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December 2013  |  Earn one hour of MCLE Credit in Legal Ethics

Lawyers representing startups: Managing ethical obligations and risks

By Merri A. Baldwin

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Baldwin

MCLE Self-Assessment Test

December 2013

SAMPLE TEST QUESTIONS

BELOW ARE SAMPLE QUESTIONS FROM THIS MONTH'S MCLE SELF-ASSESSMENT TEST.

1. To establish an attorney-client relationship, a startup client must sign a fee agreement.


2. An attorney-client relationship may be implied from circumstances.


3. An attorney’s informal communications with potential clients may not be sufficient to create an attorney-client relationship if the would-be client consults the attorney in a non-legal capacity, such as a consultant.


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Lawyers play a number of different roles in helping emerging companies form and grow. The traditional model of the lone (possibly unsophisticated) founder who turns to a lawyer to assist in forming a company, protecting intellectual property and obtaining funding from outside investors may no longer be the predominant scenario. In this latest tech boom, founders (often in groups) may utilize form agreements and software to set up companies and turn to lawyers later in the process; lawyers may provide a variety of “unbundled” legal services; companies may obtain funding through crowd funding websites or angel investors, often without the involvement of counsel; and many founders have significant experience in forming and managing start-up companies. These contexts provide a complex and varied landscape within which lawyers provide legal services, develop relationships with clients, and take stock or other interests in their startup clients as compensation for their legal services. This article will focus on how startup lawyers can manage their ethical responsibilities to their clients and minimize risks.

Knowing when representation begins

A lawyer owes certain duties to a client, including duties of confidentiality, loyalty, communication, and competence. These duties typically arise at the commencement of an attorney-client relationship. When the circumstances of the lawyer’s introduction to the client are relatively informal or the commencement of the relationship is not clearly defined, as can occur in connection with representing a startup, it can be difficult to determine exactly when the representation began and the lawyer’s understanding of when that occurred may be different than the client’s.

It is important for a startup lawyer to understand that the attorney-client relationship can start well before any agreement is reached between the attorney and client. An attorney-client relationship may be created either through an express agreement or may be implied by the parties’ conduct. Hecht v. Superior Court, 192 Cal. App. 3d 560, 565 (1987). To determine whether an attorney-client relationship may be implied, courts look to the parties’ intent and conduct. Factors include whether the attorney volunteered services; whether the potential client disclosed confidential information; whether the potential client reasonably believed he or she was consulting the attorney in a professional capacity; whether the putative client sought legal advice; whether the attorney indicated that he or she was representing the client; and the amount of contact between the two. State Bar of California Formal Opinion 2003-161. Payment of fees will be a factor supporting the existence of the relationship, but a fee agreement is not required to establish an attorney-client relationship. Streit v. Covinginton & Crowe, 82 Cal. App. 4th 441, 444 (2000). Giving legal advice is usually enough to create a “prima facie” relationship. Beery v. State Bar, 43 Cal. 3d 802, 811-812 (1987). However, a would-be client’s consultation of the lawyer in a non-legal capacity (such as a consultant) would not create an attorney-client relationship. See Benninghoff v. Superior Court, 136 Cal. App. 4th 61, 72 (2006).

Attorneys who discuss legal matters with startup founders or entrepreneurs in relatively informal settings, including through online contacts, should use caution. While an attorney may provide general information without creating an attorney-client relationship, an attorney’s detailed discussion of the legal implications of a particular person’s (or company’s) situation or options may be enough to create a relationship, depending on the facts. See Formal Opinion 2003-161. To minimize that risk, attorneys who provide online resources such as formation documents or financing templates should include disclaimers that make clear that by providing the forms, the attorney is not intending to create an attorney-client relationship, is not providing legal advice, that any use of the forms is at the user’s own risk, and recommend that the user consult an attorney.

Defining the scope of representation

It is ethically permissible for a lawyer to provide a limited scope of representation: for example, assisting a startup client with intellectual property advice but not assisting in corporate formation or stock issuance. However, any such limitation on the scope of a lawyer’s services must be reasonable, must be clearly spelled out to the client, and the client must provide informed written consent after being informed of the risks of the limited-scope representation and the available alternatives. Nicholas v. Keller, 15 Cal. App. 4th 1672, 1684 (1993). Additionally, even in a limited-scope representation, the attorney has a duty to advise the client of reasonably apparent legal problems, even if outside the narrow scope of the services the lawyer has agreed to provide. Id.

