Private Equity Owners Can Remedy Law Firms’ Agency Issues

Posted on October 2, 2023 by Tom Lenfestey

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 of interest. Moreover, they aver that a primary focus on profits could diminish legal service quality or result in un-ethical behavior by nonlawyer owners.

Given that ABS is in its infancy in the U.S., and NLO in other parts of the world has been relatively brief, there is limited data from which rigorous peer-reviewed social science research can be produced that supports the above proponent and opponent arguments.

However, Stanford Law School’s Rhode Center on the Legal Profession compiled a report on the results of alternative business structure NLO reforms in both Arizona and Utah, the findings of which strongly support proponent arguments, in terms of increased legal industry innovation and improved access to justice.[19]

The report also found that there were few reported complaints against service providers in Arizona and Utah.[20] With respect to ethical conduct of lawyer ownership versus NLO, the idea that NLO will engage in unethical behavior to any greater extent than lawyer owners is haughty, self-serving and simply preposterous.

The California State Bar recently suspended more than 1,600 attorneys for violating Client Trust Account Protection Program rules, established in response to allegations that Los Angeles attorney Thomas Girardi stole millions of dollars from his clients.[21]

Earlier in the year, the Louisiana Insurance Commissioner slapped McClenny Moseley & Associates and three of its partners with $2 million in fines, the maximum amount allowed by law, for perpetrating an illegal insurance scheme.[22]

U.S. District Judge P. Kevin Castel of the U.S. District Court for the Southern District of New York also observed a scenario of both lawyers and their firm acting unethically and providing poor service, stating Levidow, Levidow & Oberman PC “abandoned their responsibilities when they submitted nonexistent judicial opinions with fake quotes and citations created by the artificial intelligence tool ChatGPT, then continued to stand by the fake opinions after judicial orders called their existence into question.”[23]

Lawyers can, have, and do provide poor legal service in a variety of ways including, for example, double billing, padding hours, charging for extensive overhead expenses, and charging high bill rates for trivial tasks.[24] The reader should at least look on NLO opponent arguments with healthy skepticism.

Private equity ownership of law firms may remedy firm ethics and conflict of interest challenges that rob shareholders and destroy firms (which in turn hurts clients by eliminating competition).

Duke Law Professor Elisabeth De Fontenay states, “Private equity’s original purpose was to optimize companies’ governance and operations. Reuniting ownership and control in corporate America … undoubtedly helped reform management practices in a broad swath of U.S. companies.”[25]

By playing an active role in managing and operating the companies in which they invest, private equity investors leverage their expertise, experience and resources to enhance the business’s performance and value, aiming to align management’s interests with those of the shareholders.

The introduction of performance-based incentive systems and equity ownership plans for a management team aligns the managers’ interests with those of the shareholders. For instance, a private equity fund might sponsor a long-term incentive plan in their portfolio companies — in this case law firms.

A private-equity-owned law firm’s long-term incentive plan might use clawback provisions where management participants would be required to pay back all or some of awards already received under the plan,[26] such as shares transferred on the vesting of a long term incentive plan award.[27]

Such a provision would be a serious disincentive to engage in managerial misconduct or to misstate law firm financials.[28] By bringing operational expertise and strategic guidance to companies in which they invest, private equity funds identify inefficiencies, implement superior management practices, and provide resources for growth initiatives with the goal of enhancing corporate performance, ultimately increasing shareholder value.[29]

Private equity investors frequently adopt a long-term investment perspective that helps shift managerial focus toward sustainable value creation rather than short-term gains.[30] By promoting a strategic and sustainable approach, private equity investors seek to maximize long-term shareholder value.

De Fontenay notes that with respect to private equity’s takeover of public companies, there are few gains left to be had from corporate governance reform. I believe there are significant gains to be had reforming law firm corporate governance. Note that I do not view private equity ownership of law firms as a panacea for all the corporate governance challenges that law firms face, and private equity ownership of corporations has of course seen both successes and failures.

