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Shell Legal – Reverse Rate Auctions and the Durable Billable Hour

Law Dept. Management Column
H ypocrisy is the tribute vice pays to virtue. While it’s not quite hypocrisy, there have been several decades of more talk than action on appropriate fee arrangements (AFA), let alone the attendant analysis of the relationship between inputs, outputs, and value.

The death of the billable hour keeps being reported. Yet the actual data — some of which indicates that the percentage of total corporate spend on AFAs remains in the single digits — borders on suggesting that the billable hour is immortal. Even where the billable hour has receded somewhat, the underlying compensation models and the associated behavior often remain. The durability of the billable hour, coupled with a law firm’s embedded expectation to see gains in collected hours year over year (with target calculations as rudimentary as previous year plus some arbitrary percentage), only increases the disdain in which the current system is held.

The conventional wisdom is that the billable hour is the root of many of the problems that plague the legal industry. The conventional wisdom is right. But the conventional wisdom can be right without being complete.

Shell subscribes to the premise that AFAs are superior and preferable to the billable hour in almost all circumstances while continuing to appreciate that ‘effort’ is worth incentivizing. This is not lip service. Essentially all new Shell legal matters, in all areas of law, are structured as AFAs. Indeed, one of the authors was originally hired at Shell in order to oversee the transition to AFAs, as well as the enabling adoption of matter management and process improvement. Given Shell’s institutional commitment to AFAs, it often comes as a surprise that a reverse billing-rate auction was a key step in Shell’s panel review. There are two important reasons for this.

First, Shell still pays for billable hours.

Budgets tied solely to hourly rates are mostly legacy matters. But there will likely always be some small subset of idiosyncratic matters that benefit from the strengths of the billable hour: immediacy, flexibility, and tractability. By definition, such matters are rare and relatively insignificant from a budgetary perspective.

More often, billable hours are — and will be — paid as part of a hybrid fee. Under Shell’s hybrid-fee arrangements, the bulk of the compensation is paid as a combination of fixed and success fees while some hard-to-scope phases still rely on the billable hour. Just as we realize that not every matter is the same, we also appreciate that not every detail needs to be priced to the highest level of accuracy. Common in business but often anathema in law, the 80/20 rule offers an important perspective on the penchant for over-engineering. Flexibility can be deliberately built into AFAs while still modifying incentives and changing behavior.

Second, whether we like it or not, the billable hour remains dominant, for now.

The legal industry is still maturing and finding ways to track alternative arrangements. This is true of clients and firms. While the integration of large corporate procurement systems has been hailed as a harbinger of AFA dominance, most of these systems reverse engineer AFAs to day rates. For once, the “billable hour in drag” has nothing to do with legal’s status quo bias. Rather, it is procurement’s traditional approach to service providers. It is procurement departments applying to legal what they have long done with respect to accounting firms, IT services, etc.

For firms, the billable hour continues to play a central role because it is the established measure of profitability. So billable hours remain at the core of how many law firms price AFAs. Hours multiplied by rate acts as a primary driver in the pricing process. Many AFAs obscure, rather than alter, this fundamental equation.

Even when they graduate from pricing AFAs by projecting billable hour totals and adding a substantial risk cushion (i.e., they shift to a data-driven approach that mines prior matters and supports portfolio-centric projections) we recognize that many law firms will still apply a billable-hour prism to opportunity costs, utilization, realizations, etc. Understanding how law firms are approaching the economics of the relationship plays an important role in communicating with them, working with them, and getting inside their decision cycle.

The reverse rate auction is an excellent tool for creating such transparency. In a reverse auction, the roles of buyers and sellers are switched. Ordinarily (i.e., in a forward auction) buyers bid increasingly higher prices to obtain a good or service from a seller. In a reverse auction, sellers bid increasingly lower prices to obtain business from a buyer. The online auction process creates transparency and price competition in real time. The reverse rate auction brought Shell’s average rates down 18 percent.

But, to foreshadow a future article, the reverse auction is just one tool among many. Most of these tools are intended to move the conversation beyond the billable hour. How, for example, do firms price their ‘free’ value services — secondments, updates, training, allied professional support — that have become so central to deep supplier relationships as preferred provider programs have proliferated? At Shell, we are working with our firms on a comprehensive quarterly business report (QBR) that monitors these value services and other non-hourly metrics (diversity, RFP participation) in order to drive a different kind of dialogue.

Shell wants to see a world where AFAs have displaced the tradition billable hour. But, as we’ll discuss next article on ‘shadow billing,’ we think effort — with hours serving as a proxy — remains an important aspect of cost accounting and a consideration in trying to think through value. Moreover, even if hourly thinking were truly the root of all evil in the legal world, self-inflicted blindness to current realities is not the appropriate response. Rather, the way to usher in the era of the AFA is to mandate AFAs and follow through. Shell is doing that. Shell, however, is also maintaining visibility into the inner workings of its long-term suppliers, which requires the understanding of the role that the billable hour still plays explicitly and implicitly.

About the Authors

Vincent Cordo serves as the legal team's Global Sourcing Officer for Shell. He is a member of the ACC Legal Operations section.

Casey Flaherty, a former in-house counsel, is the founder of Procertas. Casey consults with law departments and law firms on legal operations, service delivery, and technology. He is the author of Unless You Ask: A Guide For Law Departments To Get More From External Relationships, written and published in partnership with the ACC Legal Operations Section.

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