Alternative Business Structures for U.S. Law Firms

Partnerships in human history, whether documented or practiced out of necessity, have existed for thousands of years (think of the Neanderthals slaying the woolly mammoth). Human beings are fundamentally social creatures, and we like working together. Perhaps this is because we can accomplish more working as a group than as individuals or, like our distant ancestors, we increased our chances of survival through partnership.

While the earliest human interactions were governed by instinct and desire, it did not take mankind long to begin documenting things. The earliest partnership agreement that I am aware of comes from Babylonia and appears to involve a grain merchant and a farmer. The specifics of the agreement deal with the amount, quality and delivery dates of barley. Unfortunately, the records of the attorney have been lost to history, and we do not know if this contract was done for straight time or under some alternative fee arrangement.

Partnerships became the most common form of organizing business sometime in the 17th century, and in terms of numbers of entities they are still the most prevalent form of business organization today.

Furley Page Solicitors (a law firm in Canterbury, England) dates itself to 1725 and appears to be the longest continuously operating legal partnership in existence today. The underlying principles of partnership (joint ownership and financial risk by the individuals involved in the business) are particularly well suited for professionals like attorneys.

Historically, law firms did not require significant amounts of capital to operate, and the capital that was needed was usually available to the attorney from personal resources.

In 1910, Cadwalader, Wickersham & Taft was one of the largest law firms on Wall Street and had less than 20 attorneys. At that time, the firm's practice (like that of most law firms) was to pay partners annually in December. This Victorian practice (which conserved capital) may be the source of the annual law firm year-end collection drive that most firms celebrate to this day.

As law firms grew, the need for capital also increased. Funds to finance lateral partners, compensate associates, open new offices and introduce new technology grew exponentially. As law firms outgrew the ability of their partners to finance themselves, banks began to loan money to firms for office expansion/technology upgrades and daily operations. Traditionally, expansion and upgrades were financed over a five- to 10-year term, while funds for operations were provided through “revolving loans” or lines of credit. The common feature of both the loans and lines was that the firms had to be free of them for a period of 30 days each year. This loan-free period was usually timed to be the first 30 days immediately following the firm's fiscal year end.

However, as law firms continued to grow, the need for cash to finance that growth increased as well. In 2009 there were more than 15 law firms that grossed more than $1 billion, and the smallest AmLaw 100 firm is a $275 million business. Law firms have become big businesses, and businesses require cash.

Individual partner capital and interim bank financing have proved to be unreliable methods of financing law firms in the recent past. In addition to the 30-day “out” requirement, most interim bank financing also requires a minimum number of partners and many a target A/R amount. The recent failures of Heller Ehrman, Thacher Proffitt & Wood, and Darby & Darby came about in part because they failed to maintain the covenants in their loan agreements, and their banks canceled the financing that the firms depended upon.

A Dramatic Change

In May 2007, a dramatic change in law firm ownership, and therefore financing, took place in Australia. Slater & Gordon issued stock and became the first publicly owned and traded law firm. It has subsequently issued additional shares to finance the acquisition of other firms. The firm has been consistently profitable since the IPO (Revenues were up 16% and profits were up 12% in the latest quarterly report) and annual cash flow from operations is averaging approximately 20%.

The ability to issue stock was a dramatic change in law firm financing. The UK is preparing for outside investments in law firms starting in 2011. In the United States, there is an ongoing debate about outside financing of law firms. One of the issues is the interpretation of Rule 5.4 of the ABA's Model Rules of Conduct. Rule 5.4 deals with the sharing of fees generated from the practice of law by non-lawyers. The problem that legal ethics experts raise is that as a public company, a law firm would have a potential conflict between its duty of loyalty to its clients and its duty of loyalty to its shareholders. A second problem that is often raised is that lawyers must protect attorney-client privilege, and if a law firm were a public company, that could endanger client confidences.

Recent seminars at Georgetown University and numerous articles have dealt with the implications of outside investments in law firms and the influences that non-lawyer investors might have on both clients and law firms. I have read convincing arguments on both sides of the issue and believe that a definitive solution in the United States is many legal challenges (and therefore years) away.

However, the need for a reliable source of sufficient financing for law firms remains. Lateral partners, mergers, new offices and technology all require significant capital that strains the capabilities of individual partners and should not be left to the whim of bankers.

A New Approach

The author's firm, KermaPartners, in the United States is working with a group of attorneys and investors to develop a new approach that ensures client confidentially, promotes excellent client service delivered in a cost-effective manner, and a reliable source of investment capital to law firms.

