From Georgetown Law: Capitalizing Law Firms

Part of our coverage of “Law Firm Evolution:  Brave New World or Business As Usual?”, a conference held March 21-23, 2010 by the Georgetown Center for the Study of the Legal Profession.  For all our posts on the conference click here.

Reported by:  Gregory P Bufithis, Esq.    Founder,  ThePosseList.com and ProjectCounsel.com

The panel moderator was Anthony Davis (Partner, Lawyers for the Profession practice group, Hinshaw & Culbertson)

Presenting papers were Anthony Sebok (Professor of Law, Cardozo Law School) and Andrew von Nordenflycht (Assistant Professor, Strategy, Faculty of Business, Simon Fraser University Faculty of Business).

The panelists were Timothy Scrantom (President, Juridica Capital Management (US) Inc.) and John Flood (Professor of Law and Sociology, University of Westminster, UK).

John Flood put things into a sociological perspective by dividing law firms into 4 centuries:   19th century “patriarchal” with 3 partners and 40 managing clerks (a 1:20 ratio); 20th century “professional” with 20 partners and 40-100 assistants; late 20th/21st century “beaucratic” with 100 partners but with shrinking equity, salaried partners, permanent associates, staff attorneys, and professional support staff; and then the 21st century which is … well … Google.  If nothing else, his choice of photos was pretty amusing (click here).

As John pointed out, large law firms have been one of the most successful institutions of the 20th and 21st centuries. They have grown hugely in number and size; each year The Lawyer Top 100 and the Am Law 200 chart the successes and failures of this particularly Anglo-American elite.  Those at the top of this group once generated a £1 billion a year ($1.5 billion) in revenues, have offices in 30 countries with 3000 lawyers spread among them. Their expertise and reach enable them to counsel on the big transactions that are the mainstay of globalization. They were the architects of globalization.

The second half of the 19th century saw the birth of the corporate law firm. The industrial revolutions of the UK and the US were in full swing, railways were expanding (and collapsing), global trade was increasing, and the stock markets were floating many companies. London and New York were being established as the centers of the world’s capital markets. Corporate law firms were small ventures with two or three partners and a large number of managing clerks (paralegals).   At the height of the railway boom, some firms had leverage ratios of one partner to 70 managing clerks. These partners were as much entrepreneurs as their clients; in fact it could be difficult to distinguish them apart. 

In the first part of the 20th century the blueprint for the modern large law firm was drawn up by Paul Cravath. His model was simple in its design and execution but radically different from what had occurred before. Instead of taking into practice sons of friends and relatives, Cravath proposed that the best qualified students from graduating from law school should be hired. Ideally, they should have served an editorship on the law review. They would be paid a good salary to prevent them from taking on other work. Instead of being assigned their own docket of cases, they would collaborate with a partner or senior associate who would dissect a case into its constituent parts and give them to a range of associates. Over time, say seven or eight years, an associate would be considered for partnership. If he met the expectations of the firm, he would be promoted. If he was not selected, the firm would place him in another firm or in the legal department of a client thereby strengthening links through alumni networks. There were always more associates than openings for partner, which then created a “tournament” between associates for these coveted positions. The tournament prevented associates from taking their expertise away from the firm too early in their probationary periods.

But the problem with the tournament strategy is that it is predicated on unlimited growth which we now all know has become unrealistic.  The model has failed, as evidenced by the many speakers and presenters at this confreence, for a myriad of reasons as expressed.  

For the rules of accounting have laid down their heavy hands.

Accounting shocker #1:  cash flow is not necessarily the same thing as income. Even for law firms who almost universally measure their economic performance on the cash basis, there are borrowings, loan payments, fixed asset purchases and depreciation that affect income and cash flow differently.  Obviously these financing and investment activities are important, but they are not where law firms get into trouble (unless they have financed operations instead of investments). Generally, trouble occurs if there is insufficient focus on the cash receipts generated from accounts receivable and the cash payments generated by payroll and accounts payable.

Accounting shocker #2:  The cash gap in a law firm is defined as the difference between when you pay your expenses and when clients pay you.  And lately there has been a … well … a bit of a disconnect.  Law firms seem to need more money these days.

As Andrew von Nordenflvcht would have it law firms need to look at outside capital.

Note:  I am familiar with some of Andrew’s work having read Inventing the Electronic Century (co-authored with Alfred Chandler) wherein they trace the history of the consumer electronics and computer businesses from a global perspective, exploring the evolution of the “Information Age”, and discussing IBM’s role in the development of technology, Japan’s conquest of the global electronics market, and more.

Andrew outlined some of the common questions about outside ownership of law firms as follows:

▪ Why would law firms need external capital?

▪ Why would investors invest in law firms, if the assets can walk away any time?

▪ Won’t it hurt the firm’s competitiveness?

▪ Which types of law firms are likely to go public?

▪ What effect might it have on the industry?

He did a substantial amount of research into other professional services: advertising, as well as i-banking and consulting services.  He sees the key in the emergence of new organizational forms to intermediate between outside investors and professional service firms, e.g., holding companies which were used in the restructuring of the advertising industry.  And what is interesting about the use of the holding company structure in the advertising industry is that the holding company was the owners of scores of highly autonomous — and competing — subsidiaries.

Andrew’s belief is that such a structure could diversify across large clients by serving conflicted clients through separate subsidiaries, e.g., the Heller Ehrman dissolution after two planned mergers was scuttled because of client conflicts.

