Avoiding Business Transactions with Clients
Avoiding Business Transactions with Clients
By David A. Grossbaum of Hinshaw & Culbertson, LLP, Boston, MA and Providence, RI. Grossbaum works extensively in the areas of professional liability defense and insurance coverage. He is a member and past chair of the Professional Liability Underwriting Society, a member of the New England Steering Committee, and an active member of the ABA Professionals’, Officers’, and Directors’ Liability Committee.
Attorneys frequently mix their own business interests with the business interests of their clients. The reasons may vary. Perhaps the lawyer is asked to review a business opportunity that has presented itself to the client, and realizes that the opportunity would be a good investment for the lawyer also. Maybe the client does not have the financial resources to pay the lawyer’s fee for evaluating the opportunity, and the lawyer takes an equity interest in the venture in lieu of fees. Or the lawyer finds a business opportunity and invites the client to invest. Lawyers also have been known to accept officer or director positions with clients based on the lawyer’s experience and knowledge of the client’s business. In many of these situations, lawyers provide legal services for the businesses.
From a risk management perspective, these situations are fraught with danger for the attorney. Ethical rules prohibit certain business transactions between lawyer and client, and strictly regulate all others. Moreover, professional liability insurers uniformly exclude claims that arise from business transactions in which the lawyer is an investor, director, or officer, even if the transaction meets ethical requirements.
Under Rule 3-300 of the California Rules of Professional Conduct, Avoiding Interests Adverse to a Client, lawyers are forbidden from entering into a business transaction with a client unless the transaction is “fair and reasonable” to the client, the details are fully disclosed in writing to the client in clear and understandable terms, the client is advised in writing that the client may seek independent legal advice and is given the chance to obtain such independent advice, and the client consents to the transaction in writing.
Clients may not actually seek independent advice due to cost considerations and time constraints, and the rule does not require that clients actually obtain this advice. Still further, while clients must consent to the transaction in writing after full disclosure, there is always the potential for clients to later say that they relied on the lawyer’s disclosure and that it was incomplete or biased based on the lawyer’s self-interest.
Most professional liability policies exclude claims arising out of the insured lawyer’s activities or services as an “officer, partner, trustee, or employee” of a business enterprise other than the named insured firm. This exclusion applies even if the insured does not have an equity interest in the business and even when the insured is not performing legal services for the entity. Another form of exclusion applies where the claim involves any business enterprise in which the lawyer, or members of the lawyer’s immediate family, has an ownership interest (usually between 10 to 25 percent) or exercises managerial control of the entity, and where the claim involves an allegation that the insured lawyer negligently performed legal services for the entity.
There are two primary reasons for business pursuits exclusions in professional liability policies. First, “there is an increased risk of loss and resulting claims when a lawyer renders professional services in connection with a business enterprise in which he is a partner. Business partners may be tempted to collusively convert business losses into a malpractice claim covered by the professional liability insurance of the partner who is a lawyer.” Dukart v. National Union Fire Ins. Co., 1993 Westlaw 3311175 (Del. Super.
Second, “when a lawyer is involved in the business enterprise, it may be difficult to separate strictly legal services from business activity. A lawyer who participates in a business is likely to lack the detachment that exists when the roles of lawyer and client are separate. A conflict of interest may complicate a lawyer’s relationship to business associates and affect the legal advice given in connection with their joint enterprise.” Greenberg & Covitz v. National
These types of exclusions have been upheld as valid limitations on coverage. Blumberg v. Guarantee Ins. Co., 192 Cal.App.3d 1286, 1296 (1987). The First Circuit Court of Appeals found no coverage where the insured attorneys formed a limited partnership with a client and also represented him in loans made to the partnership. Mt. Airy v. Greenbaum, 127 F.3d 15, 20 (1st Cir. 1997). The client later alleged that the attorneys misappropriated funds in the form of loans, unexplained disbursements, and management fees, and breached their fiduciary duty to him in their capacity as attorneys by concealing this conduct and in failing to advise him of these breaches of trust.
In Potomac Ins. Co. v. McIntosh, the insured law firm formed a limited partnership, and one of the lawyers was a limited partner in the business. When the venture failed, the lawyer/limited partner was accused of failing to disclose the risks of the investment and his conflicts of interest, and inducing the plaintiffs to sign partnership documents, including a personal guarantee, without explaining their significance. No coverage existed for the law firm. Potomac Ins. Co. v. McIntosh, 804 P.2d759, 762-763 (Ariz. 1991).
There are also cases in which attorneys act as buyers from, or sellers to, their clients, often with bad outcomes. For example, where the beneficiary of an estate sold one of the assets of the estate (an investment company) to an entity controlled by the attorney, the court characterized the claimant’s cause of action as “suing [the lawyer] because he allegedly permitted his association with [his own company] to cloud his professional and ethical judgment while he performed services on behalf of [the claimant].” Clauder v. Home Ins., 790 F. Supp. 162 (S.D.
It should be apparent that doing business deals with clients or accepting corporate positions with clients is risky. The incidence of claims is high, and insurance coverage is very limited or nonexistent. If you are going to take your chances, you can make some efforts to minimize the risk.
For starters, if you are going to invest with a client, you must provide a written explanation to the client as to the terms of the transaction, and it must be a fair and reasonable transaction for the client. The client must consent in writing after having the opportunity to obtain independent legal advice from another lawyer.
Strongly encourage your client to get the independent advice, perhaps by recommending other attorneys (at least three from which the client can choose one), and put that recommendation in writing. Considering that your professional liability policy may not cover you for these claims, see about obtaining some other form of protection. If you are acting solely as an officer or director, look into the existence of directors and officers insurance, or the possibility of indemnification from the company, if this is allowed by law.
Because so many of these claims arise where the lawyer is acting as investor and lawyer, resist the temptation to play both roles. If you are an investor, decline to perform legal work for the business entity, and request that the company hire separate outside counsel. If you are a lawyer for the client’s business, look for other opportunities for investing your own money.
In all of these situations, it will be difficult to forego the fees involved or the investment opportunities. With the prospect of an uninsured claim, and the costs of defense and possible claim payments, the cost/benefit analysis counsels against these relationships.
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, Aon and its affiliates, nor the author 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 through Aon Direct Insurance Administrators, administrators of the LACBA Sponsored Aon Insurance Solutions Program, to the LACBA members. www.aonsolutions.com
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