Again, Arizona and Utah are the only states to have made significant inroads into NLO, and hence offer contained proving grounds for the results of direct private equity ownership of law firms. Additionally, those wary of private equity should gain comfort that private equity’s NLO would likely be selective and limited, even if other states were to remove their barriers to NLO.[31]

I believe that easily scalable, somewhat commoditized practices that promise rich returns on investment to private equity’s process rationalization and efficiency enhancement will be the primary targets of private equity NLO.

These will include practices that: 1) do not require highly specialized legal talent possessed by only a small number of lawyers, 2) can easily acquire clients through scalable technology-based marketing in multiple geographies and jurisdictions and 3) can rely on remote talent and nonlawyer legal professionals to perform a lot of the heavy lifting in the delivery of legal services.

Several practices that are transactional or regulatory in nature, especially where federal law controls, such as immigration and employment law, or consumer practices that generally have high case settlement rates not requiring specialized, courtroom-intensive litigation, such as high-volume personal injury practices, meet these criteria.

European private equity, which has been in the law firm acquisition game for some time, now has focused on these practices[32] as well as insurance, health care and intellectual property practices.[33] Since these practices are scalable, private equity will likely challenge the barriers of U.S. states opposed to NLO to acquire them.

Whatever position you take on NLO, private equity firms have a track record of remedying agency and corporate governance problems at companies in other industries. While I am by no means a private equity cheerleader, nor do I see private equity NLO as a cure-all for poor law firm corporate governance, I believe private equity’s ability to own law firms will have net beneficial results for law firm shareholders, and other victims of law firm corporate governance problems.

Michael Jude Di Gennaro is the director of strategy and business development at The Law Practice Exchange LLC. He previously worked as an attorney at the Board of Governors of the Federal Reserve System.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Sean Ross, “How Do Modern Corporations Deal With Agency Problems?”, Investopedia, BUSINESS ESSENTIALS (Dec. 26, 2022), available

at: https://www.investopedia.com/ask/answers/041015/how-do-modern-corporations-deal agency-problems.asp.

[2] Fernando Turrado García, Ana Lucila Sandoval Orozco, M. Pilar García Pineda, and Luis Javier García Villalba, Agency Theory: Forecasting Agent Remuneration at Insurance Companies, 215 EXPERT SYSTEMS WITH APPLICATIONS (April 1, 2023), 119340, available at: https://doi.org/10.1016/j.eswa.2022.119340.

[3] Mike Wright, Kevin Amess, Charlie Weir, and Sourafel Girma, “Private Equity and Corporate Governance: Retrospect and Prospect,” Corporate Governance: An International Review 17, no. 3 (2009): 353–375.*, available

at: https://iri.hse.ru/data/984/481/1225/Oct%2021%20Private%20Equity.pdf.

[4] Sam Skolnik, “Firm Ownership Debate Rages Amid ABA Innovation Leader Change-Up,” Bloomberg Law (Aug. 25, 2023), available at: https://news.bloomberglaw.com/business and-practice/firm-ownership-debate-rages-amid-aba-innovation-leader-change-up.

[5] James Goodnow, “Is The Problem With Partnerships The Partnership? How permanent equity in firms might change the face of law for the better,” Above The Law (July 15, 2022, 10:48 AM), https://abovethelaw.com/2022/07/is-the-problem-with-partnerships-the partnership/.

[6] Angela Tufvesson, Is the Partnership Model in Decline?, Law Society Journal (Mar. 7,

2023), available at: https://lsj.com.au/articles/is-the-partnership-model-in-decline/.

[7]Jorge Andrés Muñoz Mendoza, Sandra María Sepúlveda Yelpo, Carmen Lissette Veloso Ramos, Carlos Leandro Delgado Fuentealba, Monitoring and Managerial Discretion Effects on Agency Costs: Evidence from an Emerging Economy, Braz. Adm. Rev. 18 (1) • 2021, available at: https://doi.org/10.1590/1807-7692bar2021190112.

[8] Morley, John D., Why Law Firms Collapse (Jan. 20, 2020). Yale Law & Economics Research Paper No. 521, 75 The Business Lawyer 1399 (2020), available at SSRN: https://ssrn.com/abstract=2580616 or http://dx.doi.org/10.2139/ssrn.2580616.

[9] Scott Flaherty, “Dewey & LeBoeuf Trial Ends in Guilty Verdict for Sanders; DiCarmine Cleared,” LAW.COM (May 8, 2017, 4:38 PM), available

at: https://www.law.com/2017/05/08/dewey-dicarmine-cleared/.

[10] MODEL RULES OF PRO. CONDUCT r. 5.4 (AM. BAR ASS’N 2020), available at: https://www.americanbar.org/groups/professional_responsibility/publications/model_rul es_of_professional_conduct/rule_5_

4_professional_independence_of_a_lawyer/.

[11] Ariz. Code of Jud. Admin. Pt. 7, Ch. 2, § 7-209 (2022), available at https://www.azcourts.gov/Portals/0/admcode/pdfcurrentcode/7-

209%20Amended%207_13_22.pdf?ver=U0e16ry0d6dSkHPeGBdgng%3d%3d.

[12] The Office of Legal Services Innovation, Utah Supreme Court – Sandbox Program, at https://utahinnovationoffice.org/sandbox/interested/.

[13] C. Thea Pitzen, Can Nonlawyers Close the Legal Services Gap?, Litigation News, Vol. 46, No. 2 (Winter 2021), 11-13, American Bar Association Litigation Section (2022), available

at https://www.americanbar.org/groups/gpsolo/publications/gpsolo_ereport/2022/april 2022/can-nonlawyers-close-legal-services-gap-two-states-remove-ban-fee-sharing partnerships-nonlawyers/.

[14] Dylan Jackson, “Arizona Green Lights Combined Elevate Entity as Its First Nonlawyer Owned Law Firm”, The American Lawyer (Jan. 13, 2022, 2:18 PM), available at: https://www.law.com/international-edition/2022/01/13/arizona-green-lights-combined elevate-entity-as-its-first-nonlawyer-owned-law-firm-378-186515/.

[15] Madeline Anderson, “Elevate celebrates US first as it is granted ownership of its affiliated law firm”, The Global Legal Post, (Jan. 14, 2022), available

at https://www.globallegalpost.com/news/elevate-celebrates-us-first-as-it-is-granted ownership-of-its-affiliated-law-firm-1330479538.

[16] Bob Ambrogi, “ALSP Axiom Opens Law Firm in Arizona Under Alternative Business Structure License”, LawSites (Jan. 23, 2023), available

at https://www.lawnext.com/2023/01/alsp-axiom-opens-law-firm-in-arizona-under alternative-business-structure-license.html.

[17] Younger, Stephen P., The Pitfalls and False Promises of Nonlawyer Ownership of Law Firms, The Yale L. J. vol. 132, 2022-2023, available

at: https://www.yalelawjournal.org/forum/the-pitfalls-and-false-promises-of-nonlawyer ownership-of-law-firms.

[18] Saavedra Teuton, Robert, One Small Step and a Giant Leap: Comparing Washington, D.C.’s Rule 5.4 with Arizona’s Rule 5.4 Abolition, 65 Ariz. L. Rev. 223 (2023), available at: https://arizonalawreview.org/pdf/65-1/65arizlrev223.pdf.

[19] David Freeman Engstrom, Lucy Ricca, Graham Ambrose, and Maddie Walsh, “Legal Innovation After Reform: EVIDENCE FROM REGULATORY CHANGE”, Deborah L Rhode Center on the Legal Profession, Stanford Law School (Sept. 2022), available

at: https://law.stanford.edu/wp-content/uploads/2022/09/SLS-CLP-Regulatory-Reform REPORTExecSum-9.26.pdf.

