Note: This is part two of a two-part series. Part one, also eligible for one
hour of MCLE credit in legal ethics, appeared in the December 2000 Bar Journal and also is
available online in the December Bar Journal web version, www.calbar.org.
California Joan, under an edict to report back to the Firms management
committee about compliance with ethical requirements in accepting stock in client
companies in lieu of fees for legal services,
felt as overwhelmed as the farmers daughter ordered by her king to spin a room full
of straw into gold by morning. (Folktale, Rumpelstiltskin.) Cali decided to consult
Silicon Valley lawyers who popularized taking stock in their start-up company clients and
attended a roundtable seminar involving some of the gurus of those law firms talking about
these ethical issues.
PRACTICAL TIPS ON THE FIVE STEPS TO RULE 3-300 COMPLIANCE
In complying with rule 3-300, Rules of Professional Conduct,
how can we ensure that the acquisition of a clients stock in exchange for legal
services is fair and reasonable to the client? asked Panel Moderator.
Much of the time, this is not a difficult issue. The value of
the stock has already been set for founders shares or for friends and
family shares or by the market.
Therefore, the amount of stock ultimately transferred can be
based upon these set values in exchange for like value of services at an hourly rate or
fixed fee, said Genaro Counsel, the general counsel of Starte Upps, the renowned
Silicon Valley law firm that had successfully started up more companies than Mrs. Fields
has cookies and had profited from successful investments in their clients.
If possible, I think the stock should be valued at the amount
per share that cash investors, knowledgeable about its value, have agreed to pay for their
stock about the same time, cautioned Elmer Ethics, Chair of the Euphoria City Bar
Association Legal Ethics Committee.
Ivy Invest, partner of another well-known Silicon Valley law firm,
Take It Public Inc., added: The value of an agreed percentage of stock to be issued
is not always reasonably ascertainable.
Suppose, for example that a lawyer is engaged by two founders
who are contributing intellectual property for their stock and they have not established
the cash value of their contribution. In this case, it is likewise difficult to establish,
with reasonable certainty, the value of the shares to be issued to the lawyer.
Therefore, the percentage of stock agreed upon should reflect
the value, as perceived by the client and the lawyer at the time of the transaction, so
that the legal services will contribute to the potential success of the enterprise.
(American Bar Association Formal Ethics Opinion 00-418.)
Well, I think that a lawyer in those or similar circumstances
should seriously consider engaging an investment professional to advise as to the value of
the securities. The client can then make its own in-formed decisions as to the
reasonableness of the transaction, El-mer Ethics retorted. (Association of the Bar
of the City of New York Com-mittee on Profes-sional and Judicial Ethics Formal Opn.
Genaro added, While that might be appropriate risk management,
we dont want to set that as a standard since those expenses are often prohibitive
for a start-up company or for small and solo law firms.
Darla Defender, a partner at a well-known legal malpractice defense
law firm, focused upon vesting of the stock after the value was determined. Vesting
of the stock may create problems of fairness, if the stock vests to the lawyer or law firm
before the services are completed.
After you have created a stock for fees agreement that is fair
and reasonable, step two involves documenting the terms of the transaction in writing, in
terms which can be reasonably understood by the client.
Most of the time, since you may be dealing with sophisticated
people, that is not a problem. However, as a risk management issue, I try to use language
in a document that could ultimately be understood by members of a jury, Genaro said.
Ivy added, Yes, but mere transfer of the stock may be an
insufficient writing. Try using a fee agreement or memorandum of understanding. Also, make sure that you have the terms of the
transaction and the consent of the appropriate directors or officers recorded in the
corporate minutes or other appropriate documents.
Once youve completed the documentation of the terms of
your stock acquisition, dont forget step three! You must advise the client, in
writing, of the opportunity to seek independent counsel of the clients choice,
reminded Darla Defender.
Next, step four requires that you afford the client an
opportunity to seek the advice of independent counsel on the transaction. While the amount
of time varies with the immediacy of the clients need for legal services, the client
must have some time to actually consult with counsel, claimed Elmer Ethics.
Ivy added her experience, If the client elects to consult
independent counsel, remember to document the name of the lawyer whom the client
consulted. If the client does not consult other counsel, have the client acknowledge that
they had an opportunity to consult counsel but declined to do so.
The last step, concluded Genaro, requires you to
obtain the clients written consent to the terms of the transaction after compliance
with the first four steps. If you have a client corporation, make sure the consent is
recorded in the corporate minutes or that other corporate formalities are undertaken.
CHALLENGES TO THE DUTY TO EXERCISE INDEPENDENT JUDGMENT
After compliance with rule 3-300, a lawyer must still determine
whether this ownership interest in the client reasonably might affect the exercise of
independent professional judgment on behalf of the client. What are the issues lawyers
should consider? asked Panel Moderator.
I think that you have to analyze the representation against the
acquisition, replied Genaro Counsel. If there is merely a fanciful,
theoretical or de minimus risk that the lawyers judgment will be affected adversely
by a potentially relevant set of interests, the ethical duties should not be
Wait a minute . . . interrupted Elmer Ethics, the
duty to exercise independent judgment on behalf of a client has long been understood to
foreclose the lawyer from undertaking a representation, even with the clients
consent after full disclosure, if there is a reasonable probability, based upon an
objective standard, that the lawyers interests will affect adversely the advice to
be given or the services to be rendered to the client. (New York State Ethics Opinion No. 712 (1999).)
I think there is some middle ground here, said Darla
Defender. Lawyer acceptance of securities as compensation for future legal services
to a client company may affect the lawyers professional judgment.
For example when a lawyer accepts a client corporations
securities as a fee for negotiating and documenting an equity investment, or for
representing it in connection with an initial public offering, there is a risk that the lawyers judgment will be skewed in
favor of the transaction to such an extent that the lawyer may fail to exercise
independent professional judgment. But this possibility is fact driven and not inherent in
Elmer added, It is also possible that the lawyers
interest may create economic pressure to get the deal done, and that this
pressure in turn may impact the lawyers independent judgment on disclosure issues,
creating liability for both client and lawyer.
Ivy Investment disagreed. This risk is not really any different
from when a lawyers cash fee depends (in whole or in part) on a business transactions
successfully closing. In both cases, the lawyer is invested in the
Yet the contingent fee arrangement has long been accepted as
ethical if the fee is appropriate and reasonable and the client has been fully informed as
to alternative billing arrangements. (ABA 389 (1994).)
There is really no ethical distinction between the
transactional contingent fee and agreeing to take client securities instead of cash fees.
(Association of the Bar of the City of New York Committee on Professional and Judicial
Ethics Formal Opn. 2000-3.)
Elmer was not to be put off. Surely, the risk to a lawyers
independent judgment would be especially high when there is a potentially very large fee
paid in client securities which represents both a significant portion of the law firms
revenues and a substantial stake in the clients business.
The desire to obtain such a fee might diminish, inadvertently,
the willingness of the attorney to advise the client company to disclose negative
information or increase the lawyers willingness to issue a questionable legal
opinion required to close the deal.
This would present a non-consentable actual conflict and the
fee arrangement might be ethically prohibited. (Association of the Bar of the City
of New York Committee on Professional and Judicial Ethics Formal Opn. 2000-3.)
Genaro Counsel said, To prevent this happening, our firms
stake in its clients is limited to 1 percent or less and we try to limit our reliance on
particularly big clients.
Elmer added another example. Compromising independent judgment
can also occur when a lawyers compensation depends directly in whole or in part on
the amount of fees generated for the firm and where the particular lawyer is also
responsible for providing the legal services involved.
To minimize these kinds of risks, our firm does not allow
individual lawyer investments in the clients for which the lawyer provides services,countered
Ivy added, Our firm allows individual lawyer investment. But as
a risk management issue, we either prohibit an attorney from working on matters of a
client that he or she brought into the firm and that is that is paying its fees through
securities or place some other partner in charge of the matters. (Association of the
Bar of the City of New York Committee on Professional and Judicial Ethics Formal Opn.
2000-3, fn. 12.)
Elmer added, In evaluating the potential for erosion of the
independence of judgment, lawyers should consider factors such as the size of the
investment in proportion to the holdings of other investors, the potential value of the
investment in relation to the law firms earnings or assets, the possible impact on
the lawyer of levels of risk involved, and whether the investment is active or passive.
(Association of the Bar of the City of New York Committee on Professional and Judicial
Ethics Formal Opn. 2000-3; see also Investing in Your Clients Business,
Wash. State Bar News (March 2000).)
Darla Defender added the final word. However, even if not
ethically mandated, if there is the potential for exposure to charges of diminution of
exercise of independent judgment. As a matter of risk management, make a full disclosure
in writing of the relevant circumstances and the reasonably foreseeable adverse
consequences to the client and obtain the clients written consent to continued
ILLEGAL OR UNCONSCIONABLE FEES
Panel Moderator introduced a new topic. In California, a lawyer
can not enter into an agreement for, charge or collect an illegal or unconscionable fee.
