Feature

posted 15 Jun 2007 in Volume 10 Issue 2

Examining alternatives

With the Legal Services Bill now passing through parliament, firms are preparing themselves for the eventual arrival of alternative business structures (ABSs). Partnerships with other professionals and business leaders may transform the competitive landscape, but do the changes offer new opportunities or pose fresh threats to profitability?

By George Bull, head of professional practices, Baker Tilly

In addition to recommending significant changes to the regulation of the legal profession in England and Wales, The Clementi Review proposed a new type of law firm. Called a Legal Disciplinary Practice (LDP), the intention was to create practices that would permit lawyers from different professional bodies to work together in the provision of legal services.

In proposing LDPs, Sir David Clementi also suggested owners and managers of a practice need not be the same and that non-lawyers (for example financial managers, information technology specialists or senior marketing personnel) could hold an equity stake in the firm. The intention was that such non-lawyers would enable the LDP to improve the provision of services to its clients. They would not, however, be permitted to provide services to clients of the LDP.

When publishing the Draft Legal Services Bill, the Lord Chancellor Sir Charles Falconer then explained the government’s objective was to promote high-quality legal services through the development of supporting business models and processes, along with systems to foster innovation.

Specifically, the Draft Bill proposed five steps to achieving this:

· Removing barriers to allow new providers into the market;

· Reducing costs through efficiency savings;

· Enabling the creation of ‘one-stop shops’;

· Enabling external investment;

· Providing appropriate safeguards.

Whereas Clementi had favoured LDPs, however, the Draft Bill proposed the creation of Alternative Business Structures (ABSs) permitting lawyers and non-lawyers to provide both legal and non-legal services to clients.

While the scope of activities of ABSs will be much greater than LDPs, however, certain features are common to both sets of proposals. For example, the ABS will have a Head of Legal Practice (HoLP) and Head of Finance and Administration (HoFA) to provide a clear structure and accountability in respect of the provision of services and the management of the practice. There will also be a ‘fitness to own’ test for external investors, and additional non-lawyer equity in an ABS could be used to fund the IT expenditure necessary to improve the delivery of services.

However, while one of the intentions of Clementi’s review was to simplify the regulation of the legal profession in England and Wales, the regulatory proposals attached to ABSs are inevitably more complex than those that might have applied to LDPs. Nevertheless, the Draft Bill carried the clear message that regulatory powers restricting the establishment of an ABS in a particular geographical area will only be exercised very rarely, partly because it is felt that consumers will always have access to other sources of legal advice via the internet.

The Joint Committee

A Joint Committee of The House of Commons and The House of Lords was appointed, under the chairmanship of Lord Hunt of Wirral, to review the Draft Legal Services Bill. After deliberation, the committee raised four concerns about the policy set out in the Draft Bill.

First, the Draft Bill evidenced a shift in emphasis from the ‘public interest’ to the ‘consumer interest’. These do not always equate to the same thing so the Joint Committee recommended that the public interest should be included in the regulatory objectives of the Bill.

Second, the Joint Committee identified a threat to the independence of the legal profession. This threat, in their perception, took the form of the level of involvement of the Secretary of State in the regulation of legal services, in particular the appointment of the chairman and members of the Legal Services Board.

Next, the Joint Committee felt that the government was going too far and too fast in the introduction of ABSs. It was concerned about the potential for conflicts of interests in ABS firms, both between lawyers and shareholders and between lawyers and non-lawyers. It was worried, both about the speed of approach and the level of uncertainty about the impact of the reforms, particularly on access to justice in rural areas and legal-aid provision. Their over-riding concern, however, was that nothing in the reforms should have a detrimental impact on the quality of legal services provided by a legal professional to a client.

Finally, the committee expressed itself unconvinced by the estimate of the costs of the new regulatory framework or the efficiency savings identified, which they regarded as “speculative at best”.

Reactions

The first reactions to the Clementi proposals were that they would apply principally to the provision of retail legal services – and so the phrase ‘Tesco Law’ was coined. Whether viewed from the perspective of larger or smaller firms, however, it is now recognised that LDPs or ABSs might offer four key advantages - albeit with qualifications.

The first, most obvious advantage is to raise capital for the future development of the business. Critics of this are quick to point out that such capital comes at a cost. The return required by external investors could lead to the evolution of management regimes that are much less tolerant and more financially-focused than many law-firm partners are used to. Indeed, with shareholder dividend flows to be funded, individual partners may receive smaller profit shares unless the external investor brings ‘something else’ such as brand strength, access to the market or technology platforms. Furthermore, there is no evidence of any lack of appetite on the part of the banks to lend money for business expansion.

Many feel that ABSs and LDPs will foster the introduction of new management. While the history of non-lawyer chief executives in the legal profession is not entirely a happy one, it is clear that the legal profession of the future must be able to motivate and reward senior non-lawyer personnel who are critical to the successful management of the business.

Running parallel with this is the alteration of partners’ perception of ‘ownership’ within a professional firm. The most successful listed professional-service firms in the UK, USA and Australia all point to the importance of their members beginning to think as owners of the business and to concentrate on building capital value as much as on generating annual distributable profits.

