Legal Services Act: the debate heats up

Last month (24 January) The Lawyer highlighted an accelerating trend that may well turn out to be one of the defining developments in this year of full Legal Services Act (LSA) implementation.
An increasing number of firms are looking at introducing corporate vehicles into their partnerships.

The technique is primarily a way of transforming a proportion of income into capital to gain a tax arbitrage, with a slew of profits set aside and charged capital gains rather than income tax.

While this is a transparent attempt to avoid paying the 50 per cent top rate of tax on partners’ income and is therefore not a directly LSA-related development, there is a growing consensus that the increasing use of corporate members could be paving the way for third parties to invest in firms after 6 October.

Certainly, the impending introduction of the LSA is helping to sharpen the thinking among law firm leaders, who are concerned about maintaining competitiveness and looking for ways to achieve the goal.

“It’s undoubtedly the case that the liberalisation of ownership will concentrate minds,” says William Wastie, head of the professional practices at Addleshaw Goddard. “There’ll only be so many investors in the market and if a firm has its house in order, has identified a need for outside capital and has a mechanism for delivering that investment, it will have the advantage over competitor firms who may be looking to do the same.”

So while corporate members have been around for years, this year’s act is likely to result in an acceleration of firms adopting them.

John Llewellyn-Lloyd, head of M&A at investment bank Execution Noble, agrees with Wastie that the advent of the LSA, which will allow non-lawyers to own corporate members for the first time, is acting as a catalyst for this model in the UK legal market.

“It may facilitate taking in external investment,” Llewellyn-Lloyd says.

And where there is ­external investment, there is likely to be an exit.

Consequently, and again for the first time, partners are considering inserting so-called ’anti-embarrassment’ clauses into their partnership agreements to avoid missing out if their firms receive external investment, for example via a flotation, a year or two after they retire.

Wastie and Llewellyn-Lloyd form part of a panel of experts that over the coming months will examine a series of trends, innovations and models the LSA’s ­introduction facilitates, offering their opinions on the pros and cons.

The series kicks off this week with a focus on corporate members and anti-embarrassment clauses.

William Wastie
William Wastie

The partnership expert

William Wastie, head of the professional practices group, Addleshaw ­Goddard

Q. What are the pros and cons of a law firm adopting a corporate member model?

A. It may prove distracting to firms when they’re still operating in a hard market and the emphasis should be on client delivery rather than internal organisation.

However, hard markets are also an opportunity to

re-evaluate and take difficult decisions. One significant advantage of the ­corporate member is the more tax-­efficient retention of profits in the business. With ­pressures on banking and other finance arrangements ­combined with the 50 per cent higher-rate income tax, this will be a significant driver.

Q. How widely do you believe it is being adopted among law firms?

A. Historically most firms adopted full distribution models and, in an age where the financing of professional practices was not under the degree of scrutiny it is today, that was not a cause for concern.

It requires a change in attitude and understanding for partners to want to move away from that model, so take-up’s not currently widespread. However, this is something that will increasingly be on management agendas.

Q. What impact, if any, will full LSA implementation have on the adoption of corporate members and why?

A. It’s undoubtedly another significant driver in ­examining how a firm’s operating and its competitors are reacting.

Lawyers are by nature cautious and a corporate ­member’s not the only way of developing an alternative business structure. However, the LSA can now be talked about in operative terms, with the Solicitors Regulation Authority’s new Code of Conduct due to be finalised in March and the regulatory regime due to go live in ­October, rather than as an issue of mere academic ­theory.

Q. What other factors are likely to have an effect on a firm’s ­decision to adopt a corporate member?

A. The amount of time putting into place the ­arrangements and the potential for creating unnecessary angst in the partnership are issues that, with firm and open leadership, can be resolved; but a badly managed project could cause at best disruption and at worst a cause of dissent.

Q. How widespread do you believe the use of anti-embarrassment provisions is among the UK’s top 100 law firms?

A. Relatively limited. Partners in the legal profession haven’t previously looked for exit value on retirement. Firms usually operate the classic ‘tenancy’ model. Law firm annuity arrangements are also increasingly rare, but with the pensions market having suffered so badly and firms wanting to manage retirements successfully

in the era of age discrimination legislation, the anti-embarrassment route may become more common.

