Recently, the New Jersey Supreme Court Advisory Committee on Professional Ethics issued an opinion that law firms could own other law firms and operate them as subsidiaries.   Enabling this action is the basic opinion that Rule of Professional Conduct 5.4(a) which prohibits fees sharing with non-lawyers, does not limit a firm to turn over its net profits to a parent company made up of lawyers.

To read some of the newspaper accounts and blog postings, this is the biggest thing to hit the legal profession since the Magna Carta.   I think we have to remember that (a) this is only one state (although there will most likely be similar opinions in many other states), (b) the specific question submitted specified that the firm would consider clients of the subsidiary as clients of the whole firm and vise versa for conflicts purposes, and (c) regardless what ethics committees decide, the driving influence for large firms will be the underwriting reaction of the professional liability carriers.  In addition, a number of firms seem to already have effectively created wholly-owned subsidiaries in some specialized areas with an interlocking matrix of of-counsels and salaried non-equity partners.  It would be tough to tell the difference between what the New Jersey opinion allows and what firms have now.

But for a significant segment of U.S. law firms, this may be a little bit of light at the end of a pretty dark tunnel.

Among mid-sized law firms – say 75 to 250 attorneys – there is an amazing amount of insurance defense work hiding out among the firm’s commercial litigation and corporate transactional practices.  Through a combination of immense pressure on rates from insurance companies and the nitpicking of bill auditors, trial lawyers doing insurance rate work are in the profitability crosshairs of a lot of firms’ management committees.  To survive, litigation practice chairs whose groups are on the low end of their firms’ profitability curve adopt the “Luge Strategy: lay flat and try not to get killed.”

For many firms, insurance defense is part of their organizational DNA.  Law firms with a significant amount of insurance defense work seem to have certain unique cultural characteristics that make it incredibly difficult to move lawyers out of the practice even if higher rate work is available.  In large part this is because, almost uniformly, partners in large law firms who mainly do insurance defense seem to possess a high level of “job satisfaction.”  Indeed, for the litigator who wants to spend his life in the courtroom there is probably no better practice (other than, perhaps, criminal law).  Appropriately, insurance defense lawyers take great pride in their number of trials to verdict, differentiating themselves as “trial lawyers” compared to “litigators” who may rarely appear in court other than to argue motions.  As one partner put it, “Being a lawyer is a vocation, being a trial lawyer is a calling.”

But there is also a dark side to this DNA that infects even a firm’s most profitable practices.  Many lawyers whose careers have been largely devoted to insurance defense work have a difficult time serving commercial clients.  Claims adjusters whose primary issues are low cost and minimum hassle don’t require the “bedside manner” skills commercial clients demand.  At the same time, the bill scrutiny that insurance companies exercise to detect excess staffing causes insurance defense lawyers to avoid the level of teamwork that their firms use as a selling point in commercial litigation.  Finally, firms with significant insurance defense work tend to have a rate paranoia that causes them to infer greater rate pushback from non-insurance clients than may actually exist.

Recognizing their inability to completely move their firms out of insurance practices but realizing the necessity to operate on a different cost structure than their full rate practices, a number have attempted to split their firms by creating an insurance defense firm within the general practice firm.  This often includes differentiated locations within the firm’s office space, offices on different floors or even a location in a separate office building.  At the same time, they attempt to use insurance defense as a testing area for new associates from which they can be promoted to other practice areas.

The primary difficulty with attempting to operate a firm within a firm – especially if one is in effect a “second class citizen” – is that it is contrary to the culture of most law firms.  What most typically happens is that, in a crunch, commercial litigation partners “borrow” insurance defense associates to work on their large cases and eventually the line between the two sides of the firm is blurred once again.

This is where the New Jersey opinion comes in.  For truly entrepreneurial firms, the ability to create wholly-owned, or even joint venture subsidiaries to provide specific types of services may create incredible opportunities in three possible strategic directions.

The first is the ability to spin off less desirable practices. Creating a subsidiary through which partners in the insurance defense practices still effectively maintain their partnership relationship with the primary firm may be the motivation and structure firms need to resolve internal practice problems.  And, by setting up a highly cost-competitive practice and being able to manage it without the constraints of its impact on other areas (or the reputation) of the firm permits the aggressive law firm to truly structure the insurance defense practice around profitability.

Second is the opportunity to acquire practices to create economies of scale.  For the firm that is able to manage a commodity practice to a profit goal, the acquisition of free standing insurance defense practices or practice groups from other firms represents generation of profit through a smaller margin against a higher volume.

However, the greatest significance of this opinion may the impact that it has on law firm consolidation.  One of the biggest hurdles in mergers is finding firms who match up well in all areas.  Of course, a consolidation must present a rational business case, i.e., together they must be better than apart.  There must be an acceptable cultural fit.  Finally, their comparative profitability has to be sufficiently close to get the partners to vote for the merger without fear of diluting their profitability.  By being able to take elements of both firms and spin them into subsidiaries, or conceivably sell them to another firm, merger participants could design a merger to maximize fit and profitability without having to “squeeze out” large numbers of partners in the process.  The result is a consolidated pro forma and humane process that could stimulate a lot more merger activity.

All in all – a lot has to happen to turn a very limited event like the New Jersey opinion into a sea change.  But for full service firms with an insurance defense practice it’s a lot better than the Luge Strategy.