Issue: April, 2009
Author: John M. Burman
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Ethically Speaking - Business Transactions with Clients
Most concurrent conflicts of interest are addressed by Rule 1.7 of the Wyoming Rules of Professional Conduct (“the Rules”). The Rules have long had a special rule (1.8) that regulates or prohibits certain types of concurrent conflicts of interest. Foremost among those conflicts addressed by Rule 1.8 is the conflict created when a lawyer enters into a business transaction with a client, often as part of a fee arrangement (in which the lawyer takes an ownership interest in a client in exchange for legal services). Although such transactions are permissible, they are strongly discouraged and heavily regulated, and aside from problems with trust accounts, more lawyers get into ethical trouble as a result of business transactions with clients than with any other issue. Far too often, the transaction is a loan from a client to the lawyer, which the lawyer does not repay, that lands the lawyer in hot water.
Over a decade ago, an article about engaging in business transactions with clients appeared in this column. Since then, Rule 1.8(a), which regulates such transactions, has been changed significantly, making an updated article appropriate. It is particularly appropriate as the procedural and substantive requirements of the amended Rule 1.8(a) are more stringent than before, meaning that a lawyer who complies with the former Rule 1.8(a) will have committed misconduct under the new Wyoming Rules.
Business Transactions with Clients are Disfavored
A lawyer has a fiduciary relationship with every client. That relationship requires the lawyer to put each client’s interests ahead of the lawyer’s. Accordingly, he or she has the same relationship with each client that a trustee has with a beneficiary of the trust. In such a relationship, one party, the lawyer or trustee, occupies a position of influence over the other and is supposed to be watching out for the interests of that person. Such a relationship has been referred to by the Wyoming Supreme Court as a “confidential relationship.” Business dealings between persons in a confidential relationship have the potential to dramatically alter that relationship. Instead of focusing primarily on the interests of the subordinate party, the dominant party has a new and conflicting interest—his or her own business interests. Accordingly, business transactions in such a context are inherently suspect. If the subordinate party subsequently challenges the fairness of a business transaction with the dominant party, the dominant party “has the burden to establish that the transaction was fair and conducted in good faith.”
The principles applied to confidential relationships by the courts have been incorporated into the Rules, which strongly discourage lawyers from entering into business transactions with clients, and impose important safeguards to protect clients if their lawyers decide to alter the normal fiduciary relationship by entering into business transactions with clients. Unfortunately, lawyers often ignore Rule 1.8(a)’s warnings and decide to enter into business relationships with their clients.
Lawyers’ business transactions with clients take many forms. Common transactions include loans to or from clients, a lawyer taking an interest in a business venture as the lawyer's fee, or a lawyer investing in a client’s business venture. Whatever the form, lawyer-client business transactions present a host of troublesome issues. A lawyer’s failure to properly resolve those issues may lead to a sanction for unethical behavior, civil liability for malpractice, and vicarious liability for the lawyer’s firm.
Lawyers have many opportunities (and often receive invitations) to become involved with clients in business transactions, and with good reason. As Professor Wolfram has observed, “many lawyers acquire impressive knowledge and a sense of judgment in business matters through their practice, and many clients come to regard their lawyers as both trusted legal advisers and respected business colleagues.” Those same virtues create significant concerns.
Clients’ trust and respect provide opportunities for lawyers to exercise undue influence and overreach in business transactions with clients. Accordingly, while lawyers doing business with their clients is ethical, it is strongly discouraged by the Rules and the courts which have addressed the issue. It is an area, according to the Missouri Supreme Court, which is “wrought with pitfalls and traps and the Court is without choice other than to hold the attorney to the highest standards.”
The Threshold Question: Is There a Lawyer-Client Relationship?
A lawyer often learns of a business opportunity from a former or current client, rather than from a person whom the lawyer has never represented. While that makes sense, it also creates problems. When a lawyer learns of a business opportunity from a former or current client, the threshold question for the lawyer is whether there is a current lawyer-client relationship with the other party or parties to the potential business transaction, or whether there is only a former client relationship. If there is no current lawyer-client relationship, the former client provisions of Rule 1.9 apply, and the business relationship is unlikely to be improper, although the lawyer will have to take care that his or her participation in the business deal does not develop into a lawyer-client relationship. If there is an ongoing lawyer-client relationship, however, the more restrictive provisions of Rules 1.7 and 1.8(a) apply.
