Source: https://www.americanbar.org/groups/professional_responsibility/policy/ethics_2000_commission/bhealey2/
Timestamp: 2019-04-23 11:57:39+00:00

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The 1998 Report of the ABA Business Law Sections Committee on Business Ethics warns that "even when precautions are taken, lawyers still risk accusations of self-dealing. The lawyer who goes into business with a client faces a heavy burden of establishing both informed consent and transactional fairness.... ." 4 Legal malpractice expert Ronald Mallen put the point more bluntly: "You not only have the opportunity to become a multimillionaire, you have the opportunity to get sued." 5 It is important to note that a number of leading firms have refused to give in to the pressures (from clients as well as from partners) to invest in clients in view of these risks.
3. what firms can do to manage the risks inherent in these situations.
Investing in clients businesses falls into the class of conflicts defined by legal ethics codes as those involving personal, financial, or business interests of the lawyer that may conflict with those of the client. In order to demonstrate the central problem that these types of conflicts cause, we will examine a recent case that exemplifies all of the problems that can (or, some would argue, are likely to) arise when lawyers or their firms invest in their clients businesses. In Rhodes v. Buechel, 7 the investment took the form of a share in the business set up for the clients by the attorneys to manage and profit from the clients intellectual property in certain inventions. The conflicts of interest that arose from this circumstance were the focal points in the litigation. In considering this case, it is important to understand that it is an example in microcosm of the kinds of conflict of interest issues and problems that arise whenever a lawyer or a law firm tries to serve as both counsel to, and investor in, a clients business. Although the facts are somewhat complex, which is typical of such arrangements, it is important to summarize them in order to demonstrate the real implications of such relationships in general.
At the time of the decision, the plaintiff had been a patent lawyer in private practice in New Jersey for 34 years. Defendant Buechel was a professor of orthopedic surgery in New Jersey. There was also a second defendant, Pappas, a mechanical engineer. The two defendants met in 1974 and began a highly successful joint venture inventing and licensing the use of various prosthetic devices. Together they developed a large number of successful patents, and were widely recognized as leaders in their field. At the very beginning of their relationship they recognized the need for competent patent counsel. Accordingly, Pappas recommended to Buechel that they consult with Rhodes, with whom Pappas had previously worked.
From 1974 until 1981 Rhodes was in partnership with two other patent lawyers, Bain and Gilfillan. Following their initial meetings, the court found all parties agreed "that Rhodes, Bain and Gilfillan would receive a one-third interest in any inventions that Buechel and Pappas would bring them, in return for legal work to include drafting and prosecuting patent applications, both foreign and domestic, working on licenses for exploiting the inventions and providing other assistance and advice as necessary." When reduced to a written agreement, the fee and services elements of the agreement were memorialized as described, but the agreement was only expressed to apply to a single, specific invention.
An assignment was also prepared by these same lawyers, and executed by Buechel and Pappas, assigning a one-third interest in the same identified invention to the law firm. The court noted that the agreement was defective in a number of respects, including (1) the clients were not told that the fee arrangement was not customary; (2) in describing the services to be provided, the prosecution and defense of infringement and interference proceedings were omitted; and (3) the clients were not advised to obtain independent counsel with respect to the fee arrangement and the business arrangements with Rhodes. Rhodes then compounded these problems by creating a corporate entity  for "tax reasons," which later turned out to be incorrect and contrary to everyones interests  to which the patent on the first invention was assigned by all the parties.
In due course, stock was issued as follows: one-third each to Buechel and Pappas, and one-ninth each to the three lawyers. Again, the court found that there was no disclosure of the conflict or advice to Buechel and Pappas to consult independent counsel. The first patent was successful, and in succeeding years until 1983, although no further fee agreements were executed, 18 additional patents, for other inventions, were applied for and assigned to the same corporate entity. There is no doubt of the success of the venture, as it earned at least $50 million in royalties.
In the early 1980s, Rhodes withdrew from his partnership with Bain and Gilfillan, resulting in acrimonious correspondence among the lawyers as to the future financial arrangements between the parties. Various changes also occurred in the way in which the patent business was structured, and in the relationships between the clients and the lawyers. However, notwithstanding that there was no agreement with Bain and Gilfillan, now his former partners, Rhodes continued to work "diligently" on an additional 27 patent applications and various patent licensing agreements  without additional compensation. Buechel and Pappas also did considerable research and other work on the inventions.
3. basis for any fee award or forfeiture.
