Taking client's stock for fees

You work in a small law firm. You have a client that you believe has a great idea for a start up company. However, the client has very little money and will not be able to afford extensive legal fees. In lieu of monetary payment, the client offers you a stock position in his company. Can you accept his offer?

ABA, state and local bar association ethics opinions view such fee arrangements as business transactions with clients and generally require lawyers to comply with Rules 1.5 Fees, 1.7 Conflict of interest: Current Clients and 1.8 Conflict of Interest: Current Clients: Specific Rules of the ABA Model Rules of Professional Conduct or the applicable state version of these rules before they enter into such transactions. Under circumstances where the acquisition of the stock is tantamount to the acquisition of a proprietary interest in the subject matter of the litigation under Rule 1.8(i), such an agreement is permitted so long as the fee is considered to be a reasonable contingent fee.

In 2000, the ABA Standing Committee on Ethics and Professional Responsibility issued Formal Opinion 00-418 [PDF] Acquiring Ownership Interest in a Client in Connection with Performing Legal Services (2000). The headnote of this opinion states as follows:

The Model Rules of Professional Conduct do not prohibit a lawyer from acquiring an ownership interest in a client, either in lieu of a cash fee for providing legal services or as an investment opportunity in connection with such services, as long as the lawyer complies with Rule 1.8(a) governing business transactions with clients, and, when applicable, with Rule 1.5 requiring that a fee for legal services be reasonable. To comply with Rule 1.8(a), the transaction by which the lawyer acquires the interest and its terms must be fair and reasonable to the client, and fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client. The client also must be given a reasonable opportunity to seek the advice of independent counsel in the transaction and must consent to the transaction in writing. In providing legal services to the client's business while owning its stock, the lawyer must take care to avoid conflicts between the client's interests and the lawyer's personal economic interests as an owner, as required by Rule 1.7(b), and must exercise independent professional judgment in advising the client concerning legal matters as required by Rule 2.1.

Rule 1.8(a) of the ABA Model Rules states:

a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to 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 in a manner that can be reasonably understood by the client;

(2) the client is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel on the transaction; and

(3) the client gives informed consent, in a writing signed by the client, to the essential terms of the transaction and the lawyer's role in the transaction, including whether the lawyer is representing the client in the transaction.

Please note that the current version of the ABA Model Rules differ from the Rules as they existed at the time Formal Opinion 00-418 was issued. In 2002 the ABA Model Rules underwent a substantial revision pursuant to the ABA Ethics 2000 Commission's (E2K) recommendations. One of these amendments consisted of re-phrasing the third sentence of paragraph 4 of the Comment to Rule 1.5 so that it includes a reference to Rule 1.8(a). The second and third sentences of Paragraph 4 of the Comment to Rule 1.5 now state as follows:

...A lawyer may accept property in payment for services, such as an ownership interest in an enterprise, providing this does not involve acquisition of a proprietary interest in the cause of action or subject matter of the litigation contrary to Rule 1.8 (i). However, a fee paid in property instead of money may be subject to the requirements of Rule 1.8(a) because such fees often have the essential qualities of a business transaction with the client.

See also the addition of the following sentence to Paragraph 1 of the corresponding Comment to subpart (a) of Rule 1.8

It (rule 1.8(a)) does not apply to ordinary fee arrangements between client and lawyer, which are governed by Rule 1.5, although its requirements must be met when the lawyer accepts an interest in the client's business or other nonmonetary property as payment of all or part of a fee.

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The E2K's Web site is located here. The E2K's Official Reporter's explanation of changes memoranda for each Rule are available here.

Opinion 00-418 stated that a "stock for fees" transaction must meet the reasonableness standards under both Rules 1.5 and 1.8:

...In our opinion, a lawyer who acquires stock in her client corporation in lieu of or in addition to a cash fee for her services enters into a business transaction with a client, such that the requirements of Model Rule 1.8(a) must be satisfied. [FN7] In determining whether Rule 1.8(a)'s first requirement of fairness and reasonableness to the client is satisfied, the general standard of Rule 1.5(a) that "[a] lawyer's fee shall be reasonable" and the factors enumerated under that Rule are relevant. ABA Formal Opinion 00-418 at 3

...In addition to assuring that the stock transaction and its terms are fair and reasonable to the client, compliance with Rule 1.8(a) also requires that the transaction and its terms must be fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client. [FN17] Thus, the lawyer must be careful not only to set forth the terms in writing, but also to explain the transaction and its potential effects on the client- lawyer relationship in a way that the client can understand it. 00-418 at 6

Opinion 00-418 stated further that the lawyer should be careful to specify in the fee agreement the scope of the services to be performed, and also whether the stock interest should be viewed as a general retainer or as a fee advance.

