Ethics Opinion 322

Whether a Nonlawyer Employed by a Law Firm May Be Partly Compensated by a Percentage of the Profits of the Cases on Which He Works

A law firm may not compensate a nonlawyer employee, hired to work on designated class action claims against defendants who are members of a particular industry, based on a percentage of the profits earned from those cases. If the lawyers in the firm and the nonlawyer were to establish a separate partnership or other form of organization to litigate the class action cases, the fee arrangement would be permissible, provided that there were compliance with the restrictions of Rule 5.4(b) and other relevant rules governing such organizations.

Applicable Rule

• Rule 5.4 (Professional Independence of a Lawyer)

Inquiry

The inquirer is a partner in a small law firm. The firm is engaged in a series of class actions, in which it represents the plaintiff class, asserting claims against defendants who all are members of a particular industry. Notice to class representatives of compensation arrangements with employees would be possible, but it would be impractical to notify the putative class members. It is likely that these cases and new, related cases will continue for some years. Fees are contingent upon settlement or recovery. The firm contemplates that it will collect fees irregularly as some cases are resolved.

The firm has hired—as an employee—a nonlawyer, who has worked as a consultant in the relevant industry, to assist it in this series of cases. The employee is currently paid a modest base salary and is paid on an hourly basis for the time that he spends on the series of cases. The firm wishes to alter the compensation system for this employee. It proposes to continue paying him a modest salary, but for future cases, plans to compensate him from the revenue received from the series of class actions. The compensation would work in the following fashion: The employee and the firm’s lawyers would keep track of their hours spent working on this series of cases as well as their expenses. As fees from these cases were received, they would be used to pay the employee for his expenses and for his time spent on the series of cases at an agreed-upon hourly rate. The firm also would be paid for its lawyers’ expenses and time spent as fees were received. If the fees were insufficient to compensate both the employee and the firm for the time spent prior to receipt, the fees would be divided on a pro rata basis between the employee and the firm, and the uncompensated hours, as well as any additional hours spent, would be compensated from the next fees that were received. If the fees were more than sufficient to compensate the employee and the firm for expenses and hours, the remaining funds would be divided between the employee and the lawyers on a pro rata basis depending on their respective contributions of expenses plus hours times hourly rates. The employee could never receive more than 49 percent of those fees. If the fees did not materialize, the employee would receive no compensation other than his modest base salary. If the fees were inadequate to compensate the employee and the lawyers for all their hours at their agreed-upon hourly rates, they would share proportionally in the shortfall.

The following example illustrates the proposal: Assume that the employee has worked 90 hours and has expenses of $1,000. Assume his hourly rate is $100 per hour. Assume that the lawyer¹ has worked 75 hours, that his hourly rate is $200 per hour, and that he has incurred $5,000 in expenses. These hours are not spent by either the employee or the lawyer on just one case, but on a series of cases. One of these cases settles, resulting in fees of $100,000. The employee would be paid $10,000 ($1,000 in expenses + 90 hours x $100). The lawyer would be paid $20,000 ($5,000 in expenses + 75 hours x $200). That would leave $70,000 in fees. These fees would be divided based on the respective “investments” of the employee and the lawyer or at a ratio of $10,000 to $20,000 or 1 to 2. Thus, of the remaining $70,000, the employee would receive $23,333, and the lawyer would receive $46,667. If fees for the same hours and expenses were only $21,000, the employee would receive $7,000, the lawyer would receive $14,000, and the uncompensated hours and expenses ($3,000 and $6,000 respectively) would be carried over and added to future hours and expenses until another fee was received. That fee would then be divided using the ratio of hours times hourly rate plus expenses invested as of that time, which might differ from the first ratio. If no more fees were earned, there would be no compensation for these hours and expenses.

The inquiry is whether this compensation system satisfies the requirement of Rule 5.4(a)(3), which is one of the exceptions to the prohibition on a lawyer or law firm sharing legal fees with a nonlawyer.

A lawyer or law firm may include nonlawyer employees in a compensation . . . plan, even though the plan is based in whole or in part on a profit-sharing arrangement.

