The Rules Permit It, BUT...
Case law on stock-for-fee agreements is sparse. The Disciplinary Rules do not speak directly to the issue of a lawyer taking equity in lieu of all or part of a fee. Although permissible, stock-for-fees arrangements should be entered only with great care. Lawyers should be on guard to assure that their fee arrangements protect the client's interests and adhere to ethical constraints. Rules 1.04, 1.06, and 1.08 are the primary Texas rules implicated by a stock-for-fees arrangement. TEX. DISCIPL. R. PROF. CONDUCT 1.04, 1.06, and 1.08 ("Rules 1.04, 1.06, and 1.08," respectively).

Rule 1.04-Fee Agreements
The Disciplinary Rules implicitly allow fee agreements accepting stock for legal fees. Rule 1.04 prohibits "unconscionable" fees but does not require that fees be paid in cash nor expressly prohibit payment in stock. A stock-for-fees transaction should not be deemed improper just because a client's stock turns out to be extremely valuable. A fee agreement will be considered improper only if it was objectively unfair at the time the agreement was made. To determine if a particular stock for fees agreement is reasonable, lawyers should refer to the eight familiar factors listed in Rule 1.04(b)(1) - (8).

The Texas rule on reasonableness of fees is unique in considering the "uncertainty of collection before the legal services have been rendered." Compare Rule 1.04(b)(8) with ABA Rule 1.05(a)(8). The reasonableness of a stock-for-fees agreement in Texas should be determined (1) as of the time the parties agree and (2) with due consideration of the uncertain value of the stock. Of course, firms with multistate practices may have to consider other states' rules.

Rule 1.06-Conflicts of Interest
Stock-for-fees arrangements present a major concern because of potential conflicts of interest between the client and the lawyer or law firm. Rule 1.06, the general rule governing conflicts, states in relevant part, "[A] lawyer shall not represent a person if the representation of that person ... reasonably appears to be or become adversely limited by the lawyer's or law firm's responsibilities to another client or to a third person or by the lawyer's or law firm's own interests." Rule 1.06(a) (emphasis added). Comment 4 states, in relevant part, "The critical questions are the likelihood that a conflict exists or will eventuate and, if it does, whether it will materially and adversely affect the lawyer's independent professional judgment in considering alternatives or foreclose courses of action that reasonably should be pursued on behalf of the client." Rule 1.06, comment 4.

Rule 1.06 permits a lawyer to invest in a client only if the investment does not interfere with the lawyer's independent professional judgment. The lawyer should be aware of the possibility that his own interests and those of the corporation could conflict. For example, if the lawyer disagrees with the client's decision regarding the goals of the representation, the lawyer might find his own investment interests make it difficult to give detached advice. If the lawyer believes his representation may be adversely limited by his investment in the client, the lawyer should withdraw as counsel unless the lawyer reasonably believes the client's interest will not be materially affected and the client consents after full disclosure. See Rule 1.06(c). It is advisable to put such consent in written terms, although not a requirement of the rule.

To minimize the potential for conflicts, many law firms who invest in clients do so through separate entities with independent investment managers, e.g., partnership investment pools. By removing the lawyers working on a matter from supervision of the investment, it may curtail the possibility that professional judgments will be clouded by potential disagreements over the client's business decisions. Additionally, many firms limit potential conflicts by minimizing the level of investment in any one client. Keeping the level of investment below a fixed percent arguably helps the firm assure that it is not a major player in the business decision-making process. Nonetheless, the basic potential conflict of interest in owning client stock does not disappear with the utilization of such methods.

The touchstone of any conflict of interest issue is whether the lawyer as a client's investor can maintain independent professional judgment in representing the client. Cautious lawyers should explain to their clients the potential for conflict in writing, consider strategies to minimize the possibility that the investment interferes with their advice, be alert for such potential conflicts, and immediately advise their clients (here again, in writing) if any conflicts do arise. Otherwise, the lawyer could be faced later with legal malpractice or other claims from disgruntled investors or a bankruptcy trustee.¹

Rule 1.08-Transactions with Clients
Under the disciplinary rules, an agreement involving stock for fees probably constitutes a "transaction" between a lawyer and client. See Rule 1.08(j). The Disciplinary Rules permit such transactions but require certain safeguards to protect the client.

Rule 1.08 permits a lawyer to enter such a transaction provided that: (a) the transaction is fair and reasonable, and the lawyer fully discloses its terms to the client; (b) the client is given a reasonable opportunity to seek the advice of independent counsel, and (c) the client consents in writing. Rule 1.08(a)(1)-(3).

Rule 1.08(a)(1) does not specify the kind of information that must be disclosed. The disclosure could include: (a) an explanation of the transaction and all of its terms; (b) the nature and extent of the lawyer's interests in the transaction; (c) a discussion of the risks and disadvantages to the client and to the attorney from the transaction; and (d) the manner in which the lawyer's participation in the transaction might affect the lawyer's independent judgment.

Rule 1.08(a)(3) requires the client's written consent to the transaction. Many times, a client who wants to hire a lawyer in a stock-for-fees arrangement will be a small, closely-held corporation. Whenever a lawyer deals with such entities, the lawyer should be careful to identify and obtain consent from the person who speaks for the client. Rule 1.12 provides guidance in identifying the decision-makers for the corporation and in recognizing when the interests of a corporation and its constituents may diverge. See, generally, Rule 1.12(a) and comments 1-6.

Under the three-prong test of Rule 1.08(a), only the third step-acquiring the client's consent-must be in writing. Other jurisdictions require more written documentation when lawyers enter a transaction with a client. See, e.g., California Rule of Professional Conduct 3-300 (requiring lawyer to disclose in writing both the terms of transaction and the advice to consult independent lawyer). To be safe, a lawyer should document as much of the transaction as possible. When evidenced in writing, documentation of both disclosure and consent can show the corporate nature of the decision for purposes of Rule 1.12, as well as the lawyer's compliance with the disclosure and consent requirements of Rules 1.06 and 1.08.

One example of the potential risk and reward for attorneys investing in clients is demonstrated by the experience of the Wilson Sonsini Goodrich & Rosati firm of San Diego, California. When their client, VA Linux, released its initial public offering, entities related to the firm owned 102,584 shares of VA Linux. The IPO was issued at $30, and meteorically rose to $239.25 on the first day of trading. By week's end, the firm had a paper profit of $25.66 million. But as of May 12, 2000, the stock was trading at about $45. For a full report of this situation, see "Wilson Cashes In as IPO Explodes," at http://www.lawnewsnetwork.com/stories/A11345-1999Dec10.html.

There is no known indication that any claims might be made against the Wilson firm as a result of the volatility of this stock. Lawyers who receive or invest in clients' securities, however, do make themselves more vulnerable to suits arising from significant declines in business fortunes, or even normal market volatility, than otherwise.

Penalty for Failing to Follow the Rules
Failure to protect the client and to follow ethical rules in a stock-for-fees agreement can lead to claims of malpractice or disciplinary proceedings. Because the stock-for-fees agreement raises possible conflicts of interest between the client and the firm, it also carries an enhanced possibility for a claim of breach of fiduciary duty. Under Burrow v. Arce, 997 S.W.2d 229 (Tex. 1999), clients can seek disgorgement of attorneys fees as a remedy for a "clear and serious breach of fiduciary duty," even if the breach caused no damages. Id. at 240. To the extent that proof supporting a jury finding of misconduct would also support its separate damage findings for dishonesty, intentional misrepresentation, fraud, conspiracy, or sanctionable behavior, liability on those claims would likely be uncovered by most professional liability policies. Most professional liability policies contain coverage exclusions relating to claims arising from situations where the lawyer invests in the client.

Some attorneys may take the position that accepting stock in a client's business is not a problem because the attorney benefits financially by helping the client succeed. However, two main sources of potential claims accompany the attorney's undertaking of such a risk: those alleged by people who lose money on valuation swings of the business, and those brought by the client if business problems arise. Investors who purchase shares at a high price and suffer a loss may claim that the attorney failed to disclose negative information, or that the attorney traded based on inside information. If the attorney tries to cash in on gains, that could negatively affect business valuation. If the attorney should exercise voting rights in way antagonistic to any one in the client company, allegations of conflicts could result. In the event of a malpractice claim, the client will pummel the attorney at every opportunity with the argument that the attorney's primary interest in participating in the deal was the promotion of his own interests above those of the client.

In a malpractice case, the fairness and reasonability of the attorney's business involvement in a client's transaction will be judged in the harsh light of hindsight. Just meeting all the terms of Rule 1.08(a) will not necessarily insulate the lawyer against the possibility of a conflict developing as the representation progresses, nor against the investors' or client's hostile reactions to such a conflict.

¹See, e.g., Banc One Capital Partners Corporation v. Kneipper, 67 F.3d 1187 (5th Cir. 1995), in which some disappointed investors of a bankrupt film production company sued a law partner and his firm over a private placement offering prepared by the firm. The partner served as an officer and Chairman of the Board of the client and the initial capital requirements had not been fully subscribed. Conspiracy and securities fraud claims were remanded for retrial because of defective jury instructions; summary judgment for the firm was upheld on the legal malpractice claim because there was no attorney-client relationship with the investors.