INVESTING IN CLIENTS/STOCK FOR FEES

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John S. Dzienkowski & Robert J. Peroni, The Decline in Lawyer Independence: Lawyer Equity Investments in Clients, 81 Tex. L. Rev. 405 (Dec. 2002). Putting aside the authors' somewhat negative view of lawyers investing in clients, this is a very comprehensive (143-page) and useful treatment of the subject. It covers the ways lawyers and law firms invest in clients, the ethics rules and ethics opinions, the interface with securities laws, and the problems for clients and lawyers sometimes introduced by such investments.  Virtually all the material that follows this paragraph on this page is considered and updated in this article.

       Lawyers Doing Business with their Clients: Identifying and Avoiding Legal and Ethical Dangers, A Report of the Task Force on the Independent Lawyer, Section of Litigation Section, American Bar Association (undated, but released in January 2002).  This is a 181 page document exhaustively treating the entire subject of doing business with clients.  The Task Force does not propose the prohibition of the practice, but rather makes suggestions for doing it safely and ethically.  One of the many helpful appendices is one containing ALAS' suggested policies and forms for law firms wanting to regulate this practice.  This wonderful compendium stands in sharp contrast with the Litigation Section's heavy-handed and ill conceived attempt ten years ago to prohibit law-related businesses.  This new report describes that effort, among many other things.  To see the report, click here.

        On July 7, 2000, the ABA Standing Committee on Ethics and Professional Responsibility issued its Formal Opinion 00-418, "Acquiring Ownership in a Client in Connection with Performing Legal Services."  It contains no surprises.  It says that such arrangements are not per se unethical.  It says that lawyers taking client securities must comply with Model Rule 1.8(a).  That means the arrangement must be in writing, the client be afforded a reasonable opportunity to consult with other counsel, the client's consent to the arrangement be in writing, and the terms be "fair and reasonable" to the client.  The opinion discusses the interplay of the "fair and reasonable" requirement of Rule 1.8(a) and the requirement of Rule 1.5(a) that fees be "reasonable."  It also deals with the need to disclose possible conflicts to the client and the role of Model Rule 1.7(b).  

        N.Y. City Bar Op. 2000-3 (2000), which was rendered soon after ABA Op. 00-418, basically tracks the ABA Op. 00-418, described above.  In brief summary, it is slightly more lenient than ABA Op. 00-418.  It says that the lawyer does not have to comply with N.Y. DR 5-104(A) (N.Y.'s version of Model Rule 1.8(a)), unless the client is relying upon the advice of the lawyer with respect to the fee transaction itself.  Thus, the Committee concludes, there may be instances in which a lawyer takes stock in lieu of fees where it would be appropriate to treat the arrangement as any other fee arrangement.  The sophistication of the client and complexity of the transaction will obviously play a role in whether this is the case.  In other respects, N.Y. City Bar Op. 2000-3 (2000) is comparable to ABA Op. 00-418.

        D.C. Bar Op. 300 (July 25, 2000).  It mentions ABA Op. 00-418 and N.Y. City Bar Op. 2000-3, only in a footnote, but states that Op. 300 reaches the same conclusions as those two opinions.  Actually, unlike N.Y. City Bar Op. 2000-3, Op. 300 does not discuss situations in which such an arrangement might not be subject to Rule 1.8(a) or its New York counterpart, DR 5-104.

        Restatement.  See §§ 76 & 126.

        Rule 1.8 and DR 5-104(A).  Failure to comply with Rule 1.8(a) can have harsh consequences. In Passante v. McWilliams, 62 Cal. Rptr. 2d 298 (Cal. App. 1997), failure to comply with California’s version of Rule 1.8(a), in part, cost the lawyer his ability to collect $32 million worth of stock from a client.  In BGI Associates, LLC v. Wilson, 7 Cal. Rptr. 3d 140 (Cal. App. 2003), a lawyer's evident failure to comply with the California rule caused him to lose breach of contract case.  Likewise, in DiLuglio v. Providence Auto Body, Inc., 755 A.2d 757 (R.I. 2000), the court held that a lawyer’s failure to comply with Rule 1.8(a) in contracting with a client could entitle the client to rescind the contract. (The court denied rescission in DiLuglio, because the client waited six years to raise the issue.)  Rhodes v. Buechel, 685 N.Y.S.2d 65 (N.Y. App. 1999) (recission appropriate where disclosure not adequate).  In In re Nelson, 681 N.W.2d 352 (Minn. 2004), the lawyer was disbarred.  In In re Trewin, 684 N.W.2d 121 (Wisc. 2004), a lawyer was suspended for five months for lending money to clients but not complying with Rule 1.8.  Same result in In re Gebo, 796 N.Y.S.2d 918 (N.Y. App. 2005).  Lawyer leased property from client without complying with New York's version of Rule 1.8(a); client stated a cause of action for breach of fiduciary duty, McMahon v. Eke-Nweke, 503 F. Supp. 2d 598 (E.D.N.Y. 2007). 

        1.8(a); Referring Client to Wife's Real Estate Firm.  N.J. Op. 696 (5/16/05).  The Committee said that where a lawyer for an executor lists estate property with the real estate broker employing his wife, the lawyer must comply with New Jersey’s version of Model Rule 1.8(a).

        1.8(a); Lawyer for Estate and Realtor for Estate Sale Should Have Complied with Rule.  In re Estate of Brown, 930 A.2d 249 (D.C. App. 2007).

        Fee unreasonable; 1.8(a) discussed.  Holmes v. Loveless, 94 P.3d 338 (Wash. App. 2004).  A law firm represented a real estate joint venture in connection with the development of a shopping center.  The fee agreement provided for a discounted billing rate for 2 1/2 years in exchange for an agreement to pay the law firm 5% of the revenues of the shopping center.  After the shopping center became successful, the joint venture balked at paying the 5%.  In litigation over the fee, this court held that the fee, while possibly reasonable when it was agreed to, had become unreasonable and was no longer enforceable. 

        Patent Practice.  In a case related to Rhodes, the court addressed a federal regulation allowing lawyers to take an interest in a patent in lieu of a fee, 37 CFR 10.64(a)(3), Buechel v. Bain, 713 N.Y.S.2d 332 (N.Y. App. 2000).  The court held that the regulation did not excuse lawyers from the disclosure requirements of DR 5-104(A).  This was affirmed by the New York Court of Appeals, Buechel v. Bain, 766 N.E.2d 914 (N.Y. 2001).  37 CFR 10.1 provides that PTO regulations do not preempt the right of states to regulate the practice of law.  L.A. County Bar Op. 507 (2001) says that a lawyer may contract with a client for a contingent fee in connection with a new patent prosecution.  It further says that 5% of net profits from the sale of the invention was not unconscionable.  It said that the lawyer did not have to comply with California Rule 3-300, California's version of Model Rule 1.8(a).  Lastly, it said the lawyer did have to comply with section 6147(a) of the California Business & Professions Code, the section regulating contingent fees.  The opinion does not mention the PTO ethics rules.  D.C. Op. 195 (1988) is the same as the L.A. opinion.  William E. Jackson, Contingent Fee Representation in Intellectual Property Cases, 1 U. Balt. Intel. Prop. L.J. 207 (1993). 

        But see Day v. Meyer, 2000 U.S. Dist. LEXIS 13470 (S.D.N.Y. 2000) (court refused to grant summary judgment to client even though California lawyer violated California's version of Rule 1.8(a)).

        Discipline.  Gersten v. Statewide Grievance Committee, 1997 Conn. Super LEXIS 1590 (Conn. Super. 1997) (lawyer disciplined for not complying with Rule 1.8(a)); Attorney Grievance Commission of Maryland v. Hines, 783 A.2d 656 (Md. 2001) (lawyer had piece of company; misbehaved).

        Taking security for fees.  ABA Op. 02-427 (2002) discusses this subject in substantial detail.  In Re Snyder, 35 S.W.3d 380 (Mo. 2000).  This was a disciplinary proceeding involving, in part, a lawyer's taking an interest in a client's real estate in lieu of a cash fee to defend a criminal proceeding.  The court held that the lawyer should have complied with Missouri's version of Model Rule 1.8(a).  That includes advising the client of the terms of the arrangement in writing, giving the client an opportunity to seek the advice of independent counsel, and getting the client's consent in writing.  The lawyer failed to comply with Rule 1.8(a) and was suspended for six months.  In McRentals, Inc. v. Barber, 62 S.W.3d 684 (Mo. App. 2001), a lawyer bought a business from a client, and the court held that he substantially complied with Rule 1.8.  In Welsh v. Case, 43 P.3d 445 (Ore. App. 2002), the court upheld a mid-stream mortgage for fees, even though Oregon DR 5-104(A) was not complied with, because the mortgage was not for the clients' benefit, and the clients were sophisticated.  In Cotton v. Kronenberg, 44 P.3d 878 (Wash. App. April 22, 2002), the lawyer had taken the client's real estate and mobile home.  The court held that the fee was not fair and reasonable and violated Rule 1.8(a).

