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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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Will Permitting Equity Investments in Law Firms by Non-Lawyers or Allowing Law Firms to Go Public Have a Significant Impact on Corporate Law Firms?


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Private and Public Equity Investment in Law Firms by Non-Lawyers

                                                                                      Jerome Kowalski

                                                                                      Kowalski & Associates

                                                                                      October, 2010

 The American Lawyer reports that in 12 months, laws in the United Kingdom will permit equity investments in and ownership by non-non lawyers of law firms.

This certainly is profoundly interesting development that has been in the making for several years. As I am sure, you know, the ABA has had a committee looking in to this issue and the related issue of allowing non-lawyers serve as principals of law firms, allowing for the admission to law firm partnerships of accountants, investment advisers and the like. Milton Berle famously defined a committee as a group that takes minutes and keeps hours. Assuredly the ABA will spend many hundreds of hours watching developments in the UK.

The issue on this side of the pond is the general tightness of capital, which is the grease that keeps  law firms operating. Traditional lenders to law firms have dramatically tightened their underwriting requirements and are following their borrowers’ adherence to lending covenants extremely closely, with waivers, previously easily granted now rarely bestowed.

A few creative law firms have circumvented these accumulated restrictions by arranging for the issuance of publicly traded bonds for the construction of or expansion of office space, using an intermediary entity so that the firm is not the issuer of these debt instruments. In different eras, I suspect that these artifices would have been the subject of severe scrutiny, if not disciplinary action. Yet, these bond offerings closed with nary a question, primarily, I believe, because law firms themselves were eager to explore every potential source of capital.  Most law firms are now providing themselves with additional capital by increasing required capital contributions by partners and in some instances even by non-equity partners.

Australia was the first nation which, so far as I know, allowed law firms to be publicly held.  The first law firm to do so was a large personal injury firm, which issued its annual report some months ago and reported astounding profitability.  Interestingly, in the United States, there is one torts lawyer (if you are an habitué of late night television, you know who he is), who spends a reported  astounding $90,000,000 annually on television advertising.  It appears that he does not spend more than a moment or two practicing law; rather he has a network of law firms throughout the United States in which I gather he is nominally a partner and clients who respond to his advertised toll free line (calls are handled by a 24/7 call center) are routed to the affiliated lawyer in the relevant jurisdiction and the advertiser simply shares in the revenue produced.  We have no idea what this lawyer earns annually, but one could safely assume his earnings justify his advertising expenditures.  One could well imagine what this and similar tort lawyers who advertise broadly could do if they had access to additional capital.

An interesting side note is that, as the adage goes, money follows money:  While large law firms are being pinched for capital, a whole industry has been spawned that provides funding for tort lawyers  on individual cases (at steep interest rates to be sure) by a variety of different entities including P&T Funding, Litigation FundingLaw Cash, Oasis Legal Finance and a host of other similar companies. There certainly has been some criticism of these funding entities, suggesting they are engaging in champerty, maintenance or other ethical violations and thus propagate burdensome tort litigation requiring tort reform. But, the real point is that financiers have already demonstrated a greater willingness to fund tort lawyers than commercial lawyers.

I personally pass no judgment on the propriety of this use of capital, but the fact is that increased access to capital is an elixir that will have broad ranging effect; not all of which will inure to the benefit of commercial law firms.  My primary point is whether public investors would be more quickly drawn to successful tort lawyers with substantially and dramatically higher profit margins than staid corporate law firms. Public ownership of commercial law firms may not be quite the elixir that some may have hoped for.

Moreover, private or public equity investments in law firms raise a host of questions which are not susceptible to easy resolution, such as:  (1) Will investor ownership of a law firm create an incurable conflict between a lawyer’s undivided duty of loyalty to his or her clients and the lawyer’s obligations to maximize profitability to the enterprise’s owner?  (2) Does investor ownership infringe upon a lawyer’s independence? (3) To what extent should non-lawyer owners have managerial control of the firm?

But before you get too bogged down in pondering these questions, bear in mind that hospitals and other health care providers have been owned and controlled by non-medical personnel for decades.

[Please see our update at  this link]

 © Jerome Kowalski, October, 2010.  All Rights Reserved

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