Entity Formation: Who is the Client?
Scope of RepresentationRepresenting Organizations Under Ethics Rules
At first glance, the ethics rules appear to draw a clear line in entity representation. Texas Disciplinary Rules of Professional Conduct (TDRPC) Rule 1.12(a) states that “(a) lawyer employed or retained by an organization represents the entity.” The rule goes on to note that the lawyer’s duty is to serve the best interests of the entity, rather than that of the constituent partners or shareholders individually.
Unfortunately, a lawyer cannot talk to an entity. The lawyer must deal with the entity through its constituents. TDRPC Rule 1.12(e) requires lawyers to explain that the entity, and not the constituents, is the client “when it is apparent that the organization’s interests are adverse to those of the constituents with whom the lawyer is dealing or when explanation appears reasonably necessary to avoid misunderstanding on their part.” Comment 4 to Rule 1.12 indicates that whether such warnings are necessary “may turn on the facts of each case.” When such a warning is necessary, the best practice is to put the warning in writing to avoid later disputes as to whether adequate warning was given.
The disciplinary rules expressly dealing with representation of entities fail to address the issue of who is represented when the entity is in the formation process. At the time formation is in progress, the entity usually does not yet exist. The nature of this representation has been the subject of conflicting analysis by ethics commentators.
The Options for a Representation Model
When a lawyer is involved in forming an entity, a number of options for explaining the nature of the representation have been used. In one scenario, the lawyer represents one of the constituents of the contemplated entity, and then may represent the entity later. Another scenario involves representing all of the constituents during formation, and may involve representation of the entity later. Finally, some authority uses a model where the lawyer may disclaim representation of individual constituents completely, and only represent the entity both at the formation and later stages. Each of these models presents issues from an ethics standpoint, and complications when malpractice claims are made.
Representing One Constituent
It is not uncommon for a lawyer to represent one constituent in the formation of an entity. When a lawyer choose to do this, it is critical that engagement letters and contracts reflect who the client is. As to unrepresented constituents, the Comment to TDRPC Rule 4.03 indicates that a lawyer “should not give advice to an unrepresented person.” This is more than just an ethical issue. An attorney client relationship can be implied by the act of giving legal advice. See, e.g. Bituminus Casualty Corp. v. Texas Window Specialties, 2006 WL 864277 (W.D. Tex. 2006)(issue of fact as to whether there was an attorney client relationship when lawyer provided both corporate and personal legal services to a constituent). As a result, if legal advice is given to unrepresented constituents, the lawyer may have an obligation to avoid conflicts. It is important that lawyers document, preferably by a signed acknowledgment, that unrepresented constituents are not the client and have not been given individual legal advice.
If the lawyer represents a single constituent and then represents the entity after formation, there is a potential for conflicts of interest between the constituent and the entity. Conflicts require disclosure and consent “when there is a substantial risk that the lawyer’s representation of the client would be materially and adversely affected…by the lawyer’s duties to another current client….” Restatement of Law (Third) Governing Lawyers Section 121. See TDRPC Rule 1.06(a)-(c). Given the duties of the lawyer to the organization noted earlier, it is clear that representing a constituent and the entity poses a risk of affecting the representation. In such a situation, when the conflict is consentable, written informed consent should be obtained from the affected clients. Restatement Section 122. See TDRPC Rule 1.06(c)(2). The disciplinary rules generally do not require written consent, but it should be noted that a new comment to the ABA Model Rules adopted in 2002 requires “written confirmation” of consent. ABA Model Rules of Professional Conduct Rule 1.7 (b)(4)
Informed consent requires that the lawyer disclose both the risks and advantages of continuing to represent the parties involved. See TDRPC Rule 1.06(c). In entity formation, there are several risks. The lawyer may receive confidential information from the constituent that the constituent does not want to share with other constituents who deal with the lawyer on behalf of the partnership. In general, the attorney client privilege does not apply between the parties to a multiple representation. The lawyer may be a witness in the event of a later dispute between the constituents, and may be unable to represent either the original constituent client or the entity. If the entity were ever to have a claim against the represented constituent, the lawyer may be prohibited from representing either the entity or the constituent. See TDRPC Rule 1.06(d). There is a significant advantage to the representation, however. The use of only one lawyer for formation and representation may significantly reduce attorneys fees. Detailing both the advantages and disadvantages of the joint representation in a written, acknowledged form will help avoid misunderstandings and claims.
