Who Wants to Be a Millionaire?
Law firms investing in hot high-tech IPOs are making a
fortune, but some critics worry the stock craze is
clouding ethics matters
BY DEBRA BAKER
Even at the height of the "dot-com" frenzy that seized the stock market
last year, no one expected anything
like the December day that VA Linux went public. The California-based computer
company sent Wall Street
into orbit as its stock price rocketed to a 698 percent gain--a new record
as the biggest first-day initial public
offering.
The fact that VA Linux hadn't turned a dime in profits and had no expectation
of doing so did little to deter
trading. Investors pushed the price upward on a gamble that the public
would see the fledgling company,
which designs hardware for the free Linux operating system, as a rival
to Microsoft.
The big winners were company executives and venture capitalists. At the
close of trading Dec. 9, VA Linux's
36-year-old CEO Larry Augustin, with his 6.6 million shares of stock, was
Silicon Valley's newest billionaire.
Not far from Augustin's side that day were lawyers from Wilson Sonsini
Goodrich & Rosati, the Palo
Alto-based law firm that helped guide the young company in its pre-IPO
days. Although modest compared
to Augustin's holdings, Wilson Sonsini's 102,584 shares of its client's
stock were valued at $24.5 million at
the close of trading. Not bad for a day's work.
Get 'Em While They're Hot
Those kinds of staggering profits in the IPO market are driving an increasing
number of law firms to take their
chances on soon-to-be public clients. The firms that do it most often say
they are capitalizing on a
technology revolution that has created a culture in which stock is considered
an acceptable alternative to
cash.
VA Linux is just one of dozens of companies whose names appear on Wilson
Sonsini's client list and in its
stock portfolio. The firm held stock in 33 of the 53 companies it represented
through initial public offerings
last year. (In two other IPOs, the firm took stock in companies in which
it represented the underwriters
handling the deals.) Its holdings in 24 of those companies were valued
in excess of $1 million each at the
close of the first day of trading.
There's nothing unusual about law firms investing in clients; firms have
done so for years. But in today's
highly charged IPO market even a modest investment--generally considered
to be an ownership share of no
more than 1 percent--can net millions overnight.
"The values are so significant that 1 percent or less is still worth a
lot," says Donald Bradley, Wilson
Sonsini's general counsel. "It is an issue that is difficult to get a real
fix on how to manage. Part of the
problem is the market. It's goofy."
Without doubt, 1999 was one of the biggest boom years in stock market history,
and IPOs made the most
explosive noises. Investors threw money at public offerings ranging from
the United Parcel Service to Martha
Stewart.
But no sector surged like technology did, with Internet start-ups leading
the way. While the average IPO had
increased in price by 170 percent in December, according to one published
report, the average Internet IPO
had increased 234 percent. The 10 top-performing IPOs of the year were
all Internet and technology-related.
In the new high-tech culture, cash-poor clients consider a lawyer's investment
as a sign of loyalty. Likewise,
law firms see the ability to offer stock to their lawyers as a way to keep
many of those same clients from
luring away their top legal talent.
Not surprising, the law firms investing most heavily in clients are based
in or near California's Silicon Valley,
the Eden for young technology companies and Internet start-ups. Client
investment is also becoming
increasingly common in other technology-driven locales such as Texas, North
Carolina and northern Virginia.
Based on the number of IPOs handled last year, Wilson Sonsini dominates
the list, followed closely by San
Francisco-based Cooley Godward; Venture Law Group in Menlo Park; Brobeck,
Phleger & Harrison, based in
San Francisco; and Gunderson Dettmer Stough Villeneuve Franklin & Hachigian,
in Menlo Park.
In on the Action
The Bay area's Cooley Godward held stock in all but three of the 23 IPOs
the firm ushered to the public
market last year. Its highest valued holdings at the close of the first
day included Alteon WebSystems, music
Web site MP3.com and graphics processor designer Nvidia. Each gave an initial
boost of more than $1
million to the value of the Cooley portfolio.
