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Alternative Business Structures: Here’s a Great Idea: Let’s Get Some Private Equity Funds to Invest in Large Commercial Law Firms and We’ll All Make a Ton of Money!

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 Jerome Kowalski

Kowalski & Associates

April, 2011

 

 

Frankly, I don’t think so.  An investment with Bernie Madoff might have been a better idea.

 

Recently, the media is chock full of virtually daily reports concerning the impending changes in the United Kingdom concerning the October 2011 kick off date when non lawyers will be permitted to invest in law firms; the so-called Alternative Business Structure (“ABS”) model, sometimes called the “Tesco laws,” a non de guerre inspired by the international consumer goods  retailer of that name. Moving at its typical glacial speed, even the American Bar Association is now looking in to adopting the model.

The ABS model is virtually naively simple in its genesis:  Allow non-lawyer investors to invest and acquire ownership interests in law firms, with large law firms then using the proceeds of that investment to grow the firms, with investors reaping substantial profits. Except that I frankly don’t see that the model has any commercial viability for large corporate commercial law firms. Others also question the financial viability of this model.

The early player in this brave new world is London based Irwin Mitchell, which is boasting about a £50,000,000 investment by a private equity firm, with the proceeds to be used to expand Irwin Mitchell’s financially successful tort focused practice to a full smorgasbord of (less profitable) commercial services.

The ABS topic continues to galvanize the profession’s attention and will continue to do so for some time, as we in the United States watch events unfold across the pond.

There are some quite serious business obstacles yet to be adequately addressed, let alone even comprehended.

As some have noted, the proceeds of capital infusions by outside investors in large law firms will likely be applied to technology and most particularly knowledge management systems, all with a view of lowering costs to consumers of legal services. The result would be increased commoditization and reduced revenues per lawyer. Thus, the consequence of such investments may well be that unless one creates a Goldman Sachs-type leverage ratio (10,000 to 1?), an extremely unlikely result for any law firm; the investor will simply not get the anticipated return.

These capital infusions will also presumably be used to lure big name and big revenue producers and pay them NFL level compensation to get them to sign on.  However, in this era of law firm partnership free agency, there is no assurance that these big ticket producers will stay beyond the moment the firm across the street offers them more money. Nor is there any viable means to restrain these lawyers from jumping to the highest bidder.

The practices which yield the highest return still remain in the plaintiffs’ class action bar and in big stakes high end plaintiffs’ contingency cases. Massive class actions and other high end cases chew up enormous amounts of capital. Law firms which have been active in this world have already amassed substantial capital and have the internal resources to fund these cases. Some still utilize traditional institutional lending from banks at favorable rates. Others utilize litigation funding companies which do tend to charge exorbitant interest rates; but, then again, these funding companies accept all of the risk in making non-recourse loans and at the end of the day, they do not remain partners of the law firm.

The Irwin Mitchell experiment raises some questions for which we do not quite have enough facts to make any intelligent responses, lacking adequate information. For example:  Why would equity investors provide capital for a firm to enter middle market practices, where the margins are lower than in tort cases and lower than that earned at magic circle firms?   In addition, we already know from several decades of experience that the ultimate additional profit to a law firm in hiring laterals is only marginally incremental, as firms are required to pay for the ramp up of the laterals and the lion’s share of profits earned by new laterals are actually paid to the laterals, with the increase in firm-wide profits is only marginal

Other commentators, most noteworthy of which is Professor Mitt Regan of Georgetown,  have noted that outside investors in a firms would exert some degree of control within a law firm and the danger he highlights is that such investors will impair the independence of the lawyers’ judgments in directing that efficiency, rather than the clients’ best interests will be a driver in handling a client engagement, all in violation of Rule 1.1 of the Model Rules of Professional Conduct under US rules; we do know that proposed new UK rules are designed to have a different result.  Here, the UK has a distinct advantage over us in rule-making. Once the ABA concludes its deliberations and some committee proposes a new set of Model Rules, those rules will need to be mulled over by 50 separate state commissions and the District of Columbia, some of which may adopt the ABA proposals, some of which may modify them and some of which may simply reject them.

But an added impediment is the preservation of client secrets and confidences. Non lawyer investor participation in law firm management necessarily makes non-lawyers privy to such secrets and confidences, with no mechanism to police the maintenance of such confidentiality by these non-lawyers.

Some of these issues were addressed at some length in Australia in 2008, which was the first country to permit non-lawyer ownership of law firms in a report issued by Melbourne Law School and the Australian Office of the Law Commissioner.  Interestingly, Australia was the first nation to permit non-lawyer ownership and the firm that was first out on the market was Slater and Gordon, a large trans-Australia law firm, which offered shares to the public.  Slater and Gordon is primarily a tort firm and its initial public reports does report a reasonably good financial performance.  As I suggest below, a firm with that type of focus might be far more attractive to outside investors.

To me frankly, a far more alluring and potentially far more financially rewarding model, ripe for non-lawyer investment would in essence be a tort contingency fee clearinghouse.  Let’s for example take the case of James Sokolove, whose ubiquitous television US advertising cannot escape the attention of even the most casual TV viewer. In 2009, Sokolove spent a reported $20,000,000 in television advertising.  Mr. Sokolove’s business model, described in 2008 in The Boston Magazine is to be a constant presence on television encouraging potential tort plaintiffs to call in on his toll free telephone line, while maintaining a network of some 400 law firms around the country to which these cases are referred for prosecution. In 2008, Boston Magazine reported that “Sokolove’s firm is currently keeping tabs on some 10,000 open cases. Approximately 300,000 calls and e-mails come into his office each year, more than at any other firm. On behalf of his clients, Sokolove has won more than $2 billion in damages or settlements, while he and lawyers working with him have pocketed some $500 million for their trouble.”  Elsewhere, it was reported that in 2007, Sokolove spent $20,000,000 in advertising.  I have heard reports, which I haven’t been able to corroborate,  that Sokolove’s current advertising budget has increased since then by some four-fold.

But, here is a far more attractive model, even if we just use the reported information for 2008:  $20,000,000 invested in annual advertising, some modest investment in infrastructure and an ultimate revenue stream of several multiples, assuming the average life span of a tort case from inception through settlement is approximately three years.

Legalzoom.com  actually invites the most intriguing – perhaps, provocative – model. It purports to be an online self-help service which merely offers forms for use by consumers of legal services to deal with a variety of maters. The company’s “founding vision,” as described on its web site, “ was for an easy-to-use, online service that helped people create their own legal documents.” It loudly disclaims and denies that it provides legal services or acts as lawyers.  Rather, it provides an amazingly broad smorgasbord of forms and computer generated advice in such diverse areas as business formation, the wide variety of different legal instruments utilized by businesses on a daily basis, as well as specific legal instruments utilized in such diverse substantive  intellectual property, labor and employment, entertainment law, financing, real estate, estate planning and more. It vigorously denies that it is engaged in the practice of law, although it is the subject of a number of regulatory investigations regarding whether it is engaged in the unauthorized practice of law. It is also defending several lawsuits, including class actions in which plaintiffs are claiming that Legalzoom is engaged in the unauthorized practice of law.

Notwithstanding its strident claim that it is not engaged in the actual practice of law but is rather simply selling simple legal forms along with instructions for consumers to fill out on their own. But, as part of its offering of services, it boasts of (a) the availability of a “customer care specialist” (at 800 773-0888) to assist customers in selecting and completing the appropriate documents; (b) a “document specialist” who will automatically contact a customer by telephone “if additional information or clarification” is needed for a document prepared by the customer;   and (c) proofreading [not automated spellchecking] by a “document specialist.”  It also boasts a long running and slick advertising campaign.

