Advocates call California ban on investor-run law firms a 'Paper Tiger'

Audio By Carbonatix

(Legal Newsline) — California has become the latest state to enact a state law restricting private equity and other non-lawyer investors from owning or running law firms.

Lawsuit abuse reform advocates, however, warn the enforcement regime established under the law means the state has now created little more than a "paper tiger."

On Sept. 20, Gov. Gavin Newsom signed into law the legislation, known as Assembly Bill 2305.

Supporters of the legislation say it is needed to ensure lawyers remain in control of the practice of law and client representation at the nearly 47,000 law firms estimated to be in operation in the Golden State.

“The principle is simple: when you hire a lawyer, the person making decisions about your case should be your lawyer—not a private equity entity looking for profit," said Assembly Member Ash Kalra, D-San Jose, who served as AB 2305's leading sponsor.

Non-lawyers have long been prohibited from owning and controlling law firms in California. However, those prohibitions were established under professional ethics rules.

Supporters of AB 2305 said in more recent years, private investors had exploited alleged "loopholes" in those rules through the use of so-called alternative business structures (ABS) and management services organizations (MSOs).

Kalra and others asserted these ABS and MSOs allowed investors to cloak their investments as loans.

AB 2305 would prohibit "private equity firms, hedge funds, and other corporate legal funders from directing or influencing the practice of law."

The law doesn't prohibit ABS or MSOs from working with law firms, as they can still be involved in general business operations or back-office management decisions.

But the law would bar private equity interests and other investors from influencing or interfering with an attorney's professional judgment in representing clients or executing legal strategy, such as in court, at trial or in settlement talks.

The law would still allow trial lawyers and other firms to secure loans from equity groups and other investors to fund lawsuits, a controversial, but widespread modern practice known as third-party litigation financing.

But supporters say the law will prohibit law firms from using the money for other uses, such as to advertise or to recruit clients for lawsuits.

The law establishes statutory damages of $10,000 per violation for both the lawyer and investor, or three times actual damages, whichever is greater.

Following passage of AB 2305 this summer, the president of California's trial lawyers group praised the legislation, saying it would help California continue to lead "the nation in protecting consumers and preserving the integrity of our justice system."

"This bill draws a clear and unambiguous line: in California, attorneys answer to their clients — full stop,” said Consumer Attorneys of California President Doug Saeltzer.

Newsom's decision to sign the legislation means California now joins the states of Illinois and Colorado in ostensibly restricting the ability of non-lawyers to own, control or direct law firms.

The use of MSOs and ABS have become hot topics in the legal community in recent years.

Business groups, like the U.S. Chamber of Commerce, for instance, have warned such arrangements would only deepen the involvement of investors in pushing and controlling lawsuits targeted at American companies.

For decades, an ever-growing investment industry have used so-called third party litigation funding to financially back lawsuits in pursuit of potential windfall profits from the funds paid by defendants to settle the lawsuits or under jury verdicts or other judgments.

Business groups and legal reform advocates have warned such outside financing not only warps the legal system, but also threatens the U.S. economy and national security.

So, these groups see the rise of legal services providers operating under ABS to be a new version of that threat, enabling even more direct involvement from private equity and venture capital seeking in the civil justice system.

On the other side, trial lawyers groups have also begun to oppose the use of ABS and MSOs, seeing them as an attempt by private investors to redefine the attorney-client relationship, wrest control of the lawsuit industry and grab a share of attorney fees, as well as the judgments.

The legislation in the Democrat-dominated states has particularly arisen following the rise of ABS arrangements in Arizona, which had brought private investment to bear on personal injury cases and other civil actions.

The Arizona ABS system has come under criticism for lack of oversight and financial conflicts of interest, among other critiques.

That system had notably allowed at least one prominent California mass tort firm, Wisner Baum, to spin off some of its business to the ABS known as Eleos Law in Arizona. According to reports, Eleos is 46% owned by non-lawyers and is funded, in part, through 5% of Wisner Baum's attorney fees.

Eleos reportedly has helped to manage 9,400 lawsuits over alleged injuries caused by the heartburn medication Zantac and 8,450 lawsuits over alleged contamination of baby food.

In California, the legislation passed overwhelmingly in both houses of the California state legislature, with strong bipartisan support, despite the strong and vocal support of trial lawyers, represented by the Consumer Attorneys of California. That group is typically allied with Democrats and often finds itself at odds with business groups and Republican lawmakers.

However, AB 2305 drew little opposition, as business groups largely remained neutral.

Lawsuit abuse reform advocates, however, said the legislation may amount to an empty gesture.

The Civil Justice Association of California had initially supported the new law, given its potential to rein in what they saw as abusive lawsuit practices by trial lawyers and outside investors looking to use lawsuits and the California legal system to generate profits.

They particularly cited allegations accusing trial lawyers from the Downtown L.A. Law Group of allegedly paying plaintiffs to generate potentially fraudulent claims of sexual abuse against Los Angeles County.

Those allegations, the CJAC said, "forced the Legislature to confront billboard lawyers who put profits – and the interests of their secret investors – ahead of victims and justice."

However, the CJAC said they believe decision by lawmakers to leave enforcement of the law to the State Bar of California means the law will fall short of its stated goals.

""nfortunately, this bill is a paper tiger," the CJAC said in comments to The Record. "Its weak enforcement mechanism will do little to deter bad actors or prevent outside investors from influencing lawsuits. Putting the State Bar in charge of policing this conduct is like asking mall cops to take down organized crime.

"The bad conduct is likely to continue. Billboard lawyers and their hidden financial backers will keep gaming our courts, while victims, taxpayers and employers pay the price."