It’s illegal in most states for private equity to buy a law firm. Lawyers have figured out a workaround.

Real estate, airlines, fashion.

It might seem like private equity has climbed the mountain of the American economy, declaring everywhere the light touches as part of its kingdom.

But one corner remains in the shadowlands: Law firms.

Nearly every state has adopted a professional ethics rule from the American Bar Association forbidding lawyers from working for nonlawyer-owned firms.

Lawyers, of course, have figured out a way around it.

The loophole, known as a “managed services organization” — or MSO — allows non-lawyers to effectively own part of law firms through a second corporate entity.

Business Insider spoke to two attorneys who advise law firms on the arrangement, which they said is becoming increasingly common.

In June, Puerto Rico’s high court allowed non-lawyer investment in law firms in order to spur economic development in the territory. Arizona, the only state that has done away with the ABA rule, in 2020, now has over 100 law firms that are open to outside investors, according to a recent Stanford Law School study. Large companies like KPMG and Rocket Lawyer now own law firms in the state outright.

The MSO model, which isn’t limited to only Arizona, could appeal to law firm owners who want to retire or who don’t want to hand their firms over to a law partner.

“We’re in the midst of the largest rolling retirement of lawyers in history,” said Lucian Pera, a legal ethics attorney at Adams & Reese who advises lawyers and businesses about setting up MSOs. “The baby boomers are getting old and retiring. And that’s a real opportunity for some people.”

Using an MSO can give private equity firms — or other kinds of companies — a chance to effectively buy a slice of legal practices. And it gives lawyers the chance to sell stakes of their companies for cold, hard cash.

It could also offer the chance to partner with a deep-pocketed company that could boost the firm and help scale it to new heights.

No one says MSOs are not OK

Traditionally, law firms have operated as partnerships among attorneys, where equity partners own shares in the firm and help manage it.

That’s partly because of ethics rules designed to maintain attorney independence, such as ABA Model Rule 5.4(d), which largely prevents nonlawyers from owning law firms or from having the right to control the professional judgment of a lawyer.

The ABA’s rules have made law practices distinct from many other white-collar professions, like finance or consulting, which may have robust ethical rules and norms but don’t impose such stringent limits on ownership. There are plenty of publicly traded banks and consulting firms, but no publicly traded law firms.

As a workaround, the law firms can set themselves up as two corporate entities, Pera said. One is the law firm itself, composed exclusively of lawyers and owned only by lawyers. The second is the service organization, which can be owned by anyone and acts as a vendor for the law firm. It is essentially the back office, taking care of all non-lawyer tasks, including marketing, accounting, human resources, real estate leases, and employing paralegals. The two corporate entities enter into a long-term contract.

Under this MSO arrangement, non-lawyers can invest in the service corporation, though not the law firm itself. Presto! You have an ethically independent group of lawyers who are exclusively working with a company that can sell shares, Pera says.

According to Pera, no state bars have issued ethics opinions that expressly bless the MSO model, but no court or regulator has found a problem with it, either.

“The pieces fit well, and there’s no regulatory approval required for a law firm to do it, just like there’s no regulatory approval required for a law firm to take out a bank loan,” Pera said.

A spokesperson for the American Bar Association said its Center for Professional Responsibility doesn’t have any ethics opinions on non-lawyers investing in MSOs.

“Lawyers are not subject to the ABA Model Rules,” the spokesperson said. “Instead, they are regulated by the state supreme courts in which they are licensed.”

Opportunities for both lawyers and investors

Tom Lenfestey is the founder and CEO of The Law Market Exchange, a sort of Craigslist for law firms.

He says private equity companies are typically interested in consumer-driven firms, like personal injury.

Investors might be able to introduce new efficiencies into those firms and get a steady stream of revenue in a larger portfolio, said Lenfestey, who also advises on law firm mergers and acquisitions.

Private equity companies might be warier of investing in Big Law firms, which typically service corporations and have fewer but bigger clients, he said. Lawyers could always jump ship and take clients with them, but consumer law firms tend to do steadier business, he said.

“Personal injury is brand-marketed — it’s the billboards, it’s the TV, it’s the digital marketing,” Lenfestey told Business Insider. “It’s not attorney relationship-based.”

Because law firms aren’t required to disclose their use of service organizations, it’s difficult to know how widespread the practice is.

Both Pera and Lenfestey declined to list the firms they’ve worked with using the structure, citing confidentiality obligations to their clients, but said it’s becoming more common.

Pera said he knows of one firm that used the structure as far back as 2006. In more recent years, more law firms and investors have become interested in using MSOs, Pera and Lenfestey said.

“There are many more that are in process right now, and some of them are quite large,” Pera said. “There’s a fairly large insurance defense firm in this country that’s looking at doing this. There’s a fairly large AmLaw-ranked law firm that’s looking at this. So there’s a non-trivial number of these that are going on.”

Lawyers who have built up their practices, and who want to cash out, can do so by effectively selling part of their firm to someone else to manage.

They can also help firms scale. Selling shares of an MSO could help finance lead generation or advertising.

Catalex Network, which launched earlier this year, is using the MSO model to invest in law firms with a longer time horizon. While a private equity firm might want to stick with a law firm for a few years before selling its stake, Catalex Network says it aims to form long-term partnerships with law firms by helping them establish MSOs, buying substantial stakes in them, combining their back-offices, and giving the firms the resources to compete with Big Law.

Catalex Network offers bread-and-butter services like IT, payroll, compliance management, and accounting. But also services that are more specific to the legal industry, like recruiting and sophisticated enterprise software that would be cost-prohibitive for smaller firms.

“I’ve seen kind of what big law resources are and I’ve seen what small law resources are,” said Jeffrey Goldenhersh, a Catalex Network founding partner, who previously worked at the Big Law firm Skadden Arps before moving to a boutique firm.

For Catalex Network, the MSO structure offers a way for the company to grow with law firms. The American Bar Association’s rules meant to preserve attorney independence, such as limits on fee-sharing with non-lawyers, are a non-issue.

And while Catalex Network handles the back office, the lawyers can do less managing and more lawyering, Goldenhersh says.

“There’s a real consolidation going on at the top end of the legal market and some of these smaller, midsize, boutique-type firms are getting a little bit left behind,” Jesse Hamilton, another Catalex founding partner, told BI. “So we’re trying to help them catch up and be able to step into the ring with some of the larger firms that have consolidated, have the best technology, the best AI, the best back office staff, and have them be able to compete and stay relevant in the industry.”

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