NEVADA LAWYER - FEBRUARY 2001
William S. Boyd School of Law - UNLVWilliam S. Boyd School of Law - UNLV
ABA Formal Opinion Permits Compensation by Stock in Client
by Jeffrey W. Stempel
One consequence of the "dot.com" revolution and Silicon Valley start-ups has been increased concern over whether attorneys may be paid by stock or options in a client company. According to reports in the legal and popular press, many of the internet-based new companies created in the 1990’s have been paying for legal services (at least in part) through stocks or stock options provided to counsel. Some prominent high tech lawyers are reported to insist on a "piece of the action" before agreeing to do legal work for these high tech start-up companies. Proponents of the practice maintain such arrangements are perfectly proper while others have argued that giving lawyers equity in the client improperly compromises counsel’s independent professional judgment.
The American Bar Association has now weighed in on the issue in favor of stock compensation for lawyers. In Formal Opinion 00-418, the ABA Standing Committee on Ethics and Professional Responsibility found that 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" (italics in original summary). But the attorney must comply with Rule 1.8(a) regarding business transactions with client, and also with Rule 1.5, which requires that fees be reasonable. According to the Committee:
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.
See Formal Op. 00-418 (summary) (italics in original) (July 7, 2000).
Lawyers have been accepting compensation in value other than currency for decades. However, the surge of start-up companies in the 1990’s made the practice far more widespread, leading to renewed concern over the practice. In response to the growing concern, the ABA Standing Committee addressed the issue in some detail in Formal Opinion No. 00-418. The Committee approved the practice both because it saw minimal danger and because it viewed such financing as a means of expanding access to legal services and to capital. "A lawyer’s willingness to accept stock instead of a cash fee may be the only way for a cash-poor client to obtain competent legal advice. Frequently, this may be the determining factor in the client’s selection of a lawyer." The Opinion also appears not to disapprove of the practice of having start-up company organizers "expect the law firm to introduce them to the firm’s venture capital contacts and to continue representing the corporation, eventually performing the services necessary to take it public."
Opponents of equity compensation for counsel have argued both that it may result in counsel taking advantage of the client or that it can cloud the lawyer’s judgment and compromise her independence by linking too closely the fortunes of the client and the lawyer. The ABA Committee Opinion analyzed the possibility as a potential conflict of interest situation between lawyer and client and found that the speculative conflicts did not bar the practice but that actual conflicts could require the lawyer to withdraw, refer a matter to other counsel, or take other action. Rule 1.8(a) provides that a lawyer "shall not enter into a business transaction with a client" unless "the transaction and the 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 reasonable understood by the client", with the client "given a reasonable opportunity to seek the advice of independent counsel in the transaction" and the client consenting to the arrangement in writing. Thus, any compensation in client stock will require disclosure, consultation, opportunity for a second opinion, and the client’s written consent.
As to the reasonableness issue, the Committee noted that Rule 1.5 requires that the fee be reasonable and lists a number of nonexhaustive factors to consider in determining reasonableness such as time involved, skill required, loss of other work, and contingent risk. The Committee suggested that one means of ensuring reasonableness would be to value the legal services to be rendered and then arrange for payment in stock of that value. However, the Committee also acknowledged that it would in many cases be difficult to value the share price of start-ups companies.
In addition, any special rights of the lawyer in the company may need to be disclosed to other investors, government regulators or other third parties. See Formal Op. 00-418, n. 18. Similarly, counsel owning shares in the company would of course be subject to securities or other laws affecting the investment and will need to be particularly careful of prohibitions on insider trading.
On the conflict of interest point, the Committee found that stock ownership did not create an inherent conflict of interest but stated that the lawyer should at the outset of the representation "inform the client that events following the stock acquisition could create a conflict between the lawyer’s exercise of her independent professional judgment as a lawyer on behalf of the corporation and her desire to protect the value of her stock." In addition, Rule 1.7(b) prohibits the lawyer to represent the client if the representation "may be materially limited . . . by the lawyer’s own interest" unless the lawyer reasonably believes that the representation will not be adversely affected" and the client consents after disclosure and consultation. Whether such conflicts arise and require the attorney to withdraw will vary with the facts of the case. "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. 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."
The Committee Opinion noted that law firms accepting equity compensation may wish to take steps to minimize conflict dangers such as limiting the amount of investment in client stock and making billing and other decisions through partners other than those working closely with the client company.
The ABA Formal Opinion is obviously important for transactional lawyers and other business counsel in that it does not bar, and can even be read as encouraging, equity compensation in lieu of cash. The implications of the opinion are less clear for litigation counsel but the reach and reasoning of the opinion appear equally applicable to payments for litigation representation. For example, under the ABA Opinion, a corporation engaged in litigation could presumably pay its trial counsel in stock.
However, the litigation context may result in different conflicts that inhibit representation or create opportunities for unfair dealing. For example, fairness of the transaction may be more open to question when a client with its back to the wall in litigation lacks cash and the lawyer agrees to take stock from the aggrieved litigant-client. In addition, litigation counsel have a duty of candor toward the court and opposing counsel. Will this duty be compromised if the value of the lawyer’s compensation hinges on the value of the client’s stock, which in turn hinges on the outcome of the litigation? Although the ABA Opinion opens the door to more creative financing of litigation representation beyond the contingent fee, counsel will be required to engage in contextual analysis of the appropriateness of such compensation and to follow the cautionary rules set forth in the Opinion in order to minimize later problems.
Although the ABA Opinion is a significant victory for lawyers arguing for stock compensation, its issuance is unlikely to quell the continuing controversy. States like Nevada may take a different view of the aptness of such financial arrangements under their respective versions of the Model Rules of Professional Conduct. NL
Jeffrey W. Stempel is Professor of Law, Associate Dean for Academic Affairs at the William S. Boyd School of Law – UNLV.