It’s time the U.S. legal industry puts pressure on State Bars to effect re-regulation that promotes competition, sanctions law firm investment capital for technology, process, and retention of top-flight talent, and allows ‘non-lawyers’ to invest in law firms, share profits, and take them public. Australia sanctioned such re-regulation of legal guild rules nearly two decades ago. The UK followed that path about a decade later with the passage of the Legal Services Act of 2007 (LSA) and its implementation in October 2011. Other developed nations—France, Germany, and Canada, for example—are on the cusp of some form of re-regulation. The U.S. has stood pat and has thrice rejected efforts aimed at re-regulation during the new millennium. Why?
Regulatory Stasis Makes No Sense For Legal Consumers And Providers
The principal reason for U.S. regulatory stasis is lawyer protectionism from competition. This misses the mark for several reasons: (1) the principal purpose of legal re-regulation—and a core mission of the profession-- is to serve clients and the larger society by encouraging innovation and competition; (2) contrary to what detractors-- especially in the U.S.—maintain, allowing lawyers to share profits with others is not de-regulation but re-regulation that advances client and lawyer interest; (3) de facto re-regulation (as discussed below) is already very much underway in the U.S.; and (4) ironically, re-regulation might just offer the best survival hope for many traditional partnership based law firms.
Critics of re-regulation maintain that ‘outside investment’--also known as ‘alternative business structures’ or ABS-- creates economic conflict for lawyers, pitting their zealous representation of clients against profit maximization. This does not pass the giggle test for several reasons. First, it is because of the existing law firm model-- built on leverage and billable hours-- that client and law firm economic interests already diverge significantly. Next, the absence of equity in the traditional partnership model means that short-term profit is the sole-- if not illusory-- ‘equity’ partners have. This means, among other things, that older partners have no long-term economic incentive to ensure the firm continues to prosper after they retire.
The Absence Of Equity Is Hurting Law Firms—And Clients
An absence of equity—in the true sense of investment in the longer-term success of the enterprise—in law firms has yielded many of the problems that are now nails in the partnership model’s coffin. The list includes: peripatetic partners, firm instability, an inter-generational battle between older partners and younger ones, an acceleration and widening of disaggregation, and an erosion of the law firm franchise brand. These structural issues, coupled with the lack of investment capital and a reluctance to adopt technology and process— are among a growing list of reasons why law firms are losing market share to in-house legal departments and legal service providers. The latter groups are succeeding—at the expense of firms—in part because they attract top talent corporate with structures that offer long and short-term compensation, including equity. This means that lawyers and other legal delivery experts have an alignment with both the short and long terms success of the enterprise. And that promotes—among other things—stability and fosters innovation. It also encourages buyer and seller to adopt a relationship rather than a transactional approach to their interactions.
The Importance of Residual Equity To Effective Legal Delivery
The traditional law firm model is adversely affected by an absence of (real) equity. ‘Equity’ partners have what amounts to a short-term stake in the firm. It has two—sometimes three—prongs: (1) capital accounts; (2) annual revenue split; and, with a small number of firms (3) pension--generally unfunded plans. The absence of a longer-term equity stake in the firm creates a ‘future is now’ leadership mentality that does not benefit clients or the firm. Why? Clients gain from firm stability, long-term relationships with key personnel, and institutional knowledge of their business gained and managed over time. Likewise, a long-term approach—promoted by equity or shares--in the firm burnishes its brand, enhances retention, and enables investment in human, IT, and process resources. It also discourages the current 'take the money and run' approach of older partners.
Corporate Legal Departments and Service Providers Better Align Performance/Reward Than Traditional Law Firms
Corporate legal departments—especially larger ones—are structured very differently than the traditional firm partnership model and have a different performance/reward structure.
It’s worth taking a closer look because it helps explain why so much work—and talent—is migrating from law firms to corporate legal departments and elite service providers.