        Rule 1.8(j): suing on note not the same as seeking to foreclose on mortgage.  Ankerman v. Mancuso, 860 A.2d 244 (Conn. 2004).

        Rule 1.8(j): mortgage taken from client during litigation not valid as against public policy.  McLaughlin v. Amirsaleh, 844 N.E.2d 1105 (Mass. App. 2006).

        Mid-stream fee changes.  In Valley/50th Ave., L.L.C. v. Stewart, 153 P.3d 186 (Wash. 2007); In re Haley, 138 P.3d 1044 (Wash. 2006), In re Richmond, 904 A.2d 684 (N.H. 2006), In re Hefron, 771 N.E.2d 1157 (Ind. 2002), Petit-Clair v. Nelson, 782 A.2d 960 (N.J. Super. 2001), and Cotton v. Kronenberg, 44 P.3d 878 (Wash. App. 2002), the courts held that lawyers who seek to change a fee arrangement after the representation is under way must comply with Model Rule 1.8(a).  In  Naiman v. New York University Hospitals Center, 351 F. Supp. 2d 257 (S.D.N.Y. 2005), the court relied, in part, on New York's version of Model Rule 1.8(a) in invalidating a mid-stream change in a contingent fee agreement.  Other authorities that deal harshly with mid-stream fee changes (but not citing Rule 1.8(a)) are United States Postal Service v. Haselrig Construction Co., 349 F. Supp. 2d 955 (D. Md. 2004); The Florida Bar v. Shankman, 908 So. 2d 379 (Fla. 2005); McConwell v. FMG of Kansas City, Inc., 861 P.2d 830 (Kan. App. 1993); Rose v. Failey, 140 N.E.2d 711 (Ill. 1957); Anderson v. Sconza, 534 N.E.2d 445 (Ill. App. 1989); Miller v. Solomon, 199 N.E.2d 660 (Ill. App. 1964); and Jordan v. Ray Schools-Chicago, Inc., 199 N.E.2d 827 (Ill. App. 1964). See also Chicago Bar Op. 93-1 (1993), which characterizes mid-stream fee changes as "presumptively fraudulent." For a recent contrary view under the Model Code, see Welsh v. Case, 43 P.3d 445 (Ore. App. 2002).

        Arbitration Clause Inserted by Lawyer in Business Agreement not Enforceable by Lawyer.  Harris v. Albany Lime & Cement Co., 2008 Ga. App. LEXIS 470 (Ga. App. April 24, 2008).  

        Lawyer taking real estate in lieu of a fee just prior to filing.  In re Wentzell, 656 N.W.2d 402 (Minn. 2003).  Lawyer disciplinary proceeding.  Just prior to his client’s filing for bankruptcy, the lawyer had the client convey property to the lawyer in payment of fees the client owed the lawyer.  The lawyer was disciplined because his disclosures to the bankruptcy court were inadequate and because of misstatements the lawyer made in connection with the conveyance.  [Note: the author of this site has been asked by law firms about taking real estate from nearly-insolvent clients in payment of fees.  While it certainly may be possible, it should be done extremely carefully, with due regard for the law of preferences, fraudulent conveyances, and the bankruptcy disclosure rules for conflicts of interest.]

        Disqualification. Pennsylvania’s version of Model Rule 1.7(b) was cited in Simms v. Exeter Architectural Products, Inc., 868 F. Supp. 668 (M.D. Pa. 1994). A lawyer attempted to represent a corporation in which he was a shareholder. The court found that relationship created an inherent conflict of interest and disqualified the lawyer.  Likewise, in Landzberg v. 10630 Berea Rd., Inc., 2002 Ohio App. LEXIS 1085 (Ohio App. 2002), a lawyer/shareholder of a tavern attempted to represent the tavern in a tort case involving an assault at the tavern.  The lawyer was also the manager of the tavern on the evening of the occurrence.  Because he was almost certainly going to be a witness, the court disqualified his law firm.      

        Class Certification Denied.  In Sipper v. Capital One Bank, 2002 U.S. Dist. LEXIS 3881 (C.D. Cal. 2002), the court held that because the lawyer who sought to be class counsel was in business with the person who sought to be class representative, the class could not be certified.

