The rules and ethics of investing in a client’s business

Attorneys with corporate clients may provide legal advice in a variety of circumstances, from advising on simple business transactions, handling litigation over business disputes, and overseeing mergers with or acquisition of other companies. Over time, some attorneys and corporate entities may build lasting relationships.

For some, a natural evolution of this bond is for lawyers to financially invest in their corporate clients or in their clients' opportunities. These kinds of investments are not uncommon. Some clients may view such arrangements as a potential reward for attorneys that have contributed to the clients' success. In a similar vein, clients may view an attorneys' investments as a vote of confidence in the client's business prospects.

Investment arrangements could also be a competitive advantage for attorneys trying to carve out business in the market. Indeed, cash-strapped clients may view these investment arrangements as a creative solution to compensate their attorneys, especially if the client is a new enterprise trying to get the business off the ground. In fact, the American Bar Association ("ABA"), in analyzing the Model Rules of Professional Conduct, has observed that this sort of arrangement may even be preferable, depending on the circumstances. See ABA Formal Opinion 00-418, July 7, 2000.

As long as the attorney complies with certain requirements, entering into these kinds of investment transactions is generally permitted by the California Rules of Professional Conduct. That said, attorneys can consider their professional and ethical obligations before consummating such arrangements.

Rule 1.8.1 Serves as a Road Map

Attorneys considering these types of financial relationships can begin with the requirements of California Rule of Professional Conduct 1.8.1. Rule 1.8.1 generally allows an attorney to invest in their clients or enter into a business investment transaction so long as three requirements are satisfied.

First, the terms of the business transaction must be "fair and reasonable" and disclosed in writing to the client. Second, the client is either represented by independent counsel in connection with the transaction or the client is advised in writing to seek the advice of independent counsel and be given a reasonable opportunity to do so. And third, the client provides informed written consent to the terms of the transaction as well as the attorney's role in it.

Evaluating the Fairness and Reasonableness of the Transaction's Terms

Whether the terms of the transaction are fair and reasonable to the client is one of the primary issues implicated when lawyers enter into transactions with clients.

Comment 3 to Rule 1.8.1 makes clear that the fairness and reasonableness of a transaction is measured at the time of transaction based on the facts that then exist. Sometimes, it can be difficult to evaluate the fairness or reasonableness of terms in hindsight, if the lawyer's investment "value" increases over time. This is one reason documenting the terms, and the basis for them at the time of the transaction, may be especially important for an attorney to later justify or explain the terms of the transaction.

In addition, a reviewing authority may scrutinize a transaction for any indication that the contracting attorney is taking improper advantage of knowledge of the client's confidential information, compromising client confidences, or creating a conflict of interest.

Written Disclosure and Confirmation

Once an attorney has assessed the fairness and reasonableness of the terms, Rule 1.8.1(a) requires the attorney to disclose the terms in writing to the client. Not only does written disclosure ensure compliance with the rules, but obtaining written confirmation of the terms also serves to protect the contracting attorney in addition to the client. Indeed, when the client confirms the terms in writing, the attorney may reduce the risk of any misunderstanding between the parties and strengthen the transaction's enforceability.

The Role of Independent Counsel

If the client is not represented by separate counsel in connection with the transaction, then the lawyer may have an obligation to advise the client in writing to seek the advice of independent counsel regarding the fairness and reasonableness of the transaction's proposed terms in compliance with Rule 1.8.1(b). Independent counsel can allow the client to consider and receive the benefit of conflict-free professional judgment. In addition, the client's use of independent counsel may also increase the likelihood that the transaction survives future scrutiny.

The client is not the only one who may benefit from obtaining independent counsel. Some attorneys grappling with issues of fairness and reasonableness may consider retaining their own outside, independent counsel to evaluate the investment terms.

Informed Written Consent

The final element is obtaining informed written consent from the client. Rule 1.8.1(c). Informed written consent means the client's agreement to the proposed transaction after the attorney has explained the surrounding circumstances and the risks associated with the transaction, including "any actual and foreseeable adverse consequences." Rule 1.0.1(e).

To comply with rules and ensure the client's consent is effective, many attorneys make sure they provide sufficient information to enable the client to appreciate the risks and include this information in documents provided to the client. These documents can be prepared with an eye towards demonstrating to a third party that the client consented after being reasonably informed.

Depending on the circumstances, the attorney may advise the client of the alternatives or objectively disclose all advantages and disadvantages of the transaction. Many attorneys also consider disclosing any potential change to the existing attorney-client relationship as the result of the proposed transaction, especially if the attorney becomes a partner of the client or the client's shareholder. Such measures work to eliminate any dispute regarding the client's consent to the transaction.