March 2000

Ethics and the Law
Investing in Your Client's Business

This article looks at some ethical issues under Washington's Rules of Professional Conduct where a lawyer acquires an equity interest in the client's business, either separately as an investment, or wholly or partially in payment of legal fees.

In the past, lawyers often charged a modest fee to set up a client's new business, hoping it would grow and generate substantial paid legal services. Occasionally a lawyer separately invested in the client's business, the client perhaps agreeing to pay the lawyer's legal fees out of the investment. This was often rewarded with a long-term lawyer-client relationship and a mutual lawyer-client loyalty as the client's business and the lawyer's practice grew.

Things are not the same today. Increasingly, clients urge lawyers, or lawyers themselves ask to invest in clients' start-up or emerging businesses, either in place of, or as part of, or as a condition for, their traditional legal fees. While some lawyers feel compelled by their clients to invest, others willingly do so, hoping to earn more from those investments than from traditional legal fees. The lawyer has three options: (1) do not invest, and hope the client will continue to use the lawyer for paid legal services; (2) invest, but discontinue providing legal services; or (3) invest and continue providing legal services. The third choice is the most ethically perilous, but perhaps most financially rewarding.

Lawyers investing in clients usually do so in their own name, or in the name of their law firm, or through an investment partnership or holding company distinct from their law firm. Before doing so, they should determine how such interests are to be held and owned, especially on a lawyer's departure from, and on dissolution of, the law practice. Regardless of how held, this article assumes the interest is obtained directly from the client or its affiliates, and does not address equity acquisitions from third parties or through open-market transactions.

A lawyer's investment in a client can be attractive to both client and lawyer. Both want the client's business to prosper. The client may receive needed but perhaps otherwise unaffordable legal services, and apply saved cash to other urgent business needs. The client may prefer knowing its legal services will cost a predetermined fixed amount of its equity rather than an uncertain amount based on unpredictable hourly-based legal fees. A fixed equity payment in lieu of legal fees likely reduces inefficiency and any incentive under hourly billing to overwork legal issues, and may avoid disputes over the reasonableness of fees. However, unless fixed fees or the equity investment in lieu of fees are intended to be entirely contingent on closing of the transaction in question, the fee agreement should specify how fees are to be calculated if the transaction is abandoned or does not close — a determination which may in effect require the lawyer to maintain hourly billing records to justify fees as reasonable. While private practitioners are always at financial risk as to their own legal practices, by taking equity in the client in lieu of legal fees, they also assume the added risk that their clients' businesses will fail, perhaps endangering their law practices. Lawyers may accept added risks, hoping clients' businesses will succeed and reward them with high-valued securities.

The two principal ethical concerns under the Rules of Professional Conduct of a lawyer considering investing in a client, either in lieu of, or in addition to, payment for the lawyer's fee, are the lawyer's duty to assure that: (1) the lawyer's fee is reasonable, and (2) the lawyer's duties as a fiduciary and of loyalty to the client are not undermined by the lawyer's self-interest in receiving legal fees or an investment return.

If a lawyer's equity interest in a client is in partial or full payment of the lawyer's legal fees, the lawyer must assure that the lawyer's fee is reasonable as required by RPC 1.5. That rule sets out eight non-exclusive factors for determining the reasonableness of a fee:

(1) The time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly and the terms of the fee agreement between the lawyer and client;

(2) The likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer;

(3) The fee customarily charged in the locality for similar legal services;

(4) The amount involved in the matter on which legal services are rendered and the results obtained;

(5) The time limitations imposed by the client or by the circumstances;

(6) The nature and length of the professional relationship with the client;

(7) The experience, reputation, and ability of the lawyer or lawyers performing the services; and

(8) Whether the fee agreement or confirming writing demonstrates that the client had received a reasonable and fair disclosure of material elements of the fee agreement and of the lawyer's billing practices.

A lawyer's fee agreement should specify the factors on which the fee is to be based. RPC 1.5(c)(1) provides that where the fees are contingent on the outcome of the matter for which the service is rendered, the agreement must be in writing. For example, an agreement under which legal fees are contingent on the successful completion of a public offering, a refinancing or an asset sale, must be in writing.

Determining what is reasonable is not easy given the rule's non-exhaustive factors and variations in lawyer expertise, client sophistication, resources, type and urgency of transactions and legal problems, and so on. For example, where a lawyer and client have agreed to a value-based fee rather than hourly-based fee, and the lawyer's efforts enable the client to dispose of a corporate asset for much more, or acquire a new corporate asset for much less than the client reasonably expected, should the lawyer not be able to handsomely profit from those efforts, even when the amount of time expended by the lawyer may have been very modest? A client may be willing, even eager, to pay more for a prestigious law firm to handle a securities offering than for a lesser-known but equally competent firm to handle it, simply because the prestigious firm's name gives the offering credibility without which underwriters might be unwilling to handle the transaction. What is a reasonable fee for a value-oriented client may be very different than for a cost-oriented client.

RPC 1.5 does not require that legal fees be paid in cash, nor prohibit a lawyer from receiving payment in other property. Determining what is a reasonable fee becomes more complex, however, where the fee is paid other than in cash, such as where it is paid wholly or partially by an equity interest in the client's business. The lawyer must then justify as reasonable both the underlying legal fee and the value of the equity interest. That valuation may well be questioned later by the client (or the client's management or other shareholders), especially if the investment has increased substantially in value or if there has been a parting of ways between the lawyer and the client.

In determining the reasonableness of a fee paid wholly or partially in the form of an equity interest in a client, it is appropriate to consider factors beyond those specifically enumerated in RPC 1.5. For example, these may include: (1) the likelihood that the transaction in question will or will not be closed, and whether there are any contingent plans for payment of legal fees; (2) the estimated current and future value of the equity 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 (e.g., client options to repurchase, prohibitions from selling to a client's competitor) or by law (e.g., holding provisions under securities laws); (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. See Opinion No. 98-13 of the Utah Ethics Advisory Opinion Committee (December 4, 1998).

A lawyer taking an equity interest wholly or partially in place of fees undertakes a greater risk of ultimate nonpayment of those fees than does a lawyer paid entirely in cash. That is because the lawyer undertakes both the risk that the transaction might not close successfully and that the lawyer might not be paid for legal services, and the added risk that, even if the transaction is successful, the investment may still turn out to be worth less than the otherwise cash value of those fees. This higher risk justifies the lawyer's receipt of a higher present value of compensation in the form of an equity interest than would the receipt of mere cash fees, even though the reward for the risk, if the business fully succeeds, may be a substantially higher amount of compensation. The present value of any restricted or non-public equity interests should be further reduced to reflect their reduced liquidity. The lawyer receiving such equity interests would be wise to seek an independent evaluation, perhaps by an investment banker, of the present value of such interests. For an interesting comparison of lawyer and investment banker fees, see Geoffrey Furlonger, Time for Business — Lawyers to Stop Billing Time?, 27 Law Office Economics & Management (1986), reprinted in Beyond the Billable Hour — An Anthology of Alternative Billing Methods, edited by Richard C. Reed, ABA Section of Economics of Law Practice (1989).

A lawyer with a financial interest in a client's business, however acquired, has a personal interest which may interfere with the lawyer's duties to the client. If there is any possibility that it will materially interfere, the lawyer may not undertake or continue the representation without compliance with RPC 1.7(b). Even if there is no possibility of a material interference, if a lawyer acquires an equity investment in the client's business directly from the client (or enters any other business transaction with the client), the lawyer must comply with the RPC 1.8(a).

Since business transactions with clients are presumed fraudulent by the lawyer, the lawyer has the burden of proving otherwise. Strict compliance with the provisions of RPC 1.7(b) and RPC 1.8(a) permits the lawyer to satisfy that burden.

RPC 1.7(b) prohibits a lawyer from representing a client if the representation of that client "may" be materially limited by the lawyer's own interests, unless two conditions are satisfied: (1) the lawyer reasonably believes the representation will not be adversely affected; and (2) the client consents in writing after consultation and a full disclosure of the material facts. The rule is intended to assure the lawyer's loyalty to the client and that the lawyer's own interests do not adversely effect the representation. Comment 6 to Rule 1.7(b) of the ABA Model Rules of Professional Conduct.