If this proposed compensation system does not fall within this exception, the inquirer asks whether, pursuant to Rule 5.4(b), the firm and the employee could enter into a joint venture arrangement. The employee would be a principal of and have a financial interest in the joint venture, which would represent the plaintiffs in this series of class actions. Were such an organization formed, could it use the proposed compensation system?

Discussion

As this inquiry illustrates, the line between the prohibited sharing of legal fees with a nonlawyer and a permissible compensation plan based on profit-sharing is not clearly demarcated. This is so because a law firm’s profits result almost entirely from its fees. In a sense, even paying nonlawyer employees a salary could be viewed as a sharing of fees, since fees are the firm’s source of revenue.

Previous Committee Opinions

Comment [1] to Rule 5.4 provides, without further elaboration, that the rule is “to protect the lawyer’s professional independence of judgment.” Presumably, the notion is that a nonlawyer with a stake in the outcome might influence the handling of the case, for instance by pressuring the lawyer either to settle faster or to hold out for more, based on the nonlawyer’s financial interest. Comment [10] says, however, that when a nonlawyer becomes a partner or principal in a law firm, as permitted by Rule 5.4(b), he or she may share in the fees.

In Opinion 233 (1993) this Committee described two historical motivations for prohibiting fee-sharing with nonlawyers in addition to preserving independent professional judgment: (1) preventing the unauthorized practice of law and (2) preserving client confidences. It is not immediately apparent how fee-sharing would threaten client confidences, at least in the context of this inquiry. It would appear that the employee would have the same job and presumably the same access to client confidences regardless of how he is paid. Nonlawyer exposure to client confidences by consultants, expert witnesses, secretaries, paralegals, and law clerks is, of course, common. We are not sure that preventing unauthorized practice is conceptually different from preserving professional independence. Both reasons add up to discouraging nonlawyers from influencing or making decisions about the practice of law, which should be reserved for lawyers. Arguably, if the employee had a more direct stake in the outcome of the class action cases, he might be tempted to interfere improperly in those cases. But if the law firm met the requirements set out in Rule 5.4(b) for admitting nonlawyers to the firm as partners (particularly assuring that they comply with the Rules of Professional Conduct), the threat to independent professional judgment or of unauthorized practice does not seem appreciably greater than in the case of a nonlawyer partner.

Some of this Committee’s opinions, issued after Rule 5.4 was adopted, have taken a liberal approach to what might be called fee-sharing. Opinion 298 (2000) said that paying a collection agency a percentage of collections does not violate the prohibition against fee-splitting. Opinion 307 (2001) said that a firm may pay one percent of its fees to a government agency for referring a case. This referral fee clearly involved fee-splitting with a nonlawyer, but we said it was not the “evil” that the rule was designed to prevent. The aforementioned Opinion 233 permitted the sharing of a “success fee” with an independent consulting firm, provided that the client consented in advance. This “success fee,” while clearly contingent on the outcome, was not clearly defined, so we do not know if it was to be fixed or to be designated as a percentage of the amount of the recovery. In fact, it is not clear from the Opinion whether the firm represented only plaintiffs, so the success fee might be triggered by a successful defense of a case.²

We must confront, however, Opinion 286 (1998). That opinion concerned referral fees to nonlawyers. The Committee thought that such fees were prohibited if contingent on the amount of recovery because such a payment is in effect paying some of the specific proceeds of a representation to a nonlawyer. If the referral fee were not contingent, if it were fixed and paid regardless of success, we said it would not be a division of fees and would be permissible. This distinction has the advantage of drawing what appears to be a clear line. If the nonlawyer is paid a flat fee, regardless of outcome, he/she is unlikely to pressure the lawyer as to how to handle the case or cross over the line of actually practicing law. Still it is hard to reconcile this result with paying a consulting firm, which will presumably participate in the case, unlike the referring party, a fee contingent on success, as long as the client grants advance approval.

Other Jurisdictions

The opinions of other jurisdictions weigh against the inquirer’s proposal.³ These opinions generally stand for the proposition that paying a percentage of firm net profits to nonlawyer employees is permissible, whereas paying a percentage of a fee in an identifiable case or series of cases is not. The inquirer referenced five opinions that he believed supported his proposed compensation system. We discuss each below.

