Private Equity Owners Can Remedy Law Firms’ Agency Issues By Michael Di Gennaro (September 22, 2023) Law firms, like many businesses, are affected by agency problems,  the significance of which depends on law firm size and structure as  well as the relationships between firm stakeholders. An agency problem arises from the separation of ownership and control in a company and is defined as the problem of motivating one party, the  agent, to act on behalf of another — the principal.[1] When principals delegate decision-making authority to agents, there  is the potential for conflicts of interest, where agents prioritize their own interests over those of the principals.[2] One example of an  agency problem is when law firm management, the agent, acts in its own best interest, rather than the best interests of the firm’s shareholders, or principals.[3] Agency problems harm firm employees, firm shareholders and, when serious enough, they  can destroy a law firm. Nonlawyer ownership, or NLO, of law firms, specifically private  equity ownership, could in part remedy law firm corporate governance problems. Unfortunately, the American Bar Association last year reaffirmed its long-standing  opposition to NLO with the adoption of Resolution 402, and two outspoken critics of  loosening law firm ownership rules were just appointed to top roles at the ABA’s Center for  Innovation.[4] Most larger U.S. law firms are structured as limited liability partnerships, with each partner’s  share of the partnership dependent on the amount of their annual business generation and  the size of their book of business.[5] That is, there is disparate ownership of the firm, with decision making left in the hands of  those partners who might be great rainmakers but poor managers. With disparate ownership comes rule by consensus, which often leads to an inability to  rapidly adapt to change, as well as a host of other problems, one of which may be sound  governance of the firm.[6] Academic literature demonstrates that concentrated managerial  equity ownership, as opposed to this disparate traditional ownership model, lends itself to  improved corporate governance by minimizing agency costs.[7] Hence, under the traditional law firm model, management may be more likely to act in its  self interest to the detriment of shareholders by: Diverting client business to their own personal ventures or outside partnerships  resulting in a loss of firm revenue; Awarding themselves excessive compensation packages, skewing profit distributions  and affecting shareholder returns; Engaging in extravagant spending thereby harming firm profitability; Failing to invest in adequate risk management infrastructure or taking excessive  risks — such as engaging in illegal activity or attempting to skirt laws — in order to  reap higher profits with little to no regard for the concomitant increased shareholder  risk; and Limiting transparency and accountability so that they can make important decisions  without consulting or informing shareholders. If serious enough, these behaviors can do more than chicane firm shareholders; they can  precipitate law firm implosions, which, according to Yale Law School professor John D.  Morley, happen with lightning speed relatively to corporations in other industries, in  substantial part due to traditional law firm ownership structures.[8] Readers may be familiar with the spectacular collapse of law firm Dewey & LeBoeuf LLC in  2012. Criminal charges were brought against the firm’s leadership, with the firm’s chief  financial officer, Joel Sanders, convicted of fraud in 2017 for concealing the firm’s financial  difficulties from leading insurers and investors.[9] While several other factors were the principal causes behind Dewey’s collapse, I believe that  this fraud turned what could have been a more orderly exit from the market into a  disastrous one. Private equity ownership may help eliminate some of these agency problems, but NLO has  only been seriously embraced by the states of Arizona and Utah. The ABA’s Model Rule 5.4,  which almost all jurisdictions have elected to adopt, generally requires that legal services be  provided by a law firm that is owned, managed and financed exclusively by lawyers.[10] In August 2020, with the Arizona Supreme Court’s approval of a rule change, Arizona  eliminated ABA rule 5.4. Arizona adopted an Arizona Alternative Business Structures, or  ABS, regime which permits NLO. An ABS is a type of business structure that allows  nonlawyers to own and manage a law firm or participate in the delivery of legal  services.[11] Utah was the first state to permit alternative business structure NLO, but only within the  confines of a controlled regulatory sandbox.[12] Other states are either mulling, or have  contemplated rule changes — e.g., California, Washington, North Carolina and Michigan — but, to date, Arizona is the only state in the union to have completely abrogated ABA Model  Rule 5.4.[13] To that end, in January 2022, Arizona issued an ABS license to Elevate, a law company,  allowing it and its affiliated law firm, Elevate Next, to function as an alternative legal service  provider.[14] This established Elevate as the first integrated law firm in the United States  owned by nonlawyers.[15] There are now scores of licensed ABSs including the prominent  Big Tech alternate legal service provider Axiom[16] and LegalZoom.com Inc., in addition to  Elevate. Arizona’s ABS model requires compliance with specific ownership and management rules as  well as approval from the Arizona Supreme Court. Additionally, nonlawyer owners must  comply with several ethical and professional obligations, including the obligation to prioritize  the interests of clients and maintain the independence of lawyers’ professional judgment. Hence, ideal nonlawyer buyers will be those with adequate managerial, operational and  compliance resources — those that private equity funds can easily possess. With any industry disruption comes an inevitable battle between those that support the  disruption, and those that oppose it,[17] including lawyers with vested interests in limiting  competition in the legal industry. With respect to NLO, proponents cite the potential for the democratization of legal service  delivery by providing underserved populations greater access to affordable legal services.  Additionally, they believe this change could lead to greater innovation in the delivery of  legal services with improved client outcomes.[18] Opponents argue that allowing NLO could compromise the independence of the legal  profession and lead to conflicts