Attorneys frequently mix their own business interests with the business interests of their clients. The reasons may vary: maybe the lawyer is asked to review a business opportunity that has presented itself to the client, and realizes that the opportunity would be a good investment for the lawyer also, for the benefit of both. Take also the situation where the client does not have the financial resources to pay the lawyer's fee for evaluating the opportunity, and the lawyer takes an equity interest in the venture in place of an hourly fee. In still other cases, it is the lawyer who sees a business opportunity and invites a good client to invest in the deal. Lawyers have also been known to accept officer or director positions with clients due to the lawyer's experience and knowledge of the client's business developed over years of providing legal advice. In each of these situations, the lawyers often continue to be, or begin to be, the lawyer for the business in which they have invested.
From a risk management perspective, these situations are fraught with danger for the attorney. Ethics rules prohibit certain business transactions between lawyer and client. However, even if the transaction is not forbidden, there are usually more reasons to avoid these deals than there are to do them. One of the reasons is that professional liability insurers uniformly do not insure claims that arise from business transactions in which the lawyer is also an investor, director, or officer.
- The Ethics Considerations
Under the Model Rules of Professional Conduct, there is a specific rule devoted to this topic, Rule 1.8. The title of the Rule itself suggests why these transactions are to be avoided: “Conflict of Interest: Prohibited Transactions.” The Rule seems to presume that “a business transaction with a client” is prohibited, unless certain specific conditions are met. First, the transaction must be “fair and reasonable” and must be fully disclosed in writing “in a manner which can be reasonably understood by the client;....” The client must consent to the transaction in writing. Even though an Ethics rule makes conduct contingent upon disclosure by the lawyer, there is always potential for the client to come along to later say that he or she relied on the lawyer's disclosure and that it was incomplete or biased based on the lawyer's self-interest, which conflicted with the client's interest.
Nonetheless, the Rule is designed to provide some protection to the lawyer, and of course to the client, in that the client must be given “the opportunity to seek the advice of independent counsel in the transaction;....” However, clients may not actually seek independent advice due to cost considerations and time constraints, and the rule does not require that they actually obtain this advice. The client who does not seek the advice may well decide to rely on what he or she thought was a complete disclosure, only to challenge it later.
- Basic Forms of the Exclusions
Most professional liability policies exclude claims arising out of the lawyer insured's activities or services as an “officer, partner, trustee, or employee” of a business enterprise other than the named insured firm. This exclusion applies even if the insured does not have an equity interest in the business, and applies when the insured is not performing legal services for the entity. Another form of exclusion applies where the claim involves any business enterprise in which the lawyer has an ownership or partnership interest (usually between 10% and 25% ), or exercises managerial control over the entity, and where the claim involves an allegation that the insured negligently performed legal services for the claimant.
- The Reasons for Business Pursuits Exclusions in Professional Liability Policies
There are three primary reasons that these exclusions have evolved in professional liability policies. First, “there is an increased risk of loss and resulting claims when a lawyer renders professional services in connection with a business enterprise in which he is a partner. Business partners may be tempted to collusively convert business losses into a malpractice claim covered by the professional liability insurance of the partner who is a lawyer.” Dukart v. National Union Fire Ins. Co., 1993 Westlaw 3311175 (Del. Super. Ct. July 13, 1993). A lawyer who has an equity interest in the party that is suing him will be putting in his own pocket a portion of any payment made by his own insurer.
Second, “when a lawyer is involved in the business enterprise, it may be difficult to separate strictly legal services from business activity. A lawyer who participates in a business is likely to lack the detachment that exists when the roles of lawyer and client are separate. A conflict of interest may complicate a lawyer's relationship to business associates and affect the legal advice given in connection with their joint enterprise.” Greenberg & Covitz v. National Union, 711 A. 2d 909 (N.J. 1998).
Finally, if a business goes sour there will be few places to look for recoupment of the losses. If a lawyer was involved in any of the business decisions, he or she will be a likely liability target. Rightly or wrongly, the lawyer will probably be perceived as a “deep pocket.”
- Some Illustrative Examples
To better picture the particular risks that a lawyer runs in entering into business deals with clients, consider some of the cases where courts have examined legal malpractice claims arising out of these deals. For example, the First Circuit Court of Appeals considered a case where the insured attorneys formed a limited partnership with one of their clients, and also represented him in loans made to the partnership. Mt. Airy v. Greenbaum, 127 F.3d 15, 20 (1st Cir. 1997). He later alleged that the attorneys misappropriated funds in the form of loans, unexplained disbursements, and management fees, and breached their fiduciary duty to him in their capacity as attorneys by concealing this conduct and in failing to advise him of these breaches of trust. He also alleged that they failed to protect or promote his interests in the limited partnership, instead acting in their own self interest.
In a Texas case, the court was confronted with a situation where the claimant joined with two attorneys to acquire and develop some land. Home Ins. Co. v. Walsh, 854 F.Supp. 458 (S.D. Tex. 1994). The two attorneys were also owners of a savings and loan association, Fidelity Federal, which loaned money to the real estate partnership. The loan ended up in default because a refinancing by Fidelity Federal fell through when it ended up under regulatory supervision. The claimant alleged that the attorneys committed legal malpractice based on acts the court believed to be performed on behalf of Fidelity Federal: “claims are clearly based upon work performed by [the attorneys] in their capacity as owners of [the bank], a business enterprise independent of the law firm.”
In another case, the insured law firm formed a limited partnership, and one of the firm's law partners was a limited partner in the business. When the venture failed, the lawyer/limited partner was accused of failing to disclose the risks of the investment and the conflicts of interest he had, and inducing the plaintiffs to sign partnership documents, including a personal guarantee, without explaining their significance. Potomac Ins. Co. v. McIntosh, 804 P.2d 759, 762-763 (Ariz. 1991).
There are also many cases in which attorneys act as buyers or sellers opposite their clients, with uniformly bad results. For example, where the beneficiary of an estate sold one of the assets of the estate (an investment company) to an entity controlled by the attorney, the court characterized the claimant's cause of action as “suing [the lawyer] because he allegedly permitted his association with [his own company] to cloud his professional and Ethics judgment while he performed services on behalf [the claimant].” Clauder v. Home Ins., 790 F. Supp. 162 (S.D. Ohio 1992).
- What Can be Done
It should be apparent that doing business deals with clients, or accepting corporate positions with clients, is risky. The incidence of claims is high, and insurance coverage is very limited, or non-existent. If you are going to take your chances, you can make some efforts to minimize the risk.
For starters, make sure that you strictly comply with the ethics rules in the state in which you are practicing. This will usually require that you make a written explanation to the client as to the terms of the transaction and it must be a fair and reasonable transaction for the client. The client must consent in writing after having the opportunity to obtain independent legal advice from another lawyer. Strongly encourage the client to get the advice, perhaps by recommending other attorneys (at least three from which the client can choose), and put that recommendation in writing.
Considering that your professional liability policy may not cover you for these claims, see about obtaining some other form of protection. If you are acting solely as an officer or director, look into the existence of D&O insurance, or the possibility of indemnification from the company, if this is allowed by state law.
Because so many of these claims arise where the lawyer is acting as investor and lawyer, resist the temptation to play both roles. If you are an investor, decline to perform legal work for the business entity, and request that the company hire separate outside counsel.
In all of these situations, it will be difficult to forego the fees involved or the investment opportunity. However, with the prospect of an uninsured claim, and the costs of defense and possible claim payments, the cost/benefit analysis counsels against these relationships.