July 2016 | Earn one hour of MCLE Credit in Legal Ethics
Ethical obligations before accepting a corporate client’s stock as payment
A startup company, which has already obtained some venture funding and has a promising product, wants to retain outside corporate counsel, but is cash-strapped. It is looking for a lawyer who will agree to take some of the startup’s stock in exchange for lower hourly rates.
The startup finds a lawyer who finds the idea appealing. The potential financial gain for the lawyer is high in the long run, and the arrangement helps the startup company because it has to pay out less cash to retain counsel to help with its upcoming initial public offering.
This arrangement, while attractive and potentially beneficial to the lawyer and the startup, is not a simple payment in kind arrangement. There are at least four key issues for the lawyer to consider in order to ensure that his or her fee agreement with the startup is both ethical and enforceable.
First, by taking a client’s stock, the lawyer is acquiring an ownership interest in the client, the startup company. As such, this arrangement is governed by Rule 3-300 of the California Rules of Professional Conduct (“CRPC”). Normally, Rule 3-300 does not govern initial fee agreements. But it does govern when, like here, the fee agreement gives the lawyer an ownership interest in the client’s property to secure future fees.
Failure to comply with this rule could result in an unenforceable fee agreement. In Passante v. McWilliam, 53 Cal.App.4th 1240 (1997), the Court of Appeal held that a company’s offer to give its lawyer 3 percent of its stock because the lawyer arranged a loan for the company was not an enforceable contract because it lacked consideration. The client made the gratuitous promise to give the lawyer a gift of stock after the lawyer arranged the loan. It was not a bargained-for promise. But the court held that even if it had been a bargained-for promise, the contract would not have been enforceable because the lawyer failed to comply with Rule 3-300.
Rule 3-300 requires that (A) such transactions must be “fair and reasonable to the client,” with the terms fully disclosed in writing in a manner that client can reasonably understand; (B) the lawyer must advise the client that the client may seek the advice of independent counsel about the transaction, and must give the client a reasonable opportunity to do so; and (C) the client must thereafter consent in writing. CRPC 3-300.
In order to ensure that the terms of the acquisition of the startup’s stock are fair and reasonable to the client, the lawyer should, for example, consider whether the value of the stock he or she will receive is proportionate to the reduction of her hourly rates at the time the fee agreement is signed.
Although it may be difficult to value stock received in a startup, factors such as liquidity, marketability and transfer restrictions should be evaluated. If possible, the stock should “be valued at the amount per share that cash investors, knowledgeable about its value, have agreed to pay for their stock about the same time.” American Bar Association Standing Committee on Ethics and Professionalism, Formal Opinion 00-418, “Acquiring Ownership in a Client in Connection with Performing Legal Services” (ABA Formal Opin. 00-418). But if the value of the stock is not reasonably ascertainable, “for example, if the lawyer is engaged by two founders who are contributing intellectual property for their stock, it may not be possible to establish with reasonable certainty the cash value of their contribution. If so, it also would not be possible to establish with reasonable certainty the value of the shares to be issued to the lawyer retained to perform initial services for the corporation. In such cases, the percentage of stock agreed upon should reflect the value, as perceived by the client and the lawyer at the time of the transaction, that the legal services will contribute to the potential success of the enterprise. The value of the stock received by the lawyer will, like a contingent fee … depend upon the success of the undertaking.” (Id.)
It “is incumbent upon the lawyer to take account of all information reasonably ascertainable at the time when the agreement for stock acquisition is made. Determining ‘reasonableness’ ... involves making the often difficult determination of the market value of the stock at the time of the transaction.” Id.)
The lawyer should then set out all of the information about the transaction in detail in writing, including the method for determining the value of the stock, for the startup to review. This will allow the startup to evaluate whether the reduction in rates in exchange for stock is fair and reasonable. This will also help the lawyer demonstrate that the transaction was fair and reasonable to the client at the time of the transaction, should there later be a dispute. The lawyer must advise the client to have independent counsel of its choice review the proposed agreement, give the client the time to do so and then ensure that the startup consents to the arrangement in writing.
Second, because this is a fee arrangement, the lawyer should make sure that the fee received in the form of stock is neither illegal nor unconscionable under CRPC 4-200. Whether the fee is unconscionable depends on the degree to which the fee agreement is procedurally and substantively unconscionable, based on such factors as: “(1) The amount of the fee in proportion to the value of the services performed. (2) The relative sophistication of the member and the client. (3) The novelty and difficulty of the questions involved and the skill requisite to perform the legal service properly. (4) The likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the member. (5) The amount involved and the results obtained. (6) The time limitations imposed by the client or by the circumstances. (7) The nature and length of the professional relationship with the client. (8) The experience, reputation, and ability of the member or members performing the services. (9) Whether the fee is fixed or contingent. (10) The time and labor required. (11) The informed consent of the client to the fee.” CRPC 4-200(B).
Third, because this fee arrangement involves a transfer of securities, the lawyer should also ensure that the arrangement does not violate any securities laws. Moving forward, the lawyer should be mindful to avoid any insider trading.
Finally, and perhaps the most important consideration, is that this arrangement could create conflicts of interest between the lawyer and the startup. Simply acquiring a client’s stock does not create an actual conflict, though it creates potential conflicts that may later ripen into actual conflicts. “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 could arise.” (ABA Formal Opin. 00-418.) For example, as a shareholder, lawyer may want the startup to enact short-term measures which would inflate the stock price, but which may not be in the best interests of the startup in the long run. Or, for example, “lawyer may obtain rights under corporate by-laws or other agreements that will limit the client's control of the corporation,” and increase the lawyer’s control of the corporation. (Id.) She also should “advise the client that as a consequence of such a conflict, she might feel constrained to withdraw as counsel for the corporation, or at least to recommend that another lawyer advise the client on the matter regarding which she has a personal conflict of interest.” (Id.)
In order to make sure that the client is informed of such potential and actual conflicts of interest, CRPC 3-310 requires the lawyer to disclose all potential and actual conflicts of interest to her client in writing when, as here, she will have “a legal, business, financial, or professional interest in the subject matter of the representation.” CRPC 3-310(B)(4). Recall that here, the lawyer will be representing the startup in its upcoming IPO after she acquires the company’s stock.
The written conflict-of-interest disclosures under CRPC 3-310 should be detailed enough to allow the client to determine the nature and extent of the actual or potential conflicts and make an informed decision whether to move forward with the fee arrangement. Therefore, the lawyer should provide these conflict disclosures when providing the disclosures required by 3-300.
In sum, for this type of a fee agreement to be ethical and enforceable, the lawyer should provide the following detailed disclosures to the startup in writing before the fee agreement is signed: (1) the basis for determining that the transaction is fair and reasonable to the client, including the value of the stock in relation to the reduction of the hourly rate; (2) the scope of the legal services; (3) the actual and potential conflicts of interest; and (4) that the lawyer may need to withdraw in the future if an actual conflict arises. She should also advise the startup in writing that it may seek the advice of independent counsel of its choice about this fee arrangement, give the startup a reasonable amount of time to consult such independent counsel and only then obtain the startup’s written consent to the fee arrangement.
Ujvala Singh is an associate at Carlson, Calladine & Peterson LLP in San Francisco, and a member of the State Bar of California Committee on Professional Responsibility and Conduct (COPRAC). Her practice focuses on legal malpractice, professional ethics and business litigation. The views expressed in this column are her own.