Outsiders As Overseers

In the wake of Enron, WorldCom, and other corporate scandals, corporate governance has come under the microscope. One reform that has been widely endorsed is the election of more independent, outside, nonexecutive directors to boards of publicly owned corporations. Outside corporate directors provide not only accountability but also perspective, diverse experience, and credibility.

Law firms might well benefit from outside directors in the same way. Indeed, some non-U.S. firms have already done so.

Historically, until the last quarter of the 20th century, law firms were small and very private, even mysterious. They shunned publicity and operated secretively, more like college fraternities than businesses.

Beginning in the 1970s, we saw the emergence of large, corporate-style law firms, with specialized departments and multiple offices, that were managed as businesses. The 1970s also saw the emergence of a national legal press reporting on legal-business issues and on individual law firms, later publishing financial information on individual firms.

The 1980s ushered in an era of exponential growth in large firms, some driven by mergers. Firms shed their secrecy and began to market themselves aggressively. By the 1990s, growth and consolidation had produced regional, national, and even global law firms, nonlawyer owners (in some places), and law-firm-owned ancillary businesses.

Today, major law firms are important business entities by almost any measure. Worldwide in 2002, six law firms had fee revenue of more than $1 billion, and 20 firms collected between $500 million and $1 billion. U.S. Department of Labor statistics indicate that the current aggregate revenues of lawyers and law firms in private law practice in the United States exceed $150 billion per year ' more than 1.6% of the U.S. economy and two-thirds more than the aggregate revenues of accounting and consulting firms.

Law firms also have a significant share of today's labor market. With about 1.3 support staff and paralegals for every lawyer in private practice, firms employ an estimated 1 million nonlawyers. The total current employment figures for law firms comes to 1.8 million ' 1.3% of the employed American work force.

And law firms are important as consumers of business equipment and services. Private law practices spend $6.8 billion on information technology each year, average more than $11 billion in outstanding bank debt, and pay occupancy costs (mostly rent) of $21 billion annually.

Ripple Effects

The result is that, because of this wide range of stakeholders dependent on them, both inside and outside, law firms are vitally important to the economy. The public has a great interest not only in the services law firms provide, but also in their economic health and vitality.

This public and economic interest is best demonstrated by the disruption caused by the business failure or dissolution of major law firms, which has occurred with alarming frequency in recent years. In the last year alone, large firms that have dissolved include Brobeck, Phleger & Harrison (once more than 800 lawyers with revenue of $500 million), Arter & Hadden (once more than 400 lawyers), and Altheimer & Gray (once more than 300 lawyers).

When this happens, clients suffer as their lawyers typically scatter to different firms, causing disruption and often significant switching costs in the redirection of their work to new firms. Many associates and staff lose their jobs and benefits, lenders and vendors lose a major customer, landlords lose a major tenant, governments lose an important taxpayer, and local economies suffer.

Because a major business failure has far-ranging repercussions on the local economy and community, law firms are arguably as accountable to their constituencies as any other business. Yet law firms are vested with a public trust that allows the profession to self-regulate. For these reasons, the argument against outside direction ' because law firms are unlike other businesses and accountable only to their owners ' is specious. As in public corporations, outside directors can imbue a firm's governance with objective accountability.

According to a recent Altman Weil survey of the 200 largest U.S. law firms, only two of 49 responding law firms included nonpartner, nonemployees on their primary governing boards (both in nonvoting capacities), one at each firm. Both persons ' an economist and another nonlawyer ' were paid an annual stipend and reimbursed expenses. Clearly, outside directors is not an idea that has been embraced by major U.S. law firms.

Not Gonna Do It

Most firms among those surveyed reported that they have never considered outside directors. Six percent are considering or have considered outside directors but have not done it, and 4% believe other methods can be employed to obtain outside input, including consultants and presumably client surveys. None seemed to view either stakeholder accountability or credibility as a reason to consider the appointment of outsiders.

Reasons given for not including outside directors were also revealing:

• Believe outsiders are not permitted under professional rules;
• Believe it would compromise client privilege;
• Do not want to expose their decision making to outsiders;
• Could not agree whom to invite;
• Restrictions in the partnership agreement;
• Not highest priority;
• It would “undermine independence”; and
• The idea is “stupid, per se”

Still, a third said they would consider outside directors if professional rules specifically allowed them. Rule 5.4(d)(1) of the American Bar Association Model Rules seems to prohibit outside directors if they are not lawyers. But what about nonpartner, nonemployee lawyers, who might be clients (corporate counsel); retired former partners; or working in other firms, nonclient corporations, or government agencies, academics, or business?

A New Perspective, And More

Law firms are notoriously incestuous, xenophobic, and shortsighted in their management. The extreme result of this is the current spate of failures and dissolutions, with all their adverse ripple effects on the local economy and community. Selecting outside directors for their business acumen, expertise, and experience would inject a new and vital perspective to firm leadership. Additionally, outside directors might provide direction that would enhance the effectiveness of the firm in serving its clients and the community, and ultimately strengthen its success as a business.

Some European firms, such as DLA, KLegal, and Landwell, have added outsiders to their governing group with apparent success. Is this a development that U.S. regulators should allow, and that major U.S. law firms should consider? Questions that will have to be resolved are: Should they be allowed in a voting or only in a nonvoting capacity? Should only lawyers be permitted to serve? Should there be a limit on the number of outsiders?

The current corporate climate and new realities in the legal marketplace make this an opportune time for the legal profession to reconsider the issue of outside input to law firm governance.