Finally, there is still the prospect of realising value for the benefit of existing equity partners. However this is structured, the investment will be judged critically by potential stakeholders.

Structuring the firm of the future

As Clementi envisaged, it seems that the implementation of reforms to the legal profession in England and Wales will produce large-scale change for high-street firms. Consolidation is inevitable, with the prospect of some firms providing outsourced services for – or competing with – the major retail organisations who are widely expected to make significant inroads into commoditised legal services. In addition to the well known partnerships, LLPs and limited company structures used by solicitors’ practices in England and Wales, other structures are also likely to be implemented. These might include joint ventures, franchise arrangements and Stock Exchange listings. The ABS proposals also open the door to private equity-funded management buyouts.

Outsourcing will also have a role to play in cost reduction for firms of all sizes and in a wide range of markets. Some of these outsourced arrangements are being implemented now, with a view to changed ownership structures once the Bill has become law. In the consolidator model, scale is important; external equity is leveraged off cashflow. The corollary of this is that the pressures on performance will be high if revenues falter.

Away from the commoditised legal services, the initial wave of interest from private equity seems to have been replaced with the realisation that initial public offerings (IPOs) may be more common than private-equity holdings in the law firm of the future. Nevertheless, the numbers of each are likely to be limited. As the debate develops, it is becoming increasingly clear that the business impact of a Legal Services Act will not be limited to those firms that become ABSs. Those firms seem set to have a profound impact on competition within the wider legal-services marketplace, and on the way in which client services are delivered. As such, all firms should now be considering the potential impact of the changes on their businesses.

Keys to success

It is instructive, therefore, to consider why some firms succeed as partnerships, while others remain no more than groups of individuals. Culture – the underlying core of beliefs and values that influence behaviour – is the dominant force in shaping professional-service firms. Cooperativeness, and a spirit of joint enterprise in effective business development, helps create an institutional firm.

For the culturally-fit firm, external equity need not necessarily require everything at the firm to be subservient to profit. Companies such as Goldman Sachs show that belief in partnership can transcend even a public listing. Strong firms may therefore take comfort from the fact that it is possible to retain partnership-style remuneration and committees, while clients continue to perceive a clear and consistent strategic identity.

By contrast, in weaker cultures, partners compete for profit share without a shared commitment to the partnership. Partners may hoard clients as a result of insecurity and damage client service.

Year prior to change

Once a firm has decided to create an ABS - whether it remains a partnership or LLP or incorporates preparatory to a private-equity stake or an IPO – a wide range of issues will have to be addressed. Key among these will be the maximising of profitability. In the course of making the firm attractive to investors, however, some partners may leave as the firm reinvents itself. Departure terms will therefore have to be carefully considered, with a watchful eye on billing patterns to make sure departing partners do not bill excessively, potentially prejudicing future client relationships. As care is taken to put in place the right management team – and partners begin to ready themselves for increased transparency and a loss of control – there will be a vigorous internal debate around capital values. To whom should shares be allocated and in what proportions? Older partners may point out that, had it not been for their efforts, the firm would not be where it is now. Younger partners may take the contrasting view that the future value of the business relies on their efforts. Compromise is necessary, with firms likely to settle on share allocations that are close to current equity participation and weighted-average remuneration levels. However, tax-efficient share-option and incentive schemes may also be established to encourage ‘rising stars’ to develop a greater equity participation in the future business. As final decisions are taken on the structure of the new business, however, it is worth remembering it is not necessary to forego all the benefits of the partnership structure. Many firms are attracted to the idea of a hybrid structure, incorporating both a limited company/plc and an LLP.

Point of change

For the firm that has planned ahead, the point of change should see a smooth transition to a corporate or hybrid structure, with tension between partner groups resolved and every shareholder understanding what is required of them for the future. Management will have become accustomed to the fact that belief in the future capital value of the business is key and that financial engineering will join professionalism and client service as fundamental drivers of the firm.

The next three years

In the post-Clementi world, partner incentivisation will be key. Financial incentives will only be part of the picture, however. Reward systems will be designed in such a way that they cause performance to improve – not merely reward improved performance. There will be a great emphasis on leadership and the quality of management systems. There will also be strains as new accountabilities – for example, visibility and transparency – vie with old loyalties.

It would be wrong to regard ABSs solely as a means of attracting external capital into a practice. At the very least, increasing the number of owners of a firm will not of itself increase the profitability of the firm. In other words, the cake might be no bigger but there would be more mouths to feed. When considering whether ABSs might have a part to play in the achievement of a firm’s strategic objectives, one must expect new, external owners to bring additional resources such as access to the market, experience or reputation.

Major change in the legal profession in England and Wales now appears inevitable, notwithstanding speculation that the proposed changes might be shelved by a new government. Current signs are that the enabling Regulations will come into force in 2010/2011. In the medium term, it seems that the impact on retail legal services will be profound. Whether increased competition and choice in this area leads to greater client satisfaction remains to be seen. However, the prospect of consolidation, private equity and IPOs in the legal-services sector as a whole requires every firm to consider its market position and business model. It is also clear that, while the impact of these changes will be profound, rumours of the demise of the partnership ethos may be premature.

George Bull is head of professional practices at Baker Tilly. He can be contacted at george.bull@bakertilly.co.uk