it’s critical to understand the flow of a billable item and to trace a typical cost recovery invoice through the process from beginning to end.

Additionally, some firms may opt to undergo a cost recovery transition in the midst of an accounting software change. Hitting two birds with one stone may reduce some anxiety and further define requirements for any new software option.

Misunderstanding Cost Recovery

“e-Discovery is the cost of doing business for our firm. We don’t bill our clients because it’s unethical to charge a client for the cost of doing business.”

Rule 1.5(a) of the Model Rules of Professional Conduct is clear that an attorney may not collect an unreasonable fee for expenses incurred. Rule 1.5(b) continues by stating that the fees must be disclosed to the client either before or within a reasonable time after beginning representation. Formal Opinion 93-379, which clarifies Rule 1.5, states that the firm may not create an alternative revenue stream outside the delivery of legal services. The opinion draws no distinction between hard and soft costs. In reality, hard costs should be billed as a pass through to the client. However, soft costs present a much thornier issue.  

Regardless, firms treat these costs very differently with soft costs being carved out more frequently. The decision on how to proceed is up to the firm. Some firms will remain with cost absorption as a perceived competitive differentiator. Others will recover costs as a pass-through to the client, whether soft or hard, in accordance with Formal Opinion 93-379. Still others spin off e-discovery as a separate function by creating a wholly-owned subsidiary that bills the firm for services performed as a hard cost.

In short, there are several ways to account for these costs—cost absorption is not the only option. Smoothing this bump in the road is why it’s important to ensure all the right people are at the table as you craft your cost recovery strategy.

Underestimating Soft Costs

With hard costs—costs that are directly paid to third parties—it can be much easier to differentiate between recoverable and non-recoverable costs, as the amount is a clear expense for the firm. In the case of soft costs—costs incurred because of work performed on a client’s behalf through in-house resources—the water can be a bit murkier.

Formal Opinion 93-379 states that a lawyer may not charge a client for overhead expenses. The actual expense for e-discovery work performed in-house includes software expenses and salaries, items that may fairly be categorized as overhead expenses. For this reason, soft costs are most often the expenses carved out of a bill.

Rule 1.5(a) contains a reasonableness test for fees incurred. One of the items listed in that test is Rule 1.5(a)(3), which measures reasonableness against costs customarily charged in the locality for similar services performed. If a firm keeps an eye on the cost of their service and compares it against amounts that other firms may be charging for similar services, there is no reason why soft costs couldn’t be similarly recoverable.

Conversion to cost recovery is not an easy process. There are a number of other “gotchas” that may be lying in wait for the unsuspecting. Clearly thinking through a cost recovery plan and playing out multiple contingencies should root out a number of complications.

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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.

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