Not your basic bean counters

As UK law firms prepare for massive regulatory shake-up and embrace new corporate working practices, the commercial experience of the profession’s current crop of finance directors could not be more welcome.

By Jason Schofield, editor, FD Legal

Globalisation and the commoditisation of legal services are but a few of the market pressures already bearing down on law firms. But the landscape is likely to become even more difficult as the UK legal market prepares for its biggest legal and regulatory shake-up in decades. Whether navigating the tax hurdles of limited-liability partnership (LLP) or preparing for life post-Clementi, law firms have had to break tradition with many elements of their partnership model and embrace a new corporate structure that is better suited to the financial-management challenges posed by de-regulation and market pressures. In particular, law firms will increasingly look to the experience of their finance directors (FDs), many of who bring a wealth of experience from outside the legal profession.

Recruiting from beyond

The legal profession is typically characterised as being years behind accountants and management consultants in terms of the technology law firms use, the way they manage themselves and the speed with which they adapt to market changes. Indeed, it is no surprise that many of the FDs in the top-50 UK law firms have developed considerable experience outside of the legal industry. Having first trained at one of the big accountancy giants, such as Ernst & Young or PricewaterhouseCoopers, many worked their way up to finance-director level in other industry sectors, such as financial services or telecommunications.

Claire Hafner, FD at Eversheds, and David McLaughlin, FD at Simmons & Simmons, are typical
in that both developed extensive financial-management experience in other sectors. Hafner was FD of BT’s multi-media and professional-services divisions respectively, and after a short stint as FD of Barclays’ UK banking division, joined Eversheds. Prior to joining Simmons & Simmons in 2005, McLaughlin worked for magic-circle firm Linklaters, and before that spent ten years in audit and six
years with Arjo Wiggins Appleton, a British-French-American paper group, which was subsequently acquired by Worms & Cie in a £2.19bn takeover deal.

Such appointments are no accident. “When I joined Eversheds, the firm was looking for a change agent and not necessarily one with legal experience,” says Hafner, one of several female FDs within the top 50. Perhaps more importantly, while working at BT, Hafner witnessed first hand the impact of deregulation on the telecoms industry and the subsequent consolidation and setting up of new forms of partnerships. Such experience will no doubt prove invaluable as the legal profession undergoes similar change.

Hafner is also a firm believer in recruiting talent from outside the legal profession, which she says helps “challenge the status quo and the more conservative approach of the profession”. McLaughlin echoes this view. Since joining Simmons & Simmons, he has changed a quarter of his London team: “You need people who are commercially aware and can adapt. Those who have only experienced the old back-office function of law firms and have merely processed transactions and slavishly carried out the requests of partners are unlikely to have the knowledge or experience to drive their firms forward.”

Neil Woodcock, chief-operational officer (COO) of international law firm Salans, points to the influence of market forces. His previous role as partner at PricewaterhouseCoopers puts him in a good position to describe the differences between the legal profession and accountancy sector, and why the latter has superior business processes and systems. “Historically, audit tendering was way ahead of legal tendering, so the accountancy profession has had a big head start,” he says. “Partners at accountancy firms are also much more likely than law-firm partners to recognise that, however talented they are, the brand is bigger than them. This has put accountants ahead of the game in terms of a ‘corporate’ approach.” Woodcock also notes that the accountancy profession has had to embrace robust risk-management practices sooner than law firms. “Having been besieged by law suits during the past three decades, partners in accounting firms quickly learnt that strong management control and discipline was an essential tool in combating claims.”

The Clementi effect

Sir David Clementi’s 2004 review of the UK legal-service market has led to a draft Legal Services Bill, which is due to pass through parliament. This is likely to result in the establishment of a new Legal Services Board to oversee front-line regulators such as the Law Society and the Bar Council. It also approves the concept of legal-disciplinary practices (LDPs), which would enable solicitors and barristers to join a single partnership, and permit non-lawyers to be involved in ownership (subject to a ‘fit to own’ test). Firms needing investment for growth and expansion, meanwhile, will be able to turn to venture capital/private equity or float as public companies.

But what does all this mean in economic terms? The likelihood of UK magic-circle firms having the desire or need to go public is unlikely. The same no doubt applies to those below the UK-100 radar. What is more likely is that firms will offer, or sell, equity to senior non-legal business managers.

Hafner questions whether the profession is ready for the exposure and scrutiny that would come from being a listed company. She also points to the ease with which firms can raise funds without the need for external investors. McLaughlin agrees, stating that the capital requirements of most firms can be met by partners, who are first-rate entrepreneurs and would not readily part with equity.

“While the working-capital needs of law firms has certainly grown, particularly in relation to IT spend, the balance sheet of most firms is still pretty thin,” says Woodcock. “The legal profession is not a natural market for external capital – the ownership profile is simply far too wide.” More importantly, Woodcock is protective of the partnership culture of the profession and the sense of responsibility that this engenders when it comes to risk management.

Perhaps more fascinating will be to watch how market forces begin to shape this brave new landscape. “The thrust of Sir David Clementi’s recommendations and the Legal Services Bill is about improving consumer choice, and, in particular, doing that by allowing new entrants to the legal-services market,” says Sacha Romanovitch, partner of Grant Thornton UK. “If mass-market consumer organisations decide that they want to get into this market, it is likely that they would want their legal offering to be available to all their customers. After all, they are mass-market consumer organisations; why would they want to treat legal services differently? To achieve this market reach they might buy law firms (then re-brand and if necessary relocate them); franchise law firms (under a common brand); or set up an internet and call-centre-based service,” she adds.