An ABA Journal analysis of Securities and Exchange Commission records showed
that one in three lawyers
representing the more than 500 companies that went public in 1999 held
stock in the clients at the time of the
offering. The analysis also showed:
* 63 law firms handled IPOs, either representing the company or the underwriter.
Lawyers from those firms
held stock in 174 of those companies.
* Lawyers' holdings in more than 40 percent of the companies were worth
in excess of $1 million each. Firms
investing in nine of the companies saw the value of their holdings soar
more than $10 million each.
* While VA Linux holdings showed the greatest first-day leap --jumping
from a $30 per share issue price to
close at $239.25--it was Wilson Sonsini's 2 million-plus shares of Webvan,
an online grocer based in Foster
City, Calif., that were valued the highest. At the close of its trading
debut, the firm's holdings in Webvan
were worth more than $51 million.
* Law firms representing three of the year's five top-performing IPOs--Dechert
Price & Rhoads' Philadelphia
office for Internet Capital Group; Venture Law Group for Foundry Networks;
and Cooley Godward for Alteon
WebSystems--all held stock in their clients.
* In addition to their stock holdings, lawyers also served as officers
or directors of about 23 percent of those
500-plus companies.
While only a handful of lawyers-turned-investors become instant millionaires--or
"double commas" in
computer speak--the vast majority of lawyers taking stock in client IPOs
last year turned respectable initial
gains. Only 18 companies ended up at or below their offer price at the
close of the first day. And because
firms most often received the stock for free or at a price substantially
below the offer price, few actually lost
money.
"The money is significant, and we are blessed to be operating here in the
valley at ground zero of a
revolution in our society," says Alan C. Mendelson, a partner at Cooley
Godward's Palo Alto office. "The
fact that we are here and enjoying the fruits of that labor is great."
But IPO-mania has some critics worrying that law practice is increasingly
being dictated by investment
strategies. Those critics fear that the lure of becoming a ".com" millionaire
may impair lawyers' professional
judgment, placing them at risk of increased liability claims.
"Law firms are motivated by greed, opportunity--whichever you want to call
it," says Ronald E. Mallen, a San
Francisco lawyer who counsels law firms on ethics and malpractice issues.
"They've decided the risk of
exposure is outweighed by the opportunity to become instant millionaires."
The legal profession historically has taken a dim view of lawyers holding
equity interests in clients, fearing
conflicts between a lawyer's own interests and those of the client. But
the massive growth of Internet
technology and related start-up ventures over the last decade is forcing
some changes in that thinking.
Lawyers, particularly those practicing in technology-heavy regions, see
the profits being made and want to
get in on it.
"Lawyers are extremely talented. They see nonlawyers participating and
they are looking at ways to
appropriately participate as well," says Philadelphia attorney Gene E.K.
Pratter, co-chair of the ABA
Litigation Section's Task Force on the Independent Lawyer. "Everyone agrees
when large sums of money are
involved there is greater risk of suspicion, but that doesn't mean there
is something reprehensible or amoral
going on. It's just on the radar screen a lot brighter."
Unlike accountants, who are prohibited by law and professional rules from
investing in client companies, no
bright-line rule exists for lawyers. The ABA Model Rules of Professional
Conduct--particularly Rules 1.7(b)
and 1.8--warn against taking interests that may be adverse to a client.
The rules do not prohibit a lawyer from
doing business with a client; they merely establish guidelines to ensure
the interest is "fair and reasonable"
and done with a client's full knowledge. (See "A Treacherous Path" at page
54.)
But a 1998 report by the ABA Business Law Section's Committee on Lawyer
Business Ethics warns that even
when precautions are taken, lawyers still risk accusations of self-dealing.
The lawyer who goes into business
with a client faces a heavy burden of establishing both informed consent
and transactional fairness, the
report states.
"There is a yellow light," says John F. Olson, a Washington, D.C., lawyer
who chaired the committee that
wrote the report. "The more ties you have, the more questions people may
raise. Lawyers aren't held to a
standard of independence, but they are held to a standard of care."