The Opinion also warned of potential conflicts between the lawyer and client of the lawyer were to acquire an ownership interest in the client:

There may, however, be other circumstances in which the lawyer's ownership of stock in her corporate client conflicts with her responsibilities as the corporation's lawyer. For example, the lawyer might have a duty when rendering an opinion on behalf of the corporation in a venture capital transaction to call upon corporate management to reveal material adverse financial information that is being withheld, even though the revelation might cause the venture capital investor to withdraw. [FN30] In that circumstance, the lawyer must evaluate her ability to maintain the requisite professional independence as a lawyer in the corporate client's best interest by subordinating any economic incentive arising from her stock ownership. The lawyer also must consider whether her stock ownership might create questions concerning the objectivity of her opinion. She must consult with her client and obtain consent if the representation may be materially limited by her stock ownership. 00-418 at 10.

State and local bar association ethics committees that have considered the "stock for fees" issue come to conclusions that are similar to those reached in Opinion 00-418. See, e.g. Colorado Opinion 109 (2001); District of Columbia Ethics Op. 300 (2000); Iowa Opinion 02-01 (09/18/02) Business transactions with clients; Fees; Conflicts of interest; Utah State Bar Opinion 98-13 (1998); and Virginia Ethics Op. 1131. Some of these opinions explore some of the issues raised in Opinion 00-418 in greater detail. For example, Colorado Opinion 109 (2001) provides an analysis of the potential problems that could arise if the fee agreement was unclear as to whether it is to be considered as a fee advance or as a retainer:

...The Issue of Advance Fees

Receipt by a lawyer of an ownership interest in a client in lieu of cash fees is equivalent to receipt of advance fees, in whole or in part, if the services for which the ownership interest is given have not yet been performed or the client does not receive some benefit in return for the ownership interest at the time the interest is received. Under Colo. RPC 1.15 and the Colorado Supreme Court's holding in In the Matter of Larry D. Sather, 3 P.3d 403 (Colo. 2000), advance fees remain property of the client until earned.

In structuring an arrangement under which a lawyer receives an ownership interest in a client before performing the legal services for which the ownership interest is given, the lawyer must determine, with the client's consent, whether some portion or all of the equity interest has been earned at the time the engagement is entered into. The justification for such a decision and the manner in which it is memorialized should comply with the requirements in Sather for dealing with a cash payment that qualifies as an "earned retainer." If the equity interest is not intended as an earned retainer and does not meet the test under Sather, it remains the property of the client. In that case, if the equity interest takes the form of, for example, certificated securities, the lawyer must keep them in a safe deposit box or another appropriate location of safekeeping (see Colo. RPC 1.15(a) and Comment to Colo. RPC 1.15

If the investment in the client is not intended or does not qualify as an "earned retainer," as described in Sather, the lawyer must consider the additional complications that result from determining the time period over which, and the legal services to be rendered for which, the equity investment is earned by the lawyer and the manner in which all or a portion of the equity investment will be returned to the client if the representation is terminated prior to completion of the representation, whether by the client or the attorney. There is a dearth of case law in this area, but the Committee believes that the writing called for under Colo. RPC 1.8(a) should describe how the equity interest will be earned, e.g., by valuing the ownership interest at the time it is granted and considering it earned in proportion to the hourly rate the lawyer charges or to specific legal services to be provided by the lawyer, and the conditions under which it could be returned to the client.

Other state bar opinions while still in general agreement with Opinion 00-418 take different approaches to some of the issues implicated. For example, Opinion 00-418 states that the reasonableness of the fee agreement is to be determined at the time the agreement is made. Iowa state Bar Opinion 02-01 states that the reasonableness of the fee is to be determined both at the time the fee agreement is made and at the time the fee is collected:

The other ethical rule which may be involved is DR 2-106(A), "A lawyer shall not enter into an agreement for, charge, or collect an illegal or clearly excessive fee." There can be no guarantee, therefore, that the approval of "an impartial third party," as proposed in your second precaution, will automatically suffice to comply with the disciplinary rule. Instead, the fee must not be clearly excessive at the time it is agreed to and at the time it is collected. As the court stated in In re Swartz, 141 Ariz. 266, 686 P.2d 1236, 1243 (1984),

"Respondent is correct in contending that the one-third contingent fee initially agreed upon was within customary limits for the type of case and was not excessive. We do not believe, however, that recognition of the propriety of the initial fee arrangement gives the lawyer carte blanche to charge the agreed percentage regardless of the circumstances which eventually develop. Either a fixed or contingent fee, proper when contracted for, may later turn out to be excessive.... [A] fee agreement between lawyer and client is not an ordinary business contract. The profession has both an obligation of public service and duties to clients which transcend ordinary business relationships and prohibit the lawyer from taking advantage of the client. Thus, in fixing and collecting fees the profession must remember that it is "a branch of the administration of justice and not a mere money getting trade." ...We hold, therefore, that if at the conclusion of a lawyer's services it appears that a fee, which seemed reasonable when agreed upon, has become excessive, the attorney may not stand upon the contract; he must reduce the fee. What is reasonable and within permissible limits will be determined by the circumstances, including the factors listed in DR 2-106."

