Note: This is part one of a two-part article. Join us next month when Meryl
Terpitude and California Joan map out the ethical bumps on the road to El Dorado,
acquiring stock in client companies.
Terpitude admired the golden aura of El Dorado in the distance. As he entered the city,
his chauffeur turned onto a broad golden palm-lined boulevard in the most fashionable
neighborhood. Meryl sighed with contentment as he surveyed the well-manicured grounds,
after passing through the gates and glided up to a huge mansion with his wife and children
waving at him from the front door.
Meryl awoke with a start, his pleasurable dreams of El Dorado still
lingering with him. While shaving, Meryl looked himself straight in the eyes and vowed to
accept his clients offers of taking stock in their startup companies.
Its the road to El Dorado! he sighed. I just hope that goody
two-shoes California Joan, with her unhealthy fixation on ethics, doesnt talk
the other partners out of making money investing in our clients.
Later that morning, Meryl approached Marvin Manage, the Firms
management committee chair, about a change in the Firms policy about business
transactions with clients. Marv, most big firms in California and a great number of
boutique smaller firms take equity positions in their client start-up companies,
Meryl pitched. In fact, some of the big firms will not even represent start-up
companies unless the client is prepared to give the firm an equity position plus its legal
fees. Were missing out on terrific opportunities enjoyed by lawyers all over the
Meryl, I still dont understand why corporate clients
would want their lawyers having a piece of them
. . . . Seems to me that a client would worry about the lawyers
self-interest and their loyalties, Marv said.
Marv, its just the opposite, said Meryl.
Clients perceive that lawyers equity stake in the client provides additional
loyalty incentives such as providing higher levels of business advice, in addition to the
routine legal services or increasing the quality and quantity of the investor contacts
made through the lawyer.
For other clients, giving stock in lieu of paying
attorneys fees is a means of assuring access to legal services while ensuring that
the company reserves precious cash for its start-up. Still other clients perceive that
transaction costs for lawyer-found investors will be lower because the lawyer is providing
dual legal and business services. [Gwyneth E. McAlpine, Getting a Piece of the
Action: Should Lawyers Be Allowed to Invest in Their Clients Stock? (1999) 47
UCLA L. Rev. 549, 569-575.]
We have two current clients with really hot products that keep
asking the Firm to invest in their companies these are opportunities that are too
good to pass up why, theyre the road to El Dorado!
All right, Meryl, maybe the Firms management committee
should revisit the Firms prohibition against taking equity positions in our clients.
Ill put it on the agenda for tomorrows meeting, Marv promised. Meryl pitched all of the other
members of the management committee, except California Joan, before the meeting.
The next day, at the Firms management meeting, Meryl presented
the proposal for changing the firms policy and permitting taking an equity position
in client companies. Most of the members of the committee, having heard of the earnings
that other firms garnered from their equity positions with clients, wanted to get on the
road to El Dorado with Meryl. However, they were concerned about the ethical proprieties
and the risks and turned anxiously toward California Joan, the Firms ethics and risk
management expert for answers.
California Joan cleared her throat and stated, There is no
California standard which expressly prohibits
the Firm from taking equity positions in clients. But, Cali went on, there are
three general danger zones where the potential for ethical violations or related risk is
high: (1) in the acquisition of equity positions, compliance with California professional
standards; (2) analysis of our liability insurance policy and compliance with the
guidelines of our insurers, if any, and (3) post-acquisition potential conflicts of
interest or other challenges to our fiduciary duties.
Legal malpractice insurance
Cali, lets take the legal malpractice issue first. If we
lost legal malpractice coverage because we take a flyer on a clients valueless
stock, that would be a disaster!shuddered Polly Policy, the Firms insurance
Well, Polly, the insurance company environment is changing on
these issues. Some legal malpractice policies specifically exclude coverage for any client
claims against a lawyer where the lawyer has had a business transaction with that client
or has invested in the client. Two years ago, our policy had that exclusion. Therefore,
lawyers or firms should check their errors and omissions policies carefully before
proceeding with equity investing in clients.
Cali, does our present legal malpractice policy also have a
complete exclusion?queried a nervous Polly.
No. Our current policy gives us legal malpractice coverage
provided that our equity positions or business activities with clients are limited.
