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Should law firms be able to float?

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Market forces should be the determining factor, not regulations

Strictly speaking, the question of whether law firms should consider an initial public offering (IPO), and whether law firms should even be allowed to have the option to IPO, are two distinct questions.

For a long time, it wasn’t even an option for law firms to float — regulation simply prohibited it. The first wave of relaxation came in Australia, when the Legal Profession Act 2004 allowed non-lawyer ownership in law firms and legal service providers could register their practice as Incorporated Legal Practices (ILPs). The second wave of deregulation came in the UK, when the Legal Services Act 2007 allowed law firms to adopt the business model of Alternative Business Structures (ABS) and the Legal Services Act 2011 allowed non-lawyer ownership.

Indeed, deregulation is welcome. This article will argue that there are no fundamental reasons why law firms should not be allowed to go public and the common arguments against law firm flotations are all invalid. Provided that adequate risk disclosures are in place, if law firms require the additional capital, and investors are willing to invest — then why not? If certain aspects of law firms as quasi-public businesses render the business a less attractive investment target, then the market could discount the share price with a ‘law firm discount’. Ultimately market forces should be the determining factor, not regulations.

Arguments against law firms going public are invalid

First and foremost, as noted by academics and commentators, the most common argument against law firm IPOs is the fear of a conflict of duties. On one hand, section 172 of the Companies Act 2006 imposes a statutory duty (albeit vaguely defined) on directors of companies to promote the success of the company. Directors of companies, who are likely to be partners in the context of law firms, owe their duties to the company and hence indirectly owe their duties to shareholders. In practice, ‘success’ is often linked to positive financial performance. On the other hand, lawyers owe their duties to their clients and the courts, and Principle 4 of the Solicitors Regulation Authority Principles 2011 expressly states that lawyers must act in the best interests of each client. Prima facie the two duties are irreconcilable and present a moral dilemma that could undermine lawyers’ professional independence. It is also argued that such a conflict of duties would render law firms unattractive investment targets as investors would have no certainty that their interests are protected.

It is, however, submitted that the fear of conflict of duties should not fundamentally undermine the viability of a law firm IPO. One solution is to include clear statements in the prospectus that the lawyers’ duties to clients and courts would prevail over the duties to the company and shareholders. This is the case with Slater & Gordon’s prospectus, the first law firm to ever go public in Australia in 2007. The prospectus states that a lawyer’s duty to the court is its primary duty, the duty to clients is its second duty, and the duty to shareholders is its third duty. Similarly, Gateley’s prospectus states:

“There could be circumstances in which the lawyers of Gateley are required to act in accordance with these duties and contrary to other corporate responsibilities and against the interests of shareholders and the short-term profitability of the group.”

In other words, the solution is to use a disclaimer to let investors be aware of the firm’s overriding duties and ‘price in’ the risk at the stage of valuation of the company. It appears that this method has worked and investors have not been put off: the Gateley IPO was oversubscribed, and its share price has risen by approximately 78% since admission. Similar disclaimers can be found in the admission documents of Gordon Dadds, Keystone Law, Rosenblatt and Knight. The collective share prices of UK listed law firms have performed strongly, up 27.1% year to date on an equal-weighted basis.

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Furthermore, it is a misnomer to think that modern commercial law firms are not profit-driven. In fact, law firms are fixated with financial metrics such as profit per equity partner (PEP) and revenue; modern law firms are structured in a way to maximise profitability. Therefore, the fear that non-lawyer ownership would turn law firms into profit-driven organisations is overstated — modern law firms already are profit-driven organisations. To the contrary, regulatory burdens and non-lawyer ownership would incentivise law firms to be more compliant and to have better corporate governance. Indeed, the 2014 Consumer Impact Report published by the Legal Services Consumer Panel concluded that no evidence could be found to suggest that public ownership would have an adverse impact on law firm ethics.

On the flip side, listed companies tend to be more cost-sensitive than non-listed companies as their financial results are under tighter scrutiny, and thus operationally tighter and more efficient. Carlos Alberto Sicupira, the founding partner behind the private equity fund 3G Capital renowned for imposing strict cost control on acquired companies, famously said: “Costs are like fingernails, you have to cut them constantly”. Introducing non-lawyer managers/owners could help law firms to further minimise inefficiencies, which, in a legal market where competition has been driven up by increasingly cost-conscious clients, is surely welcome.