Legalzoom now exists in the nether of the virtual world (yet it purportedly employs 500 people). Its board of directors of five includes four Silicon Valley entrepreneurs (who do not appear to be trained or licensed as lawyers). Its eight person management team has three members who seem have some legal training, but these folks are actually appear to be serious well credentialed  serial entrepreneurs.   It is privately held and revenue and profitability reports are not publicly available.  Yet.

It was reportedly originally funded with $2,000,000 in venture seed money and then received a whopping $46,000,000 second round of VC funding from such major VC players as Polaris Venture Partners and Kayne Anderson Private Investors.  In February, it was reported to be planning an IPO. But even before it goes public, you must wonder how many law firms with 500 employees have a $48,00,000 capital base. (yes, yes, I know, Legalzoom denies being a law firm, but to many it certainly seems to walk and talk like a duck).

Now, imagine that Legalzoom does have a successful IPO and uses part of its proceeds to open a series of kiosks and storefronts throughout the land.

[Update:  On July 22, 2011, UK based WH Smith announced an arrangement with Quality Solicitors, also of the UK under which the joint venture would open a chain of approximately 500 retail outlets in various shopping malls, manned primarily by non-lawyers, in which a host of legal services would be offered. One hundred and thirty retail outlets are to be part of the initial launch. Quality Solicitors plans on having some 50 or 60 law firms utilize these retail portals.  Some legal services will be delivered directly at the point of sale.  More complex matters will be funneled to the law firms participating in this mass marketing scheme.]

That, my friends, is the ultimate Alternative Business Structure.

And it has the capacity to be the largest provider of legal services in the land and create enormous downward price pressure on much already commoditized legal work.  And while I have no idea what Legalzoom’s long term business plan is, but if it does create a national chain of storefronts in which real live lawyers are stationed,  it has the capacity to dominate the legal landscape for the bull of legal work actually performed by most practicing lawyers in the United States.  It may not compete with AmLaw 200 firms for premium legal work, but it may suck an enormous amount of wind from a vast portion of the legal profession.

As American baseball legend Yogi Berra said, predictions are hard, particularly about the future, my own humble prediction is that these models won’t work for traditional Big Law. That’s what I said six months ago and nothing has yet surfaced to dissuade me.

The ABS or Tesco models just won’t work for Big Law.  But, they may very well for mass market, consumer oriented, commoditized practice, built on a franchise type model. Take something like legalzoom.com and open storefronts across the landscape.  The margins may be small, but they are also small at MacDonald’s, KFC and so on. Perhaps it’s time to dust off the old Jacoby & Meyers business model or the modern era Legalzoom counterpart and hawk that model to private equity investors. The returns will far exceed that which large commercial law firms can offer to outside investors. [Update:   On May 19. 2011. Jacoby & Meyers filed suit in New York and Connecticut challenging prohibitions against non-lawyer ownership of equity in law firms.  The firm suggest it will bring similar suits in other jurisdictions.]

[Update:  On May 9, 2011, several non-lawyer entrepreneurs formed a Washington DC based law firm investing some $5,000,000 of their own money in creating a new model law firm called Clearspire, LLC. (www.clearspire.com )  The firm is pursuing an entirely new model for its business, as described in The Washington Post.]

© Jerome Kowalski, April, 2011.  All rights reserved.

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13 Responses

  1. From Greg Dwyer of the College of Law in Melbourne:

    I don’t think any assessment of the proposed ABS model can be complete without looking at the Australian experience – and in particular the Slater and Gordon model.

    When S & G floated the shares were taken up very quickly – and as I understand it much of the interest came from institutional superannuation (pension) funds.

    However – you may be right as far as traditional “big law” goes – none of the large Australian practices have taken it up (although apparently they have looked at is closely) one of the reasons perhaps being that the tax regime in Australia may be problematic when the assets of the partnership pass to a new entity, as in some jurisdictions “stamp duty” or transfer tax may be payable on value of assets / goodwill / business value. And I would also think that many BL equity partners will be reluctant to share power and income while they are still actively engaged in the business, although incorporation can be an attractive exit strategy – especially as a way to realise equity or alternatively retain some shares.

