Incorporation Of Legal Practices And Strategic Alliances – A Practitioners Perspective

INTRODUCTION

This paper is being delivered in the context of “New Directions for Your Legal Practice” and looks at the incorporation of legal practices and strategic alliances as being a part of that “new” direction.

However, neither the idea of incorporation of legal practices nor that of forming strategic alliances are exactly “new”.  It has, for example, been possible since 1 July 2001 [1] to incorporate a legal practice.  At the time of the enactment of the 2000 amending Act however, it was indeed a new concept and a world first.

The 2000 amending Act inserted Part 3 Division 2 sections 47A to 47T into the Legal Profession Act, 1987 (“the Old Act”) and for the first time introduced the concept of the “solicitor director”2. Only those holding an unrestricted practicing certificate were eligible to become a solicitor director[2].

Much has since been written on the topic of incorporated legal practices[3].

INCORPORATION – THE LEGISLATION

The “Old Act”

The Old Act introduced an extensive regime of obligations and duties for solicitor directors including those referred to below and opened the door for incorporated legal practices to engage in businesses other than that traditionally undertaken of simply providing legal services.

A brief examination of some only, of those provisions is appropriate at this point.

Under the Old Act, any corporation was eligible to be an incorporated legal practice[4]. subject to at least one solicitor being a solicitor director [5]. and the solicitor director being responsible to ensure that appropriate management systems were implemented for the provision of legal services[6].

Failure by the solicitor director to ensure that appropriate management systems were implemented and maintained for the provision of legal services constituted professional misconduct[7].

Further, a solicitor director was also guilty of professional misconduct if he/she failed to report the conduct of another director [not necessarily another “solicitor director”] that “… resulted or was likely to result in a contravention of those obligations …” or any professional misconduct of an employed solicitor of the practice [8]. to the Law Society Council promptly after becoming aware of such conduct.

An incorporated legal practice was required by Section 47C (1) of the Old Act to provide legal services but was also permitted to by section 47C (2) to provide “… any other service and conduct any other business …” which a corporation could lawfully engage in.

Corporations however which did not receive or expect to receive any form of fee, gain or reward for legal services provided or in which the only legal services provided were in-house services were excluded from the operation of the Act [9].

Solicitor directors remained subject to the solicitors rules as did solicitors employed in the incorporated practice [10]. and also remained subject to the professional obligations (including client or other professional privilege) of a solicitor [11].

The Old Act also addressed many potentially anomalous issues concerning the application of certain other parts of the Old Act to the new incorporated legal practice by the enactment of such provisions as section 47I (advertising and disclosure with respect to legal services), section 47K (Indemnity Insurance) and section 47L (Trust Accounts) and others.

In addition, section 47S provided that the provisions of the Old Act and the regulations under it prevailed to the extent of any inconsistency between it and the Corporations Law.

The “New Act”

The Legal Profession Act, 2004 commenced on 1 October 2005. (“the New Act”).

Chapter 2 Part 2.6 Divisions 1 and 2 of the New Act comprise sections 132 to 182 inclusive and to a substantial degree reflect many of the provisions of the Old Act.

One of the most apparent changes is that the draftsmen of the New Act have used language which embraces the move towards a national mutual recognition regime’.

In keeping with the national “travelling practising certificate” scheme adopted by all States and Territories [12]. (and originally found at section 48Q of the Old Act), the New Act uses terms such as  “Australian legal practitioner”, “Australian-registered foreign lawyer” and “Australian practising certificate [13].

The New Act also now refers to the “legal practitioner director” rather than the old “solicitor director” and “legal practitioner partner” which means “… a partner in a multi-disciplinary partnership who is an Australian legal practitioner holding an unrestricted practising certificate.” [14].

An entirely novel and potentially far reaching requirement of the New Act is that requiring a corporation to give written notice in the prescribed form to the Law Society of its intention to engage in legal practice in the State before it can commence to practice [15].

Failure to comply with this requirement may not only attract a maximum 50 penalty units fine [16]., but the corporation will remain in default of section 137 until it complies with the requirements of the section and gives the prescribed notice to the Law Society [17].  Further any fees paid by a client of the corporation or a legal practitioner associate of the corporation during the default period may be recovered by the client as a debt due and payable [18].