A second common argument against law firm IPO is the concern over confidentiality. A public company has a duty to disclose inside information to its shareholders, but what if this conflicts with a lawyer’s duty of confidentiality to clients? This problem can be overcome similarly through a disclaimer in the prospectus to the effect that a lawyers’ professional duties would prevail. Investors could then price in the risk when they value the share. This is also the solution adopted by Slater & Gordon, Gateley and other listed law firms.

A final problem is the issue with valuing law firms. As stated above, law firms are not capital-intensive businesses. Their main assets are their lawyers, and lawyers are highly mobile. This creates two sub-problems. Firstly, valuing human capital and goodwill is more difficult than valuing other tangible and intangible properties, and this could lead to potential error. Secondly, as human capital is highly mobile, it is difficult to ensure a stable business model. The solution is to implement lock-in agreements and ensure partners remain with the firm after the IPO. Lock-in agreements form a crucial part of the structure of a law firm’s IPO, and can be found in the prospectuses of Slater & Gordon, Gateley and other listed law firms.

Let the market decide: A possible ‘law firm discount’

It is not uncommon to apply a discount to the share price to shares within certain industries. Perhaps the most common example is what is known as the ‘conglomerate discount’. A conglomerate is defined as a diversified pool of businesses and assets under the same group (e.g. the likes of Berkshire Hathaway, CK Hutchison and Virgin Group). The discount refers to a phenomenon that the share price/valuation of conglomerates (at least in the developed world) as a whole has often been subject to a discount and is valued at less than the sum of its parts. The discount is usually approximately around 15% of the sum.

The main reason for the discount is that investors believe a conglomerate structure renders the business as a whole difficult to understand, and makes it lack transparency. Investors also believe a company’s performance would benefit from a more focused management team. A further reason is a change in attitude toward portfolio construction. Investors believe diversification should be achieved within their own portfolio instead of by holding shares in a diversified conglomerate. Therefore, investors prefer to invest individually in companies with simple business lines, and subsequently hold a basket of shares from different industries to achieve diversification. All in all, the conglomerate discount is a financial concept where valuation discounts are applied to a wide industry class.

Similarly, if law firms as an industry class share common problems which render it less attractive, a discount could be placed on its share price. This can be known as the ‘law firm discount’, akin to the concept of conglomerate discount. Such common problems could be the risk of placing its duties to the court/clients above its duty of achieving maximum profitability, concerns over confidentiality, and the issue of accurate valuation. Banning law firms completely from IPO is not the right response and the developments in Australia and the UK echo this view.

Allowing outside capital has the benefits of encouraging consolidation in a fragmented industry, tighter scrutiny from investors and hence decrease in inefficiencies. The stock markets in Australia and London are efficient markets and investors are sophisticated enough to sniff out bad companies. The same could be said for stock markets in the US. The American Bar Association is currently considering relaxing its regulations and allowing non-lawyer ownership in law firms. If law firms were unattractive investment targets, the market will react accordingly. Ultimately, the solution should come from market forces, and not the government. Let the market decide.

Clive Wong is currently a financial analyst with a leading global investment bank. He focuses on advising clients on investment strategies and covering clients in the greater China region. He attended the University of Cambridge and obtained a master of laws, and graduated from the University of Birmingham with a bachelor of laws.

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Please bear in mind that the authors of many Legal Cheek Journal pieces are at the beginning of their career. We'd be grateful if you could keep your comments constructive.

28 Comments

Anonymous

The best bit is that box just above “Join the conversation”.

Boaty & McBoatface LLP

Yes, I think we should be allowed to float.

Anonymous

Birmingham?

Anonymous

Goldman Sachs

Anonymous

Big city.

Middle of England.

Lots of brown people.

Best curry this side of Lahore.

Can’t miss it.

Anonymous

Better question – why do people say “Future Trainee” ?

Colonel Sanders

Because ‘Future Battery Hen at CMS’ doesn’t bring the laaaaadies in #Playa

Anonymous

CMS is a great firm to train at. They offer a lot of fantastic secondment opportunities.

JD Partner

So I know who to target before they arrive.

Just a Barristers Clerk

Yes there may be some strong for points but we’re talking about an industry entrenched in tradition.