Whether there is a current lawyer-client relationship or only a former client relationship should be an easy inquiry. Unfortunately, it is often difficult, because lawyers do a poor job of documenting the existence and terms of their relationships with clients, and their termination of those relationships.
If the lawyer is currently working on matters for the client, the existence of a lawyer-client relationship will be (or at least it should be) obvious. The lawyer is likely logging time and/or sending bills, both irrefutable evidence of a lawyer-client relationship. More problematic is the lawyer who has completed one or more matters for a client and has no matters pending. The lawyer may believe that the absence of any current work means there is no lawyer-client relationship. The client often believes to the contrary; many clients, once they have been to a lawyer, regard that lawyer as “my lawyer,” and they expect that lawyer to be looking out for that person’s interests at all times. Where there is disagreement about the existence of a lawyer-client relationship, the Rules and the Wyoming Supreme Court say that the client’s belief, not the lawyer’s, controls, so long as that belief is reasonable.
If the lawyer follows a practice of using letters of engagement to document the existence and terms of the lawyer-client relationship when he or she begins to represent a client (although agreements regarding the scope of representation, fees, and costs for which a client will be responsible are not required to be in writing, such agreements should “preferably [be] in writing”), and of using closing letters at the conclusion of those matters, there will be a good documentary record of the relationship of the parties (for sample engagement and closing letters, see John M. Burman, Professional Responsibility in Wyoming (2008), Attachments B & C). The client or former client will also not be mistaken about whether the relationship exists. If the lawyer does not use appropriate documents, a critical issue arises. Are the circumstances such that a person could reasonably believe there is a continuing lawyer-client relationship? If so, a court may find the existence of such a relationship, even where the lawyer is not currently performing work for the client and believes there is no such relationship.
The burden of clarifying the existence or non-existence of a lawyer-client relationship, and its terms, is on the lawyer. Whether there is such a relationship “should be clarified by the lawyer, preferably in writing, so that the client will not mistakenly suppose the lawyer is looking after the client's affairs when the lawyer has ceased to do so.” Accordingly, if the lawyer believes there is no lawyer-client relationship, and there is no closing letter in the file, the lawyer should prepare one and discuss the situation with the client before taking any further action, even if the lawyer has no intention of entering into a business transaction with the client. It is simply bad practice to leave clients uncertain about their status.
Once the non-existence of a current lawyer-client relationship has been established, the lawyer must take care that his or her involvement in the business transaction does not itself give rise to a new lawyer-client relationship. The Oregon Supreme Court has held, for example, that a lawyer's involvement in a business partnership created a lawyer-client relationship where the partnership had no outside counsel. The only reasonable assumption, said the court, was that “some of the work the lawyer does for the partnership is ‘legal’ and is for each of the individual partners, including [the lawyer.]”
Other courts have been more forgiving. In Alala v. Peachtree Plantations, Inc., the Court of Appeals of South Carolina said that although a lawyer in a business partnership had performed legal services for the partners previously, there was no current lawyer-client relationship with the partnership, or with any of the partners, because the lawyer had not been expected to exercise his independent professional judgment on behalf of the partnership.
Although the Wyoming Supreme Court has not addressed the issue directly, its view seems to be more in accord with Oregon’s. In Carlson v. Langdon, the court considered, inter alia, whether a lawyer-client relationship existed in the absence of a formal agreement and any evidence that the alleged former client had paid lawyer’s fees. The court came down on the side of the former client, holding that “[although the attorney-client relationship ordinarily rests on contract, the contract need not be an express one. It may be implied from the conduct of the parties . . . .” That conduct may include the lawyer’s failure to “negate the relationship when . . . the attorney is aware of the [client’s] reliance on the relationship.”