Ethical Obligations  The court found that Rhodes egregiously and continuously failed to meet his fundamental ethical obligations of disclosure and failed to obtain consent from Buechel and Pappas throughout their relationship. The provision of the New York Code considered by the court in Rhodes v. Buechel was DR5-104(A) (22 NYCRR 1200.23(a)), which states, in pertinent part, that "[a] lawyer shall not enter into a business transaction with a client if they have differing interests therein . . . unless the client has consented after full disclosure."
(3) the client consents in writing thereto."
Thus, the Model Rule provision is somewhat more strict than the New York Code provision, among other things requiring that both the transmittal of the disclosure and the consent be in writing, the transaction be "fair and reasonable," and the client be given the opportunity to consult independent counsel.
Section 207 of the Restatement (Third) of the Law Governing Lawyers (to be published shortly by the American Law Institute) essentially follows the Model Rule, with some minor linguistic changes (such as that writing is only mandated where required by law). Accordingly, it is unlikely that a court in any other jurisdiction looking at the facts of Rhodes v. Buechel would have reached a different conclusion based on an ethics code using the Model Rule, rather than the New York Code formulation.
 "Rhodes failed to inform his clients to seek independent counsel, perhaps because it was not in his best interest to do so. More specifically, it is likely that independent counsel would advise against a percentage ownership of the property, as opposed to payment of services rendered based on a quantum meruit basis. Such would alleviate the imbalance of equities found herein."
 "Rhodes failed to advise his clients of the great potential for a lawsuit in cases where the attorney is also a co-owner of a business entity."
 "Rhodes failed to disclose that as a result of wearing two hats he might be rendered objectively incapable of deciding what is in the clients best interests. For example, as the profit margin widens and the personal stakes become increased, Rhodess objectivity may become lessened."
 "Rhodes is desirous of a percentage of the property interest because of the unique entrepreneurial opportunity presented and its likelihood of great success. This he fails to disclose."
 "Rhodes failed to inform his clients that it might be in the clients bests interests to perform particular legal services, but not in his best interest, because such could substantially reduce profits and trigger hours of hard work."
 "Rhodes failed to inform his clients that he was an employee at will and as such could be terminated at any point in time, giving rise to the false perception that they had to be co-owners infinitely."
This list was not intended to be exhaustive of all conflicting interests contemplated, but clearly illustrates that each instance in which Rhodes failed to make full and complete disclosure to his clients constituted a separate violation of the ethics rules.
. Historically, courts have treated this area of law, attorney-client fee arrangements, with special concern, applying principles different from those set forth by commonplace commercial contracts so as to uphold the integrity of our legal and judicial systems. See, Matter of Schanzer, 7 A.D.2d 275 (1st Dept. 1959), affd. 8 N.Y.2d 972 (1960); Martin v. Camp, 219 N.Y. 170 (1916).
Rhodess fundamental conflict of interest with his clients, and his failure to honor his clients interests over his own, constituted a breach of his fiduciary obligations as an attorney.
In light of his unethical actions, Rhodess request for compensation for the life of the inventions was deemed to be a violation of his fiduciary obligations to his clients. The court also considered a total forfeiture of any fees prior to termination. However, "in the interest of fairness," the court did make a quantum meruit award (of $1.5 million) for Rhodess many years of work. The basis for this decision was, first, that he had worked diligently and achieved great success for his clients and, second, that to do otherwise would create an inequitable and unjust enrichment of Buechel and Pappas.
This case has profound and important lessons for all lawyers who contemplate engaging in relationships that involve conflicts of interest, both generally as well as of the particular kind considered here.
Only documentation evidencing full disclosure and, in many circumstances, the actual receipt by the client of independent legal advice that the arrangement is fair and reasonable, the disclosure is adequate, and the consent is appropriate, will offer any basis for avoiding problems flowing from the conflict.
Consent will not be inferred under any circumstances, and fresh, actual consent is required whenever fresh disclosure is required.
It is clear that the courts retain the absolute authority to supervise attorneys fees  including even fees where there was an express agreement. Rhodes v. Buechel simply reinforces the point that this power extends to undoing apparently binding writings of all kinds, even trusts and corporate agreements.
Some readers may be tempted to suggest that the facts in Rhodes v. Buechel are egregious, and that the case should not be used to preclude without exception prudent investment, including taking fees in the form of investment interests in clients. In the comment to Model Rule 1.8, there is a reference to business transactions with clients where "the lawyer has no advantage in dealing with the client." The examples given, however, do not relate to investment, but rather to purchasing "products or services that the client generally markets to others."
