California is moving one step forward to giving law firms in the state a head start in the race to innovate. On June 28, 2019, a California State Bar task force recommended changes to the ethics rules that would permit nonlawyers to invest in law firms — which could unleash a new wave of innovation.
Innovation requires a clear vision, access to capital and world-class technology talent. These three ingredients are readily available around the U.S., but are largely inaccessible to law firms due to outdated, protectionist policies that prevent nonlawyers from being firm members, and from investing in law firms.
By prohibiting institutional equity investment into law firms, and by prohibiting law firms from giving ownership to nonlawyer talent, ethics rules in most U.S. jurisdictions deny law firms two of the three ingredients necessary to build technology. Other common-law countries have been shedding these policies in order to compete in the 21st century, but the U.S. has not.
Additionally, these policies are based on unproven, outdated concerns that restricting investment in and ownership of legal services to lawyers is necessary for client protection. There is not now, nor has there ever been, any data to support these policies. Indeed, the experience of law firms in the District of Columbia, where a change in the ethics rules in 1990 permitted nonlawyers to work and invest in law firms — including having ownership interests — demonstrates that the restrictions are not necessary.
In contrast to continuing unnecessary impediments to innovation, one of the proposals of the California task force would amend California Rule of Professional Conduct 5.4 to permit law firms to share fees with nonlawyers. Clients are protected because the fee-sharing agreement must be in writing, the client must consent in writing after a full disclosure of the fee-sharing arrangement, there must not be any interference with the lawyer’s independent professional judgment or with the lawyer-client relationship, and the total fee charged must meet the ethical definition of a reasonable fee.
If the Supreme Court of California adopts the proposed rule change, California law firms will be able to accept equity investment, and will be able to have nonlawyer tech talent join the firms to help chart innovation.
As the California proposal demonstrates, we can change the legal ethics rules in a way that protects clients while permitting law firms to innovate in ways that serve clients better.
Why Is Access to Capital Important for Innovation?
Law firms are not capitalized to sustain endeavors into improving their practices with technology. Law firms are judged — and partners are retained — on a profit-per-partner basis. If a law firm relies solely on its own capital to innovate with technology, partners would have to forgo profits for years before seeing a return.
And unless it is one of the largest firms, a firm may still lack sufficient internal capital to innovate — because technology is not created overnight. Technology takes time, experimentation, iteration and a willingness to stumble. Developing technology is not like practicing law using the billable hour. There isn’t an immediate one-to-one return for each increment of time worked.
More often than not, the development of technology will not lead to any monetary result in the short term. Just look at Amazon.com Inc. After its public offering in May 1997, Amazon did not turn a profit until the fourth quarter of 2001, when it made $5 million. It continued to have relatively weak profits, and some losses, until it broke the $1 billion profit barrier in 2016. And in 2017, it brought in $3 billion in profits — then more than tripled profits to $10 billion in 2018.
And Amazon is not alone. Netflix Inc., Uber Technologies Inc., Airbnb Inc. and other innovating companies have all taken years to become profitable.
The attribute common to all four of these companies is that they were capitalized in a manner that allowed them to (1) take risk, and (2) operate at a loss for an extended period of time. This allowed them to provide attractive pricing at the same time they created new spaces within existing markets. They did this with investments from venture capital funds set up to take sizable risks with the hope of making large returns.
While venture capital is the most common type of fund investing in technology, it is by no means the only way to fund the creation of technology. There are angel funds, structured finance funds, private equity funds, family offices serving ultra-high-net-worth investors, and other investment entities. Regardless of the type of fund or investment vehicle, the people who make these investments want equity (a piece of the company) in exchange for their investment. Why else would they invest?
Innovation is coming to the legal space in a big way. Right now, the industry is too big, too fragmented and too tech-backward. More specifically, the U.S. legal market is estimated to be about $437 billion (per Thomson Reuters). There are more than 47,000 law firms nationwide, three-quarters of which have five or fewer attorneys.
This is staggering. Do you remember mom-and-pop video stores? How about the corner hardware store? What about novelty book stores, electronics shops or the local yellow pages? History tells us that big markets, with fragmented players, get consolidated.
For some reason, lawyers like to think we’re different. That we’re above it all. We’re not, and if we don’t have the resources necessary to build technology — access to capital being number one — our industry will be changed by nonlawyers and/or foreign law firms in ways that we cannot control.
Why Do Law Firms Need Access to Technology Talent?
Lawyers do not have a firm understanding of the different skill sets it takes to build technology. There are very big differences between a law firm’s IT person, website person, social media person and the people who can write code, build scalable infrastructure, understand data and create a seamless user experience.