Q. What impact would the adoption of an anti-embarrassment clause have on a firm’s public image?

A. The argument is that, if there was a capital event, an entitlement of recently retired partners is a way of ­distributing appropriately the proceeds to a generation that’s contributed significantly to that success. ­However, this requires some limitation and also the ability to reward and sustain continuing partners.

The recognition of goodwill will be new to most firms. It not being recognised on balance sheets means debates as to its ownership will require significant analysis.

John Llewellyn-Lloyd
John Llewellyn-Lloyd

The banker

John Llewellyn-Lloyd, head of M&A, Execution Noble

Q. Do you believe the advent of the LSA, which will allow non-lawyers to own a corporate member, is acting as a catalyst for this model in the UK market?

A. Undoubtedly. It may facilitate taking in external investment.

Q. What message would adopting it send out to the ­market – prudent tax planning or positioning itself for post-LSA ­expansion?

A. Both. Simply being ­prepared, especially if you’re planning the ­possibility of ­external funding.

Q. How widespread do you believe the use of anti-embarrassment provisions is among the UK’s top 100 law firms?

A. Not widespread, although it could increase ­significantly as partners focus on the equity value of their firms upon IPO.

Q. Are they a good idea or are they ­divisive?

A. Inherently they’re divisive and easily capable of ­misinterpretation, both internally and externally.

Q. What impact would the adoption of an anti-embarrassment clause have on a firm’s image?

A.   Any sale or fundraising will require current value generators to be incentivised. Too much ‘beach money’ to non-generators is likely to reduce value for investors. So, likely to be negative, but depends on quantum.

David Stewart
David Stewart

The law firm boss

David Stewart, CEO, Olswang

Q. How widely do you believe corporate members are being adopted among law firms?

A. Limited for now, but ­likely to increase.

Q. What message would adopting a corporate member send to the market?

A. It wouldn’t be a signal about post-LSA expansion, more a sign of tax planning.

Q. What impact, if any, is full LSA implementation likely to have on the adoption of corporate members and why?

A. For those who wish to have external investment in the firm it’s the obvious route in for those investors.

Q. Are anti-embarrassment clauses a good idea or are they divisive?

A. I can’t see firms that use the advent of the LSA as a way of realising and distributing some of the net present value of the future ­revenues of the firm to existing ­partners as being either attractive to investors or ­successful in the longer term.

External investors will want to see a clear ­business plan for the investment of their funds and the ­retention of the key partners in the ­business. If external investment becomes more ­widespread, you could ­imagine retiring partners ­becoming more aware of the option and asking for it as part of an exit package, at least for a short period after leaving the firm.

The recruiter

Nick Holt
Nick Holt

Nick Holt, partner, SR Search

Q. What are the pros and cons of a law firm adopting a corporate member model?

A. One of the key pros will be the streamlining of the decision-making processes.

Management’s going to be able to manage, leaving partners to do what they do best, namely practise law and develop new clients. This in turn will give rise to increased opportunities for non-lawyer managers to make their mark. To some extent this is happening already in the larger firms, but there’s no doubt in my mind that the LSA will serve as a catalyst.

In terms of the pace of change, I suspect that most firms will adopt a ‘wait and see’ approach. We saw that when LLP status was introduced – most firms will want to be firmly in the pack with their peer groups, not out in front and not left behind.

There will be some early adopters – indeed, some firms have already made it clear they’ll go down this path, but the majority will wait and see. I think that the market will react positively to any firm that’s ­corporatising.

Meirion Jones
Meirion Jones

The business developer

Meirion Jones, director, Client Critical

Q. What message does utilising a corporate member send to the market – prudent tax-planning or post-LSA expansion ­positioning?

A. Hopefully both. The ­question’s an interesting one, as it implies that a firm’s most important constituencies are outside in the ‘market’ ­(whatever that is). In reality, the crucial constituency is the firm’s own equity partners, followed in importance by

a relatively small cohort of key clients and then the ­recruitment and lateral hire markets.

For all the PR guff firms ­produce about the importance of delivering value to clients, such as when justifying a merger, their overwhelming focus is on keeping their equity partners sweet.

The opportunities presented by the LSA could, for once, serve both constituencies equally well. Partners will get well remunerated and clients could experience some of the innovation, enhanced service delivery and greater cost-effectiveness they’ve been calling for for years.