Joint representation conflicts

Lawyers representing startups need to be very clear from the outset whom they represent, and to make expressly clear the client’s identity to those involved in the matter. If the lawyer represents the company, the lawyer’s duties are owed to the company and not to individual constituents such as officers or directors. California Rule of Professional Conduct (“CRPC”) 3-600(A). This concept may not be clear to a founder who closely identifies with the company, has hired the lawyer and has been the primary contact with the lawyer. For that reason, lawyers need to make the identity of the client explicit from the outset, including in the representation agreement and other initiation documents.

Further, where the client is the organization, the lawyer should explain whenever appropriate that the client is the organization and not the founders (or anyone else). CRPC 3-600(D) provides that a lawyer has an obligation to explain the identity of the client when, in dealing with constituents of the organization, it becomes apparent that the organization’s interests may become adverse to the interests of the constituent. Most importantly, the lawyer must not “mislead such a constituent into believing that the constituent may communicate confidential information” to the lawyer without it being used in the organization’s interest. CRPC 3-600(A).

If a lawyer decides to represent more than one client (for example, joint representation of founders, or a company and its investors), it is very important that the clients are fully informed of the risks of such joint representation, and consent thereto. CRPC 3-210(C) provides that a lawyer may not accept or continue representation of more than one client in which the interests of the clients potentially or actually conflict, unless the lawyer obtains the informed written consent of both clients. To obtain informed consent, the lawyer must inform the client of the “relevant circumstances” and “the actual and foreseeable consequences” to the client. CRPC 3-310(A)(1), (2). In the formation stage of a company, the people involved may not understand that they have at least potentially conflicting interests, especially when they believe that they have a shared vision for the new company. It is important to make clear to such clients that in fact their interests potentially conflict, especially with regard to shareholder plans, allocation of shares and options, and agreements that govern management and control, and they may want separate legal advice to best protect their own individual interests.

Lawyers investing in clients

Under certain circumstances, lawyers may have opportunities to invest in their startup clients. For example, lawyers may take a stake in the venture in lieu of their fees, since the client may be cash-strapped but in need of legal services. Similarly, lawyers may take an ownership stake in a patent or other intellectual property in lieu of fees, a practice expressly allowed under the newly adopted USPTO rules of professional conduct. See USPTO Rule 11.108(i), 37 C.F.C. §11.108. Some law firms may invest in their clients by purchasing shares or options on the same terms as other “insider” investors; this may be done through an investment entity or venture fund formed by the law firm.

Investing in clients may provide a competitive edge for a law firm. “From the client’s perspective, the lawyer’s willingness to invest with entrepreneurs in a startup company frequently is viewed as a vote of confidence in the enterprise’s prospects.” 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”). [1] Further, a law firm’s willingness to invest in an enterprise may provide an additional boost of capital for the firm (if the law firm is investing cash as opposed to providing services in exchange for stock) or as a way to provide legal services the client could not otherwise afford.

The most significant ethical concern created by attorneys investing in clients is the potential conflict between the lawyer’s financial interest and the client’s interests. CRPC 3-300 applies to lawyers who “enter into a business transaction with a client, or knowingly acquire an ownership, possessory, security, or other pecuniary interest adverse to a client.” The rule requires that (A) such transactions be “fair and reasonable to the client,” with the terms fully disclosed in writing in a manner which the client reasonably should understand; (B) the attorney advise the client of the right to seek the advice of independent counsel, and give the client a reasonable opportunity to do so; and (C) the client thereafter consent in writing. CRPC 3-300.

Adherence to CRPC 3-300 is important to ensure that the transaction is both ethical and enforceable. In Passante v. McWilliam, 53 Cal. App. 4th 1240 (1997), the Court of Appeal found that a company’s promise to award its corporate attorney 3 percent of its stock was not enforceable. The attorney arranged a loan to the corporation; in exchange, the board offered the stock, but never transferred ownership to the attorney. The court found that the promise of stock was either an unenforceable promise of a gift, or, if it was truly bargained-for, was unenforceable due to the attorney’s failure to make the disclosures required by Rule 3-300.

