Law firm subsidiary businesses - a source of conflict?

The Lawyer has reported that, in a rare example of apparent misjudgment, DLA Piper co-chief executive Sir Nigel Knowles has become embroiled in a partnership storm after it emerged last week that he and a small number of other DLA partners have personally invested in LawVest (of which Knowles is non-executive Chairman) without declaring it to DLA’s board or the partners.

DLA Piper reportedly invested £62,500 into LawVest last year, and is aiming to redefine the lower and mid-market for corporate law services, by offering fixed price annual contracts.

  

What makes the personal investments in LawVest particularly controversial is that DLA Piper and LawVest have both stated that they expect that smaller DLA Piper clients will be referred to LawVest, which intends to trade under the brand name Riverview.  In a previous blog posting I have commented on the fact that this could create an interesting dynamic as it will apparently see a shift of existing business from DLA to Riverview, albeit at the smaller end of their client base.  In these circumstances, it is perhaps surprising that Knowles and the other partners who invested personally in LawVest are said to be shocked that their actions were being perceived by their colleagues as giving rise to a conflict of interest.

The purpose of this posting is not to examine what has happened at DLA in particular, but instead to highlight a complex area that more and more firms will find themselves having to navigate as ABS structures become common, and in particular as more law firms start investing in subsidiary businesses as a consequence of an increasingly competitive and dynamic market.  

Owning valuable capital assets within partnership structures often leads to tensions at the best of times.  In the offshore environment, the vast majority of law firms set up their own trust company businesses many years ago, which in many cases became very profitable and highly valuable, saleable assets.  In the early days, owning these businesses seemed to be a genuine win-win for the law firms – they were established by the partners in the business at the time, and were very cash generative.  Everyone was happy.  But as time went on, in most of the firms the political dynamics became increasingly complex, and in some cases led to relationships between partners breaking down.  There were a number of reasons why this tended to happen:

• In some cases, as the subsidiary companies became more valuable, it started to cause difficulty with building an economic business case for bringing new partners into the law firms which owned them, particularly if the prospective partner was not working in a field which would be likely to generate more work for the subsidiary, because their fee earning potential could not “justify” the interest in the trust company that they would acquire through partnership.  Firms responded to this in a myriad of different ways.  Some cut right back on offering partnerships in those areas (which of course led to longer term recruitment and retention problems), whilst others started to offer newer partners a share of the law firm profits, but no interest in the subsidiary businesses.  This latter approach led to two-tier (or sometimes multi-layered) partnership structures – a potential source of enormous tension and bitterness for those who don’t make it to the higher tiers;
• Some firms allowed individual partners, as opposed to the partnership, to have personal investments in the trust companies, whilst other partners had no interest.  This could lead to friction in relation to referral arrangements, such as suspicion that law firm fees were being discounted in order to be able to secure work for the subsidiary company – an arrangement which would benefit only those who had a personal investment.  The mere perception of a lack of transparency (as seems to have happened at DLA) would only inflame any tensions in this respect;
• As the subsidiary business became more successful, they in many cases started to out-perform their law firm founders and this in itself could become a source of tension – on the one hand from the people running the subsidiary business (who sometimes felt that the law firm partners were getting rich off the back of the subsidiary’s success, whilst contributing little directly to it), and on the other hand from the law firm partners, who might resent the fact that the contribution of the law firm to building the subsidiary brand in the subsidiary was being under-valued.  This dynamic is perhaps something which afflicts the professions more than some other more commercial businesses spheres, but is not unique to law firms.  Anyone who has studied the enormous rift that developed between Arthur Anderson and its consultancy business, leading to its bitter split, will know that the seeds of that debacle lay in exactly the sort of tensions described here;
• If the subsidiary business needed material capital investment, then this added an extra layer of complexity, because partners at different points in their careers are likely to have different views and vested interests in investment and divestment decisions.  For example, a partner who is close to retirement is not likely to be willing to take a large income sacrifice to finance a huge IT project which will not deliver any benefits during his tenure, whereas others might feel it is essential for future growth and that older partners, if they block it, are putting a brake on the business; and
• Finally, as some law firms started to divest their subsidiary businesses, it became apparent that the structures established by many firms had resulted in something akin to a pass-the-parcel situation: interests in the subsidiary business would be passed down from generation to generation of partners, but those in situ at the time of a sale would be in line for a huge pay-day.  As partners approached retirement, there was therefore a natural tendency for them to press for a sale of the business, whilst those who had been working towards, but not yet achieved, partnership would fear that everything they had been working towards might be sold out from under their feet. 

All of these are enormously complex dynamics.  The offshore law firms, and many of the accountancy practices, have been grappling with them for years, trying a myriad of different solutions and with varying degrees of success.  As the UK legal landscape changes and becomes more dynamic and competitive, and law firm businesses become less homogenous, so the firms here will need to start addressing similar issues.  The DLA Piper/LawVest venture has hardly got off the ground before the first problems have surfaced, and we can expect more to follow. 

There needs to be clarity, transparency and a shared vision of the future at the outset, which is clearly articulated.  If there is an absence of trust between those partners that those taking the key decisions are working towards a shared goal, have only the best interests of the firm as a whole at heart, and have a proper mechanism in place for recognizing what was once termed goodwill, tensions may become unbearable. 

UK firms can and should be seizing the opportunities open to them to reinvigorate and expand their businesses.  But those who rush into such ventures without thinking through the consequences and learning the lessons from some of those businesses which have gone down that route before them, might live to rue the day.