(a) Reasonable Belief of No Possibility of Material Limitation. In applying RPC 1.7(b), the lawyer's required belief is measured both subjectively and objectively. The RPCs define "reasonably believes" as denoting "that the lawyer believes the matter in question and that the circumstances are such that the belief is reasonable." As to lawyers, the RPCs define "reasonably" as denoting "the conduct of a reasonably prudent and competent lawyer." RPC 1.1 defines "competence" as requiring "the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation."

Cumulating these definitions, the lawyer must thus subjectively believe there is no possibility of material interference, and objectively, in the eyes of other reasonably prudent and competent lawyers, that belief must be reasonable. This is not an easy standard to meet. Lawyers will have differing subjective beliefs based, for example, on the size of the investment (in proportion to their other investments or the percentage of the client owned by the lawyer), their personal comfort with differing levels of risk, whether their investment is active or passive, and the scrupulousness of their conscience. To some extent, a lawyer's subjective belief is measured by the lawyer's "gut-reaction," whereby the lawyer either feels comfortable or not in being able to give independent advice without regard to the lawyer's personal financial interest. The objective test, however, is more stringent. If other reasonably prudent and competent lawyers would reasonably believe that there is any possibility of a material interference, even if remote, the transaction is subject to the rule. As a practical matter, lawyers should assume RPC 1.7(b) will apply to any investment in a client since the burden will be on them to prove the contrary.

Lawyers wanting to become active participants in their client's business, for example, by holding a general partner interest in their real estate development joint venture, are significantly more at risk under the conflicts rules. Their ability to properly represent a client is far more likely to be materially limited and adversely affected than where the lawyer passively invests as a minority common stockholder. As an active investor, the lawyer's roles as independent counsel and partner easily become confused. It may be unclear whether the lawyer is acting as a lawyer or a partner, and whether the lawyer is giving legal advice or business advice. It may also be unclear whether or not communications with the lawyer are protected by attorney-client privilege and the ethics rules. When such an active investment fails, the lawyer's client and other investors are far more likely to claim in hindsight that the lawyer unethically violated the conflicts provisions and should thus be liable to them for malpractice and be subject to disciplinary sanction.

(b) Written Client Consent. To satisfy RPC 1.7(b), the client must "consent in writing" to the representation or continued representation. The RPCs define "consent in writing" as either "(a) a written consent executed by a client, or (b) oral consent given by a client which the lawyer confirms in writing in a manner that can be easily understood by the client and which is promptly transmitted to the client." As a practical matter, the lawyer should not rely merely on a client's oral consent but should always secure actual written consent. If the lawyer confirms in writing the client's oral consent and transmits it to the client, the lawyer should also require the client to return a signed copy of the confirmation acknowledging receipt and confirming the consent.

(c) Client Consultation and Disclosure. The rule requires that the client's consent only be given after "consultation and full disclosure of the material facts." The RPCs define "consultation" as "communication of information sufficient to permit the client to appreciate the significance of the matter in question." Although RPC 1.7(b) does not require the communication of information or the disclosure be in writing, RPC 1.8(a)(1), discussed below, does require that it be in writing. The cautious lawyer will always provide written disclosure to the client, both to better serve the client and to document that the disclosure was in fact made.

Since the rule requires full disclosure, do not skimp on disclosure. Provide at least the same disclosure a wholly independent lawyer would require, for example, for the client of a third party proposing an equity investment in the client. Then, to be safe, provide even more complete disclosure. Fully disclose, for example, why and how the representation may be materially limited by the lawyer's own interests. Explain possible lawyer/client conflicts in interest. Where the lawyer owns or is planning an equity investment in the client, explain fully the terms of the proposed investment, including the risks, advantages and disadvantages to the client and the lawyer. Explain the possibility that the lawyer acting as shareholder may become adverse in interest to the client or its management, and explain the consequences. If the lawyer is becoming an investor, explain that information communicated by the client to the lawyer as an investor is not protected by the attorney-client privilege or by ethical rules on confidentiality. Provide full disclosure to the client in advance of the transaction in a document separate and apart from the documentation appropriate for the investment itself, since the lawyer must show full disclosure and that the client had adequate time to consider the disclosure and transaction.