In today's market, the potential for windfall profits from what most consider
"fair and reasonable"
investments only serves to complicate the ethical issues.
"What happens when you hit a home run and a modest proposal suddenly becomes
80 percent of your
portfolio?" asks Jeffrey Greenbaum, co-chair of the Litigation Section
task force. "That's the issue."
At minimum, the stock interests create the appearance of a conflict, says
San Francisco lawyer James T.
Caleshu, who runs a legal services clinic that provides representation
to start-up companies in low-income
neighborhoods. At worst, he says, the stock holdings will induce a lawyer
to behave unethically or illegally
in an effort to preserve his or her financial assets.
"I practiced law for 30 years. The firms I was with had prohibitions because
they thought it compromised
them or at least gave the appearance of being compromised," Caleshu says.
"The tide has turned the other
way."
Good Odds, But Still a Gamble
With all the attention paid to the monster gains in the Internet IPO market,
few people are paying attention to
the losers, says Mallen. Despite the jackpots that many investors make,
observers estimate that in the
high-stakes game of technology, losers outnumber the winners by as much
as 20 to 1. And that doesn't take
into account the companies that make it to the public market but fail a
few months down the road.
The lure of IPO gains has critics worried that lawyers in small firms or
with less experience will take more risks
to hop on for a ride.
"Nobody has a problem as long as everyone makes a profit. It's when the
market turns that the problems will
arise. That is where the exposure is," Mallen says. "You not only have
the opportunity to become a
multimillionaire, you have the opportunity to get sued."
Law firms face a potential double whammy if a client business goes sour.
Not only will they take a financial
hit, they also increase their risk of exposure to liability, Mallen says.
"If a lawyer represents five companies that fail and one that hits, that
is five times the problems," he says.
While a larger firm might be able to handle the problems of such representation,
they could be devastating to
a small firm.
"The large firms are the ones with the opportunity. They've decided the
risk of exposure is outweighed by
the opportunity for profits," Mallen says.
Brian Redding, an associate loss-prevention counsel at the Chicago-based
Attorneys Liability Assurance
Society, says that while insurers do not report large numbers of claims
stemming from the handling of IPOs,
those that do arise can be costly.
"The problem from a malpractice standpoint is perception," Redding says.
"In the one out of 100 or 200 cases
where a law firm gets sued for SEC or other legal violations, its primary
defense is lack of scienter. ... If the
case goes to a jury and you appear to be closely aligned with the client,
you'll lose."
Creative Currencies
In Silicon Valley, where the practice of investing in clients is practically
standard operating procedure, few
major firms will accept only stock in exchange for services. But that doesn't
mean firms are paying full price
for stock. Most larger firms that invest in clients get in at the ground
floor. They invest in the company at the
same time and at the same rate as venture capitalists. And some firms offer
discounted legal fees in exchange
for stock.
"It is a great myth that most firms in California make investments by taking
stock as fees," Bradley says.
"We've always felt that when you're running a law firm, you get paid for
what you do, and you get paid in
cash."
But if lawyers do take stock in lieu of fees, the situation becomes even
more problematic because the lawyer
is that much more dependent on the success of the venture. And, in the
rush to get into the game, there are
fears that more lawyers are willing to work for stock, making the risks
still greater. Even firms that have
long-standing policies against the practice are changing their stance.
"Internet companies just don't have the cash," says Washington, D.C., attorney
Richard Rowe, whose firm,
New York City-based Proskauer Rose, changed its policy against investing
in clients because of competitive
pressures. "Some firms have taken the position that taking a fee in stock
colors the representation. Law firms
are fast getting away from that."
The pressure to invest in clients is motivated by more than self-interest,
lawyers say. In many instances, they
say, the client demands they invest in the company as a show of loyalty.
