The post-Lehman revolution has left finance lawyers facing a much-changed world. Emma Sadowski and Alex Novarese ask if their model is still fit for purpose
“The leveraged finance market reality is that there is no new business. The banks will not lend.”
So says Clifford Chance’s (CC’s) James Johnson, a man who has built a good chunk of his career in leveraged finance, a market that, more than a year after the credit crunch first struck, is still in a state of dysfunction.
Such comments also reflect the attempts by finance advisers to come to terms with a sector that, in the month since the collapse of Lehman Brothers, is facing its biggest shake-up for a generation.
Lehman’s collapse on 15 September triggered a global run on bank assets as investors feared for banks’ solvency. In the weeks since, finance partners have witnessed escalating turmoil and repeated government attempts to head off the crisis. This process culminated last Monday (13 October) with the injection of £37bn of taxpayers’ money into Royal Bank of Scotland (RBS), Lloyds TSB and HBOS.
On the same day, a string of countries announced that they would follow the UK’s model of recapitalising struggling banks and providing wide-ranging support to the interbank lending market. As such, the US Government is to use $250bn (£142bn) of its agreed $700bn (£400bn) bank rescue package to inject capital into nine banks and similar initiatives are happening across Europe.
It is a lot for even the most seasoned finance adviser to take in. “It’s like waking up the morning after a huge blizzard: the world outside your window has completely changed,” confesses CC securitisation partner Kevin Ingram.
The result of massive collective state intervention has been to so far soothe investors’ fears of a collapse of the banking system, but it is apparent that change is now inevitable for the financial services industry. At a stroke, the tide of three decades of deregulation in the securities and banking industry has been halted and the new political reality facing the financial services is a future of a contracting industry, heavier regulation and a radical reshaping as new institutions rise while others are broken up or taken over.
And, inevitably, the major shift in policy will be heavily reinforced by the end of a 15-year long super-cycle in the credit market that saw debt – and the securities industry – substantially expand from the mid-1990s until the summer of 2007.
How the financial services industry will emerge from what is expected to be 12-18 months of capital injections, bankruptcies and fire sales is far from certain. What is clear is that such upheaval is likely to create specific challenges for the peculiar legal practice model that has emerged in London of servicing banking clients.
This model grew up in the wake of the 1986 deregulation of the City, dubbed the Big Bang. It was further stoked by the competitive pressure brought to bear by the groundbreaking merger the following year between Clifford Turner and Coward Chance. The model typically evolved into large, multi-product line finance practices at major City firms.
Rapid consolidation in the banking world was also mirrored by a select group of London-based law firms. The result was that most of the large banks instructed most of the large law firms in Europe, typically across multiple product lines. Unsurprisingly, it also resulted in very large finance practices, with London’s big three practices – CC, Allen & Overy (A&O) and Linklaters – all deriving more than a third of their revenues from their finance team (see breakdown, bottom).
This broad-church model developed by London firms has a number of other distinguishing traits. In particular, high leverage, use of paralegals and standardised documentation began to become more prevalent as finance practices grew with the expansion of general debt capital markets and the structured finance markets.
Finance practices also echoed the shifting fortunes of the finance markets that they served with securitisation, structured finance in general and leveraged finance becoming more lucrative over the last 10 years. By contrast, more traditional areas of project and asset finance became less profitable for law firms – leading some firms to retrench.
Of course, this diversification and breadth of banking practices at London firms also provides an inbuilt hedge. This is why UK law firms have yet to see the kind of deep cuts seen at US practices such as Cadwalader Wickersham & Taft and Thacher Proffitt & Wood, which were highly exposed to specific sub-markets.
Moreover, UK law firms have also achieved further protection through international expansion – banking law being the most genuinely international of practice lines.
Nevertheless, in the context of high partner-to-fee-earner leverage, a bias towards the battered acquisition finance and structured products markets and the sheer size of the teams, the London model looks in need of some revision if it is to move with fast-changing times.
“Clearly the world is going to look very different for a while; law firms will have to sharpen their focus,” says Herbert Smith partner Michael Poulton. “Some firms have big securitisation teams, which were heavily exposed to niche areas such as conduit commercial mortgage-backed securities work. They will be seeing much less business at this point.”