It would appear that section 137 does not apply to practices which incorporated under the provisions of the Old Act as such incorporated legal practices would have started providing legal services prior to the commencement of the New Act.

Substantial fines may also be imposed on a corporation [19]. as well as any director, officer, employee or agent [20]. of that corporation which, without reasonable cause, holds itself/themselves out as being incorporated legal practices without having first complied with the provisions of section 137(1).

The provisions of the New Act are substantially broader and have consequences that are more far reaching than those which the Old Act first introduced with the concept of the incorporated legal practice nearly half a decade ago.

In addition to those provisions of the New Act which are referred to above, in common with the Old Act, it also addresses issues such as the application of requirements for professional indemnity insurance (section 144), conflict of interest (section 145), advertising by incorporated legal practices (section 149), vicarious liability of an incorporated legal practice (section 150), the application of the solicitors rules and a range of other considerations.

Clearly, any practitioners contemplating incorporation would do well to carefully consider the provisions of Chapter 2 Part 2.6 Divisions 1 and 2 of the New Act before jumping in.

STRUCTURES

Traditionally, legal practices have either been conducted by a sole principal or as a partnership.  Lawyers have been slow to move from these forms of conducting their business notwithstanding that other professionals, such as accountants, may have done so.

In the approximately 5 years since the option of incorporation of legal practices first became available to legal practitioners, the concept of the incorporated legal practice has not been broadly embraced by lawyers.  According to the Law Society of New South Wales there are currently 4,256 legal practices operating in the State.  Of that number only 598 are incorporated legal practices.

Clearly incorporation is not for every legal practice so then, what are the advantages and disadvantages of incorporating your legal practice?

ADVANTAGES / DISADVANTAGES

 So why incorporate?  Predictably, there are of course a range of advantages and disadvantages.

The advantages include:

  • the ability to attract a range of expertise to the board of directors;
  • diversity of activities creating greater profits;
  • shares and employee incentive schemes;
  • improved flexibility and borrowing capacity;
  • taxation and other financial advantages;
  • limited liability for key stakeholders;
  • improved management through a modern corporate business structure and client perception.

Diverse board of directors

The New Act requires that at least one of the directors of the incorporated legal practice is to be a solicitor [21]. who is also the holder of an unrestricted practising certificate.  Accordingly, it would be possible for directors to be appointed to the boards of incorporated legal practices who bring with them a broad range of skills, expertise and talents extending beyond those normally available in traditional legal practice.  Subject to such persons not being either unsuitable [22]. or  disqualified persons [23]. they could conceivably enhance the profit margins of the practices by the introduction of their particular skill sets.

It may be possible therefore for the board of directors to include financial, marketing and other experts to provide appropriate guidance to the corporation and to assist its growth, development and profitability.

Diversity of activities

It remains the case that under the New Act any corporation will be eligible to be an incorporated legal practice [24].  Accordingly, an incorporated legal practice may also engage in activities other than the provision of legal services.

Understandably, an incorporated legal practice which only provides legal services is not affected by the disclosure obligations imposed by the New Act 25[25].

However where an incorporated legal practice also provides services that a

…person might reasonably assume to be legal services …” then each practitioner director and any employee solicitor who provides such services on behalf of the practice must make the disclosure in accordance with section 146 (3) [26].

The test of the person (consumer) who “reasonably assumes” that the services being provided to him/her are legal services is an interesting one.  For example, would a reasonable person be entitled to presume that engaging the commercial recovery section of an incorporated legal practice to recover a debt due to that person was an engagement to provide a legal service or a “non-legal” service?

The New Act also requires that the disclosure to be made must state that the Act applies to the provision of legal services but does not however apply to the provision of non-legal services.

Accordingly, the corporation may, subject to meeting any licensing or regulatory requirements in respect of the proposed activity, also conduct a range of businesses including those of a real estate agent, financial advisor, accountant or   flower seller or any other activity which the corporation may lawfully engage in.