    Some Australian ILPs have used the model to share income with non-lawyers.

    Of course, all of that is quite different to the “private equity” approach which the Brits are talking up.

    And, as Profess Christine Parker has shown, there are non-financial benefits to incorporation. Here is a link to a summary of a presentation she gave and a full paper can be found on this page : OLSC Research Report on the Impact of Management Based Regulation on Incorporated Legal Practices in NSW jointly with Melbourne Law School, University of Melbourne, September 2008

    The ethics issue is a live one though, and I believe that our legal Services Commissioner has delivered a paper at Georgetown.

  2. I agree that the outside non-lawyer investment model is pretty problematic for US firms for a variety of business, regulatory and cultural reasons. But, on the business side, why is it that the accounting firms and their consulting businesses, which are professional service firms like law firms, were able to tap outside investment dollars and were profitable not only for the partners who sold their interests in whole or in part, but also for the outside investors?

    • The answers, I believe, Mr. Bush, are

      (1) The leverage issue. Large consulting and accounting firms can have 100:1 leverage.

      (2) Consultants and accountants can be contractually restrained from competing or soliciting clients, while our Rules of Professional Responsibility contribute to the free agent status of partners, thus reasonably raising concern among investors as to whether the firm’s most valuable assets, its partners, will show up for work the next day or instead move a couple of blocks away on Connecticut Avenue, with all of his or her clients in tow; and

      (3) Branding is also far more important in the space occupied by these other professional service providers. In considering the long simmering debate as to whether the client retains a lawyer or a law firm, that issue comes up far less often in those other professions. Consider the following dialogues: (a) Q. “Who does your FINRA enforcement work for you?” A. “Graeme Bush” (b) Q. “Who does your auditing work?” A. “Delloite.”

  3. […] noise emanating from across the pond about private equity investments by non-lawyers in law firms (to which I confess to having contributed), a similar thought occurred to me: If existing corporate law firms were currently publicly traded, […]

  4. […] previously discussed the potent force of http://www.legalzoom.com .  When I wrote about legalzoom.com in April of this year, […]

  5. […] 4.  Firms cannot delay infrastructure investment any longer.  That may require biting the bullet and investing firm profits in essential infrastructure and simply swallowing the dubious ignominy of a short term drop in PPP. If you take this route, issue a press release early on announcing that the firm has such a high degree of confidence in its own future, it is making a substantial investment in its own future, foregoing short term PPP in favor of  long term growth and viability. Alternatively, private equity firms are prepared to invest in a state of the art legal processing law firm affiliate, but will obviously be a significant equity participant in the profits of that venture. The paradox of this essential new technological infrastructure is that it will result in the delivery of legal services at costs lower than currently prevail in BigLaw, but is made essential by the mounting competition of alternative providers of legal services.   The ethical rules precluding non lawyer ownership of law firms play no role here. (Professor Larry Ribstein of the University of Illinois School of Law very recently conducted a compelling online symposium on the de facto and de jure deregulation of the practice of law).  Indeed, Clearspire, a breathtaking new model law firm is built entirely a new model, owned in essence by non-lawyers. The result is that Clearspire offers an array of quality BigLaw legal services by BigLaw trained lawyers, primarily at fixed fees and bills at a fraction of BigLaw rates. An important warning here:  Do not look to private equity as the safety net that will allow BigLaw to weather the coming storm. […]