The question that will ultimately be presented to a jury in these situations is whether the lawyers investment stake was sufficient enough from the lawyers point of view, to impair his or her objectivity. After all, a lawyer representing General Motors is presumably entitled to invest in a mutual fund that, in turn, invests in General Motors. However, determining where the dividing line falls between this example and the situation in Rhodes v. Buechel is precisely why the ethical rules and legal principles discussed here exist. Certainly, the more material the investment in relation to the rest of the lawyers practice, the greater the risk of triggering these ethical and legal issues. It is important to note, however, that the size of the lawyers stake is not the sole determinant of its propriety. On the contrary, the fundamental issue is whether the stake is sufficient to impair, or to create the appearance that it may impair, the lawyers exercise of independent judgment on behalf of the client.
 If you fail to make adequate disclosure, you are bound to lose.
 If you make disclosure, it will have to be so extensive that it may put off any rational client.
 If you make full disclosure, and the client accepts it and gives consent, that consent is only adequate until any new disclosure obligation arises.
 If you get consent, that consent is limited to your right to continue to act as lawyer; it does not operate to reduce your obligation of fidelity to the client.
In sum, it is not extravagant to state the proposition that accepting engagements with unresolved conflicts of interest may be the equivalent of writing an unequivocal warranty of satisfaction to the client. At worst, the lawyer may be held liable for the clients economic loss. At a minimum, the lawyer jeopardizes his or her right or ability to collect some or all of his or her fees.
The only way for a law firm to ensure that it will never face allegations such as those made in Rhodes v. Buechel is to avoid investing in clients altogether, and to refuse to take stock in lieu of traditional legal fees. Courts presume that business transactions between attorneys and their clients are fraudulent, and the burden rests with the attorney to demonstrate otherwise. 25 Moreover, juries are notoriously unsympathetic to law firm defendants. Against this backdrop and after careful consideration of all the attendant risks, many firms have adopted policies prohibiting all types of client investments. Should a firm decide that this most conservative approach is impractical, however, the following risk management recommendations, taken together, should help to mitigate the risk of malpractice claims.
No individual partner should be able to bind a firm by accepting an engagement involving any conflict of interest, particularly one involving an investment in a client.
Since engagements involving investments in clients clearly constitute a risk to the law firm as a whole, it is common sense that the partner with an interest in the decision to take on the engagement also has a conflict vis-à-vis his or her partners. Thus, for the protection of everyone in the firm, the separate and distinct decisions as to (1) whether to take on the engagement at all, (2) whether the client disclosure made or proposed is adequate, and (3) what other protections are required, need to be made independently of the introducing partner, based on full knowledge of the facts. In addition, if an investment is to be permitted, the firm must, in advance, determine in what form, in what amount, through what investment vehicle, and subject to what controls the firms investment will be made.
Accordingly, it is essential that law firms establish a clear policy  with supporting forms, systems, and procedures  in connection with the oversight and management of new client intake generally, and investments in clients specifically. This policy should require that all relevant decisions be made before the engagement is commenced, and be made not by the introducing partner but by an independent partner or committee, following the delivery to that independent partner or committee of all information necessary for a reasoned judgment as to the risks and benefits to the firm from accepting or rejecting the engagement, or from agreeing to or rejecting an investment in the client. A clear and consistent review process and criteria will assist in defending against any later challenge of the investment.
2. Full disclosure of all conflicts and potential conflicts of interest must be made to the client in accordance with Model Rule 1.8(a).
(iv) the client consents to the transaction in writing.
Disclosure under Rule 1.8(a) should be detailed and comprehensive, and should include any and all potential conflicts the lawyer can foresee. 26 The consequences of potential conflicts should also be disclosed. For example, if it is possible that the law firm may have to withdraw from the representation if a potential conflict is actualized, that possibility must be fully and clearly explained. Firms should clearly avoid the use of "blanket" waivers whenever they invest in clients. Blanket waivers are usually short consent forms presented as a matter of routine and in standard "boilerplate" language to all new clients, wherein the client purports to consent to all, or to certain, specified classes of potential future conflicts of interest. Almost by definition, a blanket waiver is bound to fail the tests set out in Rhodes v. Buechel. Only after a thorough, clear, and detailed disclosure can a clients written consent provide any protection to the firm.
In addition, not only must the engagement letter include the advice that the client seek independent counsel to review the fee arrangement, but the client should actually do so; even sophisticated clients should be encouraged to consult with independent counsel. The Supreme Court of Minnesota recently found that a loan transaction between an attorney and client that was consummated in one day violated Rule 1.8(a), because it did not give the client the opportunity to consult with an independent lawyer. 27 The existence of such independent advice approving the proposed arrangement is the best protection the lawyer can have that it will actually be enforced. Any lawyer giving such independent advice must be mindful, not only of the extent of disclosure and the nature of the conflict, but also  as provided in most versions of the ethics codes  that the arrangement is fair and reasonable to the client.
3. Investments should be made on behalf of the law firm as a whole, not by individual attorneys.
Regardless of any individuals integrity and intentions, a lawyers objectivity and independence of judgment can be seriously impaired where that lawyer has a personal stake in the finances of a client. The larger the investment in proportion to the lawyers own net worth, the greater the danger that the lawyer will be improperly influenced. When an individual invests in a client, the risks are borne by the law firm as a whole, while the potential benefit will accrue only to the individual. It is therefore wise to prohibit investments by individual attorneys, and require that any investments or acceptance of stock be undertaken by the firm itself.
4. Investments should not be the exclusive form of payment of fees.
There are two risks associated with taking stock in lieu of fees. First is a conflict of interest claim brought by the client, an investor, or a regulatory body. Second is that the client may sue for return of fees under Model Rule 1.5, on the grounds that the fee was excessive. 28 A combination of traditional legal fees and stock will help to support a law firms argument that its actions were objective and its judgment independent, should it ever have to face a jury in a malpractice action. For the same reason, the amount of stock accepted by the firm should be relatively small in proportion to the total fee.
In addition, the retainer agreement with the client should clearly state that both parties consider the payment of cash and stock to be reasonable  regardless of the future value the stock may attain. In this scenario the law firm is clearly taking the risk that, if the stock loses all value, that portion of its fee will be zero. The firm should also not take the risk that, if the stock value increases dramatically, the client will sue for return of that stock on the grounds that the amount ultimately paid for legal services was excessive.
5. Investments should be made through a separate investment vehicle set up for that purpose, with some element of independent investment advice and management.
The creation of a separate investment trust does not eliminate conflicts of interest, nor will it prevent conflicts claims by clients or third parties. Indeed, some have argued that the creation of a separate investment vehicle is an elevation of form over substance. Nevertheless, such an arrangement coupled with independent management helps to reinforce the appearance of an arms-length transaction. It has the benefit of placing an additional step between the law firm and the client, which may help to mitigate damages in the unfortunate event that a conflict-based malpractice claim is argued to a jury.
6. Investments should be small enough to be non-material to the law firm or the client.
A law firm should never invest in a client to such an extent that the firm gains a controlling interest in the clients business, or even the appearance of a controlling interest. In addition, if the investment represents a significant portion of the firms total revenues, it will be that much harder to prove that the firms legal advice was objective, and not motivated by self-interest. There is no "bright line" at which a de minimis investment suddenly transforms into an interest that establishes a conflict of interest. The best that can be said is that the more material the investment in relation either to the rest of the lawyers practice or to the clients business, the greater the risk of triggering the ethical and legal issues discussed in this article. Even absent a controlling interest, the stake may be sufficiently great to trigger these problems; but if there is a controlling interest, then the problems are likely to be unavoidable.
Once a law firm has invested in a client, it is likely that the investment will last for as long as the attorney-client relationship. The difficulties associated with explaining to a client the firms decision to sell the clients stock before the representation is concluded are myriad, and could potentially damage the relationship with the client. The firm should, therefore, carefully scrutinize the client before undertaking any investment, and consider whether a "permanent" investment is in its best interests.
8. Schedule a regular review and, where necessary, revision of the clients written consent.
There are cases that reinforce the Rhodes v. Buechel requirement that, if and when conflicts actually arise, a fresh and full disclosure must be made, and a fresh and express waiver must be obtained  even where the original waiver was made by a sophisticated consumer of legal services. 29 For each client in which a law firm has an investment, a regular review of the clients written consent should be scheduled, in order to ensure compliance with the firms ongoing duty to disclose.
The ethics rules have created a trap for the profession by permitting lawyers to accept engagements where conflicts exist if they make "full disclosure" and obtain "consent." These rules ignore the fact of the lawyers underlying fiduciary obligation  that cannot be waived  to provide competent representation wherein absolute fidelity and priority to the clients interests are paramount at all times. This legal obligation as a fiduciary essentially transforms the lawyer who accepts engagements under terms involving an investment stake in the client into something close to a guarantor of a successful outcome. Once a client establishes a breach of that fiduciary duty, the damages assessed against the lawyer will likely be directly related to the size of the clients loss, however great. Analysis by a court or jury of a lawyers actions in these cases is always conducted in hindsight, and the strong presumption that business transactions between attorney and client are fraudulent creates a very difficult hurdle for the law firm defendant to overcome.
