Put Your Money Where Your Mouth Is: Ethical Guidelines for Lawyers Investing in Clients

• Citation: Vol. 2024 No. 2
• Publication year: 2024
• Author: Written by Merri A. Baldwin

PUT YOUR MONEY WHERE YOUR MOUTH IS: ETHICAL GUIDELINES FOR LAWYERS INVESTING IN CLIENTS

Written by Merri A. Baldwin^*

Whether and how lawyers may invest in their clients is a perennial topic of interest for business lawyers, ebbing and flowing with the economy. In the dotcom boom of the 1990s Silicon Valley firms touted the huge profits they made from taking equity in their clients, riding the IPO wave to (hoped-for) mutual success. Two decades on, lawyers and law firms continue to invest in clients, often through venture funds or other investment vehicles. It is not uncommon for lawyers to invest in their clients, particularly for lawyers or law firms that represent emerging companies. It is also accepted by this point that doing so is not per se unethical, although depending on the facts, there could be ethical risk involved. It is important that lawyers who wish to invest (or take some form of stake) in their clients understand the ethical and other rules that govern their actions, and minimize the risks as much as possible for both them and their clients.

TYPES OF "INVESTMENTS" LAWYERS MAKE IN THEIR CLIENTS

Lawyers invest in their clients in a number of ways. Lawyers who represent emerging company clients sometimes take a stake in the venture in lieu of their fees, since the client may be cash-strapped but in need of legal services.⁰¹ This practice is sometimes referred to as "equity billing." Similarly, lawyers may take a stake in a patent or other intellectual property in lieu of fees. Larger law firms may invest in their clients as part of an early round of financing, on the same terms as certain other classes of investors; this may be done through an investment entity or fund that is separate from the law firm itself (and may include as members all or some of the firm's partners.) Tax consequences of these alternatives differ.

Investing in clients may provide a competitive edge for a law firm. "From the client's perspective, the lawyer's willingness to invest with entrepreneurs in a start-up company frequently is viewed as a vote of confidence in the enterprise's prospects."⁰² Further, a law firm's willingness to invest in an enterprise may provide an additional boost of additional capital (if the law firm is investing cash as opposed to providing services in exchange for stock) or as a way to obtain legal services the client could not easily afford otherwise.

As the type of work lawyers perform for clients evolves, and the needs of their clients change, the types of investments lawyers may make (or interests they will accept) may change as well. For example, the classic situation where lawyers invest in their clients is where the cash-strapped founders come to the lawyer seeking assistance in forming a company.⁰³ The lawyer's role in assisting that type of client may be quite different from the role played by a lawyer or law firm who comes in later, after the founder or group

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of founders established the company with seed funding and using entity formation assistance available on-line or through inexpensive on-line legal resources.⁰⁴ Similarly, many people who have founded start-up companies in recent years are experienced entrepreneurs or industry veterans, who often have significant personal resources or access to funding. These varying contexts provide a complex landscape within which lawyers provide legal services, develop relationships with clients, and take stock or other interests in their clients. The ethical analysis becomes more complex at the same time.

ETHICAL CONCERNS

The most significant ethical concern when a lawyer invests in a client is that of conflict of interest: a lawyer who invests in a client may be at risk of a claim of self-dealing.⁰⁵ Related issues include ensuring fairness to the client (in accordance with the business transactions with clients rule), adequate disclosure, and whether a client may give informed consent.

The potential for a conflict of interest is an obvious risk, pitting a lawyer's financial interest against the fiduciary duties owed to the client, and threatening the independence of judgment required for the lawyer to competently represent the client. California Rules of Professional Conduct (CRPC) rule 1.7 provides that a lawyer must obtain a client's informed written consent if "there is a significant risk the lawyer's representation of the client will be materially limited by ... the lawyer's own interests."⁰⁶ Moreover, informed consent by itself is not enough to resolve a conflict: the lawyer facing such a situation must also reasonably believe that he or she will be able to provide competent and diligent representation.⁰⁷

CRPC rule 1.8.1 applies to lawyers who "enter into a business transaction with a client, or knowingly acquire an ownership, possessory, security, or other pecuniary interest adverse to a client." The rule requires that (A) such transactions be "fair and reasonable to the client," with the terms...