  6. […] 4.  Firms cannot delay infrastructure investment any longer.  That may require biting the bullet and investing firm profits in essential infrastructure and simply swallowing the dubious ignominy of a short term drop in PPP. If you take this route, issue a press release early on announcing that the firm has such a high degree of confidence in its own future, it is making a substantial investment in its  own future, foregoing short term PPP in favor of  long term growth and viability. Alternatively, private equity firms are prepared to invest in a state of the art legal processing law firm affiliate, but will obviously be a significant equity participant in the profits of that venture. The paradox of this essential new technological infrastructure is that it will result in the delivery of legal services at costs lower than currently prevail in BigLaw, but is made essential by the mounting competition of alternative providers of legal services.   The ethical rules precluding non lawyer ownership of law firms play no role here. (Professor Larry Ribstein of the University of Illinois School of Law very recently conducted a compelling online symposium on the de facto and de jure deregulation of the practice of law).  Indeed, Clearspire, a breathtaking new model law firm is built entirely a new model, owned in essence by non-lawyers. The result is that Clearspire offers an array of quality BigLaw legal services by BigLaw trained lawyers, primarily at fixed fees and bills at a fraction of BigLaw rates. An important warning here:  Do  not look to private equity as the safety net that will allow BigLaw to weather the coming storm. […]

  7. […] question, namely whether the United States would follow the lead of the United Kingdom and permit non lawyer ownership and equity investments in law firms. Our cousins across the pond call this model “Alternative Business Structures” or […]

    • Sadly, I seriously doubt it.

      Just yesterday, I attended a conference at which two long term members of the ABA house of delegates were in attendance and both agreed that the ABA will continue to oppose the concept and fight tooth and nail to do so.

      My own view is that should the ABS concept achieve any success in the UK, for which I personally have some very serious doubts (see http://kowalskiandassociatesblog.com/2011/04/27/alternative-business-structures-here%e2%80%99s-a-great-idea-let%e2%80%99s-get-some-private-equity-funds-to-invest-in-large-commercial-law-firms-and-we%e2%80%99ll-all-make-a-ton-of-money/ ), perhaps things will change.

      Twenty years ago, I expected that law firms and accounting firms would ultimately combine to provide a full array of financial and advisory services to law firms. You may recall Ernst & Young’s attempt to create a law firm subsidiary with a substantial amount of investment and ballyhoo. That effort was ultimately abandoned,

      As the managing partner of an AmLaw 50 firm and ABA activist pointed out in a lecture given yesterday at the National Law Journal Managing Partner’s Conference, law firms have the dumbest structure achievable, which he correctly noted is the height of irony, given law firms; traditional role in advising clients on business structure. He made the obvious point that lawyers devote their entire careers in creating real equity and value in their own at firms and at the end of the day have no ability to cash in their equity and no exit strategy that any other entrepreneur routinely has in realizing value when they come to the age to retirement. The equity you have created in building a valuable franchise in your law firm simply can’t be monetized or passed on to your estate. He wondered aloud why clients listen to lawyers in structuring their own businesses, focusing on exit strategies when we ourselves just never get it and likely never will. The serious entrepreneur retires by selling his company or taking it public; the serious and successful lawyer retires with a bagful of war stories and a retuen of his capital, paid over many years. He or she just gets back the money he or she invested in the firm at virtually no retuen on investment and no return on the equity built up in the firm over his or her tenure in the law firm.

  8. […] law, does allow for non-lawyer ownership of law firms in the United Kingdom and Wales. But, as I predicted some time ago, there aren’t any non-lawyer buyers lining up or kicking the tires for large commercial law […]

  9. […] law, does allow for non-lawyer ownership of law firms in the United Kingdom and Wales. But, as I predicted some time ago, there aren’t any non-lawyer buyers lining up or kicking the tires for large commercial law […]

  10. The Alternative Business Structure is one that can and will revolutionize the way law is practiced. The worldwide economic recession has caused many businesses to reevaluate how they actually work. Non-lawyers investing in law firms is most likely the next step in the evolution of the law business. Access to the legal system is going to be the problem investors are going to fix which legal funding will play a role too which also involves non-lawyers.

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