The over-leveraging and over-regulation of the legal profession

How are lawyers like crashing investment banks?  Here's how (per MR):  

Over the last few decades - concurrent with the growth of leverage in the financial system - the business model of most large law firms has developed into one built on leverage as well. It is just a leverage which utilizes people rather than borrowed money. Specifically, since law firms generally bill by the hour (a system whose demise has been predicted for the near future and, in my opinion, always will be), firms increase their profitability by increasing the amount billed in respect of each equity partner. Since there is only so much time in the day, firms have tended to increase the ratio of attorneys per equity partner. Without irony, this ratio is known as..."leverage"* * *

[W]hen the [work] flow dries up, the firms are left with high fixed costs to be serviced - and the more leveraged the firm is, the harder it is to service those costs with reduced revenue. Sound familiar? It should be no surprise that large law firms have been laying off attorneys in far greater numbers than in previous downturns* * * 

Law firms are typically organized as limited liability entities (the exact form depends on the jurisdiction). It is possible that the real brake on risk-taking stems from not the private-public distinction, but * * * the distinction between the unlimited liability of general partnerships and any other form of limited liability organization, whether public or private. Should we limit financial institutions to unlimited-liability vehicles?

This will sound familiar to my readers.  For example, as I explained last month on the occasion of a thousand or so lawyer layoffs:

• Law firms have to keep their most mobile partners from walking. Yet they are thinly capitalized, and have this huge nut in lawyer pay and debt.

• In order to keep the money flowing, law firms have to have lots of associates. The big partners bring the clients in, and associate time billed at high standard hourly rates keeps the partners paid. The clients pay because that’s the price of hiring the firms.

• Then markets collapse, and the clients no longer power the gravy train. The law firms are stuck with large numbers of associates who are no longer paying their keep. Firms' ppp is plummeting and big partners might walk.

• When the thin margin of capital evaporates things can happen fast. Think bank run, a la Bear Stearns and Enron. * * *

In the longer run, we now see very clearly that running law firms as thinly capitalized worker cooperatives is not an equilibrium solution in this market.

The answer, as I've said many times before, is dropping regulatory restrictions on law firm structure and letting them be run like real businesses.  This particularly includes permitting non-lawyer capitalization and perhaps even public ownership, as well as enabling firms to hold onto their intellectual property through non-competition agreements. See, e.g., here, here, the lawyer archive of this blog, and my longer analysis more than a decade ago, Ethical Rules, Agency Costs and Law Firm Structure, 84 Virginia Law Review 1707 (1998). These regulatory changes would go a long way to fixing the overleveraging of law practice.

The excerpt that began this post suggests limited liability is the problem.  That may be true, in part.  As I discussed here, current, regulated, law firm structure may not be able to support limited liability.  Ironically, law firm limited liability is not only made worse by regulation, but is itself the product of regulation -- specifically the regulation and liability that came out of the financial meltdown of the late 80s and early 90s (there's a lesson for current times in there somewhere). 

However, I don't believe that the solution for law firms, or for investment banking for that matter, is a return to the partnership structure.  You just can't put the genie -- decades of financial and governance engineering -- back in the bottle. 

The solution (as I discuss, e.g., here, and mucho elsewhere) is what I've called the "uncorporation." 

Comments

[save_the_rustbelt]

Big firm lawyers and big firm CPAs have the same problem.

Both groups become jealous of the compensation (or former compensation) of the I-bankers, executives and the entrepreneurs, and will do just about whatever it takes to pump up short term partner compensation (a la Enron).

Short-term thinking, long-term problems.

[Yaacov Silberman]

The rules governing law firm ownership is just one example of antiquated restrictions on the practice of law that no longer mirror how the business of law is actually run. Venture funded initiatives like Optim Legal (in Australia) are just as good as putting client interests first as any U.S. law firm that is owned by lawyers. Instead, would-be law firms like Axiom have to technically remain as temp agencies and disclaim up and down that they are not law firms. But they are doing legal work nevertheless and the risk to the public is only enhanced by such companies avoiding being classified as law firms. My virtual law firm, Rimon Law Group, has been approached by outside investors, but we've had to turn them down in every instance. Business people and lawyers juggle competing interests in many cases. There's no reason we would not be able to maintain the primacy of our clients' interests over those of our stockholders. Ultimately, our stockholders would be best served by that approach, too.

[BarryW]

You are about to get your wish - at least here in the UK, where deregulation commences later this year.

There is apparently a queue of equity lined up to enter the profession.

It is hard to evisage them tolerting the manangement style of a thinly disguised workers co-operative.

Come and see us next year.

It should be interesting