Risk KnobPrologue

A story from a long-ago summer day highlights the big rewards that you can earn from taking purposeful risks.

In a little over a month, on August 5, 2015, 151 years will have passed since a commander took a gamble during the Battle of Mobile Bay.

The commander knew that the defenders had rigged 67 subsurface mines across most of the Bay’s mouth. Heavy guns guarded the remaining patch of open water.

As his attack began that morning, one of his vessels struck a mine — a torpedo — and sank within minutes. He expected that other mines likely lay in his flagship’s path. But he bet that they would either miss his hull or prove duds.

He shouted to Captain Percival Drayton: “Damn the torpedoes, full speed ahead!”

And David Farragut‘s side won the battle, captured Mobile Bay, and secured the resulting benefits for the Union.

Fortune favors the bold

The idea of taking risks to win rewards works for lawyers, too — and nowhere does it work as purely and as well as in the context of contingent fees.

In two earlier posts, I wrote, respectively, about the plusses and minuses of the hourly fee — which concentrates almost all risk on the client —  and the goods and bads of flat fees — which shift some of the “procedural” risk to the lawyers but none of the risk of losing on the merits.

The transfer of risk in the flat-fee context matters, I maintain, because it gives lawyers more control over things they can influence, aligns lawyer and client interests in avoiding unproductive work, and offers the lawyers a chance to earn a worthwhile reward for successfully managing procedural risks.

The third major way to structure a business client’s engagement of a law firm moves even more risk from the client to the firm in return for a share of the upside. In many cases, the contingent fee enables clients to bring claims they couldn’t afford to prosecute otherwise. In lots of other cases, it eases a client’s worries about unpredictable demands on cash flow. And in all instances it makes the interests and incentives of client and lawyer as indistinguishable as possible, short of marriage in a community property state.

What does contingent mean?

Let’s define what a typical contingent fee involves.

Any sort of contingent fee depends — is contingent — on a dispute’s outcome. The fee could come in the form of a lump-sum bonus, a multiple of hourly fees, or some other kind of compensation. But a usual contingent fee (I will address reverse and other unusual contingent fees in future posts) calls for the lawyers to receive a percentage of the “gross sum recovered” with respect to a claim or set of claims by settlement or judgment.

Variable percentages

The percentage will vary from case to case. It often starts at one-third. But it may range lower for engagements that present unusually large potential recoveries. The percentage also often ratchets up within a certain number of days before the final pretrial conference and again when trial begins and the lawyers’ work intensifies.

Another factor that can affect the level of the contingent percentage: who pays expert fees, travel expenses, and other costs. At my firm, where we invest about half of our hours on contingent-fee matters, we show our bias when we pay expenses both by calling for a several-points-higher percentage and by requiring a super-majority vote in favor of taking the case.

Plusses and minuses — client perspective

A client always retains the right to make some major decisions — including whether to settle and for how much — but by engaging a lawyer on a contingent fee the client as a practical matter chooses to exercise less control over the lawyer than under other fee arrangements. Because the client and the lawyer share a common interest in maximizing the recovery, the client expects the lawyer will exercise sound judgment in strategy and tactics and tends not to second-guess the lawyer’s approach. While contingent-fee lawyers do typically keep track of their time, they do not report those details to their clients, removing a key instrument that hourly clients use to manage hourly lawyers.

Nor do contingent-fee clients usually worry about whether the lawyers put enough resources into their cases. The incentive to maximize the gross sum recovered drives both client and lawyer.

Clients generally cannot avoid a promise to pay a contingent fee by discharging the lawyers without their consent. That, too, tends to lessen client control.

But the client can impose discipline by refusing to accept unreasonable settlement offers even if the lawyers recommend taking them.

The risk-sharing aspect of a contingent-fee arrangement compensates the client for the reduction in control. Unlike hourly lawyers but like flat-fee ones, contingent-fee lawyers assume what I have called procedural risk — the chance that the handling of a dispute will eat up far more resources than the lawyers planned for. Contingent-fee lawyers also assume the risk that they will receive nothing for their efforts. If they also fund expenses, out of pocket losses in business disputes can run into the millions and possibly tens of millions. 

With the shifting of great risk comes a transfer of great upside potential. The client promises to pay a portion of any recovery. The fact that the payment usually comes from money that the defendant remits allows the client to keep the promise without coming out of pocket.

Plusses and minuses — lawyer’s view

The control that contingent-fee lawyers exercise springs largely from the strong alignment of their interests with the clients’. Lawyers who work on a contingent-fee basis relish their relative freedom and the more trusting relationship that often prevails with their clients.

Liberty comes at a price. The risk of loss rests heavily on the lawyers under a contingent-fee deal. Inefficiency, bad strategy, poor execution, lack of diligence, burdensome discovery requests, fruitless motion practice, and other dumbness now come at the lawyers’ expenses as much as the clients’.

The corresponding upside gives the lawyers large incentives to handle a case quickly, cost-effectively, and successfully. Having skin in the game makes it more interesting, too.

Not for everyone

Not every case deserves contingent-fee treatment. Many do not.

All of the lawyers at my firm spend hundreds of hours almost every week evaluating and voting on contingent-fee proposals. Many more potential cases never make it even to the proposal stage. The reasons for saying no vary, but they include unpersuasive liability stories, iffy damages, client credibility issues, unrealistic client expectations, low likelihood of collection, unusually high litigation costs, and inability to resolve key issues early in a case.

Clients who can afford to pay hourly or on a flat-fee basis may also shy from contingent-fee engagements. Their reasons typically  involve a desire to maximize control over the handling of a case or concern over information and experience advantages that counsel may have in negotiating contingent fee terms.

The case for going contingent

But cases that do qualify for contingent handling provide big benefits to both client and lawyer.

The sharing of risk all but eliminates the potential conflicts between client and hourly or flat-fee lawyer.

The client largely sheds the risk of an adversary that scorches the earth with aggressive delaying and diversionary tactics and no longer shoulders alone the downside of losing.

The client’s cash flow avoids a constant drain.

And the happy day when the defendant pays the settlement or discharges the judgment makes the lawyer every bit as joyful as the client.

Next time

I’ll return to current events in the next post, on July 6.

It will concern the Second Circuit’s 2-1 decision upholding a judgment against Apple for orchestrating a per se illegal price-fixing conspiracy among book publishers. See United States v. Apple Inc., No. 13-3741 (2d Cir. June 30, 2015).

The dissenting judge on the panel urges that Apple’s role as a mere “enabler” of the horizontal cartel insulates it from liability for a per se antitrust violation.

I’ll offer thoughts on the huge stakes that the disagreement presents next Monday.

Feedback, please


In the meantime, take a minute to add a comment, post a question, or send me an email (bbarnett@thecontingency.com). I love hearing from you, and so do the other readers of The Contingency. Don’t hide your light under a basket.

Have a safe and fun Independence Day weekend.