ABA Formal Ethics Opinion 00-418 looked at the ethics of attorneys investing in clients. The opinion set forth certain conditions that must be satisfied in order to secure compliance with the Model Rules of Professional Conduct’s business transactions rule (Model Rule 1.8) in a stock-for-fees scenario: The lawyer must (1) explain the transaction so that the client can understand its terms as well as its potential effect on the lawyer-client relationship; (2) describe the scope of services to be performed in exchange for the stock, and must set forth whether the lawyer may retain the stock if the attorney-client relationship ends before all the agreed-upon services are performed; (3) disclose to the client that conflicts could arise that could affect the lawyer’s exercise of independent professional judgment, including where the lawyer’s desire to protect the value of the stock may conflict with the client’s goals; (4) inform the client that, because of these conflicts, the client should consult an independent lawyer concerning whether to enter into the transaction; and (5) that should conflicts arise after the stock is issued, that the disclosing lawyer may need to withdraw.

The question of the fairness of the transaction is one that requires attention and possible documentation at the outset under both the California rule and the ABA Model Rules. Under both sets of rules, the fairness of a transaction between a lawyer and a client is determined as of the time that the transaction was entered into. See CRPC 4-200(B). In some cases, it may be hard to value the stock (or other interest) at the time it was exchanged. Further, if the value significantly increases over time, the lawyer may have difficulty later proving the fairness of the deal. ABA Opinion 00-418 recommends that the lawyer establish a reasonable fee for her services and accept stock that at the time of the transaction is worth the reasonable fee. If possible, the stock should be valued at the amount per share that cash investors agreed to pay about the same time the stock was issued to the lawyer or law firm. If that is not possible, “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.”

In certain instances, the required level of disclosure for informed written consent may differ, depending upon the experience and knowledge of the client. At least one recent case from Massachusetts suggests that in weighing whether a lawyer made an appropriate disclosure in connection with a stock-for-fees transaction, courts may take into account “the knowledge and sophistication of the individual defendants [company founders] concerning shareholder rights and obligation in assessing the adequacy of [the lawyer’s] disclosure.” Ruby v. Murray, 70 Mass. App. Ct. 64, 943 N.E. 2d 949, 956 (2011). While not binding in California, this opinion may provide guidance to a California court that considers a similar situation under CRPC 3-300, which is similar to the operative Massachusetts rule.

The ethics opinions and most of the few cases that exist usually focus on the stock-for-fees scenario. When the situation involves a lawyer or law firm investing in their clients on the same terms as other investors, certain of the ethical risks are considerably lessened. First, if the law firm pays for stock at the same terms as are offered to other investors, the fairness of the transaction may be presumed. Axiomatically, in such instances, since the firm is not exchanging services for its shares, there is no need to value those services. Second, depending on the type of investment vehicle (a separate venture fund, for example) the potential conflicts of interest may be muted, particularly if the investment represents only a small percentage of the total equity of the company or a small percentage of the lawyer’s or law firm’s holdings.

Law firms may further minimize ethical risks by adopting guidelines that, for example, limit investment in any one client. Other factors such guidelines should address include whether to allow individual lawyers to invest or whether to limit investments to the firm as a whole; whether the firm should make any investments directly or whether the firm should set up a separate partnership or other entity (such as a venture fund) to make the investments; who should make investment decisions; and whether to take investment decisions out of the hands of the lawyers doing the work for the client. Of course, law firms should also adopt policies that minimize the risk of insider trading. The firm should confirm that its investment will not affect its malpractice coverage. Lastly, the firm should ensure that a sound process is in place to obtain informed written consent from clients, as applicable.

Merri A. Baldwin is a shareholder in the San Francisco office of Rogers Joseph O’Donnell P.C., where she focuses on business litigation and attorney liability and conduct, including legal malpractice, attorney-client fee disputes, ethics, professional responsibility and State Bar discipline defense. She is a member of the State Bar of California Committee on Professional Responsibility and Conduct, a co-chair of the Legal Malpractice section of the Bar Association of San Francisco, and an adjunct professor at Golden Gate University School of Law, where she teaches professional responsibility. She is the co-editor of The Law of Lawyers’ Liability (ABA/First Chair Press 2012). She can be reached at mbaldwin@rjo.com. This article appears in the California Bar Journal as part of COPRAC’s outreach and educational efforts. For more information on COPRAC go to calbar.ca.gov/ethics. The views expressed herein are her own.


[1] ABA ethics opinions provide guidance as to the ABA Model Rules of Professional Conduct. Those rules are not applicable in California. However, in the absence of a California professional rule or other applicable California authority, courts may look to the ABA Model Rules and ethics opinions for guidance, where those rules do not conflict with California policy. City and County of San Francisco v. Cobra Solutions, Inc., 38 Cal. 4th 839, 852 (2006).


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