Law firm capital and the financial crisis

By Published:

I don’t normally link to articles in National, the magazine I edit — this blog is my personal project and doesn’t necessarily represent my employer’s views, and so I try to keep Law21 and CBA in watertight compartments. But I’m making an exception for our September 2008 cover story “Who owns the firm?“, which looks at non-lawyer investment in and ownership of law firms, something that’s already underway in Australia and that’s coming to the UK within the next few years.

I provide the link partly because I think it’s a pretty good article — but mostly because it’s turned out to be awfully timely as well, in two respects. For one thing, the UK reform process is accelerating. The Solicitors Regulation Authority is fast-tracking plans to allow up to 25% non-lawyer partnership in UK law firms. “The timetable,” LegalWeek reports, “would put the SRA ahead of schedule, allowing it to fast-track applications when the regulations come into force, which is anticipated in March 2009.”

(The article is a little unclear on an important point. It refers to the SRA accepting applications for new Legal Disciplinary Partnerships (LDPs) — these are operations that comprise solicitors, barristers, licensed conveyancers and other legal professionals who up till now have not been permitted to form partnerships in the UK. But the proposal to allow non-lawyers to practise law in partnership with lawyers, a far more radical notion, envisions something called Alternative Business Structures (ABS). This article in Managing Partner magazine explains the difference very well.)

So the UK reform process is gathering speed. But the other reason why National‘s cover story is timely lies in the front pages of your newspaper over the past week — the financial crisis besetting the US (and increasingly, the world) economy. I won’t recap what’s going on — you already know about it, and the news is changing by the minute. Suffice to say it’s serious and it will directly affect lawyers (consider these comments by veteran Canadian corporate lawyers in today’s Globe & Mail).

Why should lawyers and law firms care about the financial crisis? The reason has little to do with the Dow Jones, the TSX, or any other stock market index that’s fluctuating wildly right now. The reason lies in the  more important indices in the credit markets. Credit is freezing up around the  world — the cost of borrowing is climbing higher by the hour, as banks grow far less trusting of other banks and of borrowers generally. Financial analysts are paying a lot more attention to the credit markets than the stock markets. Lawyers should, too.

Credit markets matter to Main Street, as opposed to Wall Street, because a lot of modern businesses rely on the liquidity of credit to keep their operations going. More than a few companies need access to credit just in order to meet their payrolls. And I would submit that few modern enterprises are as heavily dependent on credit as law firms.

Law firms have always been odd business structures. They pay out all their profits at the end of every fiscal year, and rarely commit any serious funds to long-term investments or anything more than the most essential capital or infrastructure needs. They’re also notoriously bad at cash flow — many lawyers don’t bill quickly or frequently enough, and they let outstanding receivables gather dust without forcing the collections issue. When your coffers empty every December and it takes you three months to get paid for a service rendered, you’re living an unnecessarily precarious financial life. Law firms are walking a very thin tightrope, and right now, the financial crisis is producing gusting winds.

In that context, the concept of stable outside funding is going to seem a lot more attractive in the years, and maybe even the months, to come. Many law firm leaders have so far shrugged off the idea of floating shares in the firm or taking on outside investment, on the grounds that what do firms need with deep capital reserves? That’s an attitude borne of an era of cheap and easy credit, an era that’s gone and might not be back for quite a while. The premise, and the promise, of outside investment in law firms could become a priority consideration a lot sooner than anyone expected.

Related post: Credit crisis: you ain’t seen nothin’ yet.

Print Friendly

3 Responses to “Law firm capital and the financial crisis”

  1. Jason Goodwin

    No doubt credit is an issue, and by paying out all or close to all profits at year end is hardly prudent. But I’m confused on the real competitive advantages of raising non-lawyer capital. Capital is good, sure, but what sort of expansion and investment is to be funded? On it’s face, is there something inherent in the partnership structure that prohibits forecasting and keeping some percentage of profits in reserve? Also, if the thought is that firms need more capital to “innovate”, what’s an example of an innovation that requires a huge capital expenditure?

  2. Jordan Furlong

    I don’t think there’s anything inherent in the law firm partnership structure that militates against prudent management of profits, other than the standard “herding icebergs” difficulties in a collection of independent-minded professionals. But the default expectation in most partnerships tilts towards maximum yearly draws as an entitlement, rather than an adjustable function of the business model. Many partners, if told that a certain percentage of their draws will be held back for long-term investments, would consider that a hill to die on right there. It’s a cultural issue first and foremost, and those are almost impossible to change.

    In terms of competitive innovations that would require major capital expenditures, here are three off the top of my head:

    - financing a scorched-earth recruitment and retention policy: immediately announce starting associate salaries of $300,000 a year with huge bonus potential, or some similarly mind-boggling figure to establish your firm once and for all as the kings of compensation and to win any future talent competition in which money matters more than slightly. The gradual salary escalation we’ve been seeing at large firms for the last few years is the same basic strategy, but played out in slow motion and in piecemeal fashion: this strategy would simply be entering and ending the competition all at once.

    - building a major IT-based client service mechanism. Linklaters developed Blue Flag several years ago at an astronomical (for law firms) cost, and no firm has been willing to make that kind of investment since. But Blue Flag is a client magnet for Linklaters, providing services and making money 24/7 for several years. With a massive capital infusion, I’d go out and build about five of those things, reinventing client expectations of when and how process-intensive legal services can be accessed and changing the entire competitive landscape on which my competitors have to play.

    - acquiring a competitor’s entire office. In the early versions of the Civilization empire-building game, a successful strategy for rapid growth was to build up your coffers to great heights and then bribe entire cities of rival nations to defect and join your civilization. Why wouldn’t that work in a law firm environment? Your competitor has assembled what consensus agrees is the best office in Abu Dhabi? Buy it. Offer each and every employee a 50% salary increase to start using your letterhead and put your nameplate on the front door. It happens in other industries, especially the technology industry, all the time. I’m exaggerating for effect, obviously, because there are unique ethical issues to consider in law, but no law firm has yet adopted a strategy of making lawyers offers so lucrative that they simply can’t turn them down. With capital infusions, you could.

    It almost goes without saying that tons of money alone won’t buy you a great law firm. But tons of money plus great management is an almost unbeatable combination — the Boston Red Sox are as good a recent example of that as any other. Few firms have great management and hardly any have cash to burn — give a firm those two traits and watch it conquer the world.

  3. Pulat Yunusov

    This is a great post, especially your list of capital-intensive law firm innovations.

    But the law firm’s most productive assets are essentially knowledge workers free to go on a short notice. How will capital markets be as willing to finance wages as when they invest into machines, patents, mines, roads and other property?

Leave a Reply

  • (will not be published)

 

Post Categories