This system is called the "billable hour" model. The billable hour system, in addition to being popular with lawyers is also favored by plumbers and accountants.
An important variant on the billable hour model is a system in which lawyers make binding estimates of their charges that cease to apply if surprises come up in the case, a bit like a typical automobile repair shop or a general contractor doing a renovation.
The leading alternatives to billable hours include flat fees and contingency fees. Toyota builds cars for flat fees based on the value of the car. Realtors typically charge a contingency fee based on the sales price (although this is arguably a fee based upon the size of the matter).
Also not unprecedented are fees based upon the size of the matter (common for investment managers), a flat fee per month (sometimes called a "true retainer") like your trash collection bill, and a fee for task model (popular with online advertising agencies and construction subcontractors).
A debate over billable hours, per se, missed the point. In the vast majority of cases, the vast majority of the time, there are ordinary and customary approaches to billing clients for particular types of work that become a stable industry standard. There are many kinds of cases that are almost always handled with alternative fee arrangements. There are other types of cases that are almost always handled on a billable hour basis. Part of the real debate over billable hours is really simply haggling over the size of the fee. The other part of the real debate over billable hours is over whether the categories of cases assigned to the billable hour system are too broad.
Most of the debate involves billing for "commodity work." In other words, over fees in relatively routine cases that don't put the survival of big clients at risk if done in a reasonably workmanlike fashion.
So, what is the status quo?
Billable hours are most common in litigation and negotiations where it is hard to determine what the opposing party will do, taking fees out of the lawyer's control. General Dynamics insists on cost plus contracts for new military systems for the same reason. It is hard to know how much it will cost in the end, the project is likely to be shutdown before it is carried to its natural conclusion, and clients often change their minds about what they want. Some work is too unpredictable to handle profitably on a fixed flat fee basis.
The use of binding estimates with exceptions to the general rules is common is "commodity litigation" like insurance defense litigation in automobile accidents, and employment litigation for large employers for non-executive employees. Hourly fees subject to maximum compensation cap is a variant of this approach common when the government retains a private attorney to do work that might otherwise have been done by a public employee (like criminal defense work for indigent clients).
Flat fees are common for drafting non-negotiable contracts, routine estate plans, personal bankruptcies, routine corporate documents, and intellectual property filings, where the initial engagement dicatates the scope of the work. Flat fees are not uncommon for appellate work (where settlement is unusual and the amount of work is highly predictable).
Flat fees are also sometimes used by high end firms in "bet the company" cases or in the defense of very serious criminal charges, where the value to the client exceeds anything that the lawyer could plausibly bill on a billable hour basis and the client is paying a premium to maximize the likelihood of a good result. Often these cases are contingent cases for all practical purposes because the ability to pay may be destroyed if the client loses the case.
Contingency fees are common in personal injury cases and in collections cases; I've also seem them in disputed tax cases (e.g. property tax assessment cases or defenses of multi-issue audits).
Fees based on the size of the matter are common in some states in probate and trust administration cases, and securities offerings.
True retainers are popular for lobbying, and sometimes used for municipal attorneys or serving as a general counsel for a medium sized business that can't afford a full time in house counsel. In-house counsel, prosecutors, public defenders and other government attorneys are often paid in this way as well.
A fee for task model is common in criminal law, where there is often one fee for a plea bargain, an additional one if the case goes to trial, and yet another if a case if appealed. It is also common in guardian ad litem practice, with fixed fees for activities like appearing at a hearing or conferring with a client, and in mass produced foreclosure litigation that involves a low risk of losing despite a high amount of money at stake. This used to be the mainstay of bar association fee schedules and remains common in litigation practice in Europe. In these contexts, there would be fees per motion, per hearing, per witness examination, per trial day, and so on.
The Case Against The Billable Hour
Very succinctly stated, in a long and informed post on the topic:
What's wrong with the billable hour?
From my fundamental economic perspective, all you need to know is that it starts and ends the pricing determination based on "cost of production" rather than "value to client." In my book, that's per se irrational.
Karl Marx's labor theory of value hasn't been popular in business schools as a descriptive model of how an economic marketplace works for the last half century, at least. And, in big law firms, most of the people that the lawyers ultimately report to went to business school sometime in the past half century.
Why do lawyers use billable hours anyway?
A cost plus deal with a solvent client never produces a loss, and lawyers are risk-averse. While lawyers deal with risk for their clients all the time, they greatly prefer to avoid having risk themselves. Lawyers don't like assuming risks that are fundamentally a result of the problems that their clients bring to them, particularly when their own client and the opposing party have the ability to make cases more expense to litigate.
Also, even in billable hour cases without a binding estimate of fees, lawyers are required ethically, and as a matter of good business, to scale their efforts to the value to the client for a case. A very typical conservation in a litigation partner's day involves telling a client that he can pay his lawyer a minimum of $150,000 to fight a lawsuit, or he can settle it for $30,000. A billable hours approach protects a lawyer from clients inclined who might otherwise be inclined to do something stupid. Lawyers are willing to fight the rare economically irrational case that a client wants to pursue anyway in exchange for a decent profit, but clients who routinely decide to act in an economically irrational way are usually shown the door. Sooner or later, they won't be able to pay the fees if they operate irrationally.