        Tax Court Determinations.  The following cases dealt with the imposition of negligence penalties by the IRS.  The defense was that the taxpayer relied on the advice of lawyers in not paying the tax or in paying less than the IRS claimed.  In each case the court denied the defense because the lawyer had a business relationship with the taxpayer and, therefore, had a conflict of interest.  Addington v. Commissioner, 205 F.3d 54 (2d Cir. 2000); Wiest v. Commissioner,  2002 Tax Ct. Summary LEXIS 32 (T.C. 2002); and Barlow v. Commissioner, T.C. Memo 2000-339, 2000 Tax Ct. Memo LEXIS 402 (2000).  To the same effect are Goldman v. Commissioner, 39 F.3d 402 (2d Cir. 1994),  Weitzman v. Commissioner, T.C. Memo 2001-215, 2001 Tax Ct. Memo LEXIS 252 (T.C. 2001), and Robnett v. Commissioner of Internal Revenue, 2001 Tax Ct. Memo LEXIS 26 (T.C. 2001), except in those cases, the opinion was that of an accountant who had a business relationship with the taxpayer.  A somewhat related case is Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Tex. 2007) .  There the court held that to avoid penalties taxpayers could rely on the tax shelter opinion of a law firm that represented not only the taxpayers but also the promoter of the shelters.

        Liability. Written court opinions regarding the liability of lawyers investing in clients are rare. The author is aware of a handful of malpractice settlements where the lawyer’s additional role as investor had an undeniable effect on the decision of the lawyer, his law firm, and his law firm’s carrier to settle. While such settlements are few in number, they have been for substantial amounts. An example of how a lawyer’s investment can affect a tribunal’s attitude is SEC v. National Student Marketing Corp., 457 F. Supp. 682 (D.D.C. 1978). That was an enforcement proceeding brought by the SEC against certain participants in a transaction and several of their lawyers. One of the lawyers stood to profit from the consummation of the transaction in question because he owned stock in his client. The court went out of its way to comment on that, 457 F. Supp., at 711.

        Julia D. Gray, Pillsbury Winthrop Accused of Malpractice in Atlanta Trust Fund Case, Fulton County Daily Report, December 19, 2001.  Following is a summary of the article.  Timothy Cobb is the divorced father of two sons, each of whom is beneficiary of a trust.  Crichlow is a partner at Pillsbury, and until November 2000, was trustee of the trusts.  Pillsbury represented the trusts.  The new trustee is Madelyn Adams, former wife of Cobb and mother of the beneficiaries.  She has sued Cobb, Crichlow and Pillsbury Winthrop.  It seems that the trust had made loans to Cobb's company, edaflow, totaling $2.4 million.  Crichlow is an investor in edaflow.  The trusts made additional loans totaling some $400,000 to other companies in which Cobb and Crichlow had interests.  Much of the money has been lost.  Among other claims, Adams claims Crichlow had violated the prudent investor rule (the trusts had a total value of $6.5 million).  She also claims Crichlow and the firm had a conflict of interest and were guilty of malpractice.  

        Gupta v. Rubin, 2001 U.S. Dist. LEXIS 450 (S.D.N.Y. 2001).  This opinion was in connection with the denial of a FRCP 12(b)(6) motion, so the ultimate significance of the case remains to be seen.  Nevertheless, it is an illustration of possible malpractice liability resulting from a law firm's doing business with a client.  In this case, plaintiff alleges that his law firm did not disclose its business relationship with another party, with whom the plaintiff was doing business.

        R. Robin McDonald, Scam Outfit's Law Firm Sued for Not Checking Fraud Operator, Fulton County Daily Report, August 4, 2000.  According to this article defrauded investors have sued Philadelphia's Schnader, Harrison, Segal & Lewis for its having represented an investment partnership that was running a Ponzi scheme.  A partner in the law firm had invested $50,000 in the partnership and is believed to have lost $40,000.  The principal allegation against that lawyer and the law firm is that they did not check out the background of one of the investment partners.  He had been fired from two brokerage firms and had been sued several times.  In one case he had a $1.3 million judgment entered against him.

