THE BRAVE NEW WORLD OF LEGAL SERVICES PART 1

"Alpha children wear grey. They work much harder than we do, because they're so frightfully clever. I'm awfully glad I'm a Beta, because I don't work so hard. And then we are much better than the Gammas and Deltas. Gammas are stupid."
Aldous Huxley, Brave New World 1932

As the memories of Christmas and the New Year fade away, lawyers and legal service providers, regulated and unregulated, are waking up to the reality of the changes that will materially impact their businesses in the next 12 months. The new rules will enable lawyers to share the management and control of a business which provides reserved legal services to the public with non-lawyers and will allow existing legal practices to accept external investment.

In the new world will there now be Gamma and Delta lawyers as well as Alpha and Beta ones? How many new legal service providers will appear this year, led by commercially astute management teams, and backed by well known consumer brands, significant investment in systems and processes and marketing budgets that will make the eyes of a traditional lawyer water? Will Private Equity funds be directed into existing established businesses or will we see well funded “start ups” with aggressive new business plans?

Key issues for consideration by new entrants into legal services include:

• How can a Legal Service provider satisfy an increasingly demanding consumer who wants a quality customer experience giving value for money from a technically competent professional?
• What will the licensing framework in place on October 6th 2011 for Alternative Business Structures (ABSs) look like?
• To what extent will be the changes proposed by the SRA for the financial protection of clients impact on ABSs?
• How aggressively will ABSs compartmentalise their reserved legal activates from other products?
• Will regulation prevent businesses from paying referral fees?
• What new distribution channels will open up and how cost effective will marketing investment be?

Saddled by History

There is a fundamental problem in all of the discussions around ABSs, which is simply whether an ABS is going to be forced into looking and behaving like a traditional law firm or whether the law firm can be persuaded to mutate into an ABS. Historically, law firms have operated as partnerships with young lawyers joining the business and aspiring in their career path to become partners. While in the past lawyers may only have had a responsibility to their clients, the real world today presents risks from many other sources including government bodies, firms’ own employees and involved third parties. 

With the creation of the Limited Liability Partnership in 2000, many law firms moved to change their legal status to reduce their potential liability to clients and third parties but as LLPs are still saddled with many of the disadvantages that come with a partnership. This is why most other types of businesses (excluding sole traders) operate under the umbrella of a corporate entity - the number of corporate businesses with more than one employee outnumber partnerships by more than three to one.
A partnership structure, with limited or unlimited liability will be managed and controlled by its partners who are the owners and “directors” of the business. These businesses are financed by such capital as the partners/members have been able to provide, plus debt from banks or interested parties such as the partners themselves. A key disadvantage of the partnership model is that from a tax, accounting and succession perspective it does not encourage the retention of profits as partners generally are advised to draw their profits fully each year. This means that working capital is limited and that lenders are unwilling to put money into a business where the owners are withdrawing their profits each year. In this scenario, it is difficult to structure an exit plan which is a pre-requisite for any Venture Capital Investment.
There is also a perception that the culture of these businesses is very different to that of a “normal” business – they are risk averse, unwilling to adapt and change, and immersed in practices of the past. The business is run by consensual management and, if you ask the question who in the organisation is able to hire and fire another partner, you may not always get a clear answer.  Adding in the matter of egos, culture and history, partnerships create a huge barrier to changes in control, management and structure; these factors reduce accountability and increase risk.

A partnership structure is not attractive to a potential investor who wants to see a commercial rate of return on the cash invested, not simply the funds used to pay for the pensions of retiring partners. Once an investor is in place, they will not be satisfied with the ability to influence the existing management, they will inevitably want to set strategy and exert control over the business. The management must be continually looking at ways to build additional value in the business rather than the means to take out as much capital as possible

Conversely the corporate structure looks very different.  A company must operate in a statutory and accountable environment with a formal management composition that is accountable to shareholders and stakeholders. Corporate governance is underpinned by the law to include layers of protection such as audit and remuneration committees, and rules on what capital can be extracted from the business and on dividend policy.
 
But the most obvious reason why most businesses choose a corporate entity is of course to simplify access to investment and financing.  In a sector which is changing so rapidly and is so dependent for its survival on continually renewing and changing, strong finances, available working capital and funds for investment are critical. An investor will want an easy route into the investment, the ability to control strategy, change processes and get rid of dead wood, and within a short period of time (say three to five years) execute an exit plan through sale or flotation.

This remains a core challenge for the success of the legal sector and the marriage of Alpha and Beta Lawyers with Gamma and Delta entrepreneurs.

In the next article, I will look at client financial protection and specifically the current arrangements for solicitors, the proposed changes by the SRA and how these changes will impact on ABSs. Will an ABS have to join and pay into the Assigned Risks Pool?  Is the only reason that the Solicitors’ Compensation Fund exists because a partnership cannot get full insurance for the fraudulent actions of the partners? And, if so, why should an ABS be forced to contribute to an outdated and irrelevant funding model?

William Feeny is a Director at Kings Court Trust Corporation. You can reach him on 01225 787107 or at william.feeny@trustcorporation.com.