Law firms have been turning of late to management service organizations (MSOs) to assist with myriad business activities. Moreover, they see MSOs as a mechanism for drawing in private equity to support the bottom line and support growth strategies. MSOs have long been used in the health care industry for these purposes, and so the playbook is taken from this big sector. The legal sector present issues distinct from health care, however. This is so as a regulatory matter because of the longstanding ethics rule — the ABA’s Model Rule 5.4 to be exact — which, to the extent that it has been incorporated by state courts into the regulation of lawyer conduct, might have consequences for the use of MSOs. I say equivocally “might have consequences” because it is not at all clear that law firm engagement of MSOs for various management functions, some very important, others more mundane, represents nonlawyer ownership or, further, runs the risk of prohibited fee-sharing. (Indeed, I will say more directly, even though this is largely beside the point of this post, that the argument that 5.4 restricts MSOs strikes me as rather dubious).
In any event, a few states are deeply worried about these developments and have proposed significant regulation to restrict greatly outside private investment in law firms. Private equity and hedge funds are the target of this legislation, and the stated reasons are (as with the classic arguments for the maintenance of Rule 5.4) that such investments threaten the independence of legal judgment and the fiduciary duties of lawyers to clients. Why now? Largely because of the expanded use of MSOs and the credible view that such arrangements include incentives and opportunities to raise external money for law firms.
There is much to say about the merits of Rule 5.4 and the persistence of that this rule in the face of law firm financial pressures and, as well, concerns about regulatory impediments that contribute to the access to justice crisis. The ABA has been adamant about maintaining this rule, even though many other countries do not similarly restrict law firms and, critically, a couple of states — Arizona and Utah — have recently been experimenting with alternative business structures that are inconsistent with 5.4. But my focus here is not on this important debate about the virtues of vices of this regulatory edifice, but on some of the interesting state constitutional issues that this proposed legislation from Illinois, California, Colorado, and maybe other states raises.
Lawyer ethics rules have traditionally been developed and codified by the actions of state courts. The state supreme courts act under the authority of what is called “inherent powers,” a principle that are its core reflects the prerogatives and obligations of courts to deal with matters pertaining to lawyers as officers of the court. These inherent powers include myriad elements of legal services regulation and also the organization and functions of the state courts, but they have long included matters of lawyer qualifications and, as well, lawyer ethics. The history of the inherent powers doctrine is at once opaque and under theorized. It comes to modern times from the deeply embedded idea that all things pertaining to lawyers and legal practice derive from the essential obligations of the courts to ensure that the justice system operates successfully and consistent with the rule of law. As a practical matter, inherent powers doctrine not only undergirds the broad powers courts have to configure the rules of, inter alia, lawyers’ professional responsibilities, but also protects the judiciary’s powers from intrusions from non-judicial institutions including the legislature.
Pause for a moment to consider how consequential is this idea. State regulation is by and large organized under the rubric of the states’ police power, a topic I have explored in considerable depth in a recent book, Good Governing: The Power Power of the American States (Cambridge U. Press 2024). This power is a legislative power, grounded in state constitutions, whether explicitly or implicitly as a foundational aspect of state constitutionalism in the United States. But the inherent powers doctrine effectively hives off regulatory matters pertaining to lawyers and the justice system, and allocates all key powers to the judiciary. Furthermore, it creates a bulwark between what would otherwise be the prerogative of legislatures to act, so long as consistent with the state and federal constitutions, to regulate legal services in order to protect the public health, safety, and general welfare of the state’s people and the discretion of the judiciary to make decisions involving lawyers, based upon criteria that they develop in their own discretion. To be sure, inherent powers flow from the state constitution and are not necessarily unlimited. And yet these limits cannot be set by ordinary legislative action, but only by the delineation of constitutional responsibilities, responsibilities whose content and definition will usually be adjudicated by judges.
This discussion has proceeded largely on the basis of first principles, and a deeper analysis of inherent powers doctrine would consider state constitutional law cases that have involved assertions of and challenges to these powers. But it is critical to note that the “bulkwark” idea, one that is best viewed as an element of the state’s separation of powers, is well embodied in state constitutional law. Indeed, it is no coincidence that state legislation dealing with legal services remains rare; and legislation that deals with the content of lawyer ethics is rarer still. (The most common of such statutes are those dealing with lawyer solicitation and unauthorized practice of law, neither of which are about legal ethics and conflicts as such).
So where does this leave the current crop of legislation that deals with nonlawyer investment in law firms? On shaky constitutional grounds, I would suggest. State ethics rules that basically codify Rule 5.4 might or might take care of the situation of MSO engagement with law firms. Certainly the impetus behind this proposed legislation suggests that current ethics rules are lacking in this respect. But if and insofar as the state judiciary is unwilling to expand measurably the scope of 5.4 to include activities of MSOs, this may leave this anti-MSO legislation in some serious constitutional peril.
To come at this issue from a different direction, it might be precisely this burgeoning legislative movement (whether wise or unwise, and I confess that I tend to think the latter) that puts pressure on state courts to rethink their classic commitment to the inherent powers doctrine, as it pertains to regulatory innovations such as these. Exactly how they might do so, under existing doctrine and with an eye toward the trend of creative, modern approaches to legal services regulation — what I have called “Nextgen bar regulation” — is an important question, but one beyond this particular post. More on that later. For now, it is enough to note that the Illinois, Colorado, and California are picking at a state constitutional hornet’s nest.
[Reprinted from my Substack. Daniel. B. Rodriguez. Subscribe for free!]
