It’s time to stop pretending that the $300B U.S. legal industry is anything but big business. All legal providers—including law firms-- should be able to operate from a corporate structure. That means they can accept institutional investment capital, share profits with ‘non-lawyers’, and grant shareholders residual equity in the firm after departure. This structure promotes a long-term view that better aligns the interests of lawyers, the firm, and clients. The present U.S. regulatory scheme does not allow law firms to be structured this way, and that is a key reason why firms have failed to innovate-- even as their partnership model is showing stress cracks. They
have lost considerable market share to corporate legal departments and legal service providers, both of whom have corporate structures. The regulatory double standard is harmful to clients as well as law firms and should be reformed as it has been in the UK, Australia, and soon, in other nations.
In-House Legal Departments Have Corporate Structures
In-house lawyers can share in the profits of the enterprise and acquire stock options. In fact, the long-term financial component is a key element of compensation and one of several reasons why many talented lawyers are moving from firms to corporate legal departments. The in-house corporate structure—with its short-and long- term performance metrics and rewards-- promotes an alignment of interest between lawyer and client lacking in law firms. It also encourages in-house lawyers to function dually as enterprise defenders and business partners advancing enterprise interests. There’s a push-pull in the dual roles to be sure, but good lawyers find a balance. That’s no different than when a firm client exerts financial leverage on a law firm partner to push the envelope.
The Regulatory Double Standard
The current U.S. regulatory scheme prevents law firms to operate from a corporate structure. This adversely affects legal consumers and the profession for a spate of reasons: (1) U.S. regulations that preclude law firms from accepting outside capital, profit sharing, and liquidity events—except bankruptcy—are outdated; (2) concerns that a corporate structure would undermine the attorney-client relationship and create a unique set of ethical and financial conflicts are unfounded—those conflicts already exist; (3) a large segment of the corporate legal market already operates from corporate structures—that includes in-house legal departments and service providers that together have a nearly 50% market share; (4) the boundaries between ‘engaging in the practice of law’ --law firms-- and ‘delivering legal services’--everyone else-- are blurred, overlap, and should be jettisoned provided that all legal providers—regardless of structure-- are subject to the same ethics rules and code of professional conduct; (6) this is exactly how the legal market functions in the UK, Australia, and other nations that permit some form of ‘alternative business structures’; and (7) enabling law firms to operate from a corporate structure would benefit clients and the profession by promoting long-term provider continuity and sustainability lacking in the incumbent partnership model-- while spurring innovation, competition, and, perhaps, a cultural reboot within firms.
The Law Firm Partnership Model Had A Great, Long Run. It’s Over
The traditional law firm partnership model has had a long, highly prosperous run. The data indicates that’s over for all but a handful of elite, brand differentiated law firms. Those 20 or so firms are retained for high-stakes matters whose enterprise value renders them price insensitive. And while ‘bet the company’ matters—litigation, regulatory, and the big deals—account for approximately 15% of legal spend, they represent only about 1% of all matters. Translation: law’s one-percent handle the one-percent work. And all indications are they will continue to do so— at premium rates. The traditional partnership model will continue to work for those firms, but not for other undifferentiated large firms.
It’s a different ball game for other large law firms that once handled the rest of corporate legal work. Technology, the global financial crisis, migration of legal work in-house and to well capitalized, tech and process savvy service providers, as well as changes in buyer attitude have created a new legal buy/sell dynamic. The herd of undifferentiated large firms prospered and grew on ‘fat middle’ work--everything between ‘bet the company’ and ‘retail’ matters. Law firms long described that work as ‘bespoke’. It never was. Savvy clients now reject the bespoke myth and take a value driven, transactional view of this work. Law firms are no longer its default providers. And when firms vie for work, clients routinely exact large discounts, alternative fee agreements, RFP’s, reverse auctions, and other previously unheard of concessions. Procurement departments’ entry into the legal buy process suggests that customers now consider firms to be like other vendors.
Law firms have lost approximately 20% market share during the past decade—principally to corporate legal departments and service providers. What course corrections have they made to stem this tide? Apart from a few outliers like Seyfarth and Allen & Overy, law firm change has been largely confined to internal cost-cutting measures designed to sustain PPP. Cutting back on administration, expensive offices, perks, professional staff, and outsourcing back-office functions does not, however, address client dissatisfaction. That goes beyond cost; clients cite firm inefficiency, ineffective utilization of technology, lack of diversity and budget discipline, turnover, and a limited understanding of their business as additional reasons for discontent.
Why Don’t Law Firms Innovate And Tackle Client Dissatisfaction Head-On?
Why don’t smart, millionaire law firm partners take bold, innovative steps to stem the erosion in market share and address core client concerns? Answer: the partnership model offers no financial incentive for them to do so. Law firm ‘equity’ is a misnomer; it is an annual rite of profit sharing—no more. Since partners have no long-term, post-departure economic stake in the firm, they tend to take a short-term, ‘the future is now’ approach. This has many adverse consequences to firm morale, work-life balance, diversity, succession planning, investment in technology, and long-term strategic planning. Were law firms permitted to function from a corporate structure, these issues would be ameliorated, in large part because of the economic alignment it would create between outgoing and upcoming partners. That would provide the firm with far greater stability—another element causing clients to abandon them.
PPP Is A Misleading Metric Of Law Firm Health
If one looks at profit-per-partner (PPP), the Holy Grail of law firm metrics, most large firms appear healthy. But PPP comes at a high price. The shrinking pool of equity partners is selling short at a steep cost to clients as well as the next generation of firm talent. For example, ‘service partners,’ senior lawyers that perform key aspects of client matters, have been economically marginalized within most firms-- or let go. While their client value is high, their compensation is a drag on partner profit. The ranks of incoming lawyers have also been thinned considerably because clients are no longer willing to subsidize their on-the-job training. Likewise, seasoned associates and ‘junior partners’ (read: nice title with capital contribution and no voice) are also being pruned. Where’s the next generation of talent and leadership coming from? That’s a can being kicked down the road.
The traditional law firm partnership structure is decentralized and militates against unified action, especially anything dilutive of the annual partner profit whack-up. Law firm partnerships operate like tents in a bazaar- a collection of fiefdoms fueled by business origination and PPP. Lateral moves by big book partners to firms with higher PPP underscore the short-term play that is most large law firms. It’s a free agency marketplace whose future is now. What’s in it for clients and why should they ‘invest’ in a law firm with these structural limitations and peripatetic partners? That’s another reason the delta between demand for legal services and law firms continues to widen. A growing number of talented younger lawyers are asking what’s in it for them—apart from a paycheck to help retire student debt and pay the rent. They no longer see partnership model law firms as a long-term play, either. Many are forming boutiques, going in-house, joining service providers, or going into business.
How And Why Would A Corporate Structure Benefit Clients, Firms, And The Profession?
Jonathan Molot, a co-Founder of Burford Capital and fellow professor at Georgetown Law asserts the outdated law firm partnership model creates ‘short termism.’ He argues convincingly that the absence of residual equity is the principal cause of the short-term view, noting that its adverse consequences include: high employee turnover, low morale, limited work-life balance, and client dissatisfaction.He also questions why the U.S. regulatory structure has declined to follow the path of the UK, Australia, and other nations that now sanction a corporatized law firm structure.
There is no indication that ethical problems have proliferated in countries with reregulated legal industries, but there is substantial evidence that innovation, client satisfaction, and competition have spiked in those markets. The conflicts that critics of legal corporatization cite already exist within the traditional partnership model. Firms and clients are in economic misalignment—that’s a major cause for client disaffection. Law firm credit facilities with large banks are their lifeline—why not allow them to receive investment capital to upgrade technology, improve process, and attract top talent? Law firms, in-house legal departments, and legal service providers should all be permitted to operate as corporate structures and be bound by the same set of legal practice and ethics rules. A corporate structure is not inimical to law firms because there is no inherent difference between law and other professional services that have already been corporatized. Medicine, for example has gone the corporate route—why not law?
Legal delivery is big business. Its regulatory scheme should promote competition, spur innovation, and provide clients with a wide array of options that are accessible, client centric, efficient, cost-effective, transparent, and subject to ethical oversight. The legal profession can certainly oversee compliance with the rules of ethics and professional conduct, but it has no place circumscribing structural issues. It’s time that the artificial distinctions governing the conduct of in-house legal departments, law firms, and service providers are jettisoned. All legal providers should be free to operate from corporate structures. The legal guild is dead. Corporatization will give legal service delivery new life and new options.
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