His analysis is extremely interesting and you can read his PowerPoint by clicking here.   His concluding comments at the panel:

▪  Some law firms will certainly go public and the cashing out opportunity will be quite substantial

▪  Some of those law firms will even stay public, larger firms, where costs of outside ownership are lower

▪  Some kind of organizational innovation to intermediate between capital markets and partnerships is likely to emerge, maybe the holding company, maybe just changes internal to large law firms

▪  Acquisitions by these innovators may well catalyze substantial consolidation

The other buzz phrase at the panel: litigation funding.  Litigation funding allows people with money to “fund” court cases (and, increasingly, arbitrations) on behalf of others who lack either the resources — or the appetite — to pay themselves.  The funders, typically sophisticated institutional investors, take a slice of the winnings if the case is successful and share the pain if not. 

Note:  it gained notoriety a few years back in the UK when Allianz, Europe’s largest insurer, came to London to set up a third-party litigation fund — provoking some familiar but misguided hostility.  Since litigation in the UK is expensive and success is not guaranteed no matter how strong your case is, surrendering a share of the potential upside in return for some downside protection is attractive.

Detractors base their suspicion on two main arguments:  first, that there is something distasteful, some say unethical, about a third-party that has no involvement in a legal dispute being allowed to profit from it.  Second, that the availability of third-party funding removes some of the fear of losing and so encourages people to bring groundless lawsuits. If an unsuccessful litigant no longer has to pay, opponents say, they have nothing to lose and the courts will be overrun with baseless claims.

Sebok (an expert in the practice of lending to plaintiffs) pointed out that litigation financing can be viewed as simply another way for the capital markets to help firms exploit productive assets.  Of course there are special problems relating to outsiders stirring up claims by simply funding actions by others (maintenance), particularly where the investor gets some of the proceeds (champerty) or the claims are groundless (barratry).  Also, confidentiality and privilege rules may forbid disclosure of litigation information to outside funders, making these particularly difficult investments.   And some commentators think the basic problem is that it turns litigation into a business rather than the search for corrective justice.

Which raises the question of ethics. Many litigation finance company web sites are careful to post state-by-state analyses of court and bar association restrictions on lending to law firms.   Sebok says that at least at first glance, law firm lending does not appear to be champerty, the common-law practice of vexatiously stirring up litigation, because loans are usually made on the basis of existing cases. Nor is there a conflict of interest between the lawyer and client, as long as the client understands and agrees to whatever loan-related expense the lawyer passes on. And in the macro-economic sense, there’s something ironic about free-market forces, which tort reformers claim are impeded by personal injury litigation, actually investing in litigation. Indeed, says Sebok, litigation financing might be considered something of a “safety valve” in the face of tort reform, a counteracting force.

For Sebok’s full presentation titled Third-Party Litigation Funding click here.  

We interviewed Tony after the panel and he discussed  the apparent hostility towards investment in law firms by nonlawyers, the benefits of investment in law firms and litigation services by nonlawyers, as well as the changes necessary to allow that investment.  The full interview follows:

 

So what should we think of all this?  That brings us to Timothy Scrantom.  Because it’s important to keep in mind that, like it or not, litigation is a legitimate business.  Like other basically legitimate businesses, it can turn bad. The question is whether the problems should be addressed directly by rules constraining improper litigation practices or indirectly by constraining firms’ ability to pursue the litigation.

I suspect Scrantom would opt for the former.   Juridica focuses on steady cash flows – that is, fairly solid claims whose results can be predicted – rather than novel theories or jury cases.  Financing this kind of litigation arguably helps the law deter socially inefficient opportunism.  And there are other potential benefits of outside litigation financing.  Litigation funders could provide expertise and investigation that increases litigation’s accuracy and deterrence value. This funding also helps eliminate the potential conflict of interest between a corporate client with diversified investors and a risk-averse lawyer who may have an incentive to settle cases that could be productively litigated.

Scrantom covered a lot of territory.  Some of the more interesting points:

How is capital entering the law market?

▪  Recourse or non-recourse loans to claim or judgment holders

▪  Direct purchases of interests of claim or judgment holders

▪  Recourse and non-recourse loans to lawyers secured by fees

▪  Hybrid litigation risk-sharing arrangements

▪  Derivatives: collars and floors

▪  Insurance products

What are the forces affecting capital flows into the law market?

▪  Drivers

          – – Marketplace demand

                   – The anachronistic economic model of law firms

                   –  Innovation: sophistication of corporate legal departments

                   –  The desire for corporate risk mitigation

          — Supply side opportunity

                   –  The “non-correlated investment” phenomenon

                   –  The “recession-proof” business model

                   –   The “counter-cyclical” nature of claim finance space

          — Market size: possibility of massive capital absorption

▪  Inhibitors

          — Regulation

         —  Perceptions, mythologies and prejudices

         —  The guild anachronism in the legal profession

For Scrantom’s full presentation click here.

We caught up with him after the panel for an interview where he discussed the differences between the U.S. and other markets, as well as the players in the private equity investment and potential ethical and regulatory concerns.   The full interview follows:

Litigation funding for commercial disputes works, in essence, on the same principle as forward contracts in currency markets.  Litigation is expensive and uncertain.  It can be crippling if you lose. If a third party offers to help you reduce this risk in return for a fee, it makes sense to at least investigate it.  The fee structure will be different but these two contracts are fundamentally the same because at their core they both involve one business paying another business to offset a degree of risk.