The Case for Rule 5.4 Reform — Non-Attorney Ownership of Law Firms and Employee Stock Options

ABA Rule 5.4 Historical Significance

In 1983, the American Bar Association Rule 5.4 formally established fundamental guidelines that address the ownership structure of law firms and the role of lawyers and staff within those firms. The rule was based on over a century of ethics codes and is designed to maintain independence of judgement without concern for firm revenue by eliminating external business influences and conflicts. By focusing on preventing partnerships with non-lawyers and the sharing of legal fees, Rule 5.4 plays a crucial role in shaping the overall structure and ethics of legal practice across the United States.

Rule 5.4 is also known as the “Rule on Professional Independence of a Lawyer” and primarily focuses on two areas of firm operation:

1. The Prohibition on Fee-Sharing which is rooted in the principle of maintaining the independence of the legal profession and avoiding conflicts of interest that may arise from fee-sharing arrangements with non-attorney outside interests.
2. The Restriction on Forming Partnerships with Non-Lawyers prevents lawyers from sharing ownership interests in a law firm with non-lawyers. This restriction was put in place ostensibly to uphold the integrity and professional autonomy of legal services, ensuring that legal decisions remain free from external influence. Fair enough.

 

The Rule 5.4 “What-For”

By prohibiting fee-sharing and partnerships with external non-lawyers, Rule 5.4 was designed to maintain broad ethical standards of the legal profession. It’s intended to give clients trust and confidence that the legal services they receive are not influenced by the firm’s business decisions.

Additionally, it protects client confidentiality by preventing outsiders from accessing sensitive legal information via ownership interests. Only the lawyers within the firm may have access to clients’ legal information.

The thinking is that by maintaining control over legal fees and the decision-making processes — by ensuring there are no outside investors or employee interests to be concerned with — a given firm’s lawyers will be bound only to ensure the quality and integrity of legal services provided to clients.

 

Rule 5.4 decrees that:

1. Law firms must be owned and managed exclusively by licensed attorneys in the traditional model of legal practice.
2. Lawyers must adhere to ethical considerations related to fee arrangements and partnerships to avoid conflicts of interest and ethics violations.
3. Lawyers may explore alternative business structures (ABSs) that encourage innovation and collaboration as long as they comply with the rule.

 

Unintended Consequences

 While well-intended, it turns out that the ethical may be antithetical to beneficial public policy. By prohibiting lawyers from partnering with outside investors, Rule 5.4 limits the firm’s access to capital, discourages innovation and collaboration, and prevents the potentially positive benefit of external businesses’ expertise (think recruiting, marketing, finance, etc.). Law firms are effectively shielded from best business practices that could make their services more accessible to everyone; practices that drive outside organizations’ successes are essentially barred.

Additionally, given the limited access to capital, law firms are more vulnerable to economic downturns than the broader business community. Currently where Rule 5.4 is still strictly enforced, only billing produces capital, leaving law firms unable to provide legal services as affordably as they could if they were open to outside investment. As it stands, firms must rely solely on fees for growth capital. Reforms to Rule 5.4 like the ones that have been seen in several locations could make legal services more accessible to all.

Lastly, Rule 5.4 hinders recruitment, preventing law firms from offering potential employees equity stakes or profit-sharing options, or Employee Stock Option Plans (ESOPs). That restriction is seen as a deterrent to otherwise qualified individuals taking jobs in the legal field. The ability to offer ESOPs — giving recruits a vested interest in the firm’s success — is regarded as critical to attracting, retaining, and growing top talent — just as with pay packages so common in other fields.

 

Reforms Is in the Air

There is growing evidence from outside the United States that reforms to rules like ABA 5.4 could benefit the profession — and the public. Several nations including England, Wales, Scotland, Australia, and Germany have seen increased choice and competition, greater access, and increased innovation. Legal businesses in the USA that have developed outside the “practice of law” have also demonstrated the benefits of increased access to capital and business expertise.

Parts of the USA have established regulatory frameworks to balance a lawyer’s duties to clients while allowing non-lawyer ownership. ​

Arizona (in 2020) eliminated Rule 5.4 entirely to permit non-lawyer ownership of legal businesses and allow fee-sharing, while creating a licensing requirement for Alternative Business Structures (ABSs) partially owned by non-lawyers.

Utah (also in 2020) instituted a 2-year pilot program to allow non-lawyer-owned businesses to apply for a license to provide legal services. That program has been extended to 7 years.

The District of Columbia allows non-lawyer ownership of law firms under certain conditions, as stated in D.C. Rule of Professional Conduct 5.4(b). ​

California, Massachusetts, and Georgia have begun taking small steps to reform Rule 5.4 to permit greater fee-sharing with qualified organizations.

Oregon, Virginia, and Vermont have released non-binding, opinion-based reports recommending reforms.

 

The Empire State Strikes Back

In recent years, New York State has begun nibbling around the edges of enacting reforms of its own. Of course there are detractors who argue for the status quo — and all opinions are valid — but in a formal opinion, the Association of the Bar of the City of New York Committee on Professional Ethics addressed the value of permitting ABSs which would allow a New York lawyer to enter into a business relationship with a law firm with non-lawyer owners, located in a jurisdiction that permits non-lawyer ownership of law firms — under certain conditions. It’s a mouthful…but it is digestible.

To be clear, this proposal is not seeking to permit a change in ownership of New York State law firms. Rather, it seeks to define the relationship New York State law firms can have with firms in jurisdictions where the rules are relaxed.

The proposal states that the arrangement must be non-exclusive, disclosed to the client, and must abide by the rules governing conflicts of interest, payment for referrals, and fee-sharing with lawyers in separate firms. It would not violate Rule 5.4 of the New York Rules of Professional Conduct as long as:

• The New York lawyer and the law firm agree to regularly co-counsel matters and share fees related to those matters, and
• As long as the New York lawyer is not employed by or part of the ABS, and the fee split does not compromise the lawyer’s independent professional judgment.

Enacting reforms to Rule 5.4 in New York as in other jurisdictions could create structural changes that benefit Empire State law firms and the general public alike. Given today’s massive worldwide economies and advances in technology, communications, and innovation, rules set up to prevent the unauthorized practice of law, while having stood the test of time, may be coincidentally outdated.

As in other industries not nearly as regulated as law, reforms to Rule 5.4 should lead to increased competition, better service, and more efficiently run firms — including smaller firms that bear the larger brunt of the effects of Rule 5.4. Reducing the number of lawyer-owner hours spent on administrative, marketing, and management tasks would necessarily increase time for billable legal work. Subsequently, the removal of financial inefficiencies would help make services more widely accessible and affordable.

While critics argue that removal of some regulations and ethics rules may lead some professionals to act, well, unethically, the reality does not match the fear. Call it baby steps. Call it “try before you buy” but in jurisdictions where Rule 5.4 has been eliminated or relaxed, increased disciplinary action simply has not developed. We will continue to monitor reform efforts and share any important information.

 

 Collaboration and Connection

At its heart, a law firm is a business, subject to laws like Rule 5.4 and countless other operational obstacles. In the years since the founding of Friedman Vartolo in 2016, we have encountered and overcome countless challenges related to the business side of running a successful law firm. It serves our clients well, but it is also a case study on how to get the business of law right. If you have any questions about our approach, our philosophy, or how the lessons learned from our rapid growth into a leadership position can help you, shoot me a message at afriedman@friedmanvartolo.com and we’ll talk about it.

-Adam Friedman, Esq., Friedman Vartolo Managing Partner