For the past couple of years there has been a lot of speculation about the impact of the UK’s Legal Services Act (known as “the Clementi Reforms”) on private practice law firms in the U.S.  Yesterday, Jacoby & Meyers filed suit in New York, New Jersey and Connecticut challenging bar regulations prohibiting non-lawyers from owning law firms (as is permitted in the UK, Australia and the District of Columbia).   This officially opens the topic for debate.  Get ready for a ream of articles and blog postings over the next couple of weeks arguing the ethical issues of whether law is a profession or a business and the impact of outside financial interests on lawyers’ ability to provide independent advice to clients.  Already, this morning’s Wall Street Journal seems to be casting this as an equalizing action that would help small law firms compete with global giants and allow plantiffs’ firms to finance their litigation costs while representing injured individuals seeking redress from offending corporations.

While these motivations make for interesting journalism and the ethical issues will provide fun topics for law symposium panel discussions, there are, in reality, three issues of concern to large law firms:

  1. Why would a law firm want outside investors owning part of their law firm?
  2. Who (in their right mind) would want to invest in a law firm?
  3. What does all this mean to large law firms?

Why? In the eyes of most partners, law firms have little need for capital.  Indeed, many U.S. firms effectively have no or miniscule contributed capital requirements.  Technology needs, often cited as a driving influence on capital requirements, are comparatively small and can usually be financed through off-balance sheet operating leases.  And normal working capital is readily available through short-term line of credit bank loans.  So what’s the need for outside capital?

The answer is, of course, growth.  When a law firm wants to grow, whether to add a new location, a new capability or depth in an existing practice, they have two options – hire laterally or merge.  Mergers typically involve lots of surplus capabilities, people and offices, akin to having to buy a whole cow to get a glass of milk.  But, they are self-financing since merger partners bring along a pipeline of revenue in the form of work in progress and accounts receivable.

Hiring laterally, on the other hand, is much more targeted in that the acquiring firm need only add the precise people it wants, whether it be one rainmaker or a whole practice group.  And, since non-compete agreements are largely prohibited in the U.S., laterals can be immediately available and productive.

However, lateral lawyers come to their new firm “naked” to the extent that their unbilled work and outstanding billings remain with the firm at which the work was performed.  So, if you add in a headhunter fee and the cost of support staff and associates, it typically takes eight or nine months to break even on a lateral.  Therefore, any hiring that occurs after the third or fourth month of a fiscal year takes a bite, of some degree, out of that year’s profits.  As a result, most firms tend to focus their lateral hiring in the spring and limit annual lateral growth to a net of ten percent (partners who leave have the reverse effect by removing their compensation but leaving their pipeline).  Now, while ten percent is a big number, it is not enough to feed the international growth ambitions of the large law firms.  So, having a source of working capital without horsing around with bank covenants and personal guarantees is an attractive option.

And, by the way, to the extent that stock is owned by the partners of the firm, publically tradable stock provides the equity “kicker” that law firms have so long yearned to have as a motivational tool.

Who? Ok, but why would an investor be willing to put up cash to own part of a law firm?  The same reason any investor buys stock – with the hope that its value will go up.  There are two things that potential investors see in law firms.  First, the value of non-partner members on the board of directors.  I have the honor of sitting as a non-voting member for a couple of law firm Executive Committees.  My job is to shout “BS” when I hear things that don’t make business sense.  I walk away from a lot of meetings quite horse.  Imagine what the management decision-making process and compensation setting procedure would look like in a law firm where a quarter of the board of directors was not practicing lawyers.  Second, look back to the “big bang” when securities brokers went from being partnerships to publically traded companies.  The increase in value came from the “roll up” of acquired companies and ancillary businesses.

The play for investors is almost certainly not getting a share of profits.  As with most common stock, companies may declare a dividend to pay out profits but the dividend would come after all expenses, including partners’ compensation.

What does all this mean? The stated purpose of the Jacoby & Meyers suit is to help small law firms and consumer clients.  I’m sure that Wal-Mart thinks that non-lawyer ownership of law practices is a dandy idea and it won’t be long before most Americans will get their will made in a superstore next to the guy who makes their eyeglasses.  But individual clients account for less than 39 percent of legal practice in the U.S.

The true impact will be on the segmented bulk of the legal market the media calls “big law.”  The U.S. legal market totals $260 billion (which is larger than the rest of the world combined, including England).  More than one-third of the U.S. legal spend ($90 million) is sophisticated business work that goes to the AmLaw 200 law firms.

At the same time, if you look at the largest law firms in the world, there is a surprising representation by British firms.  Despite having outposts in every country worth mentioning, the “Magic Circle” and “Silver Circle” firms have amazingly little penetration into the U.S.  UK firms want to enter the U.S. not only because they want to, but because they have no realistic alternative if they want to continue growing.   And, with their Legal Services Act, English firms have the access to capital to move into the U.S. in a big way.  At the same time, U.S. firms are sufficiently eager to expand their global interests but continue to be limited by the cost of expansion.  And, if they do nothing, they fear the echoing warning, “The British are coming.”

Access to capital, in truly large chunks, makes this a new ball game on both sides of the Atlantic.  Of course, there is an impact on the sub-AmLaw 200 law firms but we’ll discuss that in a subsequent article.

Who knows whether Jacoby & Meyers will prevail, whether other states would follow suit if they did and if anyone would actually buy law firm stock if it were offered.  But if you look around at the professional service sector, it is hard to envision law and accounting firms continuing under restrictive ownership for a whole lot longer.