Shares and employee incentive schemes

A company limited by shares is the most common structure chosen by businesses to conduct their particular business activity.

In this form of structure, partners no longer own part or all of the legal practice but shares in the company which owns the practice.  These shares may appreciate in value as the company increases profits and grows.

The highly flexible nature of shares and other securities allows for example, for varying classes of shares to be issued to build employee incentive schemes which may be attractive for retaining non-legal employees and to accommodate the interests of the former partners who may not necessarily become directors.

Different classes of shares may be created to provide for payment of different dividends to the holders of shares in each class.  Such shares may include non-voting shares where it is decided that it was not desirable for certain classes of shareholders to have voting rights.

Such incentive schemes may also be subject to pre-emptive rights or buy back arrangements which reflect the value of the shares at the relevant time.  Share options may also be a method of rewarding directors and senior lawyers and at the same time be beneficial to the company.

The company structure is also far more flexible when considering the retirement of existing partners or the admission of new partners than the partnership structure.

An issue of new shares or the transfer of shares to an incoming partner will be a far simpler procedure than admitting a new equity partner under the old partnership model.

Under the “usual” partnership structure, partners who terminate their interest in the partnership on retiring from practice are unable to participate in any subsequent benefits that may be generated by the partnership as a consequence of investment of capital made by them in the past.

In a corporate structure however, retiring partners may retain an interest in the practice by continuing to hold their shares thereby encouraging longer term investment in the company.

Alternatively, if this is not a desired outcome, retiring directors’ shareholdings may be subject to pre-emptive rights or buy back provisions thereby making their shareholding available to incoming “partners”.

Raising capital

Raising equity capital for expansion into new activities or locations and for funds to acquire new equipment or technology would be more readily undertaken than may otherwise be the case in a partnership structure.

So too with raising debt capital which may be achieved by granting security over the corporation’s assets or by way of bills of exchange, unsecured debentures and the like.

Larger and more profitable incorporated legal practices may consider floating the company in order to maximise capital investment.  This may also give rise to take over bids in cases where the corporation becomes an attractive target to rival incorporated legal practices or to other corporations wanting to acquire an incorporated legal practice.

Taxation and other financial benefits

Corporate tax rates are still more attractive than the top marginal tax rate for individuals.

Unlike a partnership, a corporation is able to retain profits, which of course is a further means of raising capital which is not available to a partnership.

Partners in a partnership structure wishing (or indeed, needing) to contribute part of their annual profit to fund expansion of the practice can only make such contributions out of after tax profits, taxed more likely than not at the top marginal rate.

A corporation on the other hand may retain profits for such a purpose.  These profits are taxed at the corporate tax rate of 30%.  Therefore an additional 18.5% (inclusive of the Medicare levy) of the profits retained will be available to the incorporated practice for as long as the sum is retained by the company.

To the extent that financial disclosure may be an issue, it is worth mentioning that Partnerships are not required to make any form of financial disclosure or to make any such information available to the public.

Corporations laws however, require certain categories of companies (namely companies with 50 or more shareholders, or proprietary companies which meet two of the following three tests, i.e. a turnover in excess of $10 million per annum; $5 million or more in assets; or fifty or more employees) to be audited and to file their financial statements with the Australian Securities and Investment Commission thereby making such financial details available to the public.

However, little if any sensitive commercial information is actually required to be disclosed in meeting these obligations.

Disclosure of profit and loss statements will not necessarily give an accurate reflection of actual profits as for example, salaries paid are not required to be to be separated between principals and other employees (unless such principals are also directors).

Competitors may gain some information as to the company’s solvency and the resources available to fund development and the like but this is not likely to be of any significant commercial sensitivity.

Mechanisms, such as the use of a holding company structure may be used in order to minimise disclosure.

Limited liability of key stakeholders

As a sole principal or in a partnership, the personal assets of the key stakeholders are generally at risk from attack by creditors.

In a partnership in particular, as the liability of partners is joint and several, the personal assets of partners may be at risk from the actions or inactions of each other as well as being accessible by creditors.