Some equity investments in a client may not materially interfere with the lawyer's representation of a client, and thus RPC 1.7(b) may not limit them. Substantially all direct equity investments in a client's business, however, are subject to RPC 1.8(a). That rule prohibits a lawyer who is representing a client from entering into a business transaction with a client unless: (1) the transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing to the client in a manner which can be reasonably understood by the client; (2) the client is given a reasonable opportunity to seek the advice of independent counsel in the transaction; and (3) the client consents thereto.

(a) Commercial Transactions Exempted. RPC 1.8(a) does not apply to standard commercial transactions between the lawyer and the client for products or services that the client generally markets to others, for example, banking or brokerage services, medical services, products manufactured or distributed by the client, and utilities services. Comment 1 to Rule 1.8 of the ABA Model Rules of Professional Conduct. The comment notes that in such transactions, the lawyer has no advantage in dealing with the client, and the restrictions of RPC 1.8(a) are unnecessary and impracticable. Thus a lawyer's purchase of an equity interest in a publicly held client through a stock purchase or reinvestment plan, or through a broker-dealer unaffiliated with the client, will generally not be subject to RPC 1.8. Similarly, an in-house lawyer for a client with an employee stock-option plan may participate in that plan, and purchase equity interests in the client, without regard to RPC 1.8. The lawyers are still subject, of course, to RPC 1.7(b) and to laws relating to insider trading, confidentiality rules, and so on.

(b) Client Relationship Must Exist. RPC 1.8(a) only applies where a lawyer-client relationship exists. It is not always clear, however, where that relationship begins and ends. As a practical matter, lawyers should assume it exists with all current clients and former clients except where there is an unequivocal disengagement letter or a very long interval since legal services were last rendered or owed to the "former" client. RPC 1.8(a) does not prohibit a lawyer from asking a client's permission to directly invest in the client's business, something formerly prohibited by Ethical Consideration 5-3 under the predecessor Rules of Professional Responsibility.

(c) Opportunity to Consult with Independent Counsel. RPC 1.8(a) requires a client to have the "opportunity" to consult independent counsel. The cautious lawyer will not be satisfied with the client merely having that opportunity, but will instead require the client to consult independent counsel. Although clients may be reluctant to incur the cost, without such independent consultation, the lawyer will have a far heavier burden of proving thereafter the lawyer did not exercise undue influence. When in doubt, overdisclose, overexplain, overconsult, overdocument, and give the client an excessive amount of time to ponder the investment and consult independent counsel. A lawyer was disciplined for not allowing a client adequate opportunity to consult independent counsel when a business loan was consummated in a single day. In re Discipline of Hartke, 529 N.W.2d 678 (MN. 1995).

(d) Limitations on Investment. The RPCs prohibit several indirect forms of investment in a client by continuing the common-law prohibitions on maintenance (providing client living expenses) and champerty (investing in a client's lawsuit), now embodied in RPC 1.8(e) and (j). RPC 1.8(j) prohibits a lawyer from acquiring a proprietary interest in the cause of action or subject matter of litigation the lawyer is conducting for a client, but does permit the lawyer to acquire a lien granted by law to secure the lawyer's fee or expense, and to contract with the client for a reasonable contingent fee in a civil case.

Great ethical dangers lie in wait for the lawyer when a client, usually unable to pay continuing legal bills, offers the lawyer (often at the insistence of the lawyer) an interest in the client's business or a lien on its property, often shortly before trial or other material event. Acquiring such an interest or lien is subject to the provisions of RPC 1.8(a), and the lawyer must take great care to assure that all those provisions are fully satisfied. Failure to do so, especially if the client is dissatisfied with the result of the litigation or other transaction, will almost certainly guarantee the client claiming the lawyer coerced the client into granting the interest or lien, and assure a malpractice suit and disciplinary grievance if the lawyer seeks to enforce the interest or lien.

