Too Good to Be True:
The Ethics of Business Transactions With Clients
By Amber Hollister
Has a client ever offered you a deal that is simply too good to pass up? Stock in a red hot technology firm? The chance to buy real estate at fire sale prices? An interest in a patent that you know will make millions? Partial ownership of a beach house overlooking the ocean?
If so, bully for you. But the ethical lawyer should remember that such golden opportunities can spell trouble. Deals that seem too good to be true may be just that, if they involve business transactions with clients.
Know the Basics
When a lawyer engages in a business transaction with a client, a higher standard of review applies because the lawyer has an inherent conflict of interest. After all, lawyers faced with fabulous deals may start focusing on their bottom lines rather than the best interests of their clients.
To protect clients, Rule 1.8(a) provides that a lawyer may not enter into “a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest to a client” unless a laundry list of conditions are met. The rule has been applied to a wide variety of business transactions. See In re Brown, 277 Or 121, rev. den. 277 Or 731 (1977) (corporate buy-sell agreement); In re Drake, 292 Or 704 (1982) (client loan to lawyer); In re Luebke, 301 Or 321 (1986) (client loan to corporation in which lawyer had a substantial financial interest); In re Griffith, 304 Or 575 (1987) (real estate deal with client). RPC 1.8(a) also applies when a lawyer accepts an interest in the client’s business (e.g., stock) or other nonmonetary property as payment of all or part of a fee. See Comment (1) to ABA Model Rule 1.8; ABA Formal Ethics Op 00-418 (Acquiring Ownership in a Client in Connection with Performing Legal Services).
Before a lawyer can do business with a client, the lawyer must: 1) ensure the terms of the deal are fair and reasonable and fully disclosed in a writing the client can understand; 2) advise the client to seek independent legal advice and give the client a chance to do so; and 3) obtain informed consent in a writing signed by the client both to the essential terms of the transaction and the lawyer’s role in the transaction. RPC 1.8(a); see OSB Formal Ethics Op Nos 2006-176 and 2005-10. Missing even one step in the process will likely mean trouble.
On top of these requirements, a lawyer should consider whether continuing to provide legal representation to the client would present a conflict given the lawyer’s financial interests in the client, that is, whether there is a significant risk that his or her professional judgment will be materially limited by his or her own self-interest in the deal. RPC 1.7(a)(2); RPC 2.1.
Fair and Reasonable
The terms of a business transaction with a client must be fair and reasonable. But what exactly does that mean? The terms of a deal are presumptively fair and reasonable if the client would be unable to obtain a better deal for the same services from another source. Formal Ethics Op No 2006-176.
On the other hand, if terms are plainly skewed to the advantage of the lawyer, they will fail the test. For example, in In re Brown, the court reasoned a business transaction was unfair where a lawyer drafted corporate bylaws stating that neither client nor lawyer could sell stock and the surviving stockholder had a right to acquire stock at book value, even though lawyer was considerably younger than the client. 277 Or at 128. The deal was unfair because it was simply too generous to the lawyer.
Between these two extremes, what is fair and reasonable is a harder question. A lawyer must always ask whether terms are objectively fair and reasonable. See In re Bartlett, 283 Or 487, 497-498 (1978); RPC 1.0(k) (reasonable means the “conduct of a reasonably prudent and competent lawyer”); Restatement of the Law Governing Lawyers §126 cmt. e. A good test is to ask, would a reasonable and independent lawyer advise a client to pass up the same transaction with another party?
Even well-meaning lawyers can violate Rule 1.8(a). The fact that a lawyer acted in good faith is not a defense. See In re Harrington, 301 Or 18, 34 (1986). Neither is the fact that a client did not suffer an economic loss in the transaction. See In re Bartlett, supra at 500; In re Scannell, 289 Or 699 (1980). The fact that a client has more sophisticated business experience than the lawyer does not always affect the analysis. See e.g., In re Montgomery, 292 Or 796 (1982).
If a deal steps outside the bounds of ordinary business practice, it is likely unfair. In In re Daniels, 22 DB Rptr 72 (2008), a lawyer was disciplined when he entered into a partnership with his client to purchase land to operate a Christmas tree farm. In two separate land deals, the client contributed cash and the lawyer financed his entire share through a land sale contract with the seller. Despite the fact that the client did not owe any debt, the client and lawyer were named in one contract and the client signed a personal guarantee for the lawyer’s debt in another. The fact that the risks were not shared equally between the lawyer and client was evidence the terms were not fair and reasonable.
At its heart, Rule 1.8(a)’s requirement that terms be fair and reasonable stems from the fiduciary principle that lawyers cannot take advantage of their clients.
The Right Kind of Informed Consent
As is often the case, details matter. It is not enough to merely discuss the potential conflict with your client and then move forward with the deal.
When seeking informed consent to a business transaction, the lawyer should keep in mind four requirements. First, informed consent is only valid if the lawyer has provided adequate information and explanation to the client about the material risks of and reasonably available alternatives to the proposed course of conduct prior to entering into the business transaction. RPC 1.0(g) (defining informed consent). Second, the lawyer must advise the client in writing to seek independent legal advice to determine if consent should be given and give the client a reasonable opportunity to seek that advice. RPC 1.8(a)(2); RPC 1.0(g). Third, the client must actually sign the written informed consent. RPC 1.8(a)(3); 1.0(q) (defining a signed writing). This means that a lawyer who merely memorializes a conversation with the client in a follow-up letter will not comply with the rule. Cf. RPC 1.0 (b). Finally, the client must give informed consent to both 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. RPC 1.8(a)(3).
Failure to comply with any one of these four requirements can lead to trouble. For instance, in In re Ambrose, 26 DB Rptr 16 (2012), a lawyer was reprimanded for failure to obtain informed consent before engaging in a business transaction with a client. The lawyer entered into a business venture with a real estate developer while representing him. Although the lawyer made written disclosures about his personal interest in the business venture, he did not obtain the developer’s informed consent to the essential terms of the project, including whether he would represent the developer in the project.
Avoiding Expensive Mistakes
While the requirements of RPC 1.8(a) may seem cumbersome, failure to comply may be expensive. When lawyers fail to obtain informed consent to a business transaction with a client, courts may allow the client to rescind the deal.
In one California case, a lawyer arranged for a $100,000 loan to a corporate client; out of gratitude, the board awarded him 3 percent of the company’s stock. Passante v. McWilliam, 62 Cal Rptr 2d 298 (Cal Ct App 1997). To the lawyer’s delight, the stock price took off until it was valued at $33 million. But then the board balked. In the ensuing litigation, the court held that the lawyer had failed to advise the company of the need to obtain independent legal advice before accepting the gift of stock. Ultimately, the court found the deal was unenforceable.
To avoid such costly mistakes, lawyers should familiarize themselves with the requirements of Rule 1.8(a) in advance of any business transactions with clients.
ABOUT THE AUTHOR
Amber Hollister is deputy general counsel for the Oregon State Bar. She can be reached at (503) 620-0222, or toll-free in Oregon at (800) 452-8260, ext. 312, or by email at firstname.lastname@example.org.
© 2014 Amber Hollister