In 2004, I started working for a small litigation management firm in Washington, D.C. Over the next four and a half years, I was fortunate to view the inside of a relatively new industry and experience the good, the bad, and ugly of risk management as it was applied to large portfolios of litigation. What follows is a reflection of the lessons learned from four years of professional practice in litigation risk management.
Introduction
Because of its somewhat politicized nature and because adverse litigation can have more effect on stock price than does continued success, most estimates of litigation cost in this country are merely WAGs (that is to say guesses). These guesses are based upon little more than conjecture at times. At other times, they are based upon survey analysis and estimates made by experts based on incomplete data. Possibly the best estimate comes from the 2005 Litigation Trends Survey commissioned by Fulbright & Jaworski (Insurance Journal, 2005). According to the survey, roughly 40% of respondents could not even estimate their average litigation costs. Of those who could, 10% said that their litigation costs were equivalent to 5% of their revenue. Other surveys, such as a recent one commissioned by the American Justice Partnership (Engler and McQuillan, 2008), places the cost of excess litigation at over $500 billion per year. It is based upon assumptions that may or may not be valid.
Whether it is $500 billion or 5% of revenue, litigation costs pose serious problems to corporate America. Yet, corporate America appears to be doing little to curb or contain it. As this paper will show, even though litigation costs are accelerating faster than inflation, there are significant barriers to cost containment and litigation risk mitigation. First, there are accounting standards that encourage treating costs separately, instead of as an integrated whole. Second, there are institutional and cultural barriers to overcome. Finally, there is the problem of sizing risk management contracts to maximize benefits for both parties.
The Problem of Statistics
For most corporations in America, the rising cost of litigation is probably only secondary to the rising cost of health insurance. While inflation has been increasing at roughly 3% per year, litigation costs are probably increasing at roughly 10% per year. There is no definitive index as with inflation obviously, but there are indicators. One indicator is the American Lawyer’s annual list of the 100 largest law firms in America. This list is based upon the revenues of the largest law firms in the country. By tracking the change in average revenue from year to year, it is possible to obtain a proxy for the increase in litigation costs. The AmLaw 100 list also shows another interesting trend. The average profit margin of the 100 largest firms has consistently averaged around 40%, indicative of a stable pricing model throughout the entire industry.
One of the criticisms of using just the 100 largest law firms to compute the entire growth of an industry is that these firms may not, in fact, be indicative of the entire industry. Even with an apparently stable pricing model and the fact that these trends also hold true for the next 100 largest firms,[1] critics have a legitimate point. There is a world of difference between an AmLaw 100 firm with offices in every major American city and a sole proprietor working in Fargo, North Dakota. However, if additional indicators show the same trend, then we can begin to say that we have arrived at the best available proxy. Enter that second indicator. The Bureau of Labor Statistics (BLS) collects yearly data on various occupations. The BLS’ Occupational Employment Statistics (OES) survey contains granular information of salary and pay for virtually every occupation in the United States. Using the results of multiple surveys, it is possible to track increases in lawyer pay over time. As the OES survey is cross-sectional, it does not suffer from the same bias that might infect the AmLaw 100 indicators. A time-series analysis of the OES surveys shows that the growth in lawyer salary has grown along the same lines as the AmLaw 100 survey.
These trends are difficult to ignore. Moreover, it is important to remember that these statistics only show one side of the equation. The total cost of litigation is equal to the cost paid out to defend one’s self plus the cost paid to the plaintiffs when one loses. We already know, based on the evidence presented above what that defense cost is and we know that this defense cost is increasing at roughly double the rate of inflation every year. We also have some idea of the scale of total defense cost simply by noting the sheer scale of the defense dollars controlled by the top 200 law firms in the United States. However, we still have little, if any, idea just how much corporations are paying out to plaintiffs when they lose.
Barriers to Total Cost Management
While we have some idea of the size and scope of the legal problems facing corporate America today, it is difficult to nail down specifics. There are several reasons for this. First of all, according to the American Arbitration Association, only about 3% of all legal disputes go to court and only half of those ever reach a verdict.[2] This means that 98+% of all legal disputes never see the light of day. Put another way, for every one case that makes the pages of local and national newspapers, there are roughly 50 that do not. These cases are either settled out of court or else the case is dropped by the plaintiff. This makes tracking costs externally very difficult.
The biggest obstacle, however, to effective external decision-making are the accounting rules that govern the disclosure of these disputes. Legal defense cost is considered to be part of a company’s operating budget and, therefore, is rarely broken out in balance sheets and cash flows. Estimates can be obtained if the size of the legal department is known. Otherwise, guesses, like those we have seen above, are the best that we can do. Liability costs are generally charged to be individual business unit that incurred the case (and are likewise considered to be operating costs). FASB rules do not require a corporation to specifically declare legal issues or their value if, in the opinion of the executive leadership, these issues will have no material effect on the company. A 5% revenue impact is significant, but it is also the aggregate total of all legal costs incurred, some of which are routine. Since it very rare that a case could even claim a 1% impact on revenue, it is highly unlikely that any company will believe that any case will trigger FASB reporting requirements. Accounting rules, therefore, provide a lot of wiggle room for companies to hide their legal issues within the balance sheet. This tendency of rules-based accounting has been frequently noted in discussions of business ethics (see, for example, Albrecht et al. 2008).
The same accounting rules that make it difficult for outside observers to grasp a company’s financial exposure to litigation can often hamper internal control and decision-making. Until very recently, law firms and corporate legal departments lacked the sophisticated information management systems that allowed for effective and efficient tracking of litigation costs. However, since accounting rules do not require that a company manage for total litigation cost and, in fact, tend to fragment litigation spending over several departments, there has been little impetus to manage for total litigation cost. Where risk management strategies have been put in place, they to focus on avoidance and prevention of litigation rather than on cost containment measures. There are two notable exceptions to this which will be discussed later in this paper.
In addition to the accounting rules that create a fragmented (at best) cost control regime within a company, legal departments have other institutional and cultural barriers that must be overcome in order to effective manage litigation risk. First and foremost, attorney-client privilege and attorney work product privilege combine to create a highly insular corporate culture within the legal departments of most companies. Those outside the sphere of the legal bubble are seen as potential leaks, not as allies in a common cause. Even if a CEO or CFO wished to strictly comply with the requirements of FASB accounting rules, he would have to rely on the judgment of the legal department and it’s outside counsel. These two entities are likely to determine that such disclosure would violate the above-mentioned privileges.
Risk Management in the Legal Context
As stated above, corporations, large and small, do engage in loss mitigation for litigation; they just do not do it as effectively as they could. Most corporations engage in the usual loss mitigation tactics: specific policies related to human resources management, safety training programs to minimize injuries on the job, retraining programs for those who can no longer endure the physical hardship of their job, etc. These programs are obviously designed to prevent lawsuits from happening in the first place. Their secondary purpose is to provide a legal defense when a lawsuit does arise in order to mitigate loss payouts. Additionally, these programs serve other purposes, such as employee retention and the dissemination of the corporate culture. Therefore, while these programs do serve a risk management function, it is hard to call them dedicated risk programs.
Two other loss mitigation/risk management programs bear mention and a brief discussion here. The first such programs are collectively called alternative fee arrangements. Most commonly a corporation will negotiate a reduced hourly rate with its largest law firms, enjoying the advantages of reduced cost and cementing closer relationships with these firms. Since the corporate legal department controls the defense cost side of the equation, they can engage outside counsel to reduce the burden on their yearly fixed budget. However, the corporation is still not controlling for cost. Based upon eLawForum’s review of several thousand cases across a variety of litigation practice areas, I can state with a high degree of confidence that the average case lasts over two years with a standard deviation of one year. Therefore, even with rate discounts, the defense cost of a case can easily spiral out of control. From an accounting perspective, a case that costs $180,000 to defend will only have an impact of $90,000 on the annual budget. Furthermore, neither the law firm nor the legal department has any incentive to settle the case quickly. If that same case above were settled in half the time (one year), the entire $180,000 would hit the corporate books at once, appearing to be a far worse result than it truly is.
Even those arrangements are rare. According to Smith (2005), “just a third of the 100-plus-lawyer firms surveyed had recently engaged in any sort of alternative billing—and fewer than a quarter of those arrangements involved litigation.” Both corporations and outside counsel law firms obviously see litigation as inherently too risky and, therefore, too expensive to be contained by alternative fee arrangements. Corporations have, however, had greater success with Alternative Dispute Resolution (ADR). ADR refers to a series of less expensive methods of resolving litigious matters. Of particular interest to us is the use of arbitration. The other methods, such as negotiations and mediations are required by virtually every jurisdiction in the country and, so do not form an integral risk management system.