The cases make clear that in the absence of documentation of the non-existence of a lawyer-client relationship, such a relationship may exist by implication and merely because of the lawyer's active involvement in the business transaction. Without proper documentation to clarify the parties’ responsibilities, including that the lawyer will not perform legal services for the business entity, the lawyer is asking for trouble. In a subsequent dispute about the lawyer's role, the reasonable expectations of the other party, a de facto client, should control. It is one more reason to use engagement and closing letters.
Lawyer-Client Business Transactions: The Ethical Standards
The Rules discourage, but do not prohibit, lawyer-client business transactions. If there is to be such a relationship, however, it involves myriad conflicts and the Rules regulate such transactions more strictly than any other type of conflict. Business transactions with clients are subject not only to the general conflict of interest standards of Rule 1.7, which regulate and prohibit some concurrent conflicts, they are also governed by the more specific and restrictive provisions of Rule 1.8(a).
The general standards on concurrent conflicts of interest are contained in Rule 1.7. A business transaction with a client is a concurrent conflict under Rule 1.7(a)(2). A concurrent conflict of interest exists, inter alia, if “there is a significant risk that the representation of one or more clients will be materially limited . . . by a personal interest of the lawyer.” A lawyer who enters into a business transaction with a client obviously has “a personal interest,” i.e., the lawyer’s business interest in the transaction in question. If that interest creates a “significant risk that the representation . . . will be materially limited,” Rule 1.7(a) prohibits continued representation in the absence of an appropriate waiver (and some conflicts may not be waived). Even if Rule 1.7 is satisfied, Rule 1.8(a) imposes additional requirements on a lawyer who wishes to enter into a business transaction with a client.
Rule 1.8(a) directly discusses and regulates lawyer-client business transactions:
A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessor, security or other pecuniary interest adverse to a client unless:
(1) the transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client;
(2) the client is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel on the transaction; and
(3) the client makes an informed decision, in a writing signed by the client, to the essential terms of the transaction and the lawyer's role in the transaction, including whether the lawyer is representing the client in the transaction.
The Rule contains both substantive and procedural requirements. It is, therefore, unethical for a lawyer to enter into a business transaction with a client which either does not meet the substantive standard or fails to satisfy the procedural steps. Those requirements apply “even when the transaction is not closely related to the subject matter of the representation.” The only time the Rule does not apply is when a lawyer and the lawyer’s client enter into a “standard commercial transactions . . . for products or services that the client generally markets to others . . . .”
The substantive standard is that two things must be “fair and reasonable to the client:” First, “the transaction” itself must be “fair and reasonable to the client . . .” Second, the “terms on which the lawyer acquires the interest” in the transaction must also be “fair and reasonable to the client.”
In determining whether the above standard has been met, a review by independent counsel on behalf of the client is more than a good idea. It is the only way to protect the client, and it is the only way the lawyer can protect himself or herself. Even if a client believes such consultation is not necessary, the lawyer should insist on outside counsel to protect the lawyer if the deal goes sour and the client begins to look for someone to blame. If the client declines to seek independent counsel after being advised to do so, the lawyer should document both the giving of the advice and the client’s decision not to consult an independent attorney.
Even assuming the transaction and the terms on which the lawyer has acquired an interest in it are “fair and reasonable to the client,” a lawyer may not ethically proceed until four procedural steps have been taken. A lawyer who misses even one of them will be subject to discipline, even though the transaction and the terms were fair and reasonable to the client.
First, the terms of the proposed business transaction, and the lawyer’s role in it, must be “fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client.” This is the only conflict of interest provision of the Rules which requires that the lawyer communicate the existence of the conflict to the client in writing. It is, of course, always advisable to disclose a conflict and its potential effects in writing. Rules 1.7 and 1.9 do not, however, contain such requirements for either concurrent conflicts of interests or conflicts involving former clients; only Rule 1.8(a) does. Furthermore, the manner of disclosure is specified: “a manner which can be reasonably understood by the client.” The practical meaning of this standard will vary with the relative sophistication of the client. A business person may reasonably be expected to understand a different type of disclosure than an elderly layperson (from whom lawyers seem prone to borrow money, and for which they are routinely severely disciplined).
Second, after the written disclosure, the lawyer must advise the client, in writing, “of the desirability of seeking . . . the advice of independent legal counsel.” The lawyer must, in other words, affirmatively recommend that the client seek independent counsel. Although not expressly required, this advisement, too, should be in writing in terms that can be reasonably understood by the client.