In order to protect themselves from unwitting liability that may be impossible to defend or controvert, law firms are therefore wise to institute policies and procedures designed to ensure independent oversight and control of all engagements that may involve these (and other) conflicts of interest. All possible steps should be taken to avoid even the appearance of undue influence over the client, or preferential treatment vis-à-vis other investors. No policies, procedures, or risk management techniques can eliminate the conflict of interest created when a law firm invests in one of its clients, but adherence to the techniques described here should help to mitigate the consequences of those conflicts.
Maharaj, THE CUTTING EDGE: FOCUS ON TECHNOLOGY More Firms Are Willing to Work for Stock Options, Equity: Professionals are accepting lower salaries  and stock  in hopes of cashing in on a booming market, Los Angeles Times, January 24, 2000.
Baker, Who Wants to Be a Millionaire?, ABA Journal, February 2000, at 36.
3 Smith, Venture Law Group Prospers By Focusing on Web Startups, Wall Street Journal, March 22, 2000.
6 Many of the lawyers professional liability claims seen at Chubb Executive Risk (reported by applicants and insureds) involve conflicts of interest, and many of those are the result of alleged self-dealing on the part of a law firm. Generally speaking, these claims contain allegations that the lawyers had a piece of the deal, and that this potential profit led them to elevate their own interests over those of the client. In several instances, the appearance of a conflict was created by a fee arrangement in which the firms compensation was contingent on the success of the clients business. The plaintiff in these claims may be the client, but may also be a third party allegedly injured by the collusion between the law firm and client.
7 Rhodes v. Buechel, N.Y.L.J., March 18, 1998, at 28 (N.Y. Sup. Ct. 1998), affd, 685 N.Y.S.2d 65 (A.D. 1 Dept. 1999).
10 Matter of Cooperman, 83 N.Y.2d 465, 472 (N.Y. 1994). See also Cummings v. Sea Lion Corporation, 924 P.2d 1011 (Alaska 1996)(attorney has fiduciary relationship to clients separate and apart from the ethics rules).
11 Rhodes v. Buechel, supra.
12 For an extended treatment of the entire subject of the law governing business transactions between lawyer and client, see Maltz, Lawyer-Client Business Transactions: Caveat Counsellor, 3 Geo. J. Legal Ethics 291 (1989). While this article pre-dates the current rash of investing in clients, it treats all of the issues which these transactions raise.
13 Rhodes v. Buechel, supra; see also Forrest Park Assocs. Ltd. Partnership v. Kraus, 175 A.D.2d 60 (1st Dept. 1991).
14 Committee on Professional Ethics and Conduct of the Iowa State Bar Association v. Mershon, 316 N.W.2d 895, 898 (Iowa 1982); In the Matter of George H. Miller, 568 S.W.2d 246, 251 (Mo. 1978).
16 Maltz, at 310, 311.
17 Rhodes v. Buechel, supra. See also Blecher & Collins, P.C. v. Northwest Airlines, Inc., 858 F.Supp. 1442 (C.D.Cal. 1994).
18 Mershon, 316 N.W.2d at 897, 898; In the Matter of George H. Miller, 568 S.W.2d at 251; Nesbit v. Lockman, 34 N.Y. 167 (N.Y. 1866).
19 Rhodes v. Buechel, supra.
20 Maltz, at 298, 299.
22 Rhodes v. Buechel, supra; see also Mershon, 316 N.W.2d 895.
23 Mershon, 316 N.W.2d at 899, citing Goldman v. Kane, supra.
25 In the Matter of the Disciplinary Proceeding against Dennis O. McMullen, An Attorney at Law, 127 Wash.2d 150, 896 P.2d 1281 (Wash. 1995). See also Mershon, 316 N.W.2d at 898. See also Maltz, at 314-316.
(2) the client consents after consultation...."
27 In re the Application for the Discipline of Jerrold M. Hartke, 529 N.W.2d 678 (Minn. 1995).
28 Model Rule 1.5 states that "[a] lawyers fee shall be reasonable."
See, e.g., Blecher & Collins, supra.
University Law Center in 1990.
Anthony E. Davis is a Partner at Moye, Giles, OKeefe, Vermeire & Gorrell, LLP (in New York and Colorado), advising lawyers and law firms on legal profession and legal ethics issues, and in the area of law firm risk management and loss control. He is an Adjunct Professor of Law, teaching "Legal Profession" at Brooklyn Law School. In addition to several books on law firm risk management, he has written and lectured widely on a variety of legal profession and ethics issues. He is a Director and Treasurer of the Association of Professional Responsibility Lawyers and Chair of the Professionalism, Ethics and Competency Committee of the Section of Law Practice Management of the American Bar Association. He received his law degree from Cambridge University, and an LL.M. from New York University School of Law. He is admitted in New York, Colorado, and as a solicitor in England.

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