(1) The Philadelphia Bar Association Professional Guidance Committee endorsed the payment of a percentage bonus to a nonlawyer employee if collections exceeded a predetermined figure, provided that “the bonus is not tied to or contingent on the payment of a fee from a particular case or specific class of cases relating to a particular client or debtor.” Opinion 2001-7 (2001).

(2) The Utah State Bar Ethics Advisory Opinion Committee approved the payment to a non-employee paralegal, provided that the paralegal’s compensation is independent of the lawyer’s compensation by the client. Employee paralegals may be compensated based upon a percentage of gross or net income, provided compensation is not tied to specific fees from a particular case. UT Eth. Op. 02-07, 2002 WL 31079593 (Utah St. Bar).

(3) The New York State Bar Association Committee on Professional Ethics would prohibit paying an employee a percentage of a fee for cases that the employee referred. It would permit payment of a percentage of the firm’s profits. NY Eth. Op. 733, 2000 WL 33347719 (N.Y. St. Bar Assn. Comm. Prof. Eth.).

(4) The South Carolina Ethics Advisory Committee approved a bonus system for paralegals based on a percentage of the paralegal’s billings to the clients, as long as the percentage is not tied to a particular fee. SC Adv. Op. 97-02, 1997 WL 582907 S.C. Bar Eth. Adv. Comm.).

(5) The Illinois State Bar Association was ambiguous. A lawyer had a substantial collections practice, mainly from a single collection agency. He segregated his collections practice from the rest of his practice and determined that practice’s net income on a monthly basis. He paid an employee a set percentage of the net monthly profit from the collections practice. The Illinois Committee found this “profit-sharing arrangement would be proper provided sharing is based on a percentage of overall firm profit and is not tied to fees in a particular case.” IL. Adv. Op. 89-05, 1989 WL 550785 (Ill. St. Bar Assn.). This opinion’s ambiguity arises out of the fact that the employee apparently would not share in the lawyer’s total profit, but in the profit from the collections practice only. Arguably, our inquirer wants to do something similar: isolate a part of his firm’s practice and pay the employee a percentage of the profits from that part of the practice. The difference, as we see it, is that the collections practice presumably would have a high volume of cases, none of which individually would be likely to have a significant effect on the collections profits.⁴ The class action cases with which the inquirer is concerned would be few in number and might result in substantial fees, such that one successful result could have a major impact on the profitability of that part of the practice.

In addition to the Illinois opinion, we have found one other opinion that permits a nonlawyer to be compensated by a percentage of a subset of a law firm’s profits, as opposed to its total profits. MI Eth. Op. RI-143 (1992) approved payment of a percentage of the net profits from a law firm’s sports and entertainment practice area to a legal assistant who worked in that practice area. The Michigan committee had earlier approved paying a nonlawyer employee a bonus calculated on a lawyer’s gross or adjusted gross income, but not tied to the employee’s efforts to solicit clients. The committee did not think that basing the employee’s compensation on the net profits of a practice area, rather than the net profits of the entire firm, jeopardized a lawyer’s exercise of professional judgment. It stated that the result might be different if the compensation plan were based on the fees generated from a particular case or a particular client. Like the Illinois opinion, this opinion is cryptic, but we assume that the sports and entertainment practice of the law firm was extensive enough so that compensation was not tied to a handful of cases or clients, which is not the case with the proposal we confront.

Moreover, all other opinions and cases that we have found permit profit-sharing with nonlawyer employees only as long as it is tied to the firm’s overall profits and not to receipt of particular fees. ABA Informal Eth. Ops. 1440 (1979) and 1519 (1986); Trotter v. Nelson, 684 N.E. 2d 1150 (Ind. 1997) (profit-sharing plan may not be tied to a particular fee); State Bar of Texas v. Faubion, 821 S.W. 2d 203 (Tex. 1991) (shared fee with a nonlawyer prohibited if based on a particular case); In re Anonymous Member of the South Carolina Bar, 367 S.E. 2d 17 (S.C. 1988) (compensation plan for nonlawyers permissible based on a percentage of profits, but not if directly related to percentage of fees generated in individual case); FL Eth. Op. 02-1 (2002) (nonlawyer assistant’s bonus must be for extraordinary efforts and cannot be based upon percentage of fees generated by the assistant); KS Eth. Op. 95-09 (1995) (may share fees with collection firm, but may not base compensation on collection firm’s collections); CT Eth. Op. 93-1 (1993) (nonlawyer employees can be paid a bonus based on firm profits as long as they do not make professional decisions for the firm); NC Eth. Op. RPC 147 (1993) (cannot pay to legal assistant bonus based on income from assistant’s real estate closings).

