July 2016 | Earn one hour of MCLE Credit in Legal Ethics
By Ujvala Singh
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As often happens, 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. Therefore, it is
looking for a lawyer who will agree to take some of the startup’s stock in
exchange for lower hourly rates.
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.
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.
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.
order to ensure that the terms of the lawyer's 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.
While 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
“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.”
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.
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
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
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.
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 CPRC 3-300.
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.
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.
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