Sometimes I feel like the “Lone Ranger” here at ZipDebt, shouting from the rooftops about why consumers should not pay 15% of their debt to third-party settlement companies. Regular ZipDebt readers already know my position on the front-loaded fee structure currently used by about 99% of debt settlement companies. My post from April 3, 2006 discussed some of the problems associated with the “15% upfront” model.

Now, attorney and longtime consumer advocate David Giacalone has written an excellent piece on the subject of debt negotiation fees. Although I’m sure his post will not win him many fans in the settlement industry, I for one greatly appreciate his effort. David is focusing on one example of a company that uses the “attorney model” for debt settlement. And while his article pertains to the questionable ethics of attorneys who charge a flat percentage of enrolled debt, it’s certainly a problem throughout the entire debt reduction industry, whether or not the firm in question is attorney-based. So I felt it would be worthwhile to discuss some of the history of the fee models used in the industry.

Consumer debt settlement evolved in the 1990s from a pre-existing model that went by various names, but was usually called “business debt arbitration.” Companies would often choose names that made them sound like a law firm, even though most were not law firms. So, “Howard, Fine, and Howard” (with apologies to the Three Stooges) would set up shop as business debt “arbitrators.” The fee model in vogue at that time was to charge a 1% retainer as a deposit, based on the amount of debt to be negotiated, with the primary fee handled on a contingency basis, and set at 25% of the savings achieved in the negotiation.

When I first started negotiating consumer debt in 1997, this is the model that I employed, and I even credited the 1% deposit against future fees earned. So the concept was based on 100% contingency. Most of the people I worked with were happy with this fee structure, since it provided some assurance that they would see results before having to pay any significant amount in fees.

Flash forward to 2000, as I became part of a company that was attempting to roll out debt settlement services on a nationwide basis. We entered the large scale market with essentially the same fee model, except that we charged 2% instead of 1%, and the 2% figure was now treated as an “administrative fee” rather than a simple retainer to be credited against future fees earned. However, the core of the approach was still intact, with the primary fee being based on 25% of the savings achieved in the negotiations.

The reason for the change from 1% retainer to 2% administrative fee was simple enough. It’s one thing to run a small individual practice, quite another matter to grow a large company with payroll, overhead, and marketing expenses. Within a matter of months, the 2% was adjusted upward to 3%, but at that time there were still no monthly fees charged to the consumer. Again, the reason for the jump was not greed, but rather marketing exigencies.

Speaking of marketing, therein lies the problem! In 2000-2001, it was possible to purchase a database of consumers who had “opted in” to receive email on the subject of financial assistance. In those days, we could send 5,000 email messages to well-targeted recipients for a cost of about $1,000, and expect a steady flow of “leads” to the sales floor. A single blast of 5,000 email messages normally returned between 60-80 responses from interested, motivated consumers. And it was usually possible to enroll about 15% of those respondents. So we could expect to bring aboard 10 or 12 new clients for every 5,000 emails sent. That translates to an “acquisition cost” of $80 to $100 per new client based on the $1,000 cost to do the mailing. This does not take into account sales commissions or other payroll expenses, but represents a very healthy acquisition cost in terms of advertising dollars expended.

To make reasonable financial forecasts, we operated on the assumption that our overall settlement percentage would average 40% (which it did for several years, until it slowly crept up to the current industry average of approximately 50%). So we expected to save the client 60% before fees were applied. Taking 25% of the expected savings of 60% yielded an assumed fee equivalent to 15% of the starting balances. (Starting to sound familiar yet?) With the average enrolled client at a level of $30,000 of debt, that meant a forecast of $4,500 in negotiation fees, plus another $900 in administrative fees (based on the 3% admin fee), for a total of $5,400 in fees to be collected over the life of the program. That’s a very healthy potential income off a $100 marketing acquisition cost.

Another way to look at the above figures is that we could generate a “lead” (in the form of an interested consumer) for approximately $12 to $16 each. However, this happy state of affairs only lasted for a matter of months, and since 2001 lead costs have been climbing ever upward. Today, an “exclusive live transfer” lead can cost up to $90 each! And leads of lesser quality (generated through a few million website “lead form” traps set up by dozens of lead brokers) can still cost $30-$50 apiece. Closing ratios on these lesser quality leads are typically around 5-7%, further eroding the ROI on marketing expenditures and inflating the acquisition cost of a new client.

One of the key reasons for the upward spiral in lead costs is based on the law of supply and demand. In 2000-2001, there were at most a small handful of such debt companies in existence, so there were only a few of us “fishing” in a very large pond. However, the debt settlement industry was (and still is) a mostly unregulated industry. So there were (and still are) very few barriers to entry. With no clear standards, no licensing requirements, and no minimum financial standard (performance bonds, etc.), anyone could set up shop and call themselves an “expert debt negotiator.” Many did. Within 1-2 years, there were dozens of copycat companies, all basically cloning the existing business model. With more and more people fishing in the same pond (although still a very large pond), the mounting competition for “fresh hot leads” drove the cost higher and higher.

When you are attempting to enroll 400-500 new clients per month, the original fee model means that you must have very deep pockets in order to get to the “back end” stream of income generated from negotiation fees. Enter the monthly “service fee,” which started out around $29/month and climbed from there. So now there were three separate fees in place, the 3% administrative fee (which other companies quickly bumped to 4%, 5%, even 8%, etc.), PLUS the monthly service fee (now typically $40-$50/month, or more), PLUS the negotiation fee of 25% of the savings.

I was present at one of the first trade conferences held by the debt settlement industry. At the conference, the CEO of one of the newer large-scale settlement companies gave a presentation in which he discussed the fee model his firm was implementing. Gone was the negotiation fee based on 25% of savings. It was replaced with 15% of the total enrolled debt as a FLAT FEE, to be paid by the client over the first 14 months of the program. I was stunned. In my estimation, this front-loading of the program fee removed the single most valuable aspect of the program from the consumer’s perspective – namely, that the fees were based results achieved. No results, no fee. Instead, the fees were now charged in advance of having accomplished anything at all for the client. This, of course, was wonderful for the debt settlement company, but a horrendously bad deal for the customer. In effect, the settlement company had now become just another creditor, elbowing out of the way the client’s legitimate creditors, and grabbing up front most of the money that should properly have gone toward settlements.

Within a matter of months, this new fee structure spread throughout the industry like an extremely contagious virus. Today, I estimate that about 99% of settlement companies charge fees based on the front-loaded model.

So that is how the magic 15% flat fee came to be the industry standard. It has no bearing whatsoever on the amount of actual work involved in negotiating debts. As David Giacalone points out in his piece, there is very little actual legal work involved, so it makes no more sense for a law firm to charge a flat 15% of the enrolled debt than it does for a non-attorney settlement firm. And a fee of 15% of the enrolled debt certainly makes no sense at all from the consumer’s perspective. It is merely an artifact of the manner in which the industry itself has evolved. If you think about it, it’s not even remotely logical. If a person has $30,000 of debt spread over 5 credit card accounts, the fee is $4,500. If the debt load is $100,000, also over 5 accounts, now the fee jumps to $15,000. Is it any more work for settlement firm to negotiate 5 larger accounts versus 5 smaller ones? No. But it makes even less sense for the consumer to be forced to pay this fee IN ADVANCE of any meaningful service being performed.