Prohibition on Sharing Fees from a Distinct Set of Cases

Although blurred somewhat by the past opinions of this Committee, there emerges a prohibition on splitting fees with a nonlawyer employee on a contingent basis arising out of a case or a category of cases, at least unless the client approves in advance (an impracticality here). This rule and its exceptions flow from precedent, but they may not be entirely logical. How does advance client approval guarantee the lawyer’s independence, for example? Money is fungible, and every employee is going to be paid out of a law firm’s revenues, which are its fees. If it is a firm’s practice to pay bonuses tied to firm profitability, each employee has an incentive to influence the outcome of significant cases, particularly in small firms where such cases could have a major effect on profitability. In fact, even if a firm has no profit-sharing program, a nonlawyer has some incentive to affect the outcome of cases because she knows if the firm does not make a profit, it cannot afford to employ her. Nonlawyer employees or employees sharing in fees on a contingent basis would seem to pose less of a threat to independence of professional judgment than permitting a nonlawyer to be a partner in a law firm and be compensated like most partners based on a percentage of profit, particularly in a small firm where one case can have a major effect on profitability.

If we accept Opinion 286’s distinction between bonuses contingent on the fees from a specific case or series of related cases, as opposed to bonuses contingent on overall profitability, we must conclude that the inquirer’s proposal would violate Rule 5.4(a). The inquirer suggests that his proposal is not tied to a specific referral, client, or fee, but rather to revenue from pooled cases. We do not see this distinction as meaningful. If the underlying policy is to diminish the incentive for the nonlawyer to interfere with the lawyer’s practice, tying the compensation to a small, identifiable set of related cases is no different than tying the compensation to a single case.⁵

Establishing a Joint Venture Organization

If Rule 5.4(a) prohibits the proposed compensation system, the inquirer asks whether the firm can enter into a similar compensation arrangement with the consultant if, rather than hire the consultant as an employee, the firm and the nonlawyer were to form a joint venture organization pursuant to Rule 5.4(b).

Rule 5.4(b) provides

A lawyer may practice law in a partnership or other form of organization in which a financial interest is held or managerial authority is exercised by an individual nonlawyer who performs professional services which assist the organization in providing legal services to clients, but only if:

(1) The partnership or organization has as its sole purpose providing legal services to clients;

(2) All persons having such managerial authority or holding a financial interest undertake to abide by these Rules of Professional Conduct;

(3) The lawyers who have a financial interest or managerial authority in the partnership or organization undertake to be responsible for the nonlawyer participants to the same extent as if nonlawyer participants were lawyers under Rule 5.1;⁶

(4) The foregoing conditions are set forth in writing.

From the description the inquirer has provided, we assume that the employee “performs professional services which [would] assist the organization in providing legal services to clients.” Rule 5.4(a)(4) provides, “Sharing of fees is permitted in a partnership or other form of organization which meets the requirements of paragraph (b).”

The District of Columbia Court of Appeals, which governs the D.C. Bar, has determined that lawyers and nonlawyers should be permitted to form a partnership or some other form of business venture. This reflects a judgment that clients can be better served when lawyers and other professionals combine to provide professional services to the public. See D.C. Rule 5.4, comments [3], [4], and [7]. Our Court of Appeals has decided that so long as the principals of these business units adhere to the Rules of Professional Conduct, such ventures are permissible.

We conclude, therefore, that forming such an organization is permissible under Rule 5.4(b). In reaching this conclusion, we recognize that it would clearly be permissible under Rule 5.4(b) for the law firm to admit the consultant as a partner. Partners are compensated in a myriad of ways, and compensation could be based on the success of the cases on which the partner/consultant works. If the compensation system could be effected in this fashion, we see no impediment to the consultant and lawyers entering into the proposed joint venture arrangement. We take comfort from Rule 5.4(b)’s requirement that nonlawyer partners adhere to the Rules of Professional Conduct and that their lawyer partners are responsible for seeing that they do. Because the cases on which the consultant/partner would work are class actions, and because all members of the class are unknown, some of the joint venture’s “clients” will not know that a nonlawyer is a principal in the joint venture. This also would be the case if a law firm with a nonlawyer partner wants to bring a class action, and the joint venture would have to adhere to the various special rules that govern class actions and protect class members.

