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Commonwealth of Massachusetts


June 1998

GETTING TOO CLOSE TO A CLOSELY HELD CORPORATION

by
Bruce T. Eisenhut, Assistant Bar Counsel

The representation of closely held corporations presents a number of complex conflict of interest issues. Conflicts that arise when attorneys for small businesses intertwine their own personal or financial interests with the prospects of the business by owning stock (either as fees or an investment) or become involved in management. In such situations, the potential damage to the client, to the lawyer and to the legal profession, often outweighs the potential for personal or pecuniary gain.

ACCEPTING STOCK IN LIEU OF LEGAL FEES

There is no per se prohibition on the acceptance of stock in lieu of legal fees so long as there is consent and full disclosure of the potentially conflicting pulls that the arrangement may have on the attorney's loyalties. See, Massachusetts Bar Association, Op. No. 76-16 and Op No. 81-11.

However, legal fees paid in property are reviewed with "special scrutiny" because this issue involves questions concerning the value of the services and the lawyer's special knowledge of the value. Mass. R. Prof. C. 1.5, Comment [2]. A legal fee agreement will be evaluated in light of the factors spelled out in Mass. R. Prof. C. 1.5(a) (1)-(8) including the time and labor required or the skill involved. The fact that the client voluntarily agreed to payment in the form of stock, even with "open eyes", will not necessarily defeat a claim that the fee was unreasonable or clearly excessive. Matter of Fordham, 423 Mass 481(1996). Thus, if a stock quickly appreciates beyond the fair value of legal services, the entity or third parties (minority shareholders) may argue that the fee is unreasonable under civil law, or clearly excessive under disciplinary law. This is not to imply that a lawyer might not benefit from an unanticipated appreciation in value if the client were sophisticated and the risk factors of the fee were clearly communicated (see Mass. R. Prof. C. 1.5, Comment [1]).

INVESTING IN A CLOSELY HELD BUSINESS

Investment by lawyers in business corporations that they represent is again not per se prohibited. See, Mass. R. Prof. C. 1.5, Comment [2]. However, an investment in shares with no readily ascertainable market value or shares in a private placement is a "business transaction" within the meaning of Mass. R. Prof. C. 1.8(a). Rule 1.8(a) requires the terms of a business transaction to be fair and reasonable, written disclosure in language the client can reasonably understand, written consent and client instruction that the advice of independent counsel is recommended. The requirements of written disclosure and written consent are new to Massachusetts practice.

In a closely held corporation, where the value of shares may be uncertain or impacted by liquidity discounts or control premiums, the attorney's desire to sell shares may be adverse to the interests of the other shareholders. In these circumstances, the lawyer's independent judgment will be called into question regarding legal advice that may potentially impact the value or marketability of shares. If a lawyer has a substantial stake in a closely held corporation, the other investors will question whether the attorney's advice is strictly neutral and candid, particularly if the corporation begins to falter and the other investors begin to look for scapegoats. An attorney needs to ask whether that perception, fair or not, is worth the investment.

Some closely held corporations will market stock through private placements. In such a situation, the promotion may, unknown to the attorney, use his well earned reputation in the community to market the shares. This will potentially harm the reputation of the lawyer or his firm if the business begins to fail, is subject to litigation or is the subject of investigation by regulators or taxing authorities. A lawyer whose name is used in marketing may also be drawn into regulatory investigation or litigation if disgruntled solicitees feel betrayed.

ATTORNEY AS DIRECTOR OR OFFICER

It is not unusual for attorneys representing a closely held corporation to be the clerk of the corporation. Since the statutory duties of clerk are ministerial and consistent with the duties of corporate counsel, such a dual role may not present any conflict issues. On the other hand, when an attorney becomes involved in the management of the business, conflict problems arise. In a recent ABA opinion, it was concluded that an attorney may serve as a director of a corporation, as well as legal counsel, so long as the client (through the managers and remaining directors) is informed of the potential problems that may arise as result of the attorney's serving in the multiple roles. See, Formal Opinion No. 98-410 (February 27, 1998). This opinion was based in part on a 70-page report by the ABA Litigation Section Task Force entitled, The Lawyer-Director: Implications for Independence (published at http://www.bna.com/resources/MPC). The Task Force report and ABA opinion advises that a lawyer generally should decline the dual roles and provides specific examples of danger areas, including undermining the attorney-client privilege and exposure to increased risk of personal liability.

