Caught in the Act

The possibility of outside investment has the potential to fundamentally change the legal landscape.

By Richard Turnor, partner, Allen & Overy

Until now, solicitors in England and Wales have only been able to practise in partnership with other solicitors and certain foreign lawyers; not with other UK legal professionals such as barristers, legal executives and licensed conveyancers. This will change in 2009, with the proposed introduction of legal disciplinary partnerships (LDPs). LDPs will include partners from all the legal professions, and up to 25 per cent of the partners can be non-lawyers who are involved in the management of the firm.

However, the most radical change flowing from the Legal Services Act will come later, when the new regulatory structure for the legal profession is up and running, probably as late as 2012. This is alternative business structures (ABSs), where outside investors will be permitted to practice law for the first time.

After ‘Big Bang’, many, if not most, of the historic financial institutions in the City of London disappeared – replaced by the global giants that feature so prominently in today’s reports of turmoil in the financial markets. Will the Legal Services Act have a similar effect on the law firms of today?

Legal disciplinary partnerships

The requirement that barristers and other legal professionals, unlike registered foreign and European lawyers, should re-qualify before becoming partners has seemed anomalous for some time. Many firms will welcome the removal of this rule. Likewise, many firms will welcome the ability to admit senior managers – often hugely influential anyway, and people who may contribute more to the success of the business than most fee-earners.

LDPs may encourage firms to recruit more barristers and other legal professionals. This could result in a reduction in the size of the independent bar – and may result in firms recruiting from a wider pool – but LDPs alone are unlikely to lead to a fundamental change in law firm structure. Those admitted as partners are likely to share the values and aspirations of the solicitors and foreign lawyer partners, and behave in much the same way.

Alternative business structures

Full-blooded alternative business structures will have a much more fundamental impact.

Law firms may welcome outside investment for many reasons. They might wish to finance the development of know-how and precedents, the building of their brand, or the cost of upgrading their IT systems so that they can compete more effectively in their existing markets. They might wish to cover the early costs of building up a business in a new market. They may want to be able to incentivise non-partners by offering them the opportunity to participate in the firm’s success by holding a share of the equity or related options. Creating a market in the firm’s equity may be an opportunity to pay off some of the less effective partners and make way for new blood. The partners might merely wish to realise the value of their future earning power, and may therefore be prepared to trade some of their future earnings, and control, for a capital sum.

But will the potential investors be out there? Lyceum Capital certainly thinks so, and has announced the appointment of a heavy weight team (Tony Williams, Richard Susskind and Paul Hewitt) to advise as it seeks to establish a position in the legal sector. Even so, before investing in a law firm, companies like Lyceum will need to be convinced of the strength of a firm’s business model, its leadership and its potential to generate additional value for investors. The opportunities will only be available in appropriate cases.

Regulatory constraints

There will also be regulatory constraints, especially overseas.
For example, Australia allows ABSs, Spain has allowed up to 25 per cent outside ownership since 2006, and Scotland is beginning to consider the possibility of reforms like those now taking effect in England and Wales. Germany focuses more on regulating the individual lawyer than the business structure. Many other jurisdictions, however, remain opposed to the concept of LDPs and ABSs owing to concerns about the independence of the legal profession.

The US, in particular, would be a problem for international firms with branches in New York and New York lawyer partners. If non-lawyers were admitted as partners, every partner who was a New York lawyer would be in breach of the New York Code of Professional Responsibility
and subject to disciplinary action.

In the Netherlands and France, as in New York, lawyers cannot share fees with non-lawyers – so even if there were non-lawyers in a separate structure, partners from New York, the Netherlands and France could not share their own fees with anyone else, even if they could receive profits from elsewhere in the global practice themselves. Structuring around these issues would be likely to cause considerable damage to global profit-sharing systems, and therefore to the firm’s global culture.

Before becoming an ABS, or even an LDP, an international practice would have to review the applicable rules everywhere it does business. It may well encounter insuperable obstacles unless, and until, overseas bars and law societies liberalise the legal profession in the same way as England and Wales.

Conflicts of interest

Introducing outside capital could create conflicts between the interests of the investor and the interests of clients, especially competitors of the investor.

The regulators will almost certainly seek to prevent unacceptable conflicts by excluding outside investors from client-confidential information or influencing firms in a way that could be adverse to the interests of clients. Consumers needing advice about real estate, matrimonial disputes and succession planning, for example, may not be unduly concerned, but a perceived lack of independence could be a serious issue for corporate and commercial clients. Firms considering the ABS route will need to convince themselves that their information barriers, and other protections, are adequate.

Career structures

Firms will also need to convince their own lawyers, and the managers who may be partners from 2009, that an ABS can offer a career as rewarding as a career in a more traditional law firm – despite the fact that future profits will have to be shared with investors. Will the introduction of outside capital, and the opportunity to participate in the equity and make a market in shares, create value and earning power that counterbalances the diluted profit shares of the partners? Why not borrow from a bank instead?