A significant advantage of incorporation is that of limited liability which, in the ordinary course limits a shareholder’s liability to their investment in the shares of the company.

Creditors and others will only have access to the assets of the company and not the personal assets of shareholders, subject of course to the insolvent trading provisions of the Corporations Act, director’s guarantees given to trade creditors and the like which may affect this position.

Improved management through a modern corporate business structure and client perception.

The benefits of operating through a company structure broadly reflect a more modern, efficient and cost effective form of enterprise.

The company structure may be perceived as being a more “business-like” structure in which the lawyers will be encouraged to take a more business-like approach to their role in the company thereby leading to happier clients, a more enjoyable workplace and hopefully, greater profits.

The company structure lends itself to the defining of the roles of the various partners.  Not every partner for example may be a director of the company.  Some partners while being shareholders in the company, may become managers of their particular group of employees or a division within the company operation.  Others, the legal practitioner directors referred to above, will be members of the board of directors.

As for client perception, this may be difficult to gauge however, generally speaking clients do not seek out businesses which are not conducted by companies in order to do business with them.  In fact the converse may well be true.

From a practical standpoint, lawyers (whether they are employees of a corporation, partners or sole practitioners) have to meet stringent regulatory, ethical and financial obligations in the conduct of their practices.  These obligations are not reduced or diminished by the introduction of the New Act.

The disadvantages include:

  • the onerous nature of the regulatory framework;
  • some taxation and related concerns;
  • perception of partners and senior lawyers;
  • other issues

 Onerous nature of the regulatory framework

 The New Act establishes a regime’ which carries with it significant penalties for non-compliance.

As indicated earlier in this paper practitioners considering incorporation of their practice should be aware of the following:

  • before a corporation can start to engage in legal practice in the State it must give written notice in the prescribed form to the Law Society of its intention to commence its operation [27].  Engaging in practice without having provided the necessary notification attracts at maximum penalty of 50 penalty units [28].
  • a corporation which represents or advertises that it is an incorporated legal practice without first having provided the section 137 notice could attract a maximum penalty of 500 penalty units [29].  In addition, an individual, i.e. a director, officer, employee or agent who makes such representations or advertisements in breach of  Section 137 (1) may incur a maximum penalty of 100 penalty units [30].
  • there is also the obligation on each legal practitioner director to implement and maintain “appropriate management systems[31]. for the delivery of legal services.  This obligation extends to the acts of other Australian legal practitioners who are officers or employees of the incorporated legal practice as well as to other non-lawyer officers and employees of the practice.  Although the term “appropriate management systems” is not defined some helpful information on appropriate management systems and a list of “ten commandments” may be found on the website of the Office of the Legal Services Commissioner (www.lawlink.nsw.gov.au/olsc).  The “ten commandments” developed by the Office of the Legal  Services

Commissioner are intended to accommodate both large and small incorporated legal practices without significant expense to, or restructuring of, the practice.

  • A legal practitioner director is capable of being found to have engaged in unsatisfactory professional conduct or professional misconduct for the conduct (or misconduct) of an Australian legal practitioner employed in the practice or for the conduct of any other non-lawyer director (not being an Australian legal practitioner) which adversely affects the provision of legal services by the practice and also for the unsuitability of any other non-lawyer director for the position of director [32].  In addition a legal practitioner director has a positive obligation to ensure the all reasonable action is taken to address and remedy any of the foregoing [33].
  • An incorporated legal practice and its directors and other officers are also clearly subject to the provisions of the Corporations Act relating to the duties and obligations imposed by that Act on officers of corporations.  The activities of the corporation (to the extent that they are not already affected) will also fall under provisions of the Trade Practices Act.

Some taxation and related concerns

Capital Gains Tax (CGT) may be a significant concern for practitioners considering incorporation.

Notwithstanding that the business of the practice may be transferred to the new incorporated entity for no consideration, CGT may itself remain an issue.  A transfer of this nature may be deemed to be not at arms length and therefore deemed to be a transfer at market value for CGT purposes.  A significant CGT liability may therefore arise.