Heres what it says:
The Company will not pay any Loss or any Defense Expenses
resulting from Claims against Insureds: . . . based on, arising out of or resulting from
any Wrongful Act by any Insured in connection with any entity other than an Insured where:
(1) such entity is a publicly traded company and 5 percent or more of
its issued and outstanding voting stock is owned or controlled directly or indirectly by
one or more Insureds, or was so owned or controlled at any time such entity was a client
of the Firm, or
(2) such entity is not a publicly traded company and 25 percent or
more of its issued and outstanding voting stock is owned or controlled directly or
indirectly by one or more Insureds, or was so owned or controlled at any time such entity
was a client of the Firm, or
(3) such entity is controlled, operated or managed directly or
indirectly by one or more Insureds, or was so controlled, operated or managed at any time
such business or entity was a client of the Firm.
By the way, the exclusion does not apply if the Firms
ownership, control, operation or management of such entity was exclusively in a fiduciary
capacity incident to the practice of law by the Firm, answered Cali. Many
insurers have similar policies. Some policies have no exclusions but the insurance
companies recommend that their policy holders follow certain guidelines.
Therefore, I strongly recommend that if we make equity
investments in our clients, we should comply with the limits of whatever policy we have
and we should examine the policy on a yearly basis, making sure that our investments stay
within any future limitations or exclusions, suggested Cali.
The committee then voted to appoint Cali and Polly to review their
legal malpractice insurance policy closely and make recommendations concerning the limits
of any Firm equity investment in clients or to recommend whether the firm should seek a
new policy of insurance without an exclusion.
The committee also asked them to review the activities of all lawyers
within the firm to ensure that their activities did not involve them in the operation or
management of any business or entity which was or had been a client of the Firm.
The committees written policy prohibiting any Firm lawyer from
controlling any business or entity which was a Firm client was adopted by the Partners.
The bottom line
Meryl Terpitude decided to bite the bullet and asked, So
whats the bottom line here, Cali? Do
you recommend that we take equity positions in clients or not?
Cali smiled at him and replied, Meryl, I have two answers for
you. The safest risk management position is to continue to serve our clients competently
and ethically without taking any equity positions in our clients.
However, the safest risk management decision is not always the
best business decision, especially in a climate where our business clients expect and
desire the Firm to invest in them. My recommendation, therefore, is that if the Firm makes
a business decision to invest in the clients it serves, the Firm should first develop
strict written guidelines for investment in clients to manage the ethical and legal
Moreover, once adopted, the Firm should follow those guidelines
to the letter in every transaction. Finally, the Firm should monitor the written policies
regularly and amend them as we discover changing situations or new risks.
Meryl, in disbelief that Cali might further his dreams of El Dorado,
was speechless for one of the few times in his life. The Committee adopted Calis
Ethical risks in acquiring stock
Marv then asked, Cali, what are some of the risks in acquiring
Cali answered, Marv, I have good news and bad news. The good
news is that three non-California ethics committees have issued opinions on the subject of
taking stock in a clients company in lieu of partial or full payment of attorneys
fees. [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 Association Legal Ethics Committee Opinion No. 300.] All three
have opined that taking stock in these circumstances is permissible, provided that a
lawyer comply with professional conduct rules in three basic areas:
Rules regulating business
transactions with clients (ABA Model Rule 1.8(a), N.Y. DR 5-104(A) [substantially similar
to rule 3-300, California Rules of Professional Conduct].)
Rules regulating amount of fees
(reasonable fees ABA Model Rule 1.5(a); excessive fees N.Y. DR 2-106(A); in
California, a lawyer cannot enter into an agreement, charge or collect an unconscionable
fee rule 4-200(A).)
Rules regulating conflicts of
interest having an interest in the subject matter of the transaction or
representation or having situations challenging a lawyers independence of
professional judgment (ABA Model Rule 1.7(b), (c); N.Y. DR 5-101(A); [in California, a
lawyer must disclose in writing a financial or business interest in the subject matter of
the transaction rule 3- 310(B)(4)].)
The bad news is that no California ethics opinion has been
generated on this subject at this time. Therefore,
in acquiring stock in our clients, each acquisition should be examined carefully to
determine that it complies with Californias professional standards using this
three-point test articulated in out-of-state ethics opinions, Cali finished.
Purchasing client stock
Meryl, finding his voice, asked, Cali, can we talk about
compliance with rule 3-300, Rules of Professional Conduct? The Firms transactional
department represents XYZ Corp., a publicly traded company. Lana Litigator, in the
Litigation Department, bought 1000 shares of XYZ Corp. out of billions on the open market.
Should the Firm have complied with rule 3-300?
I do not think so, Meryl, answered Cali. ABA
Opinion No. 00-418 holds the ABA counterpart rule does not apply when a lawyer acquires
stock in an open market purchase or in other circumstances not involving direct
intervention by the client. Although there is no California case or opinion on point, I
believe that the reasoning of this opinion applies to rule 3-300.
