September 3, 2020
By William C. Marra, Investment Manager
When asked how he went bankrupt, one of Ernest Hemingway's memorable characters in "The Sun Also Rises" replied, "Gradually, then suddenly."
The same may soon be said for how the business of law got transformed.
Last week, after years of mounting calls for reform, the Arizona Supreme Court abolished Rule 5.4 of the Arizona Rules of Professional Conduct, which prohibits lawyers from sharing fees with nonlawyers. Rule 5.4 is a relatively obscure ethics rule on the books in every state that has an enormous impact on how lawyers serve clients.
Arizona became the first state to eliminate Rule 5.4. Specially licensed alternative business structures may now allow nonlawyers to share an economic interest in a law firm. Other states may soon follow.
Last month, Utah allowed nonlawyer ownership of law firms on a provisional basis through a regulatory sandbox. California is studying the issue too. More states are certain to join the discussion. The gradual shift in views on Rule 5.4 may soon morph into a sudden change in law's business.
When you eliminate Rule 5.4, you let nonlawyers obtain equity in law firms. Investors can inject capital into law firms similar to how they invest in mom and pop shops, high-flying tech startups, and Fortune 500 companies.
Law firms can recruit nonlawyer managers by giving them an equity interest in the firm's profits. Eventually, law firms might even be publicly traded, alongside Apple Inc. and Amazon.com Inc. in the U.S. — and alongside a number of publicly traded law firms in the U.K.
While the changes concern law firm organizational structure, clients are the biggest winners.
Here are four ways how.
1. Better, Cheaper Legal Services
What's animating the push to abolish Rule 5.4 is the sense that legal services are just too expensive. Chief Justice Robert Brutinel of the Arizona Supreme Court explained that the court eliminated Rule 5.4 to "promote business innovation in providing legal services at affordable prices."
A Utah working group report that endorsed changes to Rule 5.4 similarly emphasized an access-to-justice gap in the U.S., which ranks 99th out of 126 nations in terms of access and affordability of civil legal services.
Eliminating Rule 5.4 should drive prices down and quality up, benefiting consumers. It should increase innovation, by giving world-class entrepreneurs and managers greater financial incentives to bring their creativity and experience to the legal world.
And more players in the legal space means more competition, which should lead to better, more efficient and cheaper ways of delivering high-quality legal services for clients.
2. A More Client-Focused Law Firm Structure
Today, law firms are partnerships, not corporations. This encourages focus on the short term rather than the long term, and focus on the billable hour over client-friendly alternative fee arrangements.
For partners, there's an incentive to maximize revenue today rather than build equity value for the long haul. After all, when a partner retires, she can't take her equity with her the same way an employee-shareholder of a company can.
Meanwhile, law firm associates don't own stock in their employer, the way employees at traditional companies are often given stock or options that better align their incentives with long-term growth.
Allowing law firms to have a more traditional capital structure should benefit clients in at least two ways.
First, eliminating Rule 5.4 should better allow firms to use equity rather than debt financing, have true research and development budgets, and invest in long-term projects that can meaningfully improve legal services — even if this hurts that gilded metric, profits per partner, in the short run. This should also help law firms compete with the Big Four accounting firms and other alternative legal service providers that already have traditional capital structures more conducive to long-term planning.
Second, law firms would be better equipped to deliver alternative fee arrangements, like contingent fee arrangements, that clients love. Alternative fee arrangements may not maximize year-end profits, but they can maximize profitability over the long term, both because taking the right cases on contingency increases a firm's realization rates, and because alternative fee arrangements strengthen client loyalty.
3. More Tech-Enabled Law Firms
The Utah working group report on Rule 5.4 concluded that "the elimination or substantial relaxation of Rule 5.4 [is] key to allowing lawyers to fully and comfortably participate in the technological revolution." Eliminating Rule 5.4 should accelerate technology's ability to improve clients' access to legal services.
First, existing tech companies and entrepreneurs would have greater incentive to enter and innovate in the legal field, given the larger financial rewards available to them.
Second, law firms with traditional capital structures would be better equipped to make investments in technology that might diminish profits in the short run, but increase profitability and impact in the long run. And clients should benefit from increased access to tech-enabled legal services.
4. A Win for Litigation Finance
The growth of litigation finance and the elimination of Rule 5.4 proceed from the same assumption: giving lawyers and claimholders better access to third-party capital will improve access to justice. If clients suffer from Rule 5.4's prohibition against third-part investments in law firms, it follows that clients benefit from expanded access to third-party litigation finance.
Moreover, critics of litigation finance sometimes argue that funding agreements between funders and law firms violate Rule 5.4 and impair attorney independence. Funders and practitioners have long responded that Rule 5.4 is not necessary to preserve attorney independence because various other ethics rules separately demand that independence.
These arguments are now accepted to the point where Rule 5.4 is even being eliminated entirely. An Arizona working group that endorsed the elimination of Rule 5.4 emphasized that abrogating the rule "will not remove protection afforded a lawyer's professional independence and the public" because other ethics rules already guarantee those protections.
Indeed, the Arizona Supreme Court explained that eliminating Rule 5.4 should further the purposes of the ethics rules because "lawyers have an ethical obligation to assure that legal services are available to the public," and if rules like Rule 5.4 "stand in the way of making those services available, the rules should change." That change will benefit clients above all.
This article was originally published in Law360, September 3, 2020.