If a corporate client's survival depends on the outcome of a particular lawsuit, a significant direct equity investment in the client's business by the lawyer handling the lawsuit might also be viewed as a prohibited investment either by providing the client "living expenses" or as being in effect an investment in the underlying lawsuit. The concerns underlying these prohibitions are that the lawyer's financial assistance would subsidize or encourage a client to continue a lawsuit that might otherwise be forsaken, and that a lawyer's objectivity may be sacrificed if he or she has a direct financial interest in the lawsuit.

A lawyer considering an equity investment in a client, whether as part of a fee payment or otherwise, has the burden of proving that the investment is not fraudulent to the client. In most cases the lawyer can do this only by strictly complying with, and fully documenting the compliance, with each requirement of RPCs 1.7(b) and 1.8(a). A combined checklist of requirements follows:

(1) The lawyer must reasonably believe the lawyer's representation of the client will not be adversely affected [RPC 1.7(b)(1)];

(2) The equity investment and terms on which the lawyer acquires it must be fair and reasonable to the client [RPC 1.8(a)(1)];

(3) The lawyer must fully disclose and transmit to the client in writing the terms, risks and benefits of the equity investment in a manner the client can reasonably understand [RPC 1.7(b)(2) and RPC 1.8(a)(2)];

(4) After the lawyer fully discloses the transaction and its terms, the lawyer must consult with the client [RPC 1.7(b)(2)];

(5) The client must be given a reasonable opportunity to seek the advice of independent counsel about the equity investment [RPC 1.8(a)(2)]; and

(6) The client must consent in writing after consultation and a full disclosure of the material facts [RPC 1.7(b)(2) and RPC 1.8(a)(3)].

To assure compliance, a lawyer considering investing in a client should have another lawyer in the office review the lawyer's compliance before the investment is made. Since RPC 5.1(a) requires partners in law firms to make reasonable efforts to ensure that the firm has, in effect, measures giving reasonable assurance that all lawyers in the firm conform to the RPCs, and RPC 5.1(b) requires supervisory lawyers to make reasonable efforts to ensure that other lawyers conform to the RPCs, every law office should have a strictly enforced written policy that no lawyer in the firm may invest in a client, whether directly, or wholly or partially in lieu of payment of legal fees, without first proving to the managing partner complete satisfaction and documentation of each and every requirement.

When in doubt as to the fairness or reasonableness of the equity investment, either take less or agree in writing with the client to secure and abide by an independent written appraisal or valuation of the proposed equity interest. Do not charge the client for costs associated with investing in the client. If the client can secure the equity investment on better terms from a third party, the lawyer's proposed terms are likely not fair and reasonable to the client, and the lawyer should advise the client to deal with the third party. When investing in a client, the "fair and reasonable" test is satisfied only where the lawyer, a fiduciary, puts the client's interest above the lawyer's interest.

What appears fair and reasonable at the start of the investment may appear overreaching when the lawyer-client relationship falters or the client's business so prospers as to result in an arguable windfall to the lawyer. If the client's business or securities offering fails, dissatisfied shareholders may look to both client and lawyer. An investor lawyer may find himself or herself with a conflict of interest and be unable to exercise shareholder rights he or she might otherwise have against the client, particularly where the lawyer holds confidential client information.

The Washington Supreme Court's approach to lawyer-client business transactions is direct, consistent and blunt: lawyer-client business transactions are presumed fraudulent on the part of the lawyer and the lawyer has the burden to prove they are not. In effect, a lawyer who fails to comply with his or her ethical obligations in a business transaction with a client becomes a guarantor or insurer of the success of that transaction.

In a series of cases, all involving loans from clients to lawyers, the Court made it clear that lawyers are expected to be fair and reasonable with, and not take advantage of, their clients, to fully disclose all material facts to them, consult with them, obtain their written consent, and document that disclosure and consent. These principles apply equally where the lawyer directly invests in a client's business. The underlying rebuttable presumption is that the lawyer has an unfair advantage over the client in the lawyer-client relationship which is incompatible with the lawyer's role as a fiduciary, since the lawyer is both knowledgeable about the legal aspects and has confidential information about the clients resulting from the representation. For a more general discussion of business transactions with clients, see Barrie Althoff, Gifts and Loans to or from Clients, Washington State Bar News, (December 1998), p.42, some of which is incorporated below.

