Private equity investment in professional services is not new, innovative, or outside the box. Investors have been backing professional services firms since the 1980s, beginning with veterinary clinics and later expanding into dentistry, other healthcare services, and, more recently, accounting firms in 2021. Law firms have followed a different path because ABA Model Rule 5.4 has long prohibited non-lawyer ownership. But investors have found a back door and have started to nudge it open. For lawyers, brokers, and underwriters, that door is no longer theoretical. It is about to get pushed wide open. Are lawyers and insurance professionals ready for it? The question matters because these structures do not just change law firm ownership economics. They also change how brokers explain risk, how underwriters evaluate professional liability exposure, and how law firms preserve professional independence, confidentiality, and coverage continuity while responding to investor interest.
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The History
Washington, D.C. has allowed non-lawyers to own portions of law firms while providing services that assist a firm’s legal practice since 1991, but it was really Arizona that started the avalanche. In 2021, Arizona approved Alternative Business Structures (“ABS”) and has since approved more than 150 ABS licenses to non-lawyer owned entities. Utah and Puerto Rico have also allowed more limited structures under their respective rules. Washington state and Tennessee are also exploring similar programs. By contrast, California, Colorado, Florida, and Maryland have limited or rejected ABS. Enter Managed Services Organizations (“MSO”) as an alternative. Instead of non-lawyers owning a law firm, the firm splits in two. The law firm stays 100% lawyer owned and does the legal work. A separate MSO owns the non-legal part of the practice: IT, marketing, HR, billing, real estate – the traditional back-office work. The investors buy into the MSO and get paid a fee for the services it renders. Illinois appears to have recently validated the arrangement under HB 5487. The state barred entities that are not wholly owned by lawyers from interfering with professional judgment, controlling hiring, accessing client documents, or tying fees directly or indirectly to a firm’s revenues or profits, but it appears to allow non-lawyer ownership to exist. Additionally, the firm must disclose the arrangement to its clients.
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The Risk
On its face, the most obvious risk to the structure is the sharing of fees. As Rule 5.4 prohibits the sharing of fees with non-lawyers, the compensation arrangements must reflect compliance with that rule. Any policy that ties compensation of the MSO to legal revenue appears to run afoul of the rules, and firms must take care to ensure the fee reflects fair market value, whether structured as a flat fee or a per-lawyer fee. Secondarily, and equally important, is the risk that professional judgment could be compromised. Firms must craft the arrangements to ensure that the MSO has no direct or indirect impact over the legal decisions being made. Not only is the MSO unable to direct legal decision-making, it likely also cannot tie its own compensation to long-term client outcomes, though that link is harder to measure and enforce. Investor pressure to push for early resolutions, or portfolio-based economics designed to maximize returns, may run afoul of the client’s best interests. The use of AI to provide legal services also raises significant red flags when the AI is selected, managed, and maintained by the MSO. There are also significant concerns about the breach of client confidentiality and possible waiver of the attorney-client privilege. In a model where the MSO touches billing and case management systems, privilege walls will need to be carefully – and often intricately – constructed to guard against violations of ABA Model Rule 1.6, which protects client confidentiality. In certain jurisdictions, waiver of the attorney-client privilege is also a concern when a non-lawyer-owned entity is involved in these functions. As these structures become more prevalent, insurance practitioners will need to pay close attention to the policies, procedures, and safeguards firms put around these entities to assess the added malpractice risk they create.
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The Insurance Issues
Fundamentally, a lawyers’ professional liability (“LPL”) policy covers lawyers acting in their capacity as lawyers and may specifically exclude decisions made as an owner or decision-maker in another enterprise. Because MSOs are most likely prohibited from practicing law, the typical LPL policy probably does not cover a number of the functions being performed by the MSO. In addition, individual partners with ownership interests in the MSO may not be covered under the policy for decisions they make outside the practice of law for example, as a director or owner of an outside entity. Also relevant: who are the insured parties? Who is the named insured? If the holding company is named instead, the law firm has essentially ceded its rights and protections as the named insured. The MSO itself shouldn’t qualify for malpractice coverage, since by definition it cannot practice law. Indemnity provisions between the parties could also conflict with policy language, jeopardizing coverage for a claim. Continuity is also a significant issue for insurance brokers and underwriters to assess if and when the ownership or corporate structure changes. Because LPL coverage is typically claims-made, it is important for all parties to assess the retroactive dates and the definition of “insured” to avoid an inadvertent loss of coverage for prior acts. As of now, the landscape consists of small- to middle-market plaintiff and boutique firms embracing the MSO structure, but the signs are there that the market will continue to grow. Reportedly, firms as large as McDermott Will & Schulte and Morgan & Morgan, the largest U.S. plaintiff firm, are assessing the structure and the opportunities it presents.
Brokers, underwriters, and law firms alike should expect to see many more MSOs in the years ahead.