[20] Joe Patrice, ” Legal Reforms In Utah & Arizona Made Law Better So Obviously No One Is Following Their Lead”, Above The Law (September 27, 2022, 4:33 PM), available at: https://abovethelaw.com/2022/09/legal-reforms-in-utah-arizona-made-law-better-so obviously-no-one-is-following-their-lead/.

[21] Summer Lin, “California bar suspends 1,600 attorneys for violating rules set up after Tom Girardi allegedly stole millions” Los Angeles Times (July 28, 2023, 1:56 PM), available at: https://www.latimes.com/california/story/2023-07-28/california-bar-suspends-nearly-1- 600-attorneys-for-violating-rules-set-up-after-tom-girardi

scandal?fbclid=IwAR0lryM45DkFqSdlyQFPXnzJpZW_KmkaeEushNp7t1Fcw2XbFV_nYC4D2Wc .

[22] Jim Sams, “La. Insurance Commissioner Fines Hurricane-Damage Law Firm $2 Million”, Claims Journal (May 3, 2023), available

at https://www.claimsjournal.com/news/southcentral/2023/05/03/316763.htm. [23] Mata v. Avianca, Inc., 2023 U.S. Dist. LEXIS 108263.

[24] “10 Ways Lawyers Rip Off Clients”, Business Insider, Law (Jul. 10, 2013), available at: https://www.businessinsider.com/10-ways-lawyers-rip-off-clients-2013-7.

[25] de Fontenay, Elisabeth, Private Equity’s Advantage: A Requiem, Boston U. L. Rev. Vol. 99:1095 2019, available at: https://www.bu.edu/bulawreview/files/2019/06/DE FONTENAY.pdf.

[26] Mueller, F./Rieber, D./Tank, A., Legal bases and implementation of clawback clauses: Comparison between Germany and the US, in: KoR – Zeitschrift für internationale und kapitalmarktorientierte Rechnungslegung, Vol. 20, 2020 (3), S. 132-137., available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3473896.

[27] “Do your malus and clawback provisions need updating?”, MM&K website (June 20, 2019), available at: https://mm-k.com/2019/06/20/do-your-malus-and-clawback provisions-need-updating/.

[28] Boluwaji Apanpa and Busola Farinmade, “Key Considerations for Private Equity Sponsored Long Term Incentive Plans, KPMG Nigeria, available

at: https://assets.kpmg.com/content/dam/kpmg/ng/pdf/tax/Key-Considerations-for Private-Equity-Sponsored-Long-Term-Incentive-Plan.pdf.

[29] Diamond, Stephen F., Beyond the Berle and Means Paradigm: Private Equity and the New Capitalist Order (November 16, 2007), available at

SSRN: https://ssrn.com/abstract=1004234.

[30] Dominic Barton and Mark Wiseman, “Focusing Capital on the Long Term”, Harvard Business Review (Jan.-Feb. 2014), available at: https://hbr.org/2014/01/focusing-capital on-the-long-term.

[31] Christopher Niesche, “What Private Equity Looks for in Law Firm Investments”, LAW.COM (Mar. 13, 2023, 6:01 PM), available at: https://www.law.com/international edition/2023/03/13/what-private-equity-looks-for-in-law-firm-investments/.

[32] Tom Houghton, “Fletchers Solicitors acquired by Sun European Partners as firm taken to ‘next level'”, BusinessLive (Oct. 27, 2021, 1:00 PM), available at: https://www.business live.co.uk/leads-deals/fletchers-solicitors-acquired-sun-european-21984240.

[33] Rory O’Neill, “Private equity interest in IP sets up culture clash”, Managing IP (Sep. 15, 2022), available at: https://www.managingip.com/article/2aml6wbaxna060v0piqkg/private equity-interest-in-ip-sets-up-culture-clash.