Third, after the client is advised to seek independent legal counsel, the lawyer must give the client “a reasonable opportunity to seek the advice of independent legal counsel.” What is “reasonable” will, of course, depend on the circumstances. In In re Matter of the Marriage of Foran, the Washington Supreme Court considered a similar issue when determining the enforceability of a pre-nuptial agreement. The agreement had been drafted by the lawyer for the husband-to-be. The day before the parties were to leave for their wedding trip, they came in to read and sign the agreement. The lawyer advised the wife-to-be that he was not her lawyer, and that she should seek the advice of another lawyer. She declined and signed the agreement. At the time of the divorce, the wife challenged the agreement, which was found to be unenforceable. The Washington Supreme Court upheld that determination. One reason for its ruling was that the then prospective wife “did not have sufficient time to consult with independent counsel . . . . The only realistic choice would have been to postpone the wedding. . . .” The court discussed the reason for providing such an opportunity. Its reasoning is instructive on the issue of a lawyer entering into a business transaction with a client. “The purpose of independent counsel is more than simply to explain just how unfair a given proposed contract may be; it is for the primary purpose of assisting the subservient party to negotiate an economically fair contract.” Such an analysis is likely similar to how a court will review whether a lawyer gave a client “a reasonable opportunity to seek the advice of independent legal counsel . . .” It will depend on the circumstances.
Fourth, the client must make an “informed decision, in a writing signed by the client, to the essential terms of the transaction and the lawyer's role in the transaction.” This requirement has three parts. First, the decision to allow the lawyer’s participation must be an informed one. Second, the decision must be confirmed in writing, signed by the client. Third, the client must consent to both “the essential terms” of the transaction and “the lawyer’s role” in it.
All the required advisements should be part of the written disclosure which the lawyer makes, and everything should be couched in terms that can reasonably be understood by the client. If the client does not wish to seek independent counsel, that too should be reflected in the written consent form, along with a statement that the client is aware of the recommendation to seek counsel and the reasons for the recommendation, that the client has been given a specified (and reasonable) period of time in which to consult the lawyer, and that the client is electing not to do so, despite the risks associated with that decision.
The written disclosure and consent requirements rest on the cardinal principle that a lawyer is a fiduciary and an agent for each client. As such, a lawyer is ethically and legally obligated to subordinate the lawyer’s interests to the client’s. Furthermore, a lawyer has an ethical duty to have a client make an informed decision about all aspects of the representation, including whether to enter into a lawyer-client relationship.
A lawyer has the duty to explain potential conflicts of interest in sufficient detail to allow the affected client to make an informed decision about whether to enter into or continue a lawyer-client relationship. That duty applies with extra force when the conflict is because of a business transaction involving the lawyer and the client. The client is entitled to have sufficient information to make an informed decision about whether to continue the lawyer-client relationship. In addition, the client is entitled to receive enough information to make an informed decision about whether to enter into a business relationship with the lawyer, and if so, on what terms.
While it is ethically permissible for a lawyer to enter into a business transaction with a client, such transactions are both disfavored and a recipe for trouble. The safest course for a lawyer to follow is to be a lawyer, and not a businessperson. Clients reasonably expect that their lawyers do not have personal or business reasons that might conflict with lawyers’ over-riding duty of loyalty to their clients.
If the desire to go into business with a client is so compelling that it outweighs the risks, the safest course is to stop being a lawyer, with respect to that client, and be only a businessperson. And do it all in writing. To be both a lawyer for and to enter into a business transaction with a client is both ill-advised and an invitation to ethical trouble, legal trouble, or both.
John M. Burman is the Carl M. Williams Professor of Law & Ethics and teaches professional responsibility at the University of Wyoming College of Law. If there are issues you would like to see addressed in this column, Professor Burman may be reached by e-mail at firstname.lastname@example.org.
The views and opinions expressed and included in "Ethically Speaking" are those of the author only and do not constitute an opinion, finding or viewpoint, official or unofficial, of the Wyoming State Bar or the Board of Professional Responsibility.
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