"My firm would prefer cash, but in order to get business it has to be flexible,"
adds Edward H. Cohen, a
partner at New York City's Rosenman & Colin and chair of an ABA Business
Law Section's subcommittee on
lawyers investing in clients.
Pressure to invest is also coming from inside: Law firms that don't offer
stock opportunities to their members
run the risk of losing their top lawyers to other firms, or clients, that
do.
"Retention is a very big issue," Cooley Godward's Mendelson says. "We have
lost significant numbers to
those types of opportunities."
Some Refuse to Give In
Despite the pressures of the market, some firms adhere to strict prohibitions
against investing in clients.
Sullivan & Cromwell, an international law firm based in New York City,
is second only to Wilson Sonsini in
the amount of money it handled in public offerings last year, yet it still
refuses to invest in its clients. Bill
Williams, a Sullivan partner, cites potential conflicts as the reason the
firm is not considering changing its
policy.
Regardless of competitive pressure, Mallen says law firms should avoid
investment in enticing opportunities,
particularly when the clients are the ones demanding it. A company that
is so poorly capitalized that it
cannot pay a lawyer is not likely to be a good investment, he says.
"I'm sure some clients want lawyers to share in the risk. That should be
a red flag," Mallen says. "Lawyers
are supposed to be objective and neutral."
Mallen also says many firms that get involved with client investments do
so without considering their
malpractice insurance coverage. "Many insurance companies have exclusions
that take away coverage if
[firms] have an equity interest," he says. "It is a status exclusion. It
turns on the ownership interest, not the
activity."
Even insurers are feeling the pressure of the changing technology culture.
Loss-prevention counsel William
Freivogel of the Attorneys Liability Assurance Society says that while
the insurer has frowned upon law
firms that invest in clients, increased market pressures have caused it
to relax its view.
"We don't like it, but it seems to be inevitable," Freivogel says. "The goal is to minimize the risk."
Yet firm policies that relate to investing in clients are as varied as
the number of lawyers who do it. While
some firms go to significant lengths to limit the influence a particular
investment will have on their attorneys,
others actively encourage partners to invest in clients.
Cooley Godward, under almost all circumstances, prohibits its lawyers from
making personal investments in
clients. Instead, the firm makes all of its investments in the firm's name
through an outside investment
partnership.
"We think the notion that individual partners could become individually
wealthy is not conducive to the
type of firm we want to build," Mendelson says. Within the last two months,
the firm considered liberalizing
its nearly 30-year-old policy. Partners eventually decided against making
changes.
But holding the line is harder when the competition is loosening the reins
to allow for such investments.
"One firm in our area emphasizes it to such a degree we question if it
is even a law firm," Mendelson says.
That firm is Venture Law Group, the Silicon Valley law firm considered
the most aggressive in its pursuit of
client investment opportunities. Craig Johnson, a former Wilson Sonsini
partner who formed the firm in 1993,
acknowledges that VLG provides more than legal services. "Think of VLG
as a combination of a very good
corporate/securities law firm, a consulting firm, a venture capital fund
and an investment bank, and you'll be
close to what we really do," he says.
Mandatory Investment
Venture Law Group actively seeks out investment opportunities from its
clients, and encourages individual
partners to take a personal stake in the companies. According to a May
1998 Inc. magazine article titled,
"When Is a Law Firm Not a Law Firm?" VLG partners must take 10 percent
to 20 percent of investment
opportunities.
While VLG ranked third in the total number of firms it represented and
invested in, it was the only firm that
took stock in all 17 companies for which it handled public offerings. All
of them ended the first day in the
black, and the value of VLG stock in six of the companies, including Foundry
Networks and Etoys.com, was
tallied at more than $1 million each.
Foundry Networks, a California company that makes switches and switch routers
for managing network
traffic, was second only to VA Linux with its opening-day gain of 525 percent
last September. For VLG and
its lawyers the debut translated into holdings valued at $8.4 million.
Following its debut, the stock continued
to climb, eventually making the value of the firm's holdings worth about
$14.9 million.
As a way of shielding themselves from conflicts, all three of the top firms--Wilson
Sonsini, Cooley Godward
and VLG--use outside partnerships to handle their investments.
"The whole thrust of our investment partnership is geared toward not having
an investment in a start-up that
would interfere with a lawyer's independence," Wilson Sonsini's Bradley
says.
Unlike Cooley, many firms investing in clients allow individual members
to invest. According to SEC records,
only about a quarter of law firm holdings were invested through separate
partnerships. Both VLG and Wilson
Sonsini allow lawyers to invest independently. Though they must first offer
the investment opportunity to
the firm, they are then free to purchase shares on their own or alongside
the firm.
Although Wilson Sonsini limits the amount lawyers can invest individually,
the ability to own stock directly
only heightens critics' concerns that lawyers' judgment will be influenced
by their financial stakes.
Take the Webvan IPO. Wilson Sonsini partner Jeffrey Saper, who handled
the public offering, sits on the
company's board of directors. He and the firm own a combined 2 million
shares of stock.
When allegations surfaced that Webvan officials violated federal rules
governing public disclosures about
the company, the SEC forced Webvan to delay its IPO. Even though the public
offering eventually moved
forward without further SEC action, Bradley acknowledges that a firm's
personal stake in a company can
place its lawyers in a precarious position.
"If you are a director and the firm or persons in the firm hold substantial
interests, you would have to say
that is going to raise more questions about independence and the ability
to discharge our professional
duties," Bradley says.
However, there are a number of safeguards in place that dissipate the risks
of impropriety, he says. By using
a firm partnership to do the bulk of investing, lawyers at the firm have
less of an individual stake in the
company. And, other lawyers can be brought in to handle aspects of certain
deals if conflicts do arise,
Bradley says.
In addition to firm policies aimed at addressing potential conflicts, lawyers
are subject to their clients' policies
relating to insider trading and generally are subject to a "lock-up" period
in which they can't sell their
holdings for a certain span of time, usually 180 days.
The lock-up period is what keeps many lawyers from getting overexcited
when their clients record huge gains
on the first day of trading, Bradley says. "People may think we made a
lot of money, but we can't sell the
stock. Six months from now it may trade at $5."
Historically, the bulk of IPOs are unable to maintain the momentum generated
by their stock debuts. Of the
210 Internet deals in 1999, 50 were trading below their offering prices
by mid-December. Still, the risk of loss
is often offset by the potential for a home run.
Like Foundry, Commerce One--an e-commerce software company--was able to
maintain its momentum even
after it nearly doubled its offer price of $21 during its debut in July.
When 12.1 million shares came out of
lock-up in late December, shares were trading at about $240. Wilson Sonsini's
nearly 30,000 shares were
worth in excess of $7 million.
Trend to Be Scrutinized
The issue of investing in clients is one that likely will get continued
scrutiny in the coming months. In
addition to the work by the Litigation and Business Law sections, the ABA
Center for Professional
Responsibility is also planning a program on the topic at a meeting later
this year.
For the most part, the ABA committees studying the issue appear to support
the practice. The Litigation task
force plans to finalize its report for the ABA Annual Meeting in New York
City in July. Co-chair Pratter
expects to focus on firm policies to ensure ethical and liability safeguards
are in place.
Cohen, whose Business Law Section subcommittee plans to complete its report
in coming months, says that
the potential for conflicts is not a serious one.
"Clearly, the hotness of the market is encouraging lawyers to take more
risk," Cohen says. "I don't think
there is a big liability issue. It is a potential issue, but it is not
a real issue."
Yet, even some who oppose the practice concede the fight may be over.
"It is a battle that may have been lost," says San Francisco lawyer Caleshu.
"This is an issue the profession
should have faced 10 years ago, before the insanity began. I'm not sure
now that it's not too late."
Debra Baker, a lawyer, is a senior writer for the ABA Journal. Her e-mail
address is bakerd2@staff.abanet.
org.