Within that general grouping, fortunes are thought to be differing substantially. As such, despite the high regard A&O’s finance team is held, the firm is historically seen to have been poor at managing cross-team working.
Sheer scale is also an issue, with A&O having to keep 69 banking partners busy in the City alone, of which about 17% focus on the badly-hit leveraged finance market. By contrast, A&O’s arch rival, CC, has had the benefit of a stable finance practice that is viewed as more successfully achieving flexibility between teams.
However, with A&O clearly on an upward trajectory at present and even its critics conceding it has become better at cross-team working in recent years, such concerns appear manageable.
Linklaters, in recent years the most upwardly-mobile of the larger finance teams, would have seemed particularly well-hedged thanks to its international spread and large M&A practice. However, its ejection this year from the panel of JPMorgan, one of its largest banking clients, will present challenges to its banking practice. In this context, the firm will have been relieved to have secured a string of major mandates in the wake of Lehman’s collapse, including its lead role for PricewaterhouseCoopers on the bank’s UK administration.
Linklaters head of finance and projects John Tucker comments: “Any firm operating at the top end will have to stay close to clients and it will be a premium for lawyers to be flexible.
“We place a high premium on flexibility: people may do different things – it is not linear. We regularly review our practice but there are no changes at the moment.”
Another upwardly-mobile practice that looks set to face testing times is Ashurst, whose practice has a heavy tilt towards leveraged finance and collateralised debt obligations (CDOs), two areas of the market most affected.
Herbert Smith, mid-way through a heavy investment programme in its finance practice, will face an even sterner test because its practice will almost certainly be forced to battle against a flight to quality as the overall market contracts.
In addition, several US law firms operating in London, in particular the structured finance-heavy Sidley Austin and Cadwalader, would also appear to be particularly exposed to current market conditions.
The omens would appear to be far better for some other players, especially those such as Norton Rose and Simmons & Simmons, which have been less reliant on acquisition finance and debt capital markets work in general. In particular, Norton Rose’s project/asset finance-heavy offering and Simmons’ strength in litigation and regulation would appear to be in tune with the times. Even Denton Wilde Sapte, having struggled to keep the pace with its peer group in recent years, would appear to have an opportunity to regroup around its undoubted strengths in insolvency and infrastructure.
“We think we have what may be the right sort of finance practice for the future,” says Dentons chief executive Howard Morris (pictured).
“We have made a virtue of old-fashioned stuff like trade finance… have resource in debt capital markets and derivatives, but we have never done securitisation. We do not have a production line of highly-specialised lawyers who have nothing to do and are likely to have nothing to do for the foreseeable future.”
Some firms have already moved to address this radically different market. Earlier this year, A&O launched a firm-wide initiative to move lawyers and support staff around the practice groups and offices, a process that is expected to have an impact on finance.
Likewise, Freshfields Bruckhaus Deringer and CC have, over the last 12 months, made changes to their practice groups that have shifted their firmwide practices away from segregated specialist teams towards broader umbrella groups.
A recent version of this trend saw Weil Gotshal & Manges this month bring its City finance practice together in one six-partner generalist group under Jackie Kelly. The firm cited market conditions that have obviously been testing for a practice with a substantial amount of leveraged finance and CDO-related activity.
The consensus is that firms will have to move decisively to retrain and move staff, especially since the specialisation of finance does not lend itself to redeploying junior lawyers.
One City partner at a large US firm comments: “Law firms will have to be a lot smarter. There are pools of firms with a lot of associates and they will suffer the most. The magic circle has built up those structured and leveraged finance teams and a lot of associates are not flexible.”
“When the markets change, retraining those people quickly is a sensible investment,” agrees Norton Rose banking head Stephen Parish (pictured). “The most important asset to a law firm is the people.”
However, as yet, many finance partners appear to be stuck in a level of denial as regards accepting that a radically changed market will likely require changes to how law firms’ teams operate without actually doing anything about it.
There is much talk of the flexibility of finance lawyers, fairly convincingly in the case of leveraged finance but less so in the case of structured finance and securitisation.
There is also much talk of the many opportunities for lawyers to move into bankruptcy. However, given there are literally thousands of finance lawyers working in the City and that banking lawyers hoping to transfer into restructuring will have to cope with competition from underworked corporate and litigation lawyers, pinning all their hopes on bankruptcy seems a stretch.