At first I was pretty skeptical about the idea of floating a law firm. However, a lot of firms simply do not have the right people, let alone the admin infrastructure to support such a significant increase in scale.

Ultimately, it all boils down to one question. Why?

Anonymous

The only thing that floats are the turds I leave in the lake behind the tip where I dumpster dive after court!

Anonymous

Clive?

Clive

Yes?

Anonymous

Piss off

Clive

I have it on good authority that you still wet the bed.

Anonymous

Two things spring to mind.

Firstly, saying in your prospectus that the firm’s duties will be to its clients does not affect the application in practice. If shareholders are pushing the business to act in a certain way, a craven managing partner might well bow to them to the detriment of their clients. Since, in general, major institutional shareholders have at best a shaky grasp of ethics this will always be an issue. Cost cutting is an excellent example of this, where it may hurt client service in pursuit of the bottom line – but that judgment is subjective and who is to say that a managing partner won’t bow to the demands of particularly odious shareholders demanding that certain processes be cut to generate a bigger dividend?

Second point is that it is rare for a firm to have any useful place to spend the large influx of cash generated by a flotation. Law firms mostly grow quite gradually and for good reason. Their asset is people. They can’t just plough money into, say, a new factory like a manufacturing business. They have to find and hire the right people to grow. They can’t even make acquisitions without careful thought, because this can ruin the culture which in turn can mean losing a whole chunk of good existing staff. And there’s no guarantee of keeping the good staff from your acquisition anyway.

Finally (I know I said two points), there is something attractive about the owners of a business being the senior people working there. Partners generally care about the health of the business, and they can sign off on almost anything as the owners without being subject to the crippling bureaucracy that afflicts most plcs. I’ve worked at two investment banks and an MC law firm, and at the banks even getting sign-off for a box of pens was painful whereas at the firm we have a massive stocked cupboard full of stationery. This is due to partners being actually in the office and making the decisions based on employee comfort and actual efficiency rather than penny pinching ‘efficiency’ of cutting for the bottom line. Partners can sign off on anything within reason, which generally makes things flow much more easily than a place beholden to shareholders (who, again, are often leeches desperate to extract as much value as possible from the business regardless of client or employee satisfaction).

Anonymous

Noted regarding the so called ‘ethical incompatibility’. It is perhaps worth noting that for the vast majority of firms that will float (and for those that have) the shareholders are the pre-exisiting equity partners who will be bound by the SRA code whether as a lawyer or as a shareholder.

It would be surprising if any firm would all more than, say, 10-15% equity out of the door externally and at this level it is doubtful any significant pressure to shaft clients could be applied.

The elephant in the room is really whether firms use this as a way of buying out/off dead wood equity (albeit with a 2/3 year run off)

Anonymous

Directors owe conflicting duties to client and shareholders?

Directors of all companies have to balance their duties to their shareholders and customers.

I don’t see why the law firm conflict is any starker.

Anonymous

Pespico don’t have to act in the best interests of their customers and don’t have a specific ‘snack food and drinks’ regulator ready to pounce if they fail to do so. Surely you can see the difference.

Anonymous

Clive Wrong should have been named Clive Right. He’s right. Well-argued piece.

Anonymous

I hear Gateley’s lock in period ends soon so what will happen then? I also hear that Knight has only locked in its management team which sounds crazy.
Retaining lawyers is the only way of retaining clients so anybody thinking of investing should pay careful attention to the lock in arrangements otherwise it could be seriously damaging to their wealth.

Anonymous

IPO float is good for an injection of cash to cover up for lack of organic growth.

smith global

good piece

💩

May I float in the Clifford Chance pool?

Just sayin'

If they float, doesn’t that make them a witch?

Dictionary Nazi

“Furthermore, it is a misnomer to think that modern commercial law firms are not profit-driven.”

You mean misconception. Kids, do look up difficult words before using them when you want to show off.

Sunny

I really liked your article and I agree with you that there are no valid why law firms should be prohibited from seeking external investment.
A small point. It was LSA, 2007, which removed entity restrictions and permitted external investment and non-lawyer ownership of law firms via the ABS structure. There is no 2011 legislation related to deregulation but it was not until March 2012 that the SRA issued its first ABS license.

Anonymous

Good piece

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