Arbitration is essentially “court-lite.” Both sides present their case to an arbitrator, whose decision is final.[3] The two major advantages of ADR from a risk management standpoint are that it is cheap and it is private. According to Raynor (2006), many civil cases can cost upwards of $250,000 to defend. Arbitration clauses can greatly reduce that cost because discovery time is severely curtailed in favor of an expeditious ruling. Also, unlike most civil trials, arbitration is private. The proceedings are never made public and the ruling of the arbitrator need not be explained even to the participants. For many corporations, this privacy (they believe) reduces the likelihood that they will become litigation targets. It reduces the possibility of large awards based on sympathetic juries and makes it harder for a good trial lawyer to show a pattern of behavior.
All of the above solutions address only one side of the equation: defense cost. Since eLawForum’s internal analysis shows that the liability to defense cost ratio averages 3:1, corporations are missing out on an opportunity to employ a unified and integrated litigation risk management strategy.
Total Cost Management
Total cost management is akin to the total quality management processes first perfected by Japanese automakers in the 1970s. Originally used in construction project management, it is a methodology that encourages corporations to create project portfolios in order to streamline and optimize outcomes (Hollmann, 2006). Since it normally is used for assets, most corporations have not considered using it for large liabilities.
From a risk management standpoint, total cost management sets as its endpoint a reasonable and obtainable level of losses based on historic loss rates. In order to accomplish these reduced loss levels, a corporation would then partner with one outside counsel in order to develop a unified national (or international, where appropriate) strategy for litigation arising within one portfolio or another. Most lawyers will tell you that every case is unique and that is true insofar as it pertains to the particular circumstances of the case. However, all employment cases share many similarities, as do most personal injury cases, commercial disputes, and the like. That makes it possible to place them in portfolios that can managed independently by a few in-house lawyers tasked with ensuring results.
As eLawForum practices it, total cost management is only possible if metrics are established. This requires corporate legal departments to give up some information on these portfolios. Metrics, such as total cost per case (defense plus liability), are vitally important in order to measure the effectiveness of the implemented program. These metrics are also often the hardest to quantify. As we have previously seen, corporate legal departments have little incentive to track total case cost and so most do not even bother. Reconstructing these metrics can require hundreds of man-hours and can often be an arduous task for analysts and lawyers alike. However, once these metrics are constructed and agreed upon by all parties, it is possible to construct a portfolio of cases on which outside counsel firms can bid. These firms will provide an incentivized bid in order to reduce the cost of the overall portfolio to the company. Incentives can take many forms from bonus payments for hitting certain agreed-upon financial targets to opportunities to bid on more portfolios in the future. eLawForum found that the best combination was to use a fixed fee payment schedule with “profit-sharing” payments for reducing liability.
Conclusions
Using total cost management, eLawForum cut defense costs by upwards of 75% and liability cost by as much as one-third without compromising the quality of legal service provided.[4] The real challenge is to get corporations to see their liabilities in the same light that they see their assets: portfolios to be managed in order to optimize the outcome to the company. This risk management technique provides certainty to the corporation in the form of fixed defense costs and offers greater opportunities to control liability than any of the current loss mitigation programs used today. Total cost management has the potential to do for litigation risk management what its predecessor in manufacturing did for Toyota: radically alter the landscape of litigation in order to provide a competitive advantage to the companies that implement it thoroughly.
References
Albrecht, C., Albrecht, C.C., Dolan S., and Malagueno, R. (2008, Jan/Feb.). Financial Statement
Fraud: Learn From the Mistakes of the U.S. or Follow in the Footsteps of its Errors. Corporate Finance Review 12(4). ABI/INFORM Global, 5.
Engler, J. and McQuillan, L. J. (2008). Limiting lawsuit abuse lowers cost from litigation,
creates jobs in long run. Retrieved from http://americanjusticepartnership.org/wordpress/?p=46.
Hollmann, J. (2006.) Total Cost Management Framework. Retrieved from
Insurance Journal (2005, Nov. 7). Cost of Litigation Haunts U.S. Corporations More Than
Winning Cases. Insurance Journal. Retrieved from http://www.insurancejournal.com/magazines/east/2005/11/07/features/62312.htm.
Raynor, L. (2006, October). Litigation vs. ADR. Risk Management 53(10). ABI/INFORM
Global, 30.
Smith, H. The Fix Is In. 2005 Litigation Supplement to American Lawyer. Retrieved from
[1] The American Lawyer publishes both an AmLaw 100 and 200 list each year in April and May.
[2] Source: Internal marketing documents for eLawForum Corporation.
[3] In most jurisdictions, arbitration decisions cannot be appealed in a court of law, except under very specific circumstances.
[4] Source is internal eLawForum documents gathered from dozens of clients between 2004 and 2008, when the author left the company.
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