Litigation Funders Looking to Invest in Law Firms Face Hurdles

The litigation funder Burford Capital intends to purchase minority stakes in US law firms. And more recently, AmLaw 50 firm McDermott Will & Schulte has announced that it is in preliminary discussions regarding a potential restructuring in which it would sell a portion of its operations to a third-party investor.

Legal ethical rules (outside of a few specific jurisdictions such as Arizona) prohibit non-lawyers from owning law firms, but Burford has alluded to using management service organizations in acquiring law firms.

These businesses, known as MSOs, contract with another company to provide administrative and operational services for a fee. Any industry can use an MSO, but the MSO structure has become the go-to method for private equity funds to “acquire” professional services firms in places that only licensed professions, such as medical practices or certified public accounting firms, can own them.

The complexity of these acquisitions results from the legal and regulatory hurdles faced by non-professionals seeking ownership and operation of these entities.

Medical Management

Medical practices were the first professional services industry to attract widespread private equity attention. State laws governing the corporate practice of medicine generally prohibit acquisitions of these practices by non-physicians. These laws prevent unlicensed corporations from owning medical practices, controlling their activities, or employing physicians.

To circumvent those laws, an MSO acquires all of a medical practice’s non-medical assets and then contracts to provide services, rather than take direct ownership of a medical practice. If left unfettered, an MSO could absorb all of the medical practice’s income, leaving only enough money to compensate the medical practitioners remaining at the practice.

States such as New York and California restrain this structure through fee-splitting prohibitions that limit the health-care MSO’s ability to capture profits from the practice. While many states prohibit non-professionals from directly influencing the physician/client relationship, the MSO’s ability to take on direct administrative functions and apply significant financial pressures enables them to exert substantial control.

Law Firm Entrance

The use of MSOs in the law firm space is a much newer trend—one that private equity firms (and especially litigation funders) seeking new outlets for their investment capital are keen to explore.

For traditional litigation finance firms, which are adept at underwriting risks associated with litigation outcomes and collection risk, investing in MSOs would seem like a natural fit.

As with health-care practices, the MSO structure for law firms entails a firm essentially splitting into two parts: One being the legal service-providing, client-facing portion, and the other being the MSO, which takes over functions related to administration, accounting, technology, human resources, and real estate.

MSOs typically provide the capital necessary for the practices to succeed, avoiding the need for additional borrowing. Cutting-edge computer technology, cybersecurity safeguards, and artificial intelligence tools have become a necessary part of practicing law in the US and, for many smaller law firms, prohibitively expensive. The ability to access outside capital through MSOs may be a perfect solution for some firms.

Demographics also play a role. Many “founder” law firms are led by an aging generation that may be looking to scale back their duties and/or take some money off the table. Being relieved of the administrative responsibility of running the firm and selling non-legal assets to the MSO may be an attractive solution for them.

MSO Challenges

Whether MSOs in the law firm space comply with legal ethical rules is uncertain. The vast majority of states prohibit ownership of law firms by—and the sharing of legal fees with—non-lawyers. MSO investors would argue that they’re vendors, no different from the law firm’s outside messenger service.

The counterargument is that MSOs would become so entwined with the day-to-day management of the firm that it isn’t reasonable to believe they aren’t interfering with the firm’s attorney-client relationships.

Only one decision so far, from the Texas Commission on Professional Ethics, has touched on the issue. The commission ruled that MSO fees based on a percentage of the firm’s revenues would constitute prohibited fee-sharing.

So MSO fees that are fixed or are “cost-plus” may be permitted, at least in Texas. But it’s unclear how MSOs will be viewed in other US jurisdictions with more conservative legal ethics administrators.

Another big challenge for MSO investors in law firms is that their most valuable assets essentially walk out the door every evening: The law firm partners are generally free to retire or move to other firms at any time.

Because most forms of non-compete agreements for attorneys are unenforceable, it’s difficult to guarantee that an investor’s “collateral” will remain for the length of the investment term. Investors must ensure the rainmaking partners of the firm have enough incentive to stay. Providing these partners with minority equity in the MSO itself is one tool that health-care investors use.

Investments in law firms through MSOs are distinct from investments made through alternative business structures permitted in Arizona—and in some form, other US jurisdictions such as Utah and Washington, DC—in which the elimination of the fee-sharing rules permits direct investments in law firms.

Regardless of Burford’s confidence in its ability to put capital to work, the growth in the law firm MSO space is bound to attract regulatory scrutiny. State bar associations and state judiciaries soon will raise concerns about the potential for private equity firms and litigation funders to exert undue influence over law firms and otherwise interfere with the attorney-client relationship.

Until each relevant jurisdiction lays out the parameters of what MSOs may and may not do, investors should proceed with caution and take lessons from the decades of experience built up by practitioners in the health-care MSO space.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Paul B. Haskel is a partner at Crowell & Moring and co-chair of the firm’s financial services group.

Paul J. Pollock is a partner at Crowell & Moring and concentrates his practice on mergers and acquisitions and corporate finance.

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