A lawyer who also participates in corporate management may, albeit unwittingly, jeopardize client confidentiality. Closely held corporations often do not conduct themselves with attention to corporate formalities. A lawyer who provides advice may be providing legal advice, business or other financial advice, or some combination of both. The ethical obligation of confidentiality applies to the representation of a client, Mass. R. Prof. C. 1.6(a), not to a director's general business advice. If the lawyer is also a director or officer, what information in the lawyer's possession (advice, files and work product) is confidential or protected by the attorney-client privilege? There are no easy answers to this question and case law is inconsistent. Thus, the client must be advised of the risk that the lawyer may be required to reveal information to third parties (auditors, regulators, litigants) that would not have to be disclosed if the lawyer were not also an officer or director. The ABA Task Force discussed the possibility of setting up screening mechanisms or procedures to allocate legal and business advice, but these procedures may be unworkable or cost prohibitive.

WEARING TWO HATS

There are other potential danger areas when a lawyer wears two hats; the most common should be disclosed to the corporation before the corporation consents to the dual roles. For example, if the majority of the board of directors favors a policy that the attorney in his role as director opposes, what is the lawyer to do? The ABA answers that the lawyer should diligently pursue the majority-will (assuming its legality) even if the lawyer personally disagrees with the decision or policy. Another approach is for the lawyer to decline representation on that specific issue and recommend that the corporation retain independent counsel.

The ABA recommends the retention of independent counsel in any case where the lawyer is concerned about personal liability in his role as director. Consistent with common sense, the lawyer should not participate as director in discussions concerning whether to interview or retain outside legal counsel and should recuse herself when discussions concern the relationship between the corporation and the lawyer.

The lawyer should likewise refrain from participation in a policy decision that might result in incurring substantial legal fees to the lawyer or law firm. See, Federal Deposit Insurance Corp. v. Mmahat, 907 F. 2d (5th Cir. 1990) (lawyer-director improperly urged approval of risky loans in order to generate legal fees to firm). In litigation against the corporation questioning an action(s) of the board of directors in which the attorney participated, Mass. R. Prof. C. 3.7 (generally prohibiting a lawyer from acting as advocate if she is a necessary witness) may disqualify the lawyer from representing the corporation in connection with that dispute. See also, Harrison v. Keystone Coca Cola Bottling Co., 428 F. Supp 149 (M.D. Pa. 1977).

Another problem with respect to dual roles relates to insurance coverage. Lawyers may believe that they are adequately covered if they obtain both legal malpractice coverage and directors and officers coverage. However, each carrier might argue that coverage does not apply if in a given fact situation the role of the attorney/director is muddled. Under some D&O policies, coverage does not apply unless the officer/director is acting "solely" as an officer/director.

By serving as a treasurer of a corporation, or taking an active role in the financial affairs of the corporation, the lawyer may be subject to the risk of being deemed a responsible party by the Department of Revenue or the Internal Revenue Service. In such a situation, the lawyer's personal stake is so substantial that it is unlikely that the lawyer can render uncompromised independent judgment. Mass. R. Prof. C. 1.7(b), Comment 6.

It may be that the most compelling reason not to become involved in the entrepreneurial activities of a closely held corporation has nothing to do with the legal complexities described above. Often, the legal complexities can be ameliorated by adequate disclosure, consent, insurance coverage, recusal at the appropriate times and common sense. The largest concern may be loss of credibility. Attorneys who only serve as counsel can avoid interjecting themselves into every personality dispute, family squabble and off the wall proposal, remain strictly neutral and render dispassionate advice. This will often not be practicable when the attorney is involved in the corporation's day-to-day business activities.



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