In re McGlotlen, 99 Wn.2d 515, 524-525, 663 P.2d 1330 (1983), outlines the Court's approach:

The disclosure which accompanies an attorney-client transaction must be complete. Moreover, the burden upon the attorney defending his or her actions is a great one.

So strict is the rule on this subject that dealings between an attorney and his client are held, as against the attorney, to be prima facie fraudulent, and to sustain a transaction of advantage to himself with his client the attorney has the burden of showing not only that he used no undue influence, but that he gave his client all the information and advice which it would have been his duty to give if he himself had not been interested, and that the transaction was as beneficial to the client as it would have been had the client dealt with a stranger. [citations omitted] . . . .

Thus, an attorney attempting to justify a transaction with a client has the burden of showing (1) there was no undue influence; (2) he or she gave the client exactly the same information or advice as would have been given by a disinterested attorney; and (3) the client would have received no greater benefit had he or she dealt with a stranger.

In the same case, the Court declared its intent to hold lawyers to a high standard in meeting the RPC requirements wherever the lawyer's status as a lawyer gives him or her disproportionate influence over the persons with whom he or she is dealing. 99 Wn.2d 515, 517. The Court found in that case that although the lawyer's "conduct as measured against ordinary standards was entirely proper, it did not meet the stringent requirements imposed upon an attorney dealing with his or her client." [99 Wn.2d 515, 525]. In a subsequent case, the Court, quoting the extended quotation above, also stated that, "Although McGlothen was decided under the former Code of Professional Responsibility, this rule applies equally under the RPC." In re McMullen, 127 Wn.2d 150, 164, 896 P.2d 1281 (1995).

The Supreme Court subsequently observed that while RPC 1.8 does not explicitly require the lawyer's advice to seek independent counsel be in writing, or that the client's consent to the transaction be in writing, "the prudent attorney will advise the client in writing . . . . A prudent attorney will normally obtain the consent of the client in writing as well." In re Gillingham, 126 Wn.2d 454, 462 note 5, 896 P.2d 56 (1995).

The Court disbarred a lawyer for numerous conflicts of interest, including loaning without client consent one client's trust funds to another; advising another client to loan money to a corporation partially owned by the lawyer without disclosing the lawyer's interest or advising the client to seek independent counsel; and representing that same corporation when it was sued by another client who had also invested in the corporation at the lawyer's invitation. In re Stock, 104 Wn.2d 273, 704 P. 2d 611 (1985).

The Court suspended another lawyer from practice for twice borrowing money from clients without providing clients with full written disclosure of his precarious finances. In re Johnson, 118 Wn.2d 693, 826 P.2d 186 (1992). It suspended another lawyer for, among other things, borrowing client money without meeting the RPC requirements, even though the client originally offered the money to the lawyer as a gift, but at the lawyer's request, instead loaned it. In re Gillingham, 126 Wn.2d 454, 896 P.2d 656 (1995).

The Court suspended another lawyer for borrowing from a financially unsophisticated client on terms unfair and unreasonable to the client, and for not fully disclosing material facts to the client, including that the lawyer was not credit worthy. In re McMullen, 127 Wn.2d 150, 164, 896 P.2d 1281 (1995). The interest rate, at a rate then current for secured loans, was viewed as unfair because the loan in question was unsecured, thus suggesting the client was entitled to a higher rate of interest. The investment was also inappropriate for the client in terms of the client's age and need for current income.

An investment in a client's business, if wholly or partially in payment of fees, must be "reasonable" in amount under RPC 1.5 in relationship to the value of the legal services rendered. Any direct equity investment in a client is presumed fraudulent to the client unless the lawyer can prove, among other things, that it is fair and reasonable to the client, that the lawyer fully disclosed in writing to the client all material facts, that the lawyer consulted with the client, that the client had a reasonable opportunity to consult independent counsel, and that the client consented in writing to the transaction. The lawyer will have a harder time proving this where the lawyer is an active rather than a passive investor, and where the lawyer secures the interest from a continuing client immediately before litigation or other material event. If a lawyer carefully complies with the RPCs, however, and satisfies his or her fiduciary duties to the client, the lawyer may invest in a client's business to the profit of both client and lawyer.

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