The plain fact is, in a market in which the wider City is predicted by mainstream commentators to be set to lose 50,000 jobs as the banking industry contracts, finance teams would appear to be oversized and the wrong shape for the current market.
The likelihood is that there will be a reshaping of finance practices that will see a return to more generalised practice – a fundamental shift after a 20-year drive in finance law towards specialisation.
Partner/fee earner leverage also looks likely to come down, partly because there are fewer deals, making such teams a bigger cost, but also because term agreements are being watched more closely.
This suggests a stronger focus on partner-driven teams to win the business and make sure it has been done correctly. Such a shift raises interesting questions regarding the contradictory forces shaping finance law. On one level there will be pressure to cut costs through commoditising areas of debt capital markets that lean heavily on standardised documents. But set against that, there will be increased pressure for law firms to stress test agreements and overhaul documents to reflect a more conservative lending environment with more covenants.
It could be that the only way to square the circle would be for a consensus to emerge between clients and law firms on what elements of banking law falls on the commoditised side of the line and what areas banks need a truly bespoke, partner-driven service. It also seems likely that there will be a shift away from leveraged finance and structured finance in favour of projects finance, asset finance and general lending.
And while much remains unclear about how the banking industry will look once the dust settles, several broad patterns can be predicted.
Banks are likely to become, at the top end, larger and more heavily-regulated and be required to hold more capital to cover losses. This suggests that this emerging group, of which JPMorgan, Bank of America and even Lloyds TSB are prime examples, will generally become more risk-averse.
It also seems very likely that new tiers of client will emerge. For a start, many retail-heavy banks in Europe, with the obvious exception of Barclays, are predicted to be more focused again on their core business after years of focusing on expanding their institutional business. This suggests that banks such as RBS, Lloyds, HSBC and Santander will be more rigorous and process-driven in terms of their panels and, conversely, less attractive clients to finance teams.
There would also appear to be a likely boom in regulatory work for lawyers, expanding on what has until now been a lucrative and strategically important but relatively small practice area.
If all this seems like a gloomy outlook, the plain fact is that the turmoil also represents the biggest opportunity in the banking market since the 1990s, when the status quo was largely solidified with the collapse of Barings and the wider submission of London’s investment banks to foreign owners.
A radical reshaping of the industry promises new opportunities for law firms to forge new client links. Current expectations, which were underlined at Legal Week’s recent Evening With debate, which included contributions from Deutsche Bank’s Simon Dodds and Freshfields chief executive Ted Burke, is that as a new breed of universal banks emerge, some mid-tier players such as BNP Paribas and Santander will fortify their position after benefiting from forced asset sales.
Likewise, with banks increasingly moving away from investing and trading on their own account, expectations are high that institutions such as private equity houses, hedge funds and even sovereign wealth funds will fill some of the vacuum.
It is also true, as some advisers point out, that dramatic falls in debt trading levels do not mean that there will not be heavy demand in the primary market, probably for more bespoke documents.
As CC’s Ingram comments: “It will become more of a banking market than a trading market – less frothy, which isn’t a bad thing for lawyers. There will be a higher premium for top-quality legal work moving away from the deal factory model.”
Linklaters’ Tucker also cautions lawyers to ignore the hyperbole, observing that the “rumours of the death of securitisation are premature”.
There will also be a new breed of boutiques emerging as bankers flee the confines of risk-averse superbanks. The cumulative effect of such changes will mean real opportunities for law firms that position themselves astutely. It will also present European law firms with an opportunity to break away from the one-size-fits-all model they have adopted, which has served to reinforce a rigid hierarchy in banking law.
It will be interesting to see which firms seek to position themselves at the smaller, bespoke end of the market and which feel they need to tie themselves into the often commoditised needs of the universal banks. There will surely be opportunities for some US law firms and some of the more nimble members of the chasing pack.
Kirkland London finance partner Stephen Gillespie (pictured) sums up this mood: “This is a genuine recession – once the dust settles, buying opportunities will emerge, and our private equity and hedge fund clients will be well placed to capitalise given that they are one of the few sources of liquidity in the market.”
Finance, however embattled it is at the moment, is plainly not going to stop being a core practice area for the world’s top law firms. But those that recognise the opportunities of the new banking order could do a lot better than those betting on the status quo.
The big three in finance – many mouths to feed