“A lot of the reforms have the consumer in mind, so I think there will be a lot of consolidation of smaller high-street firms as they struggle to justify their rates and where economies of scale will become more relevant,” says Hafner. At the corporate end of the scale, she adds, “We might start seeing white-label firms offering white-label-type services to the likes of large insurance companies or large banks, who then subsequently may decide to invest in those firms.”

Firms that float as public companies could change the way they remunerate their key people by offering share options, potentially turning the existing partnership model on its head. “For some lawyers, the thought of having to wait a long time to become partner may be a little daunting,” says Hafner. “In this context, share options could prove to be a great retention tool, provided there is a market to crystallise their options. It will be very interesting to see whether the firms that do go public start attracting the talented people who would have otherwise joined a traditional top-tier firm, and whether being offered share options was one of the decisive factors.”

The use of share options is, of course, commonly used in the corporate sector as a long-term incentive plan. But Hafner is equally quick to point out that the traditional partnership model may be flexible enough to bite back: “Firms may decide to offer incentive schemes that mirror incorporated businesses, such as shadow options.”

The prospect of injecting public capital into a law firm – or even admitting non-lawyers to the ranks of equity ownership in a private firm – has received mixed reviews. According to PricewaterhouseCoopers’ 2005 Financial Management in Law Firms survey, while close to 60 per cent of the top-25 UK firms support the concept of external investment in their firms, they also acknowledge that there will be material changes to their culture, governance and business model. Among larger firms, 81 per cent see greater costs of regulation and compliance but at the same time only 13 per cent see any benefit flowing to clients.

LLP converts

As firms move towards a more corporate culture, the shift to LLPs can only gather pace. A survey conducted by Legal Week in December 2005 indicated that 84 per cent of the top 50 UK law firms have already converted to LLP status or are considering the move.

Converting to an LLP makes a lot of sense for firms that wish to limit the personal liability of existing partners and protect them from the potentially catastrophic impact of a claim.

“I certainly believe in the concept. It is incredibly valuable for raising the whole awareness of risk management. It will get firms thinking about it in a way they haven’t before. When I look around our offices, all of our partners are responsible people, they wouldn’t be partners if they weren’t. But there is always that risk someone might do something that causes a problem,” says Woodcock.

From a finance perspective, the benefits are clear – more transparency and the adoption of recognised accounting procedures that present a true and fair view of the business, rather than one that ensures equity among the owners of the business. This means that the statutory balance sheet might present a very different picture from the partnership balance sheet. “Even nowadays when you read the legal press there is a lack of consistency on how you calculate profit per equity partner (PEP) and whether you need to include fixed-share partners as well as equity partners. Also, a lot of the key-performance indicators are subject to interpretation,” says Hafner. Indeed, while the annual publication of league tables shines a spotlight on the financial fitness of law firms, the veracity of the figures cannot be proved. Woodcock agrees: “I sometimes look at published figures and often wonder what’s behind some of the numbers.”

LLP conversion also gives rise to an interesting debate about what constitutes accumulated profit, because in a partnership environment all the profit goes to partners. And for firms with US connections that account on a cash basis, such as Salans, Woodcock is quick to point out that there will be an obvious requirement for a formal reconciliation between accrual-based accounting and any cash-based accounting that is used as the basis for partner capital accounts and distributions.

Creating the right legal structure that works for tax and regulatory purposes, while recognising the different local regulatory requirements in all of the jurisdictions where the firm operates, is an obvious stumbling block.

In particular, the tax position of France is proving problematic. Salans, for example, is one of many firms that is committed to converting to an LLP but has yet to make the transition. “We are waiting in the wings because of the lack of tax transparency of income coming from an LLP into France, which gives rise to double taxation at present. Thankfully, it is understood that France will make legislative changes very soon,” says Woodcock.

Hafner agrees that this can be a significant problem for law firms that want a presence in France. But she remains optimistic: “According to tax specialists I have spoken to, a lot of law firms have opted to treat LLP as being transparent in France, anticipating the change that is to come from the French tax authorities in the coming months. Other firms, meanwhile, have opted for the more prudent approach and provided for potential double tax.”

The process of conversion is not inherently complicated, but it can be easy to underestimate the work required to get it right. When Allen & Overy wrapped up its conversion to a UK LLP in 2004, the firms managing partner David Morley and senior partner Guy Beringer reportedly signed more than 1,000 pieces of paper to create an entirely new firm, as required by UK law, and sent out more than 8,000 notices to current and recent clients explaining its new legal status.¹

McLaughlin is more sceptical about the benefits of LLP conversion and calls for a higher degree of self-regulation: “I’m personally in two minds about whether it’s a good thing. One danger is that individuals in firms could start taking more risks simply because they have more cover, but quite often the greatest risk is in those countries where LLP protection is not possible. My initial preference would be to enhance the terms of engagement and to put more money into minimising or preventing the risk from happening in the first place. Accounting firms did this a long time ago – for example, the firm I worked for had a professional-standards-review department where any audit fees over a certain threshold had to go through an independent assessment process, which had the added benefit of improving the quality of the work performed.”

What comes next?

Few would argue that by mid-2007 law firms are likely to face an entirely different landscape. Of course, it’s clear that the Legal Services Bill will have less of an impact on large or mid-size firms. The real brunt of the proposals will be felt at the high-street level, where smaller firms will be forced to consolidate and compete on price as services become increasingly commoditised.

But firms of all sizes are starting to realise that running a law firm in today’s environment is no different to running any other company. The adherence to recognised accounting standards, performance-related remuneration that extends to non-fee earners, shadow-partner status for senior support-team members; these are all indicative of a profession that is trying to adopt a more corporate-orientated culture, which bodes well for the future.

Reference

1) Heather Smith, The American Lawyer, January 2006.