July 2014 | Earn one hour of MCLE Credit in Legal Ethics
Forming a closely held corporation can pose ethical dilemmas
Attorneys engaged to form and thereafter represent a closely held corporation face a quagmire of potential conflicts and uncertainty in the law regarding who their clients may be. In particular, California lacks clear guidance both on whether a corporation not yet formed may be a client and, if so, whether attorneys may truly limit their representation to the entity (to the exclusion of the founders) when the corporation being formed is closely held. Accordingly, determining what is permissible and what some best practices might be necessitates drawing analogies from other situations where relatively few decision-makers typically control an entity, such as those involving partnerships or subsidiaries.
Rule 3-600 of the Rules of Professional Conduct provides a framework for this discussion. Per the rule, in representing an organization attorneys must conform their representation to the concept that the client is the organization itself, acting through its highest authorized officer, employee, body, or constituent overseeing the particular engagement. Further, in dealing with an organization’s directors, officers, employees, members, shareholders, or other constituents, attorneys must explain the identity of the client whom the attorney represents whenever it is or becomes apparent that the organization’s interests are or may become adverse to those of the constituent(s) with whom the attorney is dealing. But an attorney representing an organization may also represent any of its directors, officers, employees, members, shareholders, or other constituents, subject to the provisions of rule 3-310 (governing conflicts).
Although the volume of California’s published decisions is many times that of most states, there are inevitable gaps in guidance. One of those is whether attorneys may properly represent corporations (as opposed to the initial shareholders) that the attorneys are engaged to form and represent thereafter. One potential issue is that before the entity is formed the putative client exists only prospectively. Case law from other states suggests that is not only possible, but also practical, for attorneys to be deemed to represent the nascent entity. In such situations, courts have reasoned that the attorney-client relationship exists retroactively between the attorney and the to-be-formed corporation (not with the individuals) from the time the attorney is retained until the corporation is actually formed (by filing incorporation papers). (See, e.g., Jesse by Reinecke v. Danforth (1992) 169 Wis.2d 229, 240-242, 485 N.W.2d 63, 67-68; Manion v. Nagin (8th Cir. 2005) 394 F.3d 1062, 1068-1069.)
The rationale for this is simple. If the person who retains the attorney to organize the corporation is considered the “client,” then later representation of the corporation by that lawyer could create a potential or actual conflict. That, in turn, could give rise to the standard risks of conflict representation including potential disqualification. In the view of these courts, such a result conflicts with the purpose of ABA Model Rule 1.13, which (like California Rules of Professional Conduct, rule 3-600) provides that an attorney representing a corporation represents the entity and not the individual constituents (shareholders, officers, etc.).
Indeed, if attorneys were deemed unable to represent the entity that they were forming, the question of when and how to obtain a conflict waiver would be more complex. Under Rule 3-310(C) of the Rules of Professional Conduct, an attorney may not, absent informed written consent of each client, accept engagements where the interests of two current clients potentially or actually conflict. Likewise, an attorney may not be adverse to a client or former client from whom the attorney received confidential information material to the employment, absent informed consent of each client. (Rule 3-310(E).) And if a corporation was not deemed to be a client until after its formation, then an attorney would be unable to secure conflict waivers from “each client” at the outset of the representation. It could likewise be difficult to obtain a waiver from a founding shareholder after the corporation is already formed, particularly if adversity has already developed between the founder and the corporation. Such a situation would effectively preclude an attorney who represented a founder during formation from representing the entity in most disputes regarding that founder’s rights.
While the law in California does not provide clear guidance, many lawyers who represent start-ups believe that they may properly represent the to-be-formed entity, and regard the corporate entity as their client rather than the founders. That position is consistent with Rule 3-600, and many believe would be upheld by a court examining the issue, particularly in the context of a company that is expected to become publicly held. But resolution of this issue could be more nuanced when the representation involves the formation of closely held corporations. The identity of the client at the outset of the representation and even thereafter may rely on how the entity will operate post-formation. A corporation’s management and ownership typically are separate. But that separation does not exist as neatly in a closely held corporation. (Representing Partnerships: Who is/are the Client(s)? (1995) 26 Pac. L.J. 961, 986-87.) In that regard at least, a partnership, which is owned and managed by the partners, is more similar to a closely held corporation. And, in California, attorneys engaged to represent partnerships may owe duties to the partners as well.
In Responsible Citizens v. Superior Court (1993) 16 Cal.App.4th 1717, the court relied upon individual facts and circumstances to conclude that a partnership, rather than the individual partners, should be treated as the client. Accordingly, the court reasoned that representation of the partnership did not automatically create an attorney-client relationship with the individual partners. But the court identified the following factors to determine whether such a relationship existed with the individual partners: (i) the size of the partnership, (ii) the nature and scope of the attorney’s engagement, (iii) the contacts between the attorney and the partners, (iv) the attorney’s access to financial information regarding partners’ interests and (v) whether the attorney agreed to refuse taking on other matters that would be adverse to individual partners’ interests.
