F.Y.I. Ethics

Divided Loyalties: A Lawyer's Duties to a Client's Creditors
By M. Colette Gibbons and Elin Brenner

You face a confounding issue. A client had promised to pay his third party creditors on the sale of an unencumbered piece of real estate. After the sale closing, the client has a change of heart. He instructs you that the creditors are not to be paid from the proceeds held in your firm's escrow account because he needs working capital for his troubled venture. You had helped prepare standstill agreements with the creditors and close the real estate transaction. Do you owe any duty to your client's creditors?

Widely disparate answers have resulted in the jurisdictions that have addressed this issue. Some courts hold that a lawyer has no duty to a client's third party creditors and is required to follow a client's instructions even if the instructions violate the terms of an assignment agreement between the client and the creditor. Other courts have held that a lawyer must pay a third party creditor or assignee of the client.

Model Rules of Professional Conduct

Model Rule 1.15, Safekeeping Property, states that a lawyer must maintain third party funds in an account separate from the lawyer's own funds to protect the third party's property and must keep complete records of the funds or property. This model rule states that when a lawyer receives funds in which a "client or third person" has an interest, the lawyer must promptly notify the client or third person of the receipt of such funds and must deliver "any funds or other property that the client or third person is entitled to receive." The Comment to Model Rule 1.15 states that when a third party has claims against funds or other property in a lawyer's custody, the lawyer may have a duty to protect the third party claims against the client's wrongful interference and may refuse the client's request to hand the property over to the client. The model rule does not define "entitled," however, and the lawyer is left in the position of trying to determine who is "entitled" to the funds: the client or the third party.

Model Rule 1.2(d) forbids a law-yer to assist a client in conduct the lawyer knows is criminal or fraudulent, and Model Rule 4.1 states that a lawyer in representing a client shall not knowingly make false statements of material fact to a third person. Model Rule 4.1 also prohibits a lawyer from withholding material information from a third person when disclosure is necessary to prevent client fraud, unless disclosure is prohibited by Model Rule 1.6, which prohibits disclosure of client confidences.

Model Code of Professional Responsibility

DR 9-102(B)(4) states that a lawyer must pay a client all funds in the lawyer's possession to which the client is entitled. Although DR 9-102(B)(4) is similar to Model Rule 1.15, it does not suggest a duty to pay a third party all funds in the lawyer's possession to which the party is en-titled. The Model Code requires a lawyer to follow the client's lawful instructions but allows a lawyer to refuse to participate in acts that the lawyer believes to be unlawful. On the subject of confidentiality, the Model Code states that a lawyer may not disclose client confidences or use them to the client's disadvantage without the client's consent, unless permitted by the Model Code or required by law. The same provision further prohibits a lawyer from using client confidences to the benefit of a third party without the client's consent.

The Model Code also prohibits a lawyer from withholding information that the lawyer is legally required to disclose, making false statements or assisting in illegal conduct in representing a client. The same Model Code provision requires a lawyer who knows that the client has per-petrated a fraud to call on the client to correct the fraud and, if the client refuses to do so, to reveal fraud except when the information is protected as a privileged commu-nication. DR 7-102(B)(1).

Restatement of the Law Governing Lawyers

Section 73, Duty to Certain Non-Clients, The Restatement (Third) of the Law Governing Lawyers (1994), is more unequivocal than either the Model Rules or the Model Code: a lawyer has a duty to a non-client when the client retains the lawyer with the intent of benefiting the non-client. A lawyer must also protect the rights of a third party to whom the client owes a fiduciary duty if that party is unable to protect itself. The comments to  73 state that because a lawyer must follow the client's instructions regarding represen-tation, a duty to protect a third party only arises when the third party beneficiary is not reasonably able to protect itself and the lawyer clearly knows that he or she must take action to prevent or rectify a breach of a client's fiduciary duty.

Case Law - No Duty to Third Parties

One court has held that a lawyer is not liable to a client's third party creditor when the lawyer makes no agreement with the third party. American State Bank v. Enabnit, 471 N.W.2d 829 (Iowa 1991). Another court also found no lawyer duty to a third party in Chesapeake Associates, Limited Partnership v. Holland Corp., 141 B.R. 737 (Bankr. D. Kan. 1992) (suit by Chapter 11 trustee of a limited partnership against a subcontractor). The court concluded that because the comments to the Model Rule merely state that under applicable law a lawyer "may have a duty" to protect third party interests from the client's wrongful interference, the rule does not create an independent duty to creditors of the client.

In Struck v. Binns, 1995 WL 57481 (E.D. Pa. Feb. 10, 1995), the court found that there was no de facto escrow agreement between a law-yer for one party to a negotiation and another negotiating party who unknowingly deposited money in the lawyer's personal account believing it to be an escrow account. The court concluded that, absent proof that a lawyer holding an escrow account knew of the terms of the escrow agreement between the client and a third party, the lawyer is relieved of any duty to abide by the terms of the agreement.

Duty to Disclose or Pay Third Parties

Other courts have held that a lawyer who knows of the client's agreement with a third party must notify and pay that party when the lawyer receives the funds in question, despite the client's con-trary instructions. In Leon v. Martinez, 638 N.E.2d 511 (N.Y. 1994), the court held that when there is an enforceable agreement between a client and a third party, the lawyer not only has a duty to inform the third party of the settlement but also has to pay the as-signee as the person then entitled to receive the funds. In Birmingham News Co., Inc. v. Chamblee and Harris, 617 So. 2d 689 (Ala. Civ. App. 1993), the court held that, although a lawyer is generally not liable for a client's breach of an agreement with a third party, if the lawyer has notice that the client has assigned funds to a third party and the lawyer disburses the assigned funds to the assignor (the client) or any other agent, the lawyer may be liable to the assignee. The court cited Bonanza Motors, Inc. v. Webb, 657 P.2d 1102 (Idaho Ct. App. 1983), in which an Idaho court held that once a client has made a valid assignment to its creditor, the client's lawyer cannot disregard the assignment even at the client's request.

The court in Wood v. Chicago Title Agency of Las Vegas, Inc., 847 P.2d 738 (Nev. 1993), also relied on Bonanza Motors. Although in Wood the escrow agent was not a lawyer, the holding is very similar to those in both Bonanza Motors and Birmingham News and could probably be applied to lawyers acting as escrow agents for client funds. The court held that after an obligor has received notice of an assignment, the obligor must pay the assignee _ the assignor cannot release the obligation without the consent of the assignee (citing Arthur L. Corbin, 4 Corbin on Contracts  890 (1951); quoting Martinez v. Martinez, 650 P.2d 819, 822 (N.M. 1982)). The court also concluded that once the obligor determines to whom the money rightfully belongs, the obligor is obligated to pay the assignment. If the obligor is unsure what to do when the assignor's instructions appear to violate the assignment, the obligor may seek guidance from court or file an interpleader without being subject to contempt; however, if the obligor distributes the money according to the assignor's instructions, the obligor acts at its own peril and will be liable to the assignee if its actions constitute a breach of its duty to the assignee.

Conclusion

Resolution of whether a lawyer owes any duty to a client's creditors may rest on contract law rather than ethical maxims, on whether a lawyer is acting as an escrow agent under an escrow agreement and whether the courts in the particular jurisdiction have sided with clients or third party creditors. Needless to say, a lawyer holding funds subject to third party claims should proceed with caution if the client decides that the client, and not the third party, should be paid.

M. Colette Gibbons is a lawyer with Kahn, Kleinman, Yanowitz & Arnson, Co. L.P.A. in Cleveland, Ohio. Elin Brenner is a law student at the University of Michigan.