You can’t invest in American law firms—yet. But it’s only a matter of time.
We live in an age where just about any income-generating asset one can imagine, from homeloans to professional football players, has been securitized, collateralized and sold to investors.So you might expect there would be no ubiquitous class of large, highly profitable businessesthat has failed to tap their receivables for capital.But if so, you’re wrong. Consider the American law firm and its peculiar partnership-basedcapital structure.
Every state in the US prohibits outside investment in law firms by blocking lawyers from sharingprofits with non-lawyers. These perfectly well-intentioned rules aren’t likely to be relaxedanytime soon. Proposals to allow outside ownership have so far been dismissed by theAmerican Bar Association.
But over time, this ownership model is eroding. In fact, in several places around the world, youcan already see the cracks, and something new emerging through them. The United Kingdomhas allowed outside investment in law firms since 2012. Australia saw its first law-firm publicoffering in 2007. And it already happens in Washington, DC, where non-lawyers are partners inmany law firms that focus on lobbying work.
Simultaneously, the partnership capital structure does US law firms a disservice when it focuses their attention on the short term, as it does far more acutely than at other privately held businesses. Partners in law firms don’t have permanent equity, so they forfeit their capital when they retire. This incentivizes them to earn as much as they can during their working years and leaves firms without anyone to think about their long-term value as businesses. Exacerbating the situation, US law firms’ earnings are taxed before they are distributed to partners, creatinganother disincentive for reinvesting post-tax dollars back into the firm.
Meanwhile, clients are pressuring firms to be more efficient—often code for “lower yourrates”—and have shown no hesitation about taking their business to lower-cost firms. In thebuyers’ market of legal services, if law firms stay focused on pulling out profits in the short term,they’re far more likely to engage in a race to the bottom.
No other industry operates this way, including other professional services. Consultants andadvisors of all sorts provide high-end business services using conventional capital structureswith conventional equity (and with no inherent ethical problems, I might add). There’s no reasonlaw firms couldn’t do likewise.
The good news: there are several indications that the old law-firm ownership model is breakingdown. Most of the big firms have turned to professional managers, installing CEOs or otherMBA-trained officers to help them run more efficiently. Many also employ financialprofessionals, often to help lawyers analyze cases so they can more precisely price theirservices and manage their risk.
And law firms are starting to get more sophisticated in their use of financial instruments. BurfordCapital, which I co-founded in 2009, provides litigation financing to clients and law firms.Litigation finance started off as a way for firms to manage the cost and risk of discrete cases.Today, however, it is becoming a form of corporate finance. Companies and firms are financingentire portfolios of litigation, using the capital to fund operations and other business costs.
Financing a portfolio of income-generating assets is different from raising cash by selling equityin the firm. But the two could be considered cousins, and they both represent a level of financialinnovation that we’d never seen in law firms until the past few years.
As American firms increasingly embrace tools like litigation finance, and as they see theiroverseas brethren raising large sums at lower costs of capital, I believe they’ll also be morelikely to start coming around on the question of outside investment and ownership.
And if that happens, it will allow firms to take a longer view that will result in better client serviceand better lawyering. And it will allow American capital to participate and further one of oureconomy’s most profitable sectors.
Jonathan Molot co-founded Burford Capital and serves as Chief Investment Officer.
He is a Professor of Law at Georgetown University Law Center and a leading expert on litigationfinance. He served as counsel to the economic policy team on the Obama-Biden PresidentialTransition Team and as a senior advisor in the Treasury Department at the start of the ObamaAdministration. He clerked for Supreme Court Justice Breyer and practiced law at Cleary,Gottlieb, Steen & Hamilton in New York, and at Kellogg, Huber, Hansen, Todd, Evans & Figel inWashington, D.C.