Indeed, this analysis may work both ways. In Johnson v. Sheppard, Mullin, Richter & Hampton (1995) 38 Cal.App.4th 463, the court reached the opposite conclusion. Relying on these same factors, the court held that the attorney’s representation of a partnership imposed upon him an obligation of loyalty to the partnership and to all partners in terms of protecting their entitlement to benefits from the partnership. Whether this created an attorney-client relationship between the law firm and the individual limited partners was not determined. But the court held that the attorney had a duty to look out for all the partners’ interests, and if this could not be accomplished because of conflicts of interest among them, then the attorney had a duty to terminate the representation (or obtain appropriate waivers of the conflict).
May attorneys then, absent written consent of the shareholders, ethically undertake representation of closely held corporations without also undertaking representation of the individual shareholders? Similar to the partnership context, the answer to this question may depend on the facts and circumstances of the particular case. In a slightly different context, the State Bar of California Standing Committee on Professional Responsibility and Conduct Formal Opinion No. 1989-113 analyzed whether an attorney who represented a publicly held corporation could represent a party adverse to that corporation’s wholly owned subsidiary. In that situation, the subsidiary was as closely held as a corporation can be, with a single shareholder. The opinion concluded that the attorney could, subject to certain exceptions, take on a representation adverse to the subsidiary because he had never represented the subsidiary and there was no prospect that the parent would ever be made a party to the suit.
The ethics committee’s opinion reasoned that “[a] parent corporation, even one which owns 100 percent of the stock of a subsidiary, is still, for purposes of rule 3-600, a shareholder and constituent of the corporation. Rule 3-600 makes clear that in the representation of corporations, it is the corporate entity actually represented, rather than any affiliated corporation, which is the client.”
Indeed, in the example addressed in the opinion, successful litigation against a subsidiary necessarily would have had an adverse impact on the parent as the sole shareholder because its asset would lose value (or, if seeking affirmative relief, would fail in its attempts to obtain relief.) But Opinion 1989-113 concluded that such a factor, by itself, did not create a conflict. Attorneys’ duty of loyalty to their clients extends only to direct adverse consequences on existing clients. And the impact on the parent as a shareholder would be indirect. Accordingly, of the numerous and varied consequences which a representation of one client may have on other clients, well-established legal authority interpreting the duty of loyalty limits the scope of ethical inquiry to whether the other affected clients are parties to the case or transaction in which the attorney is acting. (Formal Opinion No. 1989-113.)
The ethics committee opinion identified two situations when parent and subsidiary corporations should be treated as one entity for conflict purposes: the alter ego exception and through duties arising from receipt of confidential information from non-client affiliates. As to the former, the committee opined:
The doctrine of alter ego, which has been established to avoid injustices in permitting entities or individuals to hide behind the corporate veil, provides helpful principles in determining when affiliated corporations should be treated as the same entity for conflict purposes. When a corporation is the alter ego of another entity or has sufficient unity of interests, they should be treated as the same entity for conflict purposes. In determining whether there is a sufficient unity of interests to require an attorney to disregard separate corporate entities for conflict purposes, the attorney should evaluate the separateness of the entities involved, whether corporate formalities are observed, the extent to which each entity has distinct and independent managements and board of directors, and whether, for legal purposes, one entity could be considered the alter ego of the other.
In other situations, in the course of representing the parent, attorneys may obtain confidential information directly from the non-client subsidiary under circumstances where the subsidiary could reasonably expect that the attorney had a duty to keep such information confidential. There, attorneys may be precluded from acting adversely to the subsidiary in matters related to the subject on which the attorney had obtained such confidential information. (See Garner, A Representational Trinity: The Parent, the Sub, and the Holy Lawyer (March 2013) Cal. Bar J. [providing an extensive discussion on parent subsidiary conflicts].)
The crux of all of this is that whether an attorney may represent a closely held corporation during formation without at least also being deemed to represent the individual shareholder who contracted with the attorney for the engagement may depend upon the particular factual circumstances, including the purpose and scope of the representation, the nature of the corporation, and the roles played by the shareholders. An important tool to maximize an attorney's objective to limit her representation to the nascent entity is a well-drafted engagement letter at the beginning of any representation. The letter should specify who the client is – and perhaps even who are not the clients – consistent with Rule 3-600’s provision that attorneys must clarify the identity of the entity client. That way, with expectations united at the start, the likelihood of a later dispute is minimized.
David M. Majchrzak serves as counsel in the San Diego office of Klinedinst PC. His practice focuses on professional liability defense, especially in the areas of legal malpractice, insurance coverage litigation, and directors and officers liability claims. He is a member of the State Bar's Committee on Professional Responsibility and Conduct and the San Diego County Bar Association's invitation-only Legal Ethics Committee. The views expressed herein are his own. This article appears in the California Bar Journal as part of COPRAC’s outreach and educational efforts. For more information on COPRAC, go to www.calbar.ca.gov/ethics.