Sort of Pregnant

The classic definition of a merger in the corporate world is where two companies become one.  And this definition has long carried over to the legal world where mergers were viewed in the bright line context of all or nothing – when two law firms get together it is either a merger or it is some kind of loose affiliation. But the recent flurry of international mergers is causing a blurring of the merger definition, which may soon influence domestic mergers.

Over the past twenty years there have been hundreds of law firm consolidations in the United States.  The majority of these mergers have involved firms of differing sizes, where the larger firm effectively acquires the smaller.  These are cast as mergers because the assets of the two firms are merged and a single partnership is created.  Typically in such situations, the larger firm dominates the transaction and the name, leadership, compensation system and culture of the larger firm becomes that of the combined firm.  There have, however, been a number of significant mergers involving firms of a like size where a new firm is effectively created using best practices rather than copying the pattern of one of the participants.  But, regardless of how the combination is accomplished or the compatibility of the partners, the definition of a merger, in the U.S. vernacular, has consistently included the creation of a single business entity operating with a single profit pool.  As one managing partner put it, “It’s like pregnancy; either you are or you aren’t.”

The Global Perspective

Firms operating on a more global basis, however, tend to use a different definition for merger.  The intricacies of multi-national tax law and international money transfers, currency fluctuations, together with unique law society regulations in different countries makes it difficult to operate an international firm with a single profit pool.  For example, Lovells, the UK firm that recently merged with Hogan & Hartson, operated with 12 separate legal entities before the merger.

It is interesting, therefore, to note that among the most recent US – UK law firm “mega-mergers” (Hogan Lovells, SNR Denton, and DLA Piper) none involved the sharing of profits. This is made possible through an entity known as a Swiss Verein which allows multiple partnerships to operate under a single entity while maintaining independence from each other for liability and regulatory purposes.  Not surprisingly, this is the legal structure of choice for most professional services firms operating internationally, including the major accounting firms.

The use of separate profit pools in creating a merged firm is not without controversy.  The most frequent argument in opposition is that the firms’ partners will not refer matters and cross sell if they are not participating in the profits of the whole firm.  The concern is that a firm with separate profit pools effectively becomes an association of law firms or a best friends network operating under a single name.  Clients have voiced concerns about the ability of firms to provide seamless service and handle multi-national matters if the partners effectively work for separate law firms.

On the other side, firms with separate profit pools argue that opponents place too much emphasis on the importance of money as a motivator.  They suggest that firms spend too much time focused on financial integration at the expense of ignoring the important issues of creating a combined culture, shared practices and joint business development.

The Real Impact of Separate Profit Pools

The impact of Swiss Vereins and separate profit pools on the U.S. legal market may be greater than just the large firms expanding their global presence.  UK law firms have been surprisingly timid in their expansion to the U.S.  In part, this is due to the massive size of the U.S. legal market ($260 billion compared to 25 billion pounds for the UK) and the cost of creating a significant presence in a country that has 51 separate law societies.

But two factors seem to be causing the U.K.’s Magic and Silver Circles to begin moving more aggressively to the Americas.  First, they are simply running out of other places to expand. The U.S. legal market is larger than the rest of the world combined and the most logical growth prospects (China, India and Brazil) have strict limitations on practice by foreign firms.  But more importantly, their cost concerns about meaningful expansion to the U.S. may have been mitigated by a new source of capital.  The U.K. Legal Services Act (the Clementi Reforms) removes the traditional limitation of bar admittance for owners of law firms. Many anticipate that the result will be akin to the “Big Bang” among Wall Street broker dealers in the 1980’s when they became able to issue stock to capitalize their massive expansion.  And, even though this could place U.S. firms at a severe competitive disadvantage, it is unlikely that meaningful changes in bar rules permitting non-lawyer ownership will occur in America in the near future.

However, it is believed that, through a Swiss Verein, U.S. firms could access large amounts of capital raised though public offerings by their U.K. counterparts.  And the ability to accomplish international mergers that would provide this access is significantly facilitated if the firms maintain separate profit pools and compensation systems.

While that is an interesting scenario, I suspect the greatest impact could have nothing to do with international mergers or Swiss Vereins.  Instead, it will involve U.S. domestic mergers and how much easier they become with the greater acceptance of separate profit pools and compensation systems.  It is generally held that law firms with levels of profit per equity partner that differ by 20 percent or more find it impossible to merge.  Partners in the more profitable firm fear a dilution of their profitability and a situation where their compensation would have to be reduced to fit their new partners into the compensation system.  That fear is greatly assuaged if the compensation of the partners of the less profitable firm is limited to their own profits.   The maintenance of separate profit pools could also be viewed as taking some of the risk out of mergers.  After all, if the profit pools and compensation are never combined, it would be relatively easy to dissolve the merger if it doesn’t work out.

Now, I have to tell you that this whole concept scares the hell out of me.   The concept of massive law firms where separate geographic offices and practice groups are independently owned but are required to operate under a common name and meet certain standards of consistency and quality is the worst nightmare of most law firm managing partners.

But as one looks at the rapid maturation of the legal industry and the increasing commoditization of many practice areas, it is not hard to envision a significant change from the one-firm concept in law firms.  The efficient handling of legal engagements that are sufficiently routine and involve a high volume of matters scattered across the country is tremendously enhanced by large, well-funded and entrepreneurial law firms.  Although these may sound like franchise operations, they are functionally not very different from the way many multiple office firms have organized themselves: diverse offices cobbled together under an umbrella brand with very little interoffice transfers of work and dramatically different cultures in each location – only on a bigger scale.

So as I read articles and see bloggers talking about the demise of “big law,” my reaction is:  hold on to your hats folks; I suspect the concept of really big law is just beginning.