Winds of change

From performance-linked pay to finding new fee structures, and even entirely new business structures, Fergus Payne, joint head of partnerships at Lewis Silkin, considers firms’ financial management options for 2010.

It would be an understatement to say that the legal sector is in a state of flux at the current time. Real and prospective changes abound in relation to the structure of law firms, the delivery of services, partner and associate remuneration and profitability.

2009 was an incredibly challenging year for most firms, with a relatively small number not being forced to make some difficult decisions. Many firms undertook restructuring exercises with significant partner and associate departures, much of which was well reported and, in some cases, the extent of which has been revealed by the recent publication of LLP accounts.

After years of firms announcing record profits and on a seemingly upward trend, last year a large number of firms also had serious financial management issues to address as clients slashed their legal expenditure budgets in a difficult trading environment. Firms had to deal with the issues of falling workloads, retaining star performers, protecting profits so far as they were able, and in extreme cases even survival.

There were swingeing cuts in overheads, most obviously in relation to staff costs, which led to rounds of redundancies, particularly in departments where workloads have been hardest hit and, perhaps earlier than previously seen in an economic downturn and certainly in larger numbers, partner departures and de-equitisations.

At the most extreme we saw a handful of law firm insolvencies and numerous small firms closing their doors. Banks continue to monitor the performance of firms struggling closely in an uncertain trading climate. Borrowing by law firms is no longer as straightforward as it once was, and many firms will have had no option but to seek increased facilities or require partners to make additional contributions to the firm’s capital.

Pay packaged

What has changed in 2010? There is a degree of cautious optimism being expressed by some larger practices, but uncertainty abounds, with a stuttering economy, higher tax rates and a general election due on 6 May and, in the longer term, regulatory change to come. However, some themes are emerging despite mixed messages about trading and ongoing levels of work. There is certainly more stability than 12 months ago, although it remains difficult to gauge what this will really mean in terms of revenue and profits for the year 2009-10.

Recent reports in the legal press indicate that there will be a low number of partner promotions in the 2010 annual cycle, as was the case in 2009, and that trainee retention rates across the UK’s top law firms have been hit, with firms retaining under 80 per cent of their newly-qualified lawyers. In spite of this, a number of firms are likely to put teams currently working reduced hours back to full time, with effect from the new financial year in April or May. This was only to be expected. Forced part-time work is not sustainable on a long-term basis where the aim is to retain the star performers.

An increasing number of law firms are also announcing plans to move away from the traditional lockstep model for associate pay, however, and adopt merit-based systems, with a view to linking pay more closely to performance. According to the press, a number of UK top-50 law firms, including Simmons & Simmons, Barlow Lyde & Gilbert and Field Fisher Waterhouse are already taking steps to move towards competency-based pay. Managing part-time and flexible working however will remain a challenge in the coming years.

Asking what is feasible

Pressure on fees remains and firms have been forced to be more flexible and imaginative about fee structures and alternative charging models. While the chargeable hour may not yet be on its death bed, clients now customarily seek fixed or capped fees and discounts. Much of this change has been driven by clients, in fact, who increasingly look for certainty in billing and greater efficiency in service.

Moreover, while the legal sector develops alternative charging models, it would appear that legal process outsourcing (LPO) also continues apace. Cost considerations, timing and competition have pushed more law firms to look at this as technology has enabled projects to be unbundled and parts are outsourced to countries like India. On large transactions, major firms are focusing on the structuring and execution of a transaction, and aiming to deal with the routine elements more cost effectively. Allen & Overy became the first magic-circle law firm to outsource legal work when it entered into arrangements with LPO provider Integreon at the end of 2009. Given that large firms have been outsourcing business functions for many years, perhaps we should not see LPO as a surprising development. However, it will be interesting to see whether a reluctance on the part of firms and clients to send work overseas leads to more work being undertaken in offices with lower overheads in the UK.

Although it is still early in the year, we might have expected to have seen some more mergers in 2010. There were a number of high-profile mergers in 2009: Hill Dickinson and Middleton Potts, Speechly Bircham and Campbell Hooper, Beachcroft’s takeover of the Kingslegal insurance business, and of course, the transatlantic pairing of Lovells and Hogan & Hartson. In other parts of the sector there were also more defensive mergers, with firms looking to the safety of consolidation as a route out of the recession, and it will be interesting to see how successful such mergers are in the long term.