Based upon discussions with leading legal experts, we believe that the solution to the problem lies with the innovative application of already-existing business models. In our approach, a law firm will contract with a management company to provide all of its non-legal functions. Most law firms already outsource basic business services, such as mail/messenger and photocopy services. Many law firms outsource word processing and discovery analysis, and some firms outsource accounting and IT services. As we already noted, most if not all law firms also avail themselves of bank financing. In our model, a law firm would consist of only the attorneys and conflicts-checking personnel. The firm would own no books, desks or equipment. It would have no office or computer leases, nor any support staff on its payroll. All support services, staff and facilities will be provided by the management company on a long-term basis. The management company will also provide financing for the firm.

The management company, owned by outside investors, will be remunerated on a per-attorney basis and the amount of capital used by the law firm. It will execute long-term contracts with client firms that have specific service level agreements in place to ensure quality, protect client information and reward performance. The management company would provide these services to multiple law firms. This arrangement would enable it to achieve savings from purchasing economies of scale and the outsourcing and consolidation of higher value-added services such as IT support, electronic records management and client accounting to lower cost across geographic areas.

All of these services are currently available a la carte to law firms. What has not yet happened is their consolidation into a focused business offering from a single vendor that allows attorneys to “one stop shop” for all non-legal support activities.

A Good Model

A good model to look at would be the medical practice groups that now dominate the delivery of medical services in the United States. Approximately 70% of all practicing physicians now belong to such groups. The groups provide centralized files, support services and office space. The doctors are either employees of the group or rent the space and support services. Twenty years ago, these medical groups were anomalies; now they are the norm. The groups provide administrative management and support while the doctors provide the professional services.

A management contract with an independent vendor would provide law firms (just like the doctors in medical groups) with better, cheaper services and reliable financing, and would enable the attorneys to focus on the practice of law. Just like in the old days.

J. Mark Santiago is a partner with KermaPartners LLP and leads the North American practice. Santiago has consulted to the legal profession for more than 25 years in the areas of performance improvement, compensation systems, merger due diligence, and integration and administrative support outsourcing. He is a frequent speaker and author and was the chairman of the Am Law CFO conferences for 11 years. He was also one of the three originators of LegalTech in 1981.

Partnerships in human history, whether documented or practiced out of necessity, have existed for thousands of years (think of the Neanderthals slaying the woolly mammoth). Human beings are fundamentally social creatures, and we like working together. Perhaps this is because we can accomplish more working as a group than as individuals or, like our distant ancestors, we increased our chances of survival through partnership.

While the earliest human interactions were governed by instinct and desire, it did not take mankind long to begin documenting things. The earliest partnership agreement that I am aware of comes from Babylonia and appears to involve a grain merchant and a farmer. The specifics of the agreement deal with the amount, quality and delivery dates of barley. Unfortunately, the records of the attorney have been lost to history, and we do not know if this contract was done for straight time or under some alternative fee arrangement.

Partnerships became the most common form of organizing business sometime in the 17th century, and in terms of numbers of entities they are still the most prevalent form of business organization today.

Furley Page Solicitors (a law firm in Canterbury, England) dates itself to 1725 and appears to be the longest continuously operating legal partnership in existence today. The underlying principles of partnership (joint ownership and financial risk by the individuals involved in the business) are particularly well suited for professionals like attorneys.

Historically, law firms did not require significant amounts of capital to operate, and the capital that was needed was usually available to the attorney from personal resources.

In 1910, Cadwalader, Wickersham & Taft was one of the largest law firms on Wall Street and had less than 20 attorneys. At that time, the firm's practice (like that of most law firms) was to pay partners annually in December. This Victorian practice (which conserved capital) may be the source of the annual law firm year-end collection drive that most firms celebrate to this day.

As law firms grew, the need for capital also increased. Funds to finance lateral partners, compensate associates, open new offices and introduce new technology grew exponentially. As law firms outgrew the ability of their partners to finance themselves, banks began to loan money to firms for office expansion/technology upgrades and daily operations. Traditionally, expansion and upgrades were financed over a five- to 10-year term, while funds for operations were provided through “revolving loans” or lines of credit. The common feature of both the loans and lines was that the firms had to be free of them for a period of 30 days each year. This loan-free period was usually timed to be the first 30 days immediately following the firm's fiscal year end.

