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Should Your Lawyer Own a Piece of Your Dot-Com?

By Jay Hollander

Jay Hollander, Esq. is the principal of Hollander and Company LLC, www.hollanderco.com, a New York City law firm concentrating its efforts in the protection and development of property interests relating to real property, intellectual property and commercial interests, as well as related litigation.

The content of this article is intended to provide general information relating to its subject matter. Providing it does not establish any attorney-client relationship and does not constitute legal advice. Personal advice in the context of a mutually agreed attorney-client relationship should be sought about your specific circumstances.

Summary: It's not uncommon for lawyers representing Internet companies to receive some stock in lieu of legal fees. Although this kind of arrangement may benefit both lawyer and company, it also involves some risks and raises some ethical issues. This article helps to explain how a technology company can decide whether it's a good idea to pay a lawyer with stock.


Introduction

I guess we all knew that it was just a matter of time. How long could there be talk of repeated dot-com riches without start-up companies' lawyers resenting how much value their legal services created for these companies and how little of the rewards were actually shared with them?

Eventually, customarily risk-averse lawyers found a way to participate in the Internet gold rush with little risk and at favorable prices. This has been -- and is -- done by taking stock in the client's company as part of the fee for legal services.How should clients deal with this issue? Is it fair? Is there a choice? Is there a benefit? Does it pose any problems? For all these questions, the lawyerlike answer is... it depends.

Not a Completely New Issue

First, let's realize that this issue, while dressed up in Internet clothes of late, is not completely new. Warnings against "greedy" attorneys preying on unsuspecting clients have been a constant standard for tort reformers for quite some time, seeking to curb the fees obtained by class-action and other contingency-fee attorneys. Also, despite recent attention, lawyers have taken stock in their start-up company clients for a very long time.What's different now is the amount of money and speed of gains involved, as well as the increasing frequency of the practice. When shepherding profitless companies to IPO in months or a year or so provides one-day stock pops worth millions, the obvious question arises of whether it's right for lawyers to be paid this way. Even more so when one considers that, in many cases, the stock comes in addition to hourly rates. More still when one considers the glaring inconsistency between a lawyer's ability to do this compared with, say, accountants, who are currently forbidden from such equity participation in their clients, or even judges, who must excuse themselves from participating in cases where they have financial interests.So, why, exactly, is it a problem, if, in fact, it is one? Basically, the oodles of real and potential paper profits coming from stock gains is rubbing up against time-honored ethical obligations that attorneys owe to their clients, obligations requiring fair dealing, reasonable fees, exercise of judgment in the client's best interest, and avoidance of even the appearance of impropriety.There is also the perception among some that this is a no-lose situation for lawyers who get stock at venture-capital prices while taking little or none of the risk, on behalf of clients who need legal services and don't have the money to go down the block to attorneys who don't insist on being one-way partners on the upside of the client company's value.But is this a fair criticism? Certainly, it is true that start-up companies, who want certain top-notch lawyers but lack the funds to pay for them, might feel they are being strong-armed into excessive fees or dilution of their ownership stake. But is this really different from personal-injury victims who hire lawyers on contingency and potentially give away substantial portions of their recoveries?Arguably, yes. Some might argue that the risks of recovery, both as to outcome and amounts, are much more substantial for personal-injury attorneys than in the case of pre-IPO start-ups. Of course, this argument is ultimately more anecdotal than theoretical. Many a contingency attorney has settled a case quickly, thereby benefiting from percentage compensation, and there are some companies that don't do well on IPOs, or that tend to perform poorly afterwards.

Reasonableness of Fees

Then there is the question of reasonableness of fees. If a law firm is retained to provide services that, in the firm's experience, have a fairly predictable fee range, is it reasonable to exact stock as a fee when the value of that stock can appreciate to many times the worth of the services provided on an hourly basis? Here, too, the answer is not as clear as it might appear at first glance. Certainly, $100 worth of services shouldn't wind up costing $10,000 solely due to stock-price appreciation. But, shouldn't lawyers be entitled to some premium for taking stock in lieu of fees from companies that otherwise lack the funds or the know-how to get off the ground at all? What would be the value of the stock of a company that didn't have the resources, personal contacts or legal knowledge to obtain proper financing in a sound manner, or to go public while the market for its goods or services is at its peak? In an era of Internet frenzy, it's also important to look at it from the attorney's point-of-view. Valuable legal talent has been siphoned off to venture-capital firms and general-counsel positions in high-tech companies because of their ability to offer stock-investment opportunities to their employees. Allowing stock investment in clients is, in a very real way, an exercise in employee-retention for many law firms, especially those involved in corporate and securities practices.And, after all, the process is not completely risk-free for the lawyers. Even though getting in on the ground floor increases the chances that the lawyer will profit from stock appreciation in the short term, there are malpractice risks down the road if and when the stock falls off a cliff. Don't discount the willingness of disgruntled public investors to sue lawyers for malpractice when highly touted companies don't perform well, while being advised by attorneys who have already sold their own stock before the price plummets.Finally, it should be noted that some clients actually like the idea of their lawyers accepting fees in stock because it makes them feel that the lawyer is aligned with their interests and will be thinking of the client first, even in the lawyer's own self-interest.

Ethical Issues and Opinions

Still other questions linger, as stock-related profits of law firms allow their compensation to rival those of early investors. Clients have every right to ask, "Are there no limits to this?" "What if a law firm represents an actual or potential competitor and also has stock in that company?" "What do we do to prevent our lawyers from creating a good-old-fashioned conflict of interest, that is, acting in their own self-interest rather than ours?"Increasingly, national and local bar associations have sought to address these thorny and persistent issues, setting voluntary parameters that may serve as a guidepost for lawyers and law firms seeking to make stock participation a component of their fee arrangements with client companies.Interestingly, despite the potential for abuse, illustrative ethics opinions that have come out do not call for a blanket prohibition on lawyers taking equity positions in their corporate clients. Instead, they tend to reinforce traditional obligations of reasonableness and fairness to the client, and client consent.The American Bar Association's Standing Committee on Professional Conduct, for example, has issued Opinion Number 00418. In the main, the opinion construes the Association's Model Rules on Professional Conduct to allow either taking stock in place of fees or allowