Elite law firm mergers and reputational competition: is bigger really better? An international comparison.

AuthorAronson, Bruce E.

ABSTRACT

Although rapid law firm growth has persisted since the 1980s, the acceleration of this trend over the last decade by means of mergers is puzzling. Why would normally conservative law firms embark on a merger strategy that appears to encompass significant risk and uncertain benefits? Is this trend a peculiarly U.S. phenomenon?

Most of the popular explanations for law firm mergers focus on a single factor: Law firms everywhere cite strikingly similar reasons based on a presumed client demand for "one-stop shopping." This Article contributes to providing a more robust, multi-causal explanation for law firm behavior through a comparative study of reputational competition among elite law firms in selected jurisdictions--the United States, the United Kingdom, Germany, Australia, and Japan. It posits that industry consolidation and changing market conditions have intensified law firm competition and that since firm quality is hard to measure, law firms compete largely on the basis of reputation. Due to their risk-averse nature and the fear of losing existing clients, many law firms are thus paradoxically driven to engage in (defensive) mergers to meet the competition.

Through an examination of reputational competition, the Article considers circumstances that are likely to lead to mergers, particularly the elements of reputational signaling, herd behavior, and reputational status as "first-tier" law firms. It identifies "rules of the game" for firm behavior with respect to international mergers. The Article finds that the impact of a strategic decision, such as a merger, by a first-tier firm is of far greater significance than a similar action by another elite firm and is much more likely to lead to defensive actions, such as mergers, by competitor firms. Thus, which firms engage in merger activity in a given market is an important factor in explaining and predicting both the reaction of competitors and whether mergers will become widespread in that market.

This Article further suggests that the common phenomenon of law firm mergers is likely a result of law firms reacting to similar types of changes in their operating environment (i.e., a parallel development), rather than convergence to a U.S. model of the law firm.

TABLE OF CONTENTS I. INTRODUCTION II. RECONSIDERING ACADEMIC THEORY RELATING TO LAW FIRM GROWTH BY MERGER A. Market Change and Law Firms' Response: The U.S. Experience B. Academic Theory and the Puzzle of Law Firm Mergers C. Developing a More Robust Explanation III. THE UNITED STATES AND THE UNITED KINGDOM: NATIONAL OR GLOBAL MARKETS? A. United States B. United Kingdom IV. INTERNATIONAL MERGERS AND ALLIANCES: THE EXAMPLES OF GERMANY AND AUSTRALIA A. Germany B. Australia V. THE EMERGENCE OF ELITE LAW FIRMS AND MERGERS IN JAPAN VI. RECONSIDERING EXPLANATIONS FOR LAW FIRM MERGERS A. Evaluation of the Case Studies and Reputational Competition B. Convergence or Parallel Development? VII. CONCLUSION I. INTRODUCTION

Over the last decade, the legal profession in the United States has gradually become accustomed to the idea that bigger is better for law firms, and a merger is now a common tool to achieve greater scale. In one recent example, within five years two little-known regional law firms merged, added three smaller firms by merger, doubled in size through another merger in October 2004, and in January 2005 completed an international merger with an English firm to create the world's third-largest law firm, with more than 2,700 lawyers at forty-nine offices in eighteen countries. (1)

This recent trend of "serial mergers" highlights a seemingly ever-accelerating race among law firms to grow and achieve a credible size and national (and, increasingly, international) presence or platform. But why would generally conservative law firms embark on a merger strategy which appears to encompass significant risk and uncertain benefits? Is the merger trend truly a result of sophisticated multinational clients demanding "one-stop shopping" for legal services on a global scale, or are there other causes? Which firms among the large or elite corporate law firms are likely to pursue a merger strategy?

These questions are not unique to the United States, as the law firm merger wave has also seemingly engulfed other developed countries. Most of Germany's leading law firms have entered into international mergers or alliances. Even in Japan, which is often perceived as a society where law firms, lawyers, and the law itself are unimportant, all of the top four law firms entered into domestic mergers during the period 2000-2005. And, the first international merger between a significant Japanese firm and a foreign firm (a top English firm, Linklaters) also occurred in 2005. How do these firms' circumstances and motivations compare to those of law firms that undertake mergers in the United States?