        Other Cases on Investing in or with Clients: Avianca, Inc. v. Corriea, 705 F. Supp. 666 (D.D.C.), aff'd, 1995 U.S. App. LEXIS 30863 (D.C. Cir. 1995); Rothman v. Wilson, 121 F.2d 1000 (9th Cir. 1941); Ruth v. Crane, 392 F. Supp. 724 (E.D. Pa. 1975), aff'd, 562 F.2d 90 (3d Cir. 1977); In re Spear, 774 P.2d 1335 (Ariz. 1989); Gold v. Greenwald, 55 Cal. Rptr. 660 (Cal. App. 1966); Melson v. Michlin, 223 A.2d 338 (Del. 1966); Tower Investors, LLC v. 111 East Chestnut Consultants, Inc., 864 N.E.2d 927 (Ill. App. 2007) (partners invested in entity that lent money to clients; client was unsuccessful in using this against firm); Comm. on Prof. Ethics and Conduct of Iowa State Bar Ass'n. v. Humphreys, 524 N.W.2d 396 (Iowa 1994); Comm. on Prof. Ethics and Conduct of Iowa State Bar Ass'n. v. Mershon, 316 N.W.2d 895 (Iowa 1982); Mathews v. Spears, 24 So. 2d 195 (La. App. 1945); Goldman v. Kane, 329 N.E.2d 770 (Mass. App.01975);  Rowland v. Monroe, 1996 Minn. App. LEXIS 1195 (Minn. App. 1996);  In re Lowther, 611 S.W.2d 1 (Mo. 1981); In re Discipline of Singer, 865 P.2d 315 (Nev. 1993); In re D'Angelo, 733 P.2d 360 (N.M. 1986); In re Reiss, 502 A.2d 560 (N.J. 1986); Greene v. Greene, 436 N.E.2d 496 (N.Y. 1982); In re Harrington, 718 P.2d 725 (Or. 1986); In re O'Byrne, 694 P.2d 955 (Or. 1985); In re McGlothlen, 663 P.2d 1330 (Wash. 1983). 

        Other Ethics Opinions:  Col. Op. 109 (2001); D.C. Op. 179 (1987);  Kan. Op. 98-06 (9/15/98);.Miss. Op. 230 (1995); Pa. Op. 89-158 (1989); Utah Op. 98-13 (1998); Va. Op. 1593 (1994).

        Treatises.  Hazard & Hodes §§ 11.17 & 12.2-12.5; Rotunda & Dzienkowski § 1.8-2(a)(1).

        Law Reviews.  John S. Dzienkowski & Robert J. Peroni, The Decline in Lawyer Independence: Lawyer Equity Investments in Clients, 81 Tex. L. Rev. 405 (Dec. 2002); Jason M. Klein, No Fool for Client: The Finance and Incentives Behind Stock-Based Compensation for Corporate Lawyers, 1999 Colum. Bus. L. Rev. 329; Gwyneth E. McAlpine, Getting a Piece of the Action: Should Lawyers be Allowed to Invest in their Clients' Stock? 47 U.C.L.A. L. Rev. 548 (1999); Richard M. Maltz, Lawyer-Client Business Transactions: Caveat Counselor, 3 Geo. J. Legal Ethics 291 (1989).

Investing/Taking Stock - Some Practical Guidelines

        Much is being written about the trend of law firms investing in clients and taking stock in lieu of fees. Some law firms have done fabulously well in doing both. The interest of firms that have not done these things to begin doing them is intense. Thoughtful commentators and the author agree on the following:

  1. Taking stock in lieu of fees and investing in clients should not be done at the whim of individual lawyers but rather under supervision of the firm’s management group or special committee set up for that purpose.  That will make more likely an objective evaluation of the economic viability of the arrangement, quality of the client, compliance with securities laws, and adherence to applicable conflict of interest and other ethics rules.

  2. All firms should have an insider trading policy and take steps to ensure that all lawyers and staff are periodically reminded of it.

  3. Be constantly mindful of Model Rule 1.8(a) – in particular its requirement that the client be urged to seek other counsel, and its requirement that the client ’s consent to the arrangement be in writing.

  4. Ensure that these practices do not run afoul of the firm’s malpractice insurance policy.

  5. Try to ensure that each position not be a large percentage of the client’s securities or a large percentage of the firm’s investment portfolio.

  6. Avoid shady clients. If the enterprise fails – and many high tech enterprises have begun to fail – the risks of being involved in an aiding and abetting claim, or a claim that the firm was a principal violator of SEC Rule 10b-5, are substantial.

        Recent thoughtful articles on these subjects appear at the June 7, 2000, Current Report of the ABA/BNA Lawyers’ Manual on Professional Conduct (discussion of the 26th ABA National Conference on Professional Responsibility); and at the June 15, 2000 Legal Times ("Risky Business," by Vanessa Blum).

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