What steps do lawyers need to take to ensure that they do not run afoul of these
prohibitions set forth in rule 4-200, Rules of Professional Conduct?
Darla responded first. Uncon-scionability is determined by the
factors enumerated by rule 4- 200(B). Therefore, any fee including stock should be
evaluated according to those factors to make sure the fee is not unconscionable.
Elmer Ethics chimed in again. But securities received for legal
services is a more complex question. Lawyers should consider additional factors,
especially when stock relates to start up businesses or is part of a public
offering of securities.
The Association of the Bar of the City of New York Committee on
Professional and Judicial Ethics Formal Opn. 2000-3 listed some of these additional
(1) the likelihood the transaction in question will or will not
close and whether there are any contingent plans for payment of legal fees; (2) the
estimated current and future value of the equity [i.e., securities] interest considering
all the normal risks of a start-up business and any specific risks to the business or its
assets; (3) the liquidity of the interest, including whether it is now or may in the
future be publicly traded; (4) any restrictions on transfer of the interest, whether by
agreement with the client . . . or by law; (5) the percentage amount of the interest, and
what, if any, degree of control it provides the lawyer over the business; and (6) what
restrictions, if any, are placed on the money used to pay for the equity interest
for example that it must be used to pay future legal bills.
Genaro Counsel raised another point. Some ethics committees in
other states have opined that a contingent fee is created where securities are given as an
attorneys fee in payment for legal services furnished in a public offering. (See
Kansas Bar Association, Ethics Opinion 98-6 (Sept. 25, 1998); Association of the Bar of the City of New York
Committee on Professional and Judicial Ethics Formal Opn. 2000-3.)
The difficulty in estimating the value of the securities or the
size of the fee until the success or failure of the matter or transaction has been
established creates elements of contingency. Moreover, the failure of the offering will
likely lead to no securities being given, or whatever is given being worthless, creating
further analogies to a contingency fee.
Therefore, lawyers fee agreements in these type of
circumstances should include the statutory requirements for a contingency agreement.
(See Business & Professions Code §6147.)
Ivy Invest added another wrinkle. Especially with securities in
a startup company, the fair market value of the stock cannot be determined with any degree
of assurance, until the transaction or matter is completed. If an equity stake in a
corporation turns out to be successful, the value of the stock at a high point might seem
unconscionable in relation to the services rendered if the value is determined only with
the wisdom of hindsight.
Genaro added, To make this evaluation after a success is
completely unfair. It overlooks the value of
the fee that the client agreed to pay or the lawyer accepted, because it eliminates the
risk that the lawyer undertook that the venture would fail and the securities would have
little or no value!
Yes, for every one big success, there are only a few
investments where the law firm breaks even and some start-up clients stock becomes
worthless, added Ivy.
That is why recent ethics committees have opined that whether
the fee violates ethical limits on fees must be determined at the time that the
transaction was entered into, giving value to the lawyers risk. (See American
Bar Association Formal Ethics Opinion 00-418, Association of the Bar of the City of New
York Committee on Professional and Judicial Ethics Formal Opinion 2000-3, District of
Columbia Bar Associ-ation Legal Ethics Committee Opinion No. 300.)
Darla Defender added one issue: When the applicable corporate
law prohibits a corporation from paying fees for future professional services, a lawyer
should ensure that the stock does not vest until after the completion of the legal
services to prevent the collection of an illegal fee prohibited by rule
WITHDRAWAL OR DISCHARGE
Panel Moderator asked, Darla, what should a lawyer or law firm
do when they have accepted securities in whole or in part as a substitute for cash fees
and they are discharged by the client or withdraw before finishing the contemplated legal
Rule 3-700(D)(2), Rules of Professional Conduct require a
lawyer to refund any part of a fee paid in advance that has not been earned,
answered Darla. If work has not been completed, unearned portions of the stock must
be credited or refunded to the client.
Leaving the seminar, Cali resolved to consult with the participants
to tailor a risk management program that was appropriate to her firms individual
clients and her firms desired investments and covered other practical legal
compliance issues. Most of all, Genaro Counsels closing words rang in her ears:
Dont get greedy, dont think you are going to get rich from any single
clients stock, and be careful out there!
Ellen R. Peck is the chair
of the State Bars Committee on Profession-al Responsibility and Conduct, a professor
of law/professional responsibility at Concord University School of Law, and a co-author of
the Rutter Groups California Practice Guide Professional Responsibility. She
practices in Escondido.