Structural shift

Bolt-ons of teams and partner moves also appear to be prevalent. Recent restructurings by firms at partner level have not been limited to those individuals whose practices have been affected by the recession, and this has contributed to the trend of partners and teams becoming ever more mobile, as they look for fresh opportunities or firms change their market focus.

Some firms are currently reviewing their internal constitutional arrangements to consider the appropriate partnership model and remuneration structure. Over the past few months, we have read of DLA Piper calling in a major accountancy firm to help conduct a major overhaul of its partnership model, Reed Smith asking non-equity partners to pay to retain their partnership status and Lovells deciding to alter the remuneration system for junior partners to align its pay system with its merger partner, Hogan & Hartson. It is also clear elsewhere that there has been a move away from the rigidity of the traditional lockstep model over time to increasingly bring performance-based aspects into partners’ remuneration.

At the same time, the full implementation of the Legal Services Act 2007 draws ever nearer. Part of this change began with the introduction of legal disciplinary practices last year, allowing ownership of up to 25 per cent of a firm by non-solicitors. The initial take-up of LDPs has been limited however, which is not entirely surprising, as the recession forced many firms to focus on other issues.

The introduction of alternative business structures (ABSs) is the most radical aspect of the Legal Services Act, and it is this which may transform the legal profession over time. Firms will be able to adopt a range of business models in place of their traditional structures and, as well as being able to accept external investment, they will be allowed to go into business with other professionals. The Legal Services Board (LSB) has confirmed that it will be possible to operate as an ABS from late next year.

The LSB has laid out a timetable, which will see businesses able to apply for a licence to become an ABS from summer 2011, and successful applicants able to provide legal services by October. The LSB’s consultation on approaches to licensing closed in February 2010. The LSB is now shortly set to publish guidance explaining how approved regulators such as the Solicitors Regulation Authority (SRA) can apply to become a licensing authority to approve and regulate ABSs.

In spite of the many uncertainties, both the legal and national press are full of stories about the seemingly hearty appetite for external investment on the part of law firms and prospective investors. In truth, it is difficult to gauge how many firms will really raise such funding as soon as it becomes possible. Undoubtedly there are many serious discussions taking place, with firms at all levels of the market examining their options. One senses that the recession may have led to a cooling off on the part of prospective investors, but the proximity of October 2011 has rekindled interest.

Why might law firms want the proceeds of external investment? The most commonly given reasons are to facilitate the acquisition of other practices or recruitment of big hitting partners, investment in IT and property; reduction in debt and the distribution of accrued profits; and, possibly the most contentious, enabling a generation of partners to cash out and retire.

However, for many large international practices, external funding remains unlikely for the foreseeable future. Non-lawyer ownership is prohibited in many of the foreign jurisdictions in which they operate. In addition, it is probably not necessary for many such firms, because banks will be willing to continue to meet their funding requirements. This may not be the case for smaller firms, however, which may well be one of the reasons for serious consideration of external investment as an alternative source of funding.

Listing on a stock market will also be possible as a consequence of the Legal Services Act. The prospect of flotation may be attractive to firms carrying out high-volume, commoditised work such as personal injury cases, which can be standardised through investment in technology and processes. Other professional practices such as surveyors and accountants have listed in the past with mixed success.

There is much to be done by the regulators within the next 18 months, and a number of uncertainties remain, including the regulatory framework for ABSs and unresolved issues between the Law Society and the SRA. To complicate matters further, the SRA has announced that the Solicitors Code of Conduct will be rewritten, with the intention that there is a move away from detailed rules of conduct to what is described as “outcomes-focused regulation”. The new code, which is intended to come into force to coincide with the introduction of ABSs in 2011, will set out the principles by which law firms will be expected to conduct their business and the outcomes they must achieve. Given that the current code was only introduced in 2007, it is little wonder that many in the profession have expressed concern about the latest proposed changes.

Structural change in the widest sense is already underway in the legal sector and it looks set to continue. The recession may have been the catalyst leading to firms addressing overheads and efficiency to maintain profits, but client expectations and impending regulatory reforms will mean that changes will undoubtedly continue. Firms will need to be very clear about their financial strategies for the future, and there is certainly no shortage of challenges for law firm managers in 2010.

— fergus.payne@lewissilkin.com