Technology is not created by a single person who can do everything sitting in a back office somewhere. Technology requires a collaborative effort between many different areas of expertise being pulled together by skilled project managers. When done properly, an engineering effort is akin to a large orchestra creating beautiful music in unison.
Even if law firms continue to purchase and incorporate new technologies developed by others, there is a growing role for nonlawyers within law firms to assist lawyers in understanding and using these technologies. Using analytics and artificial intelligence are just two examples where effective use of technology benefits from a team that includes non-lawyers with tech backgrounds.
In order to attract top technology talent into the legal space, law firms will have to offer them the same thing that Amazon, Uber, Netflix and Airbnb did: an equity stake. Sure, some small innovations may be achievable by luring technology talent with oversized salaries, but those salaries will not be sustainable over the long run to create and effectively use major innovations. Without talent there is no innovation.
What Is the Risk of Not Allowing U.S. Lawyers to Innovate?
Whether legal ethics change to permit law firms to acquire the investment and talent to innovate, innovation is coming from the outside.
LegalZoom.com Inc. now has over 4 million users, of which 2 million are small businesses, using the do-it-yourself legal platform for legal services usually performed by lawyers such as creating business entities, writing contracts and other agreements, registering intellectual property, writing wills, trusts, powers of attorney and deeds, and allowing individuals to represent themselves in a variety matters without lawyers.
Atrium is an online platform providing legal services to startups, and Axiom is an online legal services provider that provides talent and technology to corporate legal departments. These are just a few of the innovations that are redirecting clients away from law firms to alternative legal services that promise lower costs or services more tailored to legal consumers’ needs.
Some of these alternative legal services providers are also responding to the critical access to justice problem in our country. It is too expensive for most working-class and some middle-class individuals to participate in our justice system.
Estimates from state-by-state studies show that approximately 80% of the civil legal needs of low-income Americans, and 40% to 60% of the civil legal needs of middle-income Americans, go unmet. Innovation in the practice and delivery of legal services could help close this justice gap.
How Best to Open the Door to Innovation?
The old guard fears the influence of nonlawyers on our profession. For the reasons noted above, the current framework is not sustainable.
While California may enact a rule change to open up law firms for innovation, that is not enough. The American Bar Association should spearhead the move to innovation by changing Rule 5.4 of the ABA Model Rules of Professional Conduct, much like California is poised to do.
Such a change would allow nonlawyer ownership in law firms, and would permit law firms and solo practitioners to share fees with nonlawyers provided the agreements are in writing, the client agrees in writing, there is no interference with the lawyer’s independent professional judgment or the lawyer-client relationship, and the total fee is reasonable.
These types of rules would protect clients, and they can be easily achieved if the ABA responds to today’s needs rather than being stuck in the past. If the ABA were to act, states would follow.
It is critically important to remember the current version of ABA Rule 5.4 is based on nothing more than the belief that nonlawyer investment in and ownership of law firms is bad for clients. This is an opinion and not a fact. Allowing people who understand business and technology to help law firms make better decisions is good for lawyers and good for our clients. If law firms can have access to more capital, that will help, not hurt, clients.
Proof for this proposition is plentiful. Imagine a world where lawyers used analytics to decide whether a client would be better served by taking a prelitigation settlement offer or filing a lawsuit. Imagine depositions and court appearances seamlessly scheduled via video conference. Imagine a world where every law firm had a proper database able to deliver business analytics in real time.
Imagine a client portal that kept your clients abreast of everything they needed to know. Imagine being able to expand and contract your workforce — depending on caseload — and the ability to in-source legal expertise to meet a specific client’s needs. Imagine access to justice not just being a buzzword, but a technology-enabled endeavor.
Imagine technology empowering lawyers with the ability to spend more time lawyering, and less time worrying about their businesses. Imagine being able to think creatively and having technology partners capable of bringing your creativity to life.
Henry Ford famously said that if he had “asked people what they wanted, they would have said faster horses.” Likewise, a large number of lawyers want the practice of law to remain as it was when they entered the legal profession, but merely wanting that has not and will not stop change.
There are entrepreneurial lawyers among us. There are lawyers with big, bold, very interesting visions for where we can take our industry. We must stop tying their hands behind their backs.
Let’s give these lawyers the ingredients they need to execute on their visions. Let’s loosen the rules, and create a framework where lawyers can collaborate with the capital sources and talent pools necessary to innovate in a meaningful way. Let’s finally enter the 21st century.