The recent wave of mergers among large law firms, both in the United States and in many other countries, presents an interesting puzzle. Neither the prior literature on the growth and development of law firms nor the business strategy explanations provided by the firms themselves fully explain this trend. Supply-side theories, emphasizing how law firms' internal structures can provide a strong impetus for growth, (2) encounter difficulty in explaining mergers, as a merger would presumably tend to destabilize any such internal system. Demand-side explanations emphasize client demand and often include application of the traditional "theory of the firm" to law firm growth with the resulting view that firms will merge if it is more efficient for them to do so. (3) But efficiency is difficult to measure, and it is unclear that law firms are even attempting to measure it.

Law firms themselves justify mergers with demand-side explanations that are surprisingly consistent: Mergers are a response to client needs for greater attorney specialization, large teams of lawyers for significant projects, one-stop shopping, and a greater law firm presence in the relevant market. (4) There is no empirical evidence to back up this presumption of client demand, and one can find large corporations and law firm consultants who claim it is unfounded. (5) By nature, mergers are a risky business, and it is unclear that most mergers are successful. What then seemingly compels law firms to undertake mergers to achieve growth?

In addition, the wave of law firm mergers is by no means uniform. Despite the decade-long trend of law firm mergers in the United States, a number of leading firms have not engaged in mergers and apparently have no intention of doing so. On an international level, nine out of ten law firms in Germany entered into international mergers or alliances within a year's time around the year 2000, while in other developed countries, such as Australia, no international merger activity occurred. (6) And while most of the leading U.K. firms have embraced a full-service global strategy, the top U.S. firms continue to rely on a national strategy with only selective international expansion.

As law firms themselves have struggled to keep pace in a rapidly changing operating environment over the last decade, scholars face the challenge of providing a more robust theoretical explanation of firm behavior with respect to the recent wave of law firm mergers. To contribute to this effort, this Article focuses on reputational competition, in particular on three reputational elements that deserve greater emphasis or are absent from the literature. The first element is reputational signaling. (7) This Article posits that law firms are reacting to changes in their operating environment (including deregulation, consolidation of clients, and globalization) which have made the market for legal services more fluid and have increased competition among law firms. As competition is based largely on firms' reputations for quality, elite firms have become desperate to signal their quality to clients and other core constituencies.

The second reputational element is herd behavior. Under conditions of uncertainty and incomplete information, firms that are concerned about their reputational standing may be more likely to engage in defensive mergers based on the actions of other firms. Finally, the third element is the role of first-tier law firms. (8) First-tier law firms are a small group of the most profitable firms that have established reputations for expertise in important areas. The concept of first-tier firms is significant both because it has not been explicitly discussed in the academic literature and because it is the reputational element most readily observable in actual firm behavior. In general, first-tier firms, at least in large domestic markets like the United States, do not pursue a strategy of rapid growth and mergers that might place their high profitability at risk. It is the other elite firms or first-tier firms in smaller markets (like the United Kingdom) that are likely to compete through a growth-by-merger strategy.

The international and comparative aspect of law firm growth and mergers has been largely ignored, (9) despite its potential to shed light on the causes of law firm behavior in the United States. This Article demonstrates that law firm mergers are not a particularly Anglo-American phenomenon driven by aggressive management of law firms as large businesses, but rather also occur in other developed countries. This raises an additional question from a comparative law perspective of whether, in terms of the recent debate in the area of comparative corporate governance, there is a worldwide movement towards convergence to a U.S. or Anglo-Saxon model of the elite law firm or whether local conditions lead to a path-dependent result preventing any such convergence.

Although these are broad issues, the goals of this Article are modest. First, the Article emphasizes reputational competition through an examination of reputational...

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