The CGT roll-over provisions will provide some relief however, it will be necessary for all of the partners in the practice to choose to obtain the roll-over relief.  Further, the only consideration which those partners may receive for the transfer of their interest in the partnership, are non-redeemable shares in the new incorporated entity.  The incorporated legal practice will also have to assume all the liabilities of the old practice.

These shares must be held by the former partners in their own right and not by their spouse or a family trust.

Different considerations apply in respect of pre-CGT interests which may preserve their pre-CGT status.

Payroll tax may be an issue where the corporation’s monthly salary and wages bill exceeds $50,000.00.

Whereas partners drawings and profit shares are not included with salaries and wages for payroll tax purposes, under the new incorporated structure, the partners will be employees of the company and will therefore be receiving salaries which will be taken into account for payroll tax purposes.

Similarly with the superannuation guarantee surcharge, partners salaries will be subject to this surcharge in the new incorporated entity.

As employees, former partners salaries will also be subject to inclusion in the company’s salaries and wages figures for the calculation of workers compensation insurance premiums.

It may be the case that substantial increases in expenses for payroll tax, the superannuation surcharge and workers compensation premiums may result from becoming an incorporated legal practice.

Perception of partners and senior lawyers

In the new incorporated structure former partners become employees of the incorporated legal practice.  Some may perceive this as a reduction in their status particularly if they do not also become members of the board of directors.

Senior employed solicitors who aspire to partnership status may also feel that their prospects for recognition and advancement in the organisation have been reduced.

Some of these effects may be overcome or reduced by the use of the staff incentive schemes referred to above.

Other issues

 

Floating the incorporated legal practice may expose it to the possibility of a takeover.  This may result in a sense of insecurity for employees who perceive that their positions with the company may be in danger should a takeover occur.

Further, in the event of the liquidation of the incorporated practice it will cease to exist and it assets will be distributed.  The liquidator will also be in the position to deal as he thinks appropriate with name of the corporation.

These may be issues of concern to practitioners who are currently contemplating incorporation.

STRATEGIC ALLIANCES

 

Sections 165 to 182 of the New Act deal with multi-disciplinary partnerships (MDPs).

So what are MDPs?

Section 165(1) of the Legal Profession Act, 2004 (the New Act”) defines an MDP as follows:-

A multi-disciplinary partnership is a partnership between one or more Australian legal practitioners and one or more other persons who are not Australian legal practitioners, where the business of the partnership includes the provision of legal services in this jurisdiction as well as other services

In effect, an Australian legal practitioner may now form an MDP with other persons in much the same way as incorporated legal practices can include other non-legal activities in their field of operation provided that the provision of legal services forms part of the business undertaking of the partnership.

For the purposes of the New Act, a partnership between one or more Australian legal practitioners and one or more Australian-registered foreign lawyers in not an MDP [34]. nor is a complying community legal centre [35].

Australian legal practitioners who are not employed by an incorporated legal practice but choose instead to practice either as sole practitioners or in partnership may therefore form an MDP.

Section 167 imposes on a legal practitioner partner the obligation to give similar notice provisions to those affecting incorporated legal practices under section 137 of the New Act.  A maximum penalty of 50 penalty units in default may apply.

Each legal practitioner partner in an MDP is also responsible for the management of the provision of legal services in an MDP and to ensure that “appropriate management systems” are implemented and maintained [36].

Similar disclosure obligations are found in section 173, to those imposed on incorporated legal practices by section 146 of the New Act.

Section 170 makes it clear that a partner in an MDP who is not an Australian legal practitioner does not contravene the Act, the regulations or the professional rules because he/she is a member of a partnership which:-

  • includes the provision of legal services in its business enterprise;
  • pays or provides any fee, gain or reward from the MDP that includes the business of an Australian legal practitioner;
  • holds himself/herself out as a member of an MDP which services include the provision of legal services; and
  • shares with any other partner the receipts, revenue or other income of the partnership which includes the business of an Australian legal practitioner.

Issues such as the application of the legal profession rules (section 175), requirements relating to advertising (section 176), the sharing of receipts from an MDP (section 177) and undue influence (section 180) are also addressed.

