Nothing defines the City of London quite as much as its propensity to check the bottom line –the importance of which has been underlined by the financial crisis and renewed attention to risk management. The downturn brought dark days for London lawyers. With liquidity at an all-time low, funds were tight; the bottom line was scrutinised more than ever.
Although it was not conceived as such, the Legal Services Act 2007 perhaps provides a partial strategic solution to these travails. The act provides for external investment and for the creation of alternative business structures (ABSs) that will be licensed by the Solicitors Regulation Authority.
ABSs represent what one commentator has called a ‘radical liberalisation of ownership and investment restrictions on law firms’. As Baker & McKenzie’s Gary Senior says: ‘The biggest challenge on the horizon for those involved in the regulation of law firms is how they handle the anticipated arrival of external funding for law firms.’
Going to the bankLaw firms, including City practices, traditionally turn to bank borrowing for investment. Chris Perrin, executive partner and general counsel at Clifford Chance, is chairman of the City of London Law Society’s (CLLS) influential Professional Rules and Regulation Committee. He points out that City firms – of all sizes – have historically raised capital through the banking system, although he accepts firms will take a view on the opportunities afforded by the ABS reforms.
Others, however, draw a distinction between firms large and small. Bank borrowing may work for the magic circle, but others may find it more difficult to re-emerge intact from debt-heavy situations. As one partnership adviser, Peter Garry, a partner at Cripps Harries Hall, points out: ‘The next tier down of City practices might well find external investment more attractive than bank finance, always assuming that they could obtain large sums in bank finance at all in the current climate.’
Patricia Robertson QC, a leading regulatory lawyer at Fountain Court, London, and a member of the Bar Standards Board, also agrees that law firms are considering the prospect of ABSs, saying: ‘I don’t doubt that they will be looking into this; there have even been rumours of a City law firm considering flotation as a possibility.’
David Furst, chairman of accountancy firm Horwath Clark Whitehill, suggests that there is a generational aspect, too; partners coming up to retirement, and looking to sell their stake in the firm, are also likely to be interested in external buyers.
In an increasingly competitive market, the onus is on firms to maintain the highest quality they can. This may mean strategic expansion, diversifying into new areas and investing in IT systems. External investment may be a more attractive way to raise these very necessary funds.
As Nick Jarrett-Kerr, author of a recent book, Strategy for Law Firms - After the Legal Services Act says, firms are restructuring their management arrangements and operating on corporate lines: ‘It means getting lawyers to work more cohesively and embrace modern working practices and technology. What is perhaps most important, it means having a clear and compelling strategy for growth and development once the recession is over.’
The CLLS, in its submission to the Legal Services Board on ABSs, suggested that the reforms may facilitate the ‘unbundling’ of matters presently handled in their entirety by one firm. Due diligence and disclosure exercises could be handled by other service providers in tandem with law firms.
The society also suggested that reform may ‘cause our own firms to rethink the way services are delivered…. where quality and delivery could be enhanced by separation out from the main practice and injections of external capital and expertise’.
Robertson agrees, saying one issue for City firms is whether any part of what they currently do could be hived off as a separate commoditised business – for example supplying legal service outsourcing through an ABS-type structure.
Investors, too, might be interested in this. Mike Jones, managing director of Intrinsic Values, a business development consultancy, suggests that ‘most private equity firms interested in the legal sector are now targeting ancillary and support services to the legal market, rather than law firm partnerships’.
So the concept has been on management agendas for some time now. As Tim Eyles, Taylor Wessing’s managing partner points out, it cannot be avoided: ‘For City firms seeking to follow their clients’ activities around the world, the opportunity to use external funding to help finance growth, in order to service the needs of those clients as they grow, is in principle an avenue it would be naive not to explore as one of the tools to assist that growth,’ he says.
So, is the City legal landscape on the verge of a radical makeover? Taylor Wessing is definitely gearing up to address the changes. The firm formed a group of partners dubbed ‘The Change Group’ in June last year. The group’s remit is to consider the implications of the reforms: ‘In particular, we are examining what opportunities (if any) the LSA would provide to further our strategy as an international law firm – and of course what issues it throws up,’ says Eyles.
Gavin Ingham Brooke, chief executive of media consultancy Spada, says firms may look to expand their offer in a particular sector by adding complementary professional advice, noting: ‘One need only see the way in which Bircham Dyson Bell has worked in public affairs, as has DLA Piper, to see that law firms have previously looked at areas which cross over with the law and set up successful hybrid offers’.
As one senior lawyer at a magic circle firm notes, ‘if, for example, the investor is a large financial adviser, and the law firm specialises in private client work, the lawyers may be prepared to give up some independence in exchange for the likelihood of referral work. The possibility of sharing the costs of basic office infrastructure, such as IT and accounting systems, might also be attractive’.
A tempting prospect, clearly, since the advantages are numerous. As well as offering opportunities to restructure, Eyles comments that the LSA could also provide extra tools, including ‘access to capital, transparency of ownership, and a capital creation opportunity for all’. And at a time when associate and trainee retention is more crucial than ever, the potential for a revitalised approach to rewards and career structures is very welcome.
The flip sideYet firms are not universally enthusiastic. Perrin points out that the competition generated between City law firms is part and parcel of their success. To the extent that ABS availability will increase law firm competitiveness, he says the CLLS welcomes the changes.
However, he cautions: ‘I suspect that the larger firms in the CLLS will not be taking up these opportunities. For international law firms, the task of setting up an ABS would be virtually impossible; dealing with the regulatory requirements of many overseas bar associations, which are opposed to such changes, would make it structurally very difficult to fit our international partners within an ABS, and so would be restrictive.’
However, he concedes: ‘There could be a market for those firms without an international presence, such as smaller City firms or mid-size provincial/regional firms, which are looking for fresh investment and to smarten up their act in their offering to their client base.’
Tina Williams, of Fox Williams, is not so sure about this. She says few will take up external investment for the simple reason that it is a very expensive form of finance. Inter-generational tensions might also be created since, by accepting external investment, partners are agreeing to forego future income on a permanent basis.
This view is echoed by Eversheds’ Martin Warren, a member of the firm’s senior management team: ‘Law firms are very cautious, and the key question is what will you use the money for? Most City firms don’t need large amounts of extra money.’
Williams agrees that the key question here is ‘what would they do with the money?’ She says investors will be looking to finance firms with a clear strategy for gaining a competitive advantage. Firms that simply want to move to better offices or pay off older partners are likely to be disappointed. By contrast, those with a sensible expansion strategy, involving the acquisition of other law firms, or investment in IT to create efficiencies, will be attractive investment targets.
Patricia Robertson stresses that it may not be clear exactly what investors will be purchasing: ‘The firm can only tie in the legal talent for a limited time and they certainly cannot tie in the firm’s clients, given the extent of client mobility with panel reviews.’
Independence dayLaw firms have traditionally operated as independent entities, and for City partnerships this has been a major draw. Lawyers have no one to answer to other than their partners, and as such the rewards – and the responsibilities – fall solely at their feet.
By bringing in a third party, this autonomy, which has proven so attractive, could potentially be decimated. Cyrus Mehta, head of EU and Competition at Nabarro, points out: ‘External investors would expect to be involved in the strategic decisions and management of the firm, bringing in a greater element of external scrutiny. There are also complex issues relating to the valuation of a law firm’s business and the impact which equity ownership would have on traditional revenue distributions.’
This loss of independence will certainly be hard to swallow. Equally, Perrin points out, while firms might benefit from the kinds of investment typical of private equity investors in other industries – boosting their capital for a period – most private equity investors usually have an exit strategy. ‘How would law firms cope with the withdrawal of such capital, especially if seeking such investment was their reason for creating an ABS in the first place?’
For some, this is all just a step too far. As one managing partner of a silver circle firm commented, bringing in external investors, or even floating the firm, would happen ‘over my dead body’.
Mark Dawkins, managing partner at Simmons & Simmons, is also sceptical, although he is more sanguine in his observations. ‘Direct external investment does not seem to be on the agenda of any of the large City firms. Most established firms have relatively low capital requirements, which can be met by partners, or supplemented by bank lending, both of which are simpler to organise and less expensive than allowing external investment. In addition, neither involves loss of control.’ It seems, for the moment at least, the perceived advantages are not enough to merit the partnership relinquishing control of the reins.
Attracting, retaining and meeting the needs of the client is always the main object. Any decisions taken by management must be made with the client in mind. The bottom line is quality of service, and if this is not compromised, the ABS approach may nevertheless be a viable one – at least from the client’s viewpoint. ‘The principal concern for clients will be around the quality and efficiency of the service they receive. If the relevant funding helps achieve greater depth of coverage or expertise, why would they object?’ asks Eyles.
Jarrett-Kerr agrees: ‘Clients may be persuaded that external investment means more investment in things which are important to them – specialised staff, good systems, better knowledge management and above all better client service.’ Warren, meanwhile, notes: ‘Clients want service from those they trust – an ownership structure is neutral to them as long as they get continued good service.’
After all, such clients will often be large quoted companies whose own ownership changes day by day, so they will feel comfortable with external investment.
While it may seem unlikely that clients will have a fundamental problem with their advisers taking on outside ownership, difficulties could arise, however. As Mehta notes, ‘external ownership would create additional risks of conflict of interest, in that conflicts may now arise not merely as against other clients of the firm, but also as against investors in the firm’.
Furst agrees, ‘especially in light of the conflict of interest that has emerged in recent weeks as a result of Deloitte’s takeover of Drivers Jonas’.
RegulationThe Solicitors Regulation Authority’s relationship with the City has not always been a happy one. Yet, as Law Society president Robert Heslett pointed out recently, the appointment by the SRA of a corporate regulation director with an extensive background both in the City and in the practical application of principles-based regulation ‘is a powerful statement of intent. It is an important step which the Society welcomes wholeheartedly’.
From the prospective regulator’s point of view, the SRA’s executive director of regulation Samantha Barrass points to a commonality of approach that in a fundamental sense does not distinguish City law firms from others: ‘We wish to provide consistent risk-based regulation of all firms, notwithstanding the types of provider they will be. So our concern is to have all involved, including more traditional law firms – and City firms.’
To that end, she adds, the SRA has embarked on ‘what is probably one of the broadest engagements of the profession’. It is asking for views on the new code of conduct and changes to the regulatory framework, as part of a 12-week consultation that began on 30 April. There will be a second consultation on the new raft of regulations, including the new code, at the end of May.
Some have argued that the emphasis placed by the previous government on the speed of reform has put a considerable burden on both the SRA and law firms in accommodating these root-and-branch changes.
Given that the SRA must be authorised as a regulator of ABSs, and must be ready to regulate law firms who seek to exploit the reforms, Perrin feels that the timetable is too ambitious. He suggests that the rule book consultation, which currently straddles the summer period, when key partners across the City will be on leave, will not allow for the kind of detailed response required. He believes a more protracted consultation would serve the SRA and LSB better.
Barrass disagrees: ‘The consultation process is ambitious, but it’s important to bear in mind there will be a further consultation in October, which will give us a chance, if necessary, to respond to the views we receive and recognise any significant changes that need to be made.’
Noting that the Conservatives previously indicated that the timetable for ABS reform might be delayed, Perrin suggests that new justice secretary Ken Clarke may take a more relaxed line on implementing the act. Barrass, however, says: ‘We do not expect any dramatic change to the implementation of the act. That said, we will wish to keep close to any ministerial stakeholders’ views of the timetable, and maintain an active stakeholder liaison for that purpose.’
Robertson welcomes the SRA’s new thinking in this area. She believes that hiring key people from the Financial Services Authority, including Barrass, is enabling it to consider City-related issues in a more intelligent way, incorporating a more collaborative approach to regulation.
The final word goes to the Law Society’s Heslett, who said last December: ‘What happens next lies in the lap of the SRA, but whatever path it pursues has to be with the agreement of the wider profession’.
Ben Rigby and Anastasia Hancock are freelance journalists