How do you finance a growing practice? It is impossible to have a successful practice without good cases and managing good cases to a successful conclusion requires money for working capital. So, how does a growing practice secure the working capital it needs?
Historically, growing practices in need of working capital have had limited financing alternatives. A law practice’s largest and most valuable asset, their case inventory, has been of little value for financial transactions. Most firms find that banks will only lend them rather small amounts, if they will lend at all. Banks simply do not view potential fees from cases as adequate collateral for a loan. They are simply not set up to evaluate this type of collateral. This makes it all but impossible for the smaller firm to finance large cases.
Previously, the only alternative has been to give up a large portion of the fee to a financially stronger co-counsel willing to finance the case.
Attorney Financing With a Non-Lawyer Third Party
This paradigm has changed with the introduction of asset-based lending to the legal profession. The development of highly specialized litigation finance companies knowledgeable in case and attorney evaluation now make loans available to many practices for which no financing has previously been available. Moreover, their loan-to-value ratios are double or triple those of traditional financial institutions.
Non-traditional lenders are starting to provide loans that more properly reflect the value of a practice’s contingent assets – case inventory. While financial condition of the parties always matters in a capital transaction, even more important are the attorneys’ skill, track record and case inventory.
Financial transactions with attorneys are shaped by ethics issues. The intrinsic problem is that the non-lawyer entity has an incentive to attempt to “maximize its earnings to the detriment of the representation of clients.” The attorney must maintain control and independent professional judgment: the non-lawyer entity must have no power or authority to direct or control the activities of the lawyer (RPC Rule 1.7(a); RPC Rule 5.4(c)). (It goes without saying that lawyers may not split legal fees with a non-lawyer entity. RPC Rule 5.4(a))
Various Rules of Professional Conduct require that:
(1) there must no interference with the lawyer’s independence or professional judgment or with the client-lawyer relationship, and
(2) information relating to representation of a client is protected as required by RPC Rule 1.6.
(3) revealing to a third party any information acquired during the professional relationship with a client (“Confidential Material”) unless the client gives informed consent.
If these conditions are met, a financial arrangement with a non-lawyer entity is permissible if:
o Repayment is not tied to the results obtained by the lawyer
o The rate of interest charged is absolute and not contingent on the outcome of the litigation.
Since there is no way to achieve this with a non-recourse transaction, the attorney must be responsible for the loan.
Beware of Sham Transactions
There are private lenders that have attempted to avoid the restrictions imposed by the Rules of Professional Conduct by using a law firm as a conduit for its transactions. If the law firm is offering nothing but financing, this transaction is likely to be considered a sham and required to comply with all of the appropriate rules.
Factoring Fees on Settled Cases
It is important to point out that there is a great distinction between a contingent fee on an unresolved case and an account receivable on a settled case. Since the issues have been resolved, the latter presents no conflict (assuming the transaction does not run afoul of 2) above); the receivable can be sold, factored or otherwise financed like any other receivable. Fees can be factored on a recourse or non-recourse basis at very reasonable costs.
The Structure of Today’s Market
Every credit market has a hierarchy and this one is no different. Rates vary from about 5% for the most creditworthy to 60% for the least.
Since case expenses including working capital represent only a small fraction of the value of a case, even the highest rate loans, which are primarily asset based, represent very favorable economics for the growing firm. Consider the following alternatives for a firm that needs $50,000 in financing in order to handle a $500,000 case with a contingency fee of 33% (potential fee of $165,000):
(1) Co-counsel Financing: 50% of the fee equals $82,500;
(2) Working Capital Loan at 60% equals $30,000 per annum. Depending on the case duration (break-even is 33 months)
The largest and most creditworthy firms have always been able to get bank financing at reasonable terms; these have always been credit transactions rather than asset financing. Generally, the bank will take a blanket security interest on all assets of the firm, including case inventory and will usually require the personal guarantees of the principals, as well.
These prime borrowers can use their financial strength to borrow and then turn around and invest the capital in cases brought to them by smaller firms unable to get the financing themselves. The cost of these transactions can be huge since they are based on the results of the case rather than on the amount that is financed.
Just below these prime borrowers is a group of firms that are creditworthy enough to secure a bank line but not at the best terms. The amount of the line is usually insufficient and the rate is well above prime.
These firms can usually obtain significant funds from a non-bank lender at rate of 16% – %20%. A security interest and personal guarantees will be required.
The vast majority of firms have been limited to the amount of capital they can borrow on their own personal credit.
RPC Rule 1.7(a), a conflict of interest exists if the representation of one or more of a lawyer’s clients is materially limited by the lawyer’s responsibilities to a third party or by a personal interest of the lawyer. This conflict can be waived by the client. However, regardless whether there is no conflict, or there is a conflict that is waived by the client, the lawyer must still insure that (1) there is no interference with the lawyer’s independence or professional judgment or with the client-lawyer relationship, and (2) that information relating to representation of a client is protected as required by RPC Rule 1.6.
RPC Rule 5.4(a) prohibits a lawyer from sharing legal fees with a non-lawyer entity. RPC Rule 5.4(c) prohibits a lawyer from entering into certain arrangements with a third party that would give the third party the power to direct or regulate the lawyer’s professional judgment in rendering legal services to a client.
RPC Rule 1.6(a) generally prohibits a lawyer from revealing to a third party any information acquired during the professional relationship with a client (“Confidential Material”) unless the client gives informed consent.