The Perils of Doing Business with Your Client
(County Bar Update, May 2003, Vol. 23, No. 5)

The Perils of Doing Business with Your Client

Business relationships with clients often create a conflict between the lawyer’s personal interest and those of the client. There is an increased risk of a malpractice suit where a conflict of interest exists. In defending a legal malpractice case, the three most troubling types of business relationships between lawyers and clients are: 1) investment in a client’s business, 2) acceptance of stock in lieu of a cash fee, and 3) acceptance of a position as an officer or director of a client corporation. This article will review some representative types of business transactions with clients, and the ethical and legal malpractice issues they present.

Routine Business Transactions

Consider Relevant Ethical Rules.  As a fundamental rule, all fee agreements must meet the ethical requirements of Model Rule 1.8 (a) of the ABA Model Rules of Professional Conduct (or the equivalent rule adopted in each state):
  The transaction must be fair and reasonable to the client.
  The fee arrangement must not involve differing interests between lawyer and client.
  The terms of the transaction and any potential conflicts of interest must be fully disclosed to the client.
  The client must be given a reasonable opportunity to seek independent legal advice.
  The client must consent to the arrangement.

Scrutinize the Transaction. Before engaging in business transactions with clients, serious consideration should be given to the following issues:

  Does the transaction involve publicly traded securities of a client? If so, the buying and selling of such stock through normal securities broker channels ordinarily will not raise any risk management concerns, provided precautions are taken to comply with the firm’s insider trading regulations.

  How substantial is the investment? Some experts suggest that if a particular investment exceeds 5% of a lawyer’s net worth, or involves the purchase of 2% or more of a client’s stock, it is probably substantial enough to create a conflict of interest likely to compromise the lawyer’s representation of the client.

  Did the investment result from direct negotiations with the client or otherwise give the lawyer a possible edge over other investors? If so, there is a much greater likelihood that the lawyer or law firm will become the target of a later suit claiming inside information or preferential treatment.

Investment in a Client’s Securities

Avoid Investment in an Initial Public Offering (IPO). When acting as counsel for the issuer or underwriter of an IP0 under the Securities Act of 1933, a lawyer (or the lawyer’s firm) should never invest in the underwriters’ original offering of stock. It is not uncommon for the price of IP0 stock to soar in the early months of an offering. Windfall profits obtained under these circumstances often will be held to be a conflict of interest if, following the failure of the enterprise, suit is brought by disappointed investors who have suffered large losses. In addition, such profits may subject the lawyer and/or firm to an inquiry or investigation by the SEC.

Accepting Client’s Stock in Lieu of a Cash Fee

Start-up companies or corporate clients whose budget for legal services is high may suggest that the law firm accept corporate stock in lieu of cash for the legal services rendered.

  Consider potential dangers inherent in a business scenario. While the conflict of interest rules in the ABA Model Rules of Professional Conduct do not specifically prohibit the acceptance of stock or other property from a client in respect of payment of fees, the ethical requirements of Rule 1.8(a) must be heeded. Several authorities, such as the Restatement of the Law: The Law of Lawyering, frown upon this practice, analyzing the host of ethical dangers inherent in accepting stock as payment of legal fees.

  Be prepared to withstand scrutiny under a judicial microscope. Even if a “stock in lieu of cash fee” transaction passes the hurdle of fairness and reasonableness initially, it constitutes a “business transaction” between lawyer and client. Such arrangements are disfavored by many courts because they place lawyers in a position to take (or fail to take) appropriate action on behalf of clients to enhance their personal interests.

In addition, while the acceptance of stock might not constitute an actual conflict of interest, the mere appearance of such a conflict could be the pivotal factor in a jury trial. Wary of the inherent dangers of self-dealing with clients, courts scrutinize these business transactions more closely than other dealings between attorney and client. Because of the attorney’s superior knowledge and education, many courts will hold the attorney to a higher standard of care. In cases of this nature, lawyers have the burden of proving that they acted fairly and in good faith after disclosing all pertinent facts to the client. Given the general attitude of the courts in nearly all states, this is a difficult burden to meet.

Insider Trading

Evaluate Potential Liability for Insider Trading and SEC Scrutiny.  Another issue concerns possible exposure of clients linked to insider trading. Under usual circumstances, the purchase or sale by a law firm of the publicly traded stock of a client would survive ethical and legal scrutiny, provided the firm exercises necessary precautions against insider trading violations. However, where the firm is representing the client in active litigation, the opportunity and temptation to act on inside information increases greatly.

Assess Tax Considerations. Before accepting property from a client as compensation for services, a firm should consider the potential tax problems involved. For example, how would the stock in question be valued for tax purposes — book value or market value? In what year will the value of the stock be reported as income to the firm? These issues will certainly be of prime concern to the IRS, a governmental agency that regularly targets lawyers.

Evaluate Management Precedent Set by Stock for Fee Arrangements. The acceptance of stock in lieu of a fee from one corporate client could create a management precedent the firm might later regret with that client as well as others. The arrangement also could lead to bickering within the firm, particularly if the stock decreases dramatically in value and partners complain it was held too long.

Because of the problems inherent in business transactions with clients, many firms either flatly prohibit the transactions with clients and acceptance of stock or other property from clients in lieu of cash fees, or allow such arrangements only in special cases, after approval by partners not directly involved with the client representation at issue. Implementation of these policies, or those similar, can significantly reduce legal malpractice claims that can result from such activities.

This article is intended to inform the reader of potential liability exposures for attorneys. This article reflects general principles only and does not render legal advice. Readers should consult legal, financial, insurance and other advisors if they have specific concerns. Neither the Los Angeles County Bar Association nor Aon and its affiliates assumes any responsibility for how the information in this article is applied in practice or for the accuracy and completeness of the information. Reproduction without written permission is prohibited. This article is made available to County Bar Update by Aon Direct Insurance Administrators, administrators of the Aon Attorneys’ Advantage Program, part of the LACBA Sponsored Aon Insurance Solutions Program. The Aon Attorneys’ Advantage Program provides a wide variety of benefits and products exclusive to LACBA members. For information or to contact a representative, visit http://www.aonsolutions.com.

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