ABA Journal

The New Normal

What happens to BigLaw when banks become software companies?

By Paul Lippe

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Paul Lippe

For the latest in the ongoing debate between those predicting disruption for law firms, and those who see a slower evolution, see the report (PDF) from Georgetown Law and Ron Friedman’s response. Georgetown sees disruption; Ron is not having it.

But here at the New Normal, we’ve always maintained that client change drives legal world change. A few years ago, Marc Andreesen, the Netscape founder and venture capitalist, wrote a seminal piece “Why Software is Eating the World.”

With every day bringing new headlines of disappointing financial performance for large banks, software appears to be on the verge of eating the banks, so expect big implications for law firms.

The BigLaw model (a term I eschew but will use for this essay) has always been centered on banks as clients. Global, megabanks in New York, London, Hong Kong, Frankfurt and other financial centers, and the largest regional banks in midsize cities like Boston, Denver, Minneapolis, Miami or Dallas, were usually a law firm’s top clients. When people talk about the BigLaw model, they are overwhelmingly talking about the model of representing banks and other large financial institutions.

With apologies for oversimplification, we can describe three phases of the model:

Classic (1937-1980)

• Bank competition is limited, and regulation enhances the oligopoly.
• A separation emerges between retail and investment banking.
• Law firm relationships are institutional, and banks are anchor clients of firms.
• Law firm fees are mostly paid by bank counterparties; fee structures are not super price-sensitive.
• Bank business was sustainably profitable, although subject to cyclical crises and bubbles; profitability is rooted in opacity around costs to consumers of different services.
• Banks are trusted institutions—their reputations are prized.

Globalizing and risk-taking (1980-2007)

• Banks scale up, consolidate, take more risk and globalize.
• There is a dramatic increase in banker pay that takes a very high share of firm profits—there is a clear separation between interests of individual bankers and the bank as institution.
• U.S.moved to lightened regulation; the Big Bang is effected in the UK.
• Law firm relationships are less institutional, but more profitable—fees now based on mergers and acquisitions, new products and revenue-generating one-time events.
• Much of apparent bank profitability is based on mispriced risk, leads to rolling write-downs.
• Law firm pay jumps in parallel with banks, but less so.
• Universal banks promise integrated cross-product relationships, but rarely deliver. Regional banks largely get consolidated.
• In-house legal functions grow dramatically.

Post-crash (2007-2015)

• There is intense regulatory scrutiny driven by public mistrust and entrepreneurial state attorneys general.
• Electronic evidence means increased transparency, means that it’s pretty easy to prove liability for banks. Legal problems are frequently rooted in scale and complexity, which is a mismatch for law firms optimizing legal reasoning and reputation.
• The financial crisis leads to parallel regulatory response globally. Banks now become legally liable for either (i) losing money, (ii) failing to disclose risks that emerge in hindsight or (iii) selling products to customers when customers lose money (e.g., the Moore v. GMAC Mortgage settlement). There is newly implied fiduciary duty and product liability-like standards of conduct similar to the pharmaceutical industry.
• There are extraordinary fees for law firms for nominally one-time compliance and litigation events. Law firm financial performance is now uncorrelated with bank financial performance.
• Continued high regulatory pressure and complexity means high-cost, high-friction, and lots of decision-averse, risk-averse behavior inside banks.
• Continued high settlement values impact capital. Continued adverse headlines (LIBOR, ATM system failures) mean there is no relief from regulatory pressure.
• There is massive growth of compliance and risk functions inside banks that are now bigger than legal.
• The shadow banking system competes with banks for talent, deals, capital—there is more margin compression.
• A few banks adopt a Silicon Valley legal model and demonstrate that quality can be delivered at lower cost.

Every day we see new headlines about huge settlements for banks, which now approach $200 billion since the financial crisis. The banks may be in the worst of all possible worlds from a public relations and regulatory standpoint—their regulators “tax” them as if they are infinitely profitable, whereas their sustainable return on equity might really be 8 percent to 10 percent, no better than their cost of capital.

One striking example is the Royal Bank of Scotland. RBS of course epitomized bad timing by embarking on one the largest mergers in history with ABN-AMRO in 2007. Now they are 70 percent-plus owned by the U.K. government, their regulator, but even eight years after the financial crisis still make headlines with new, multibillion-dollar legal exposures.

So how do the U.K. government or consumers win if RBS can’t operate sustainably within the regulatory constraints? It’s hard to see how Elizabeth Warren-style “bank-bashing” or transferring money from shareholders and depositors to various claimants would make sense in the U.K., where the economy is so heavily dependent on the financial sector. It’s equally hard to imagine how breaking up 20 very large banks into 100 or 200 medium-large banks changes anything, notwithstanding my fondness for Bernie Sanders.

The BigLaw bank legal model was designed for a high-margin world where regulation created competitive barriers for banks and law firms “blessed” money-making activities. Now the banks have to compete in a software world—as Allen & Overy recently wrote: “Fintech describes the growing convergence between technology and financial services.”

The New Normal: Banks as Software companies

• Speed, efficiency, simplicity of interaction and execution are everything in world of tighter margins.
• There is more tolerance for operational risk, less tolerance for reputational risk.
• Customer relationships are based on stickiness, data, anticipating needs—meanwhile, data becomes a focus of regulation.
• There is more integrated management of banks and a focus on common interface to the customer.
• The emergence of well-financed “fintech” startups is targeting disruption in niche sectors, including the mega-transformation possible with blockchain.
• The entrance of uber-rich, ubiquitous tech companies (Google, Apple, Amazon) means new competitors and margin compression.
• Transparency is inevitable, both about pricing and misdeeds.
• Technology is a bigger part of execution.
• There are as yet few scale economies, but still many diseconomies in the federated structure of universal banks.
• Lawyers have to be more quantitative in assessment of risk.
• Customers expect trust.
• Law firms’ fees must come from operating profits.

The banks, with the help of their law firms, must convince their stakeholders that they can make money in a socially useful and ethical way, embracing the modern competitive environment, rebuilding trust, enhancing efficiency, accepting transparency and delivering on convenience. Whether getting there means more disruption for banks or law firms is too soon to say.

Paul Lippe is the CEO of the Legal OnRamp, a Silicon Valley-based initiative founded in cooperation with Cisco Systems to improve legal quality and efficiency through collaboration, automation and process re-engineering.

Editor’s note: The New Normal is an ongoing discussion between Paul Lippe, the CEO of Legal OnRamp, Patrick Lamb, founding member of Valorem Law Group and their guests. New Normal contributors spend a lot of time thinking, writing and speaking about the changes occurring in the delivery of legal services. You’re invited to join their discussion.

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