However, as law firms continued to grow, the need for cash to finance that growth increased as well. In 2009 there were more than 15 law firms that grossed more than $1 billion, and the smallest AmLaw 100 firm is a $275 million business. Law firms have become big businesses, and businesses require cash.

Individual partner capital and interim bank financing have proved to be unreliable methods of financing law firms in the recent past. In addition to the 30-day “out” requirement, most interim bank financing also requires a minimum number of partners and many a target A/R amount. The recent failures of Heller Ehrman, Thacher Proffitt & Wood, and Darby & Darby came about in part because they failed to maintain the covenants in their loan agreements, and their banks canceled the financing that the firms depended upon.

A Dramatic Change

In May 2007, a dramatic change in law firm ownership, and therefore financing, took place in Australia. Slater & Gordon issued stock and became the first publicly owned and traded law firm. It has subsequently issued additional shares to finance the acquisition of other firms. The firm has been consistently profitable since the IPO (Revenues were up 16% and profits were up 12% in the latest quarterly report) and annual cash flow from operations is averaging approximately 20%.

The ability to issue stock was a dramatic change in law firm financing. The UK is preparing for outside investments in law firms starting in 2011. In the United States, there is an ongoing debate about outside financing of law firms. One of the issues is the interpretation of Rule 5.4 of the ABA's Model Rules of Conduct. Rule 5.4 deals with the sharing of fees generated from the practice of law by non-lawyers. The problem that legal ethics experts raise is that as a public company, a law firm would have a potential conflict between its duty of loyalty to its clients and its duty of loyalty to its shareholders. A second problem that is often raised is that lawyers must protect attorney-client privilege, and if a law firm were a public company, that could endanger client confidences.

Recent seminars at Georgetown University and numerous articles have dealt with the implications of outside investments in law firms and the influences that non-lawyer investors might have on both clients and law firms. I have read convincing arguments on both sides of the issue and believe that a definitive solution in the United States is many legal challenges (and therefore years) away.

However, the need for a reliable source of sufficient financing for law firms remains. Lateral partners, mergers, new offices and technology all require significant capital that strains the capabilities of individual partners and should not be left to the whim of bankers.

A New Approach

The author's firm, KermaPartners, in the United States is working with a group of attorneys and investors to develop a new approach that ensures client confidentially, promotes excellent client service delivered in a cost-effective manner, and a reliable source of investment capital to law firms.

Based upon discussions with leading legal experts, we believe that the solution to the problem lies with the innovative application of already-existing business models. In our approach, a law firm will contract with a management company to provide all of its non-legal functions. Most law firms already outsource basic business services, such as mail/messenger and photocopy services. Many law firms outsource word processing and discovery analysis, and some firms outsource accounting and IT services. As we already noted, most if not all law firms also avail themselves of bank financing. In our model, a law firm would consist of only the attorneys and conflicts-checking personnel. The firm would own no books, desks or equipment. It would have no office or computer leases, nor any support staff on its payroll. All support services, staff and facilities will be provided by the management company on a long-term basis. The management company will also provide financing for the firm.

The management company, owned by outside investors, will be remunerated on a per-attorney basis and the amount of capital used by the law firm. It will execute long-term contracts with client firms that have specific service level agreements in place to ensure quality, protect client information and reward performance. The management company would provide these services to multiple law firms. This arrangement would enable it to achieve savings from purchasing economies of scale and the outsourcing and consolidation of higher value-added services such as IT support, electronic records management and client accounting to lower cost across geographic areas.

All of these services are currently available a la carte to law firms. What has not yet happened is their consolidation into a focused business offering from a single vendor that allows attorneys to “one stop shop” for all non-legal support activities.

A Good Model

A good model to look at would be the medical practice groups that now dominate the delivery of medical services in the United States. Approximately 70% of all practicing physicians now belong to such groups. The groups provide centralized files, support services and office space. The doctors are either employees of the group or rent the space and support services. Twenty years ago, these medical groups were anomalies; now they are the norm. The groups provide administrative management and support while the doctors provide the professional services.

A management contract with an independent vendor would provide law firms (just like the doctors in medical groups) with better, cheaper services and reliable financing, and would enable the attorneys to focus on the practice of law. Just like in the old days.

J. Mark Santiago is a partner with KermaPartners LLP and leads the North American practice. Santiago has consulted to the legal profession for more than 25 years in the areas of performance improvement, compensation systems, merger due diligence, and integration and administrative support outsourcing. He is a frequent speaker and author and was the chairman of the Am Law CFO conferences for 11 years. He was also one of the three originators of LegalTech in 1981.