Upward view: Why law firms need non-executive directors

David von Simson, managing partner at Europa Partners, considers how non-executive directors can bring financial stability to law firms

The boardroom bastions of British law firms have in recent years been breached to admit a small trickle of non-executive board members.

Margaret Salmon joined Addleshaw Goddard in 2009 after a distinguished career at the BBC, Kingfisher and Alliance & Leicester, with a background in HR. In early April 2012, Lucinda Riches, a highly successful investment banker from UBS, was appointed to SJ Berwin’s board. Separately, Irwin Mitchell has brought in two NEDs in the run-up to its intended stock exchange debut.

While hardly a flood, this is nevertheless an interesting trend and provokes two questions: '¨

1. Is this a harbinger of things to come?'¨

2. What, other than serving as introducers of new clients, can non-executives achieve in firms which (unlike Irwin Mitchell) remain as partnerships?'¨

The need for beefing up the management of law firms could certainly be said to be evident in light of the enormous challenges facing the profession.

In the last week of April, it was reported that US law firm Dewey '¨& LeBoeuf was facing bankruptcy, '¨after a period of some months '¨during which rumours had circulated '¨of partner defections.

The firm was reported to be in merger negotiations to solve its problems and to be facing an imminent deadline on its credit facilities. Meanwhile, it was subletting significant portions of its office space to reduce costs. There was talk of a pre-packaged bankruptcy.

At the end of 2010, Dewey ranked 23rd in a global league table of law firms, with billings (subsequently revised down) of US$910m. Formed five years ago as a merger between two firms, one dating back to 1909 and the other to 1929, the new entity had recruited aggressively. The proximate cause of its difficulties '¨is thought to derive from meeting guaranteed compensation packages offered to poached rainmakers. One can only wish Dewey and its staff well.

The event has much wider significance because the bankruptcy of a large professional services firm run as a partnership has hitherto been regarded as nearly inconceivable in the absence of an external shock.

The reasons for the demise of Arthur Andersen in 2001 derived directly from its involvement as an auditor to Enron. Had Dewey been brought low by a massive civil suit or criminal charges in connection with its work, it would have underlined the vulnerability of professional services firms to their exposure to even one bad client.

But, it would not have been as out of the ordinary as the events that have recently unfolded. Here, almost unprecedentedly in a firm of this size, we are looking at a purely internally-generated problem (if reports are to be believed): the firm simply lost control of its remuneration structure and cost base.

Could the same happen with an equally-venerable UK law firm? Undoubtedly. And can the increasing tendency to appoint non-executive directors provide a safeguard? Only to '¨a limited degree.

The difficulty derives from the '¨nature of partnerships themselves. '¨There is a pleasant, rather clubby feel to '¨a partnership, which provides a cultural '¨glue and a sense of comfort to its adherents that is absent in the case of public companies.

In some senses a throwback to an earlier age, a partnership is a structure that survives today more for regulatory and tax reasons – but at a certain cost. Moreover, in the UK, the regulatory reasons for its survival have been removed by the Legal Services Act.

Management challenges

People businesses are notoriously hard to manage. Investment banks suffer the same problems as other professional services firms in this regard and, like them, law firms have also grown out of all recognition over the past 40 years.

A study we conducted earlier this year showed that six of the largest UK law firms (Allen & Overy, Freshfields, Linklaters, Clifford Chance, Hogan Lovells and DLA Piper) would be FTSE-100 companies if quoted on the stock exchange. Most are now large multinationals, with offices on several continents. These offices, in turn, are subject to different regulatory regimes, and running the firm as an integrated whole is near impossible.

This is the task faced by the firm’s senior and managing partners. But, what are their qualifications for the job? In industry, each would have run successive profit centres in diverse organisations, having been headhunted each time to best fill a new opening. They would have worked up through an organisational hierarchy and may have spent time at Harvard Business School '¨or INSEAD.

In law firms, the story is different. '¨The senior partner and managing partner will never have worked outside of one industry and will, quite possibly, have remained within the same firm for most '¨of their careers. They will have risen to the top and, at a certain point, become less client facing, while nevertheless being recognised for their authority and undoubted organisational capabilities. Their constituency is the rest of the partnership, to whom they have to periodically subject themselves to re-election.

This is not to denigrate in any way '¨the undoubted qualities and professionalism of the senior partners '¨and managing partners that run large '¨law firms. But the management challenges '¨they increasingly face are immense. Meeting those challenges would '¨arguably be easier with the powers of a CEO and the oversight of a chairman.