Proprietary interest in the subject matter of the representation

State and local bar opinions, as well as ABA Formal Opinion 00-418, discuss the propriety of a lawyer's accepting stock in a corporation where the value of the stock is contingent on the outcome of the matter or where the stock itself is the subject of the litigation under Rule 1.8(i). Rule 1.8(i) states:

(i) A lawyer shall not acquire a proprietary interest in the cause of action or subject matter of litigation the lawyer is conducting for a client, except that the lawyer may:

(1) acquire a lien authorized by law to secure the lawyer's fee or expenses; and

(2) contract with a client for a reasonable contingent fee in a civil case.

ABA Opinion 00-418 states:

In our view, when the corporation has as its only substantial asset a claim or property right (such as a license), title to which is contested in a pending or impending lawsuit in which the lawyer represents the corporation, Rule 1.8(j) might be applicable to the acquisition of the corporation's stock in connection with the provision of legal services. If the acquisition of the stock constitutes a reasonable contingent fee, however, Rule 1.8(j) would not prohibit acquisition of the stock. [FN27] Rule 1.7(b) prohibits representation of a client if the representation "may be materially limited ... by the lawyer's own interests," unless two requirements are met. The lawyer must reasonably believe that "the representation will not be adversely affected," and the client must consent to the representation after consultation. [FN28]

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(Note: after the E2k amendments to the Model Rules subpart (j) of Model Rule 1.8 is now subpart (i))

Kansas Opinion 98-06 begins with a discussion of the policy considerations behind contingent fees generally, touching on some of the issues raised in ABA Formal Opinion 94-389 (Contingent Fees) (1994). The Kansas opinion discusses the reasonableness of the contingent fee in situations where the lawyer may have a proprietary interest in the subject matter of the litigation stating:

The rules allow use of contingent fees in matters where the litigation does not produce a common fund or res. Unfortunately, neither MRPC 1.5 nor its comment discusses when the line between legitimate fee and proprietary interest is crossed. Professor Charles Wolfram has stated this determination is a "subtle" enterprise. Wolfram, Modern Legal Ethics, West Pub Co., 1986.

The requirement of reasonableness in subject matter contingent fee agreement must be augmented by some element of risk that there will be no success I the representation. If there is little or no risk of nonrecovery, the fee should be on some non-contingent basis. Kansas Bar Association Opinion 98-06 at 3.

See also D.C Bar Opinion 179 (1989) which states:

...Accepting corporate stock is, in pracyical effect the same thing as accepting an interest in the "subject matter of litigation" itself. But, viewing the reality of the situation, it also seems to us that it must be recognized that the stock received is, in substance, a "contingent fee" in a civil case, and thereby, if "reasonable," subject to the exception provided in paragraph (2) of th Rule of DR 5-103(a)

There has been a large amount of commentary written on this topic, some of which is critical of the practice of stock for fees transactions and that warn of the risks involved. See, e.g. John S. Dzienkowski & Robert J. Peroni, The Decline in Lawyer Independence: Lawyer Equity Investments in Clients, 81 TEXAS L. REV. 405 (2002); Thar, Taking an Equity Interest in a Client: Is It Worth the Risk?, 89 Ill. B.J. 101 (2001). See Also, Rotunda and Dzienkowski, Lawyer's Deskbook on Professional Responsibility, § 1.8-2 (2005-06 ed.), Gwyneth E. McAlpine, Comment, Getting a Piece of the Action: Should Lawyers Be Allowed to Invest in Their Clients' Stock?, 47 U.C.L.A. L. REV. 549 (1999); Kahrl & Jacono, "Rush to Riches": The Rules of Ethics and Greed Control in the Dot.com World, 2 Minn. Intell. Prop. Rev. 51 (2001), Debra Baker, Who Wants to be a Millionaire?, 86 A.B.A. J., Feb. 2000, at pp. 36, 37; Puri, Taking Stock of Taking Stock, 87 Cornell L. Rev. 99 (2001). For a list of additional authorities follow the "additional resources" link below.

For further information on this topic, See, The report of the ABA Litigation Section's Task Force on the Independent Lawyer. Section III of the Report, entitled Particular Transactions between Lawyers and Clients that raise issues Under the Law of Fiduciary Duty and Ethics that begins at page 40 of the Report. The full text of the Report is located here.

More information on this topic is available at this online resource page.

ETHICSearch is intended to stimulate awareness of ethical problems and illustrate the varying approaches of different jurisdictions. It is not intended as legal advice. The ABA Model Rules of Professional Conduct and the opinions discussed are advisory only; the ethics rules, laws and court decisions of your jurisdiction may dictate a different result.

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