Reward is an essential driver for human beings. It has many forms—financial, professional, psychological, etc. Most business structures key reward to performance—both short and longer term. Specifically, an individual is connected to the immediate and longer-term objectives of the enterprise through a reward structure that has a present component-- salary; an intermediate one—bonus; and a longer-term one—equity. By structuring s reward system in this temporally tiered fashion, performance is a balance of short and longer-term impact. Translation: the individual strives for immediate and long-term results and is rewarded for both.
The traditional law firm structure is all about short-term gain-- maximization of profit-per-partner-- and not about the long-term play. Why? One reason is that few firms have funded pension plans these days. But even more significant is the absence of residual equity in the traditional law firm partnership structure. Once a lawyer hangs up her trial bag, the flow of money ends. ‘Equity’ in law firms means sharing annual profit and—if one is fortunate—recouping capital contribution. There’s no long-term financial alignment with the firm. That fosters a ‘future is now’ mentality and is a reason why traditional law firms are not responding aggressively and proactively to market changes and client demand for more efficient, cost-effective delivery models.
Law Firms Have Two Alignment Issues: Internal And Client
Most of the focus on the traditional partnership model these days relates to its misalignment with clients. That’s certainly fair. Many foundational elements of the partnership model are at odds with client objectives—high fees, billable hours, a pyramidal structure, a limited understanding of client objectives and risk tolerance, etc. These are some key reasons why in-house legal departments have grown dramatically in size, influence, compensation, expertise and direct responsibility for case management in recent years. Ditto for the growth of legal services providers, another antidote to sourcing work to law firms.
It’s a common misconception that migration of work in-house—or to global service providers-- is solely a cost/labor arbitrage play. It’s much more than that. As my friend, Steven Greenspan, Vice President and Chief Litigation Counsel at United Technologies told me recently, ‘Expansion of in-house legal teams cannot be viewed simply as a cost-play; it’s really a quality play, with cost benefits.’ In-house legal teams not only enjoy a ‘home field advantage’ over outside counsel, but they also have superior knowledge of the client’s business, enterprise objectives, risk tolerance, and corporate DNA. But there’s one other key element: their roles and performance/reward structure are very different than law firm partners.
Corporate Counsel Are Half-Lawyer/Half-Business Partner And Have A Vested Interest In The Long-Term Success of the Enterprise
Corporate counsel once served as ‘legal traffic cops’ that monitored the legal heavy lifting performed by outside counsel. No more. Ben Heineman, a former BigLaw partner who left to become General Counsel of GE, wrote an insightful book chronicling the transformation, ‘The Inside Counsel Revolution: Resolving the Partner-Guardian Tension.’ As the title implies, Heineman’s central thesis is that in-house counsel play two distinct but inter-related roles: business partners in the enterprise and its ultimate defenders. That’s the performance element of the equation.
Metropolitan Counsel examined a recent study of GC compensation by Equilar, an executive compensation and benchmarking company. Not surprisingly, the study found that the larger the size of the company by revenue, the more balanced GC compensation between fixed and at-risk (e.g. bonus and stock). Alignment of interest between GC and company—both in the short and longer-term-- is the challenge and objective and reward reflects the dual roles Heineman describes for GC’s. The Equilar data found that GC’s of companies with greater than $15 billion in revenue received a median of almost $700,000 in long-term incentives – the single greatest component of their pay. That means that they have a true long-term alignment of economic interest with the enterprise by whom they are employed. This alignment benefits lawyer/business partner and client and helps explain why so many top lawyers are pounding on the doors of corporate legal departments seeking senior management positions.
U.S. legal delivery would benefit from re-regulation. Many large firms that have been among the strongest critics of regulatory change, ironically, would be among its principal beneficiaries. Law firms need investment capital, structural reform that includes realignment of interest not only internally within the firm but also with clients, and a new delivery model that melds legal with IT and process expertise. Law firms also need to provide true equity for stakeholders to slow down the fast-moving legal carousel of laterals and firm mergers that is a boon to legal recruiters but a bane to firms and clients. Law firms might consider that the stability achieved by alignment of internal assets is a first step towards better long-term alignment with clients.