Lawyers agree to alternative billing rates because they are comfortable that they can manage the unprofitability risk in that case, because the value is at least as great as the cost plus involved in producing the work, and because the client prefers the predictability or can't afford to pay otherwise.
Alternative billing gives lawyers a strong incentive to do work efficiently to give the client the same value at a lower cost, something that the lawyer is in a better position to do than the client in most cases. Typically, in flat fee and contingent work, a greater share of the work is done by paralegals and junior associates, the work is more form driven, lead attorneys take settlement more seriously as an option, and unproductive discovery is trimmed in litigation.
Equally important, in the end, it all boils down to price. Shifts to alternative billing are, in part, simply a face saving way to allow firms to negotiate with their clients over the price they are charging for legal services. In negotiations between in-house counsel and an outside law firm, which is a common situation, both sides have a good idea what the expected kind of work costs on a billable hour basis. The in-house counsel often spent years doing precisely that kind of work on a billable hour basis at the firm that is now outside counsel. A shift to a flat fee arrangement allows the client to reduce cost, while offering the law firm an opportunity to win back the profits sacrificed by becoming more efficient.
Once efficiencies have been implemented at the firm in question, the sophisticated client may very well return to a billable hour fee arrangement, while paying lower bills for the same work.
Law is a service industry. In the long run, they are paid what the market can bear. The market will not, in the long run, accept 33% contingencies to do fully secured prime mortgage foreclosures. The market will accept $1,000 per hour billing rates if the typical total cost of a deal is considerably less than the value the client gets from the work, particularly if the client can be persuaded that less expensive lawyers would provide less value.
"Biglaw" can afford to pay high salaries and still make big profits because they work on matters that have high value to their clients, often because their clients are big businesses whose significant entity level cases reflect their immense scale. It is easier to do high quality work that creates value while remaining profitable by making a multi-billion dollar financing transaction for a publicly held company work smoothly, than it is to do the same thing for a business that needs hundreds of thousands of dollars of financing.
Firms that deal with "human scale" cases like automobile accidents, rank and file employment matters, unpaid mortgages, and estate plans for mere millionaires, still manage to make nice upper middle class incomes if they can bring in enough work, but they don't make what big business senior executives do handling it.
Firms that do work for individuals often have no choice but to limit their fees to the often low per case value of the cases that they handle, and to accept payment only when the value is produced, because that value (be it a real estate closing or a personal injury settlement) is the only reason that the client has an ability to pay at all.
The post I cite also describes push back from clients who don't want to subsidize extreme profits for the lawyers, and this may have merit. The executives that big law firms work for have seen unprecedented declines in their incomes, and that impacts what they think it takes to hire someone who handles decisions similar in gravity to those they handle themselves. CEOs are willing to let their lead lawyers earn similar rates of pay to what their senior managers earn, on the kinds of matters that the CEO deals with directly. When senior managers in big corporations make less money, they are less comfortable with hiring lawyers who more money than they do to handle anything but the very most dire matters.
There are a couple of other aspects you didn't mention:
1. Incentivisation. Billable hours encourages gold-plating, while fixed price encourages cutting corners.
2. Tort reform. If, for example, contingency-based arrangements were outlawed, a lot of frivilous (plus some worthwhile, of course) lawsuits would be prevented.
Your point on incentivisation is basically correct.
Your point on tort reform is very likely wrong. Contingency based arrangements do much more to discourage frivilous lawsuits than encourage them.
Lawyers are risk averse (even contingency fee lawyers), and take tend to take suits only if liability is much more certain than sheer economically rational actor analysis would suggest. These suits are inherently non-frivilous.
The bad incentives of contingency fees are that they discourage low dollar value claims even if meritorous (not necessarily a bad thing) and that they provide windfalls to lawyers in high damages, certain liability cases (at the expense of a severely harmed client); some states do limit contingency fees in high dollar cases as a form of consumer protection in these situations.
There may be some gambles on high damages, uncertain liability cases, but (1) they are rare (as high damages cases are generally), (2) there is an especially low incentive to take low liablity probability cases in contingent fee arrangements, and (3) there is no good reason to believe that other systems of compensation would encouorage different outcomes in this area.
Class actions are designed to make possible the high merit, low damages cases that don't make economic sense with contingency fees on a case by case basis. The main problem has been that there are agency issues involving settlements (they almost always settle if they are not dismissed), with plaintiffs' attorneys getting fat fees relative to the actual benefit to those harmed. Government agency action and statutory damages for minor violations that makes suits worthwhile in small cases to avoid systemic incentives to cheat in small dollar cases may be a better solution in some kinds of class actions.
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