Also, in order for rule 3-300 to apply, there has to be a
business transaction with the client (not present when purchasing publicly traded stock on
the open market) or the acquisition has to be adverse to the client. The
California Supreme Court has held that whenever the lawyer has acquired the ability to
summarily extinguish the clients interest in the clients property without
judicial intervention it is adverse and the lawyer must comply with rule
3-300. [Hawk v. State Bar (1988) 45 Cal.3d 589.]
In purchasing stock on the open market, a lawyer does not
acquire the ability to summarily extinguish the clients interest in the stock
because there are client opportunities for judicial and administrative intervention.
Therefore, I do not think that rule 3-300 applies.
Of course, there are other issues for example, federal
regulations against insider trading must be complied with. Also, there may be other
applicable conflict rules which arise which I will describe later.
Accepting stock for fees
Marv Manage asked, Our client ABC Corp. owes us a substantial
past due bill for defending it in litigation for which there was no insurance coverage.
ABCs President has indicated that the company has some cash flow problems. She has
asked whether we would take shares in the company at a value equal to the amount of the
past due attorneys fees owed. Do we have to comply with rule 3-300 if we say
Marv, I think rule 3-300 applies, since its official discussion
states: Rule 3-300 is intended to apply where the member wishes to obtain an
interest in clients property in order to secure the amount of the members past
due or future fees.
Why should rule 3-300 apply to this situation, Cali?
argued Meryl. If we are taking stock that is exactly equal in value to the amount of
past due fees owed, isnt that like taking cash or a check (which do not require
compliance with rule 3-300)?
Well, Meryl, unlike cash or checks which have pretty much the
same value in time, the value of shares of stock can fluctuate, sometimes even sharply
from day to day. Therefore, while the shares of stock may be worth the exact amount of
fees on one day, the next day, week or month, the value may increase dramatically. By
accepting the shares of stock, we would acquire the ability to summarily extinguish
ABCs ownership of the stock (and thereby potential profits) by selling the stock to
a third party, without any judicial intervention. Therefore, I am concerned that taking
stock in lieu of cash for the satisfaction of past due attorneys fees may well be
considered an adverse pecuniary acquisition, even if we were to ignore the
language of the official discussion.
In any transaction in which we acquire stock in exchange for
future or past services, we should assume, for risk management purposes, that rule 3-300
applies and go through the steps of compliance. After awhile, our compliance steps will
become routine, Cali urged.
The Committee determined, as a matter of policy, to comply with rule
3-300 in all transactions wherein stock of a client was acquired in connection with fees
for attorney services.
Acceptance of stock for compensation does not invoke the presumption
of undue influence
Ernie Estate Planner got alarmed. Cali, any transaction between
a trustee and a beneficiary by which the trustee obtains an advantage from the
beneficiary, is presumed to violate the trustees fiduciary duties as set forth in
Probate Code §16004(c). I understand that §16004(c) has been expressly applied to the
attorney-client relationship, although solely for shifting the burden of proof. [Ramirez
v. Sturdevant (1994) 21 Cal. App. 4th 904, 916, 26 Cal. Rptr. 2d 554, 560.] If we accept
stock in lieu of attorneys fees, are we presumed to be in violation of our fiduciary
Actually, no, Ernie, Cali answered, trying to quell the
rush of panic spreading throughout the committee. The last sentence of §16004
specifically exempts from the presumption any agreement relating to the hiring or
compensation of the trustee/attorney. This exemption has been held to apply even
where there is a pre-existing attorney-client relationship. [Walton v. Broglio (1975) 52
Cal.App.3d 400, 404, 125Cal.Rptr.123.] Therefore, as long as we acquire the stock as part
of our hiring or compensation, the presumption of undue influence will not apply. Even
though the presumption does not apply, we still have to comply with rule 3-300.
Five steps to comply
Marv then asked Cali
what steps were required to comply with rule 3-300. Cali said compliance with rule 3-300
involves five steps:
Ensuring that the acquisition is
fair and reasonable to the client.
Documenting the terms of the
transaction in writing, in terms which can be reasonably understood by the client.
Giving the client a written
advisement of the opportunity to seek independent counsel of the clients choice.
Affording the client an
opportunity to seek the advice of independent counsel on the transaction.
Obtaining the clients
written consent to the terms of the transaction after compliance with the first four
Marv then adjourned the meeting asking Cali to be prepared to present
further detail on concepts of fairness and reasonableness in stock
transactions and compliance with the other four steps at the next meeting. As they left
the meeting, Cali smiled at Meryl, saying Meryl, were on the road to your El
Ellen R. Peck is the chair
of the State Bars Committee on Professional Responsibility and Conduct, a professor
of law and 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.