An MDP may comprise a combination of any of the following:-

  • solicitor/accountant;
  • solicitor/accountant/financial advisor;
  • solicitor/accountant/real estate agent;
  • commercial solicitor/mediator;
  • family solicitor/counsellor/mediator;
  • solicitor/town planner/surveyor;
  • solicitor/migration agent/ travel agent;
  • solicitor/migration agent/interpretation service;
  • solicitor/building inspector/pest controller.

The combinations are limited only by the imaginations of the partners, the Act and the regulations.

So is an MDP also a strategic alliance?

It would be reasonable to suppose that the partners of an MDP intend to remain in partnership indefinitely and to pool their endeavours for the general advancement of the whole enterprise (viz: the MDP).

On the other hand a strategic alliance may be created for a single purpose, such as a particular tender for the provision of certain services (including legal services) to government or for some other venture.  Each member of the alliance remains separate and distinct and comes together with the other member(s) of the alliance for the particular venture or undertaking.

In essence the client (or prospective client) is offered a panel of service providers who may be called on to provide their particular services or skills on an “as needed” basis during the life of the particular enterprise.

No pooling of fees, receipts or income is necessary as each member of the alliance remains distinct.  As with an MDP however, the combination of skills is almost unlimited thereby providing great flexibility to meet the particular requirement at hand.  Further, the members of a strategic alliance may vary from enterprise to enterprise.

An example of this may be seen in the “team” model of collaborative practice where, in a family law collaborative matter, the client may be offered a team of collaborative professionals comprising the lawyer, an accountant, a counsellor and a child expert.  Similarly, in a commercial collaborative matter the team may comprise the lawyer, a town planner and an environmental consultant.

Conclusion

 

It is clear from the number of practices (only 598) that have chosen to incorporate that incorporation is not perceived by practitioners as being a “must do”.

Some writers are critical of incorporation and take the view that many of the “advantages” of incorporation can be achieved through other means or that other priorities should take precedence over certain of those advantages.

The New Act also creates a regulatory regime’ which will enable sole practitioners and partnerships to engage in MDPs to achieve some of the advantages available from the diversity available to an incorporated legal practices.

Some may choose the even more flexible structure of a strategic alliance along the lines of that described above.

The form of the structure through which lawyers choose to provide their services may not be a matter of particular interest to the public at large.  The principal concern for lawyers and the public is more likely to be the level of service provided, that service being based on sound knowledge, high professional standards and ethical practice.

At the end of the day, it will be the practitioners themselves who will decide.  For some no doubt, incorporation will be seen to have some real advantages and for other, not.

Delivered by Robert Lopich at a CLE Seminar on Tuesday, 22 August 2006.  For further information contact the author by email at:-          [email protected] ]

 

 


[1] Legal Profession Amendment (Incorporated Legal Practices) Act, 2000

[2] section 47B

[3] refer (2001)39(2) LSJ 46; (2001) 39(7) LSJ 26; (2001) 39(9) LSJ 49; (2002) 40(5) LSJ 50 and (2006) 44(3) LSJ 48 to name but a few.  

[4] section 47D(1)

[5] section 47E(1)

[6] section 47E(2)

[7] section 47E(3)(a)

[8] section 47E(3) (b) and (c)

[9] section 47C(3)(a) and (b)

[10] section 47G(1)

[11] section 47H(1) and (3)

[12] eg: section 55 Legal Practices Act, 1996 (Vic) and section 47 Legal Profession Act, 2004 (QLD)

[13] section 4

[14] section 133

[15] section 137(1)

[16] section 137(2)

[17] section 137(3)

[18] section 137(6)

[19] section 138(1)

[20] section 138(2)

[21] section 140(1)

[22] section 141(1)(c)

[23] section 152(1)

[24] section 136(1)

[25] section 146(1)

[26] section 146(2)

[27] section 137(1)

[28] section 137(2)

[29] section 138(1)

[30] section 138(2)

[31] section 140(2) and (3)

[32] section 141(1)

[33] section 141(2)

[34] section 165(1)

[35] section 165(2) and (3)

[36] section 168(1) and (2)

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