As we proceed through 2012, '¨the lot of those running any of the global behemoths that Anglo-Saxon law firms have become – while easier than that '¨of their smaller brethren – is nevertheless far from being a happy one. The combination of three factors, not unrelated, conspire to create a perfect storm.

1. Costs

The first is the difficulty of cost control in an environment in which compensation is its most formidable element. Every few years, US firms decide to move further into the London market, headhunters are engaged and cheque books are waved under the noses of incumbent rainmakers.

Firms are increasingly reliant on big clients and those clients can, in turn, come to regard the individuals advising them as more important than the firms they work for. The result is that salaries, bonuses '¨and compensation costs ratchet up faster than the speed at which fees charged to clients follow.

Whether you want to attract rainmakers – or just keep the ones you have got – you have to pay up. Nor does lockstep (modified or not) enable you to reward the brightest and the best in the way that you would like.

Does it matter if compensation '¨costs rise? After all, in a partnership, '¨the employees are also the shareholders. Well, yes it does, for reasons we shall see and even in the absence of a clear outcome for Dewey.

Investment banks have dealt with this problem (in part, at the behest of regulators) by tying in senior employees with long-term incentives rather than annual payouts. This provides for a much more stable compensation environment and means that rainmakers who jump ship leave a lot of accumulated wealth behind.

But law firms work essentially on the basis of an annual profit and loss model, with a total payout at the end of each year. Moreover, the shareholders are so '¨in name only – they have nothing to '¨lose because, on retirement, their equity passes substantively to the next generation, without any capital reward to the generator of the goodwill to the firm.

Why stay at the firm when a higher annual payout is being offered next door? It is the very antithesis to how investment banks now function to control costs.

2. Reserves

The annual payout brings us to the second problem: law firms have, in relation to their size and complexity, very little by way of reserves. In plain English, they are undercapitalised and operationally leveraged. Where was Dewey’s rainy-day money when it needed it?

Law firm partnerships have grown up with the idea that they don’t need capital. Ignoring investment needs in premises, IT, international expansion and so forth (which themselves can require considerable capital), such thinking ignores their increasing operational leverage.

Up until now, reliance has been placed on the comforting knowledge that banks have been willing and eager to lend to partnerships – none more so than those comprised of conservative and sophisticated lawyers. But this brings us to problem number three – the banking crisis.

3. Loans

Banks throughout Europe and elsewhere in the world are shrinking their balance sheets as fast as they can, as a consequence of massive capital write-offs and higher capital adequacy requirements. Credit is scarce. The banking crisis is not at the beginning of an end; Churchill would at best have called it the end of the beginning.

Nor will the bank manager’s mood have been lightened by events at Dewey '¨& LeBoeuf. Maybe lending to law firms does not look quite as risk free as it did '¨six months ago.

How NEDs can help

Facing unprecedented strategic challenges as their clients require them to have '¨an increasing global footprint, big law firms have neither the certainty of bank financing nor a comfortable equity reserve to support them.

How can these FTSE-100 size businesses set out to move from Victorian corporate and governance structures to something more likely to endure? Could the trend to introduce non-executive directors help?

The role of NEDs in the corporate world has changed out of recognition in a generation. Both supervisors and shareholders have successfully sought to increase the powers of NEDs – not just in the interests of protecting shareholder interests, but also in providing support to the ever-more complex process of managing big companies.

Good corporate governance, like a well-drafted national constitution, is an exercise in creative tension. Correctly devised, it functions like a well-rigged sailing ship or a finely-tuned violin – opposing interests are balanced.

NEDs can play an invaluable function in law firms as senior advisers, sounding boards, grey hairs and introducers of potential clients.

But, NEDs will fall far short of being as effective as they are in the corporate world so long as there is no clear separation of the functions of human and financial capital. Without that separation, NEDs don’t have a constituency that '¨elects them, thereby giving them '¨the necessary authority.

Perhaps the most useful advice '¨NEDs can give is to change the firm’s corporate structure away from a partnership to a PLC form, with a view to: '¨

• radically overhauling compensation structures;

• building up corporate financial reserves to substitute for fickle bank financing; and

• making good use of the firm’s most underutilised asset: its goodwill.

'¨The equity value of British law firms '¨has been unlocked by the Legal Services Act, but lies idle. That is more than '¨an opportunity lost and a contributor '¨to financial vulnerability, because it effectively reduces the usefulness of NEDs and their ability to support the management committee.

Once human and financial capital have been separated out (even if they remain for a long time largely if not wholly in common hands), corporate governance within law firms will be much better placed to face an increasingly competitive world.

vonsimson@europapartners.com