In the wake of Enron, WorldCom, and other corporate scandals, corporate governance has come under the microscope. One reform that has been widely endorsed is the election of more independent, outside, nonexecutive directors to boards of publicly owned corporations. Outside corporate directors provide not only accountability but also perspective, diverse experience, and credibility.

Law firms might well benefit from outside directors in the same way. Indeed, some non-U.S. firms have already done so.

Historically, until the last quarter of the 20th century, law firms were small and very private, even mysterious. They shunned publicity and operated secretively, more like college fraternities than businesses.

Beginning in the 1970s, we saw the emergence of large, corporate-style law firms, with specialized departments and multiple offices, that were managed as businesses. The 1970s also saw the emergence of a national legal press reporting on legal-business issues and on individual law firms, later publishing financial information on individual firms.

The 1980s ushered in an era of exponential growth in large firms, some driven by mergers. Firms shed their secrecy and began to market themselves aggressively. By the 1990s, growth and consolidation had produced regional, national, and even global law firms, nonlawyer owners (in some places), and law-firm-owned ancillary businesses.

Today, major law firms are important business entities by almost any measure. Worldwide in 2002, six law firms had fee revenue of more than $1 billion, and 20 firms collected between $500 million and $1 billion. U.S. Department of Labor statistics indicate that the current aggregate revenues of lawyers and law firms in private law practice in the United States exceed $150 billion per year ' more than 1.6% of the U.S. economy and two-thirds more than the aggregate revenues of accounting and consulting firms.

Law firms also have a significant share of today's labor market. With about 1.3 support staff and paralegals for every lawyer in private practice, firms employ an estimated 1 million nonlawyers. The total current employment figures for law firms comes to 1.8 million ' 1.3% of the employed American work force.

And law firms are important as consumers of business equipment and services. Private law practices spend $6.8 billion on information technology each year, average more than $11 billion in outstanding bank debt, and pay occupancy costs (mostly rent) of $21 billion annually.

Ripple Effects

The result is that, because of this wide range of stakeholders dependent on them, both inside and outside, law firms are vitally important to the economy. The public has a great interest not only in the services law firms provide, but also in their economic health and vitality.

This public and economic interest is best demonstrated by the disruption caused by the business failure or dissolution of major law firms, which has occurred with alarming frequency in recent years. In the last year alone, large firms that have dissolved include Brobeck, Phleger & Harrison (once more than 800 lawyers with revenue of $500 million), Arter & Hadden (once more than 400 lawyers), and Altheimer & Gray (once more than 300 lawyers).

When this happens, clients suffer as their lawyers typically scatter to different firms, causing disruption and often significant switching costs in the redirection of their work to new firms. Many associates and staff lose their jobs and benefits, lenders and vendors lose a major customer, landlords lose a major tenant, governments lose an important taxpayer, and local economies suffer.

Because a major business failure has far-ranging repercussions on the local economy and community, law firms are arguably as accountable to their constituencies as any other business. Yet law firms are vested with a public trust that allows the profession to self-regulate. For these reasons, the argument against outside direction ' because law firms are unlike other businesses and accountable only to their owners ' is specious. As in public corporations, outside directors can imbue a firm's governance with objective accountability.

According to a recent Altman Weil survey of the 200 largest U.S. law firms, only two of 49 responding law firms included nonpartner, nonemployees on their primary governing boards (both in nonvoting capacities), one at each firm. Both persons ' an economist and another nonlawyer ' were paid an annual stipend and reimbursed expenses. Clearly, outside directors is not an idea that has been embraced by major U.S. law firms.

Not Gonna Do It

Most firms among those surveyed reported that they have never considered outside directors. Six percent are considering or have considered outside directors but have not done it, and 4% believe other methods can be employed to obtain outside input, including consultants and presumably client surveys. None seemed to view either stakeholder accountability or credibility as a reason to consider the appointment of outsiders.

Reasons given for not including outside directors were also revealing:

• Believe outsiders are not permitted under professional rules;
• Believe it would compromise client privilege;
• Do not want to expose their decision making to outsiders;
• Could not agree whom to invite;
• Restrictions in the partnership agreement;
• Not highest priority;
• It would “undermine independence”; and
• The idea is “stupid, per se”

Still, a third said they would consider outside directors if professional rules specifically allowed them. Rule 5.4(d)(1) of the American Bar Association Model Rules seems to prohibit outside directors if they are not lawyers. But what about nonpartner, nonemployee lawyers, who might be clients (corporate counsel); retired former partners; or working in other firms, nonclient corporations, or government agencies, academics, or business?

A New Perspective, And More

Law firms are notoriously incestuous, xenophobic, and shortsighted in their management. The extreme result of this is the current spate of failures and dissolutions, with all their adverse ripple effects on the local economy and community. Selecting outside directors for their business acumen, expertise, and experience would inject a new and vital perspective to firm leadership. Additionally, outside directors might provide direction that would enhance the effectiveness of the firm in serving its clients and the community, and ultimately strengthen its success as a business.

Some European firms, such as DLA, KLegal, and Landwell, have added outsiders to their governing group with apparent success. Is this a development that U.S. regulators should allow, and that major U.S. law firms should consider? Questions that will have to be resolved are: Should they be allowed in a voting or only in a nonvoting capacity? Should only lawyers be permitted to serve? Should there be a limit on the number of outsiders?

The current corporate climate and new realities in the legal marketplace make this an opportune time for the legal profession to reconsider the issue of outside input to law firm governance.