The new competitors

However, the market will change as new competitors emerge. New leaner, and more efficient, law firms may emerge such as Lyceum Capital. Others bring together practices, and provide them with management expertise and the cash they need to develop their businesses. Even if these firms can’t compete as effectively for cross-border work for regulatory reasons, they may, in time, have a substantial impact on the domestic commercial market if they succeed in attracting lawyers of the right calibre – utilising the ability to offer share options and other incentives, for example. They may be able to field larger teams, with wider experience, more cost effectively than their rivals.

Of course they may also create peer pressure when their rivals see that the partners have sold their goodwill for substantial sums, and that fee-earners and support staff have the opportunity to participate in equity. This may encourage even those firms that do not allow outside investors to return to the practice of valuing goodwill, so that partners can realise the value of their interests in the business when they retire.

However, this process will initially have much less immediate impact among global firms, many of which have no need of extra capital. Even though an initial public offering (IPO), for example, could theoretically finance a transformational merger between a US firm and a UK firm, and create a top-end firm competing at the highest level on both sides of the Atlantic, the New York bar code will, for the time being, make that impossible.

Perhaps the greatest change in the short term will come from organisations that already have customer bases and systems that can easily be adapted to the provision of legal services. Such companies might simply have to set up a law subsidiary, hire some lawyers and bring in some know-how. They can therefore become formidable competitors very quickly indeed, especially for consumer-oriented work such as personal injury and residential conveyancing. These new competitors will be able to create economies of scale, and systems that will enable them to drive prices down, precisely as the Office of Fair Trading would have hoped when it first criticised the legal professions seven years ago.

One can easily imagine motoring organisations such as the RAC, insurance brokers and independent financial advisors, for example, diversifying into the provision of legal services. Even supermarkets seeking to maximise the benefits of their retail outlets my be tempted to provide legal as well as banking services. What effect would this have on law firms in the town centre?

Such organisations may not be able to enter the global market because of the regulatory issues.
They may not be able to compete as effectively for bespoke commercial and dispute resolution work because of the independence issues and the difficulty of attracting and retaining lawyers of the right calibre and experience. However, they may have a devastating impact in the large parts of the market, where regulation, independence and individual experience are regarded as less crucial than convenience, price and efficiency.

Structure of the future law firm

Such corporate law firms may simply be subsidiaries of the parent company, with incentive arrangements designed to align the interests of senior legal staff with those of the shareholders, like the arrangements associated with the corporate sector today. However, some may establish these subsidiaries as limited liability partnerships (LLPs), enabling senior fee-earners to participate in profits directly as members, and achieving significant
tax savings.

Law firms wishing to raise outside capital from private equity funds, or through an IPO, may adopt a similar structure, with investors participating in an LLP through a corporate member. Such structures are tried and tested, having been adopted by many fund managers and professional practices outside the law. An LLP would make it possible to replicate the ethos of the traditional partnership to some extent, but with the crucial difference that investors will be likely to insist on the introduction of
outside management expertise and require a share in the profits. Investors are likely to favour merit-based systems of profit sharing, with which they will be more familiar, although some may be attracted by the powerful motivational and collaborative effect of lockstep systems.

The appearance of such firms will then put pressure on other firms to adopt structures that enable the most successful fee-earners to reap extra rewards, senior non-legal staff to participate in the equity, and retiring legal and other staff to realise the value of their shares of goodwill. Thus, the law firm of 20 years’ time may be almost unrecognisable, although no doubt some firms will successfully hold out against change for many years to come.

Responding to the challenge

Some firms may feel that their market is unlikely to change for the time being, or that they are prevented from changing their structure by regulatory problems internationally. Others may choose to concentrate on areas of practice where the traditional law firm has the advantage.

Many firms, however, will have to respond as they face new and powerful competition throughout their practice, as well as pressure from partners and staff leaving to join their more successful competitors. In a rapidly changing market, firms must at least remain fleet of foot. A firm forced out of business in five years’ time by a supermarket competing down the road may regret taking on an expensive 10-year lease next year.

For other firms there may be opportunities to finance growth, to incentivise staff and unlock equity and rejuvenate the practice. The best firms will anticipate the changes and seize the opportunities, whether by using the new ABS model or finding other ways to compete more effectively, perhaps through consolidation in order to achieve economies of scale and the ability to hire the necessary management expertise.

Each firm will need to look critically at its strengths and weaknesses, and to steer a course that takes advantage of the opportunities, while neutralising the threats – even if, in some cases, that itself may mean selling the business to a new competitor while it still has value.

Richard Turnor is a partner at Allen & Overy. He can be contacted at richard.turnor@allenovery.com