We point out, however, that the organization must adhere to the restrictions set out in Rule 5.4(b) as well as other restrictions set out in the Rules and elsewhere. For example, Rule 7.5(d) would require clients to be informed with clarity whether they were being represented by the law firm or by the joint venture organization, which would have to have a different names. These two entities would have to be separate entities in fact. Efforts would have to be made to protect the client secrets of the law firm from the members of the joint venture organization who were not firm members. Many of the considerations set forth in our Opinion No. 303, which concern the sharing of office space by unaffiliated lawyers, would apply. These would include separate letterhead, separate filing systems, appropriate signage if the same offices are utilized by both entities, proper telephone greetings by the receptionists, restrictions on access to computerized records, and the like.

We also believe that there would be some substantial practical barriers to the formation of such a joint venture organization unless the class action cases were all brought in the District of Columbia. No other U.S. jurisdiction permits lawyers and nonlawyers to practice together in this fashion. In fact, a member of the Virginia bar, who practices in a District of Columbia law firm that includes a nonlawyer as a partner, apparently may not engage in the practice of law in Virginia. VA Eth. Op. 1584 (1994). Were this joint venture organization to litigate any of these class actions in jurisdictions other than the District of Columbia, it might well face a claim that under the rules of the forum jurisdiction, it had entered into an unethical fee arrangement. See Rule 8.5(b) (choice of law rule applies disciplinary rules of foreign jurisdiction to conduct in connection with judicial proceedings in that jurisdiction.) In short, we believe that these practical limitations, plus the requirement that separate firms adhere to the appropriate formalities to operate in fact separately, may mean that such arrangements will be of utility only in limited circumstances.

Nevertheless, our Rules permit such organizations, and we see little distinction between forming such a joint venture organization with a consultant as a principal and the formation of a small public utilities law practice with an economist as principal. In each case the nonlawyer shares the fees, has a say in the organizational governance, and may be involved in every case. Rule 5.4 expressly allows the latter structure, and Comment 7 expressly endorses an economist’s joining a public utility practice. If our Rules allow one, they should allow both. So while the compensation plan would violate Rule 5.4(a) if implemented by a law firm, it is permitted by Rule 5.4(b) if the firm and the nonlawyer employee form a joint venture organization, provided that they adhere to the restrictions that the Rules impose on such an organization.

Adopted: 16 February 2004
Published: 17 February 2004

1. For simplicity, assume only one lawyer in the firm works on these cases.
2. Comment [8] to Rule 3.4 endorses the payment of a contingent fee to an expert witness, provided that the fee is not a percentage of the recovery. This may not be fee-splitting since the expert would presumably be paid from the client’s share of the recovery. An expert witness may not have much opportunity to interfere with the lawyer’s professional independence given the witness’s limited role. It was important to the Committee’s analysis in Opinions 233 that the same economic result could have been achieved had the client contracted with the consulting firm to pay a success fee directly rather than the fee flowing through the law firm.
3. Currently no U.S. jurisdiction other than this one permits nonlawyers to participate as partners or principals in law firms. The precedent from other jurisdictions reflects a more strict prohibition on the sharing of fees with nonlawyers, and thus its relevance is lessened somewhat.
4. The assumption is based on the typical nature of a collection’s practice. The Illinois opinion does not address this point.
5. We do not mean in any way to suggest that nonlawyer employees may not be paid a bonus because of exceptional performance or that a bonus or other compensation may not be tied to firm profitability. Many other jurisdictions have approved such arrangements and found them not to violate Rule 5.4, as long as the compensation was not tied to the fees earned from a specific case or set of cases.
6. Rule 5.1 sets forth the responsibilities of a partner or supervisory lawyer to make reasonable efforts to ensure that the lawyers she supervises or practices with conform to the Rules of Professional Conduct.