Ron Friedmann had an interesting post on Monday on the rule against outside investment in law firms. He argues that the Rule has a negative effect on innovation in law because startup law firms (and presumably other law firms) cannot raise the capital they need to innovate. It certainly seems possible that certain capital-intensive law firm models, such as those based on new technology, might be inhibited by the inability to secure outside investment, and so Ron may have a point.
However, I have often thought there is a sufficient workaround that would make this sort of investment possible within the existing system. Model Rule of Professional Responsibility 5.4 (and others like it) essentially say that a lawyer may not "share legal fees with a nonlawyer." The basic problem for investors under the Rule, therefore, is that a nonlawyer investor who had an equity interest in a firm would indirectly be receiving legal fees and therefore would arguably violate the Rule.
One wonders then why such firms don't simply look to lawyers to invest the capital they need to innovate. Certainly there are a sufficient number of lawyers with disposable wealth they could invest to cover the capital needs of any number of startup law firms. Even a startup law firm that had very ambitious plans would need only a modest amount of capital (i.e., millions rather than billions) to make its vision a reality. Certainly they should be able to raise that money from among lawyers, the group that would arguably have the most expertise and experience to assess the validity of such business models in the first place.
Of course, such investors would not actually personally represent clients, but the Rule only appears to require the investor be a "lawyer," not that he or she actively represent clients. So why are there not groups of angel investors, or superangel or venture funds whose investors are all lawyers that fund startup law firms based on disruptive technologies and business models?
One answer might be that lawyers would fear competition and therefore shy away from investment in more efficient structures, but that seems unpersuasive. If I am a partner in a Wall Street practice I don't fear competition from an innovative law firm that would provide routine legal services.
Another answer might be that it is not efficient for law firms to develop capital-intensive technologies in house. Instead, they rely on startup companies that do not practice law or generate legal fees, then purchase new technologies from them. This is the classic "make-or-buy" decision that we would look to transaction cost theories (e.g., Coase) in analyzing.
The question Ron raises is interesting, because the workaround identified above (investment by lawyer angels or venture funds) seems plausible, so we need to explain its absence to assess how much of a constraint on innovation Rule 5.4 really imposes. Many businesses have a "money partner" and a "sweat equity partner." It seems that one could do exactly the same thing in the law firm world, by simply drawing the money partners from the ranks of lawyers. Does the fact that the market hasn't seemed to innovate this sort of "lawyer-only" venture capital fund suggest that there is no unmet need for such investments in law firms? Or are there are other ethical rules that would prohibit such an arrangement?