Representation of All Constituents
Representation of all constituents in the course of entity formation is quite common. The ethical issues noted in the representation of a single constituent apply to representation of multiple constituents. In addition, the possibility of known differences between the constituents adds to the risks of representation. The Restatement provides discussion of a scenario involving partnership formation under Illustrations 4 and 5 of Section 130 which notes conflicts requiring informed consent arising from different contributions to the partnership by the partners. It is also common for there to be unresolved differences that are subject to negotiation when a partnership is formed.
When there are unresolved differences, lawyers must consider TDRPC Rule 1.07, the intermediary rule, before deciding to take on the representation. Mediating disputes between clients is permitted with informed consent if neither “contested litigation” or “contentious negotiations” are anticipated. Comment 4, TDRPC Rule 1.07. A lawyer may have a hard time objectively analyzing whether potential negotiations will be “contentious.”
A variation on the multiple constituent representation model can arise when a lawyer has a long time client who is involved in the entity formation. Comment i to Section 132 of the Restatement analyzes whether a lawyer can represent a long time client in a matter as well as a new client on a one time basis, and retain the ability to represent the long time client in the event of a dispute among the parties. The new client is called an accommodation client. The Restatement allows for this type of arrangement, if the new client is aware of the long time representation and does not expect the lawyer to keep confidences. The Texas Rules arguably allow for accommodation clients if “prior consent is obtained.” TDRPC Rule 1.06(d). This suggests that for accommodation client status to work in Texas, a lawyer needs to get such consent in writing before beginning representation.
The difficulty in relying on accommodation client status is that nothing changes the basic conflict rule that the lawyer must able to adequately represent all of the clients. When a lawyer relies on accommodation client status to represent a long time client, in a malpractice claim the new client may argue that the lawyer had only the long term client’s interests at heart during the time that the lawyer represented both clients.
Representation of Only the Entity
A few cases and commentators have suggested that a lawyer can represent only the entity from the start. The author has found in discussions with law firms that this is a model commonly used by lawyers in entity formation. The best exposition of this model of representation is found in Arizona Ethics Opinion 02-06 (2002). To date, no Texas case law or ethics opinion addresses the “entity only” model of representation.
The Arizona opinion analyzes rules very close to Texas Rules 1.05 (Confidentialty), 1.06(General Conflict Rule) and 1.12(Organization as Client). Because partnership and incorporation statutes permit ratification of actions prior to formalization of the entity, the opinion reasons that a lawyer may represent the entity only if the forming constituents are notified and they ratify pre-formation actions of the entity after formation of the entity. Interestingly, the opinion does not address who the client is in the event that the entity is not ultimately formed.
The Arizona opinion details how the lawyer should deal with constituents. Besides the requirements of notifying the constituents that they are not the client and subsequent ratification of pre-formation actions, the opinion notes that all of the constituents should be warned that confidential information must be shared with other constituents, though not with others outside the organization. The opinion also indicates that the lawyer should regularly remind the constituents that the organization is the client, rather than each of the constituents individually.
As one would expect with an ethics opinion, the details of potential liability with regard to this model are not discussed. Missing from the opinion is any discussion of how the lawyer may be subject to liability for an implied attorney client relationship despite the existence of the documentation regarding the organization as client. InManion v. Nagin, 394 F.3d 1062 (8th Cir. 2005), the court acknowledged that it was possible for a lawyer to represent only the entity, but noted that giving legal advice to a constituent as to their individual situation created an attorney client relationship.
The practical issue in many situations is how the lawyer can avoid giving legal advice to constituents when forming an entity. Consider whether answering the following questions, which may be raised in the course of working with constituents in forming an entity, could constitute individual legal advice:
- What is my potential liability under the entity alternatives?
- What are the tax implications?
- What are my options if I want to withdraw from the entity?
It may be difficult for a lawyer to repeat at all times necessary that she or he represents only the entity. Lawyers who rely on this model should understand the follow through necessary to make certain that they represent only the entity.
Conclusion
Regardless of the model representation chosen, it is clear that entity formation requires documentation that explicitly identifies the client or clients and identifies potential conflicts of interest. If some constituents are not represented, the lawyer should document that those constituents are not represented and may seek other counsel. Further, the constituents must be told about the nature of confidentiality in the formation process and afterwards once representation of the entity begins. When disputes arise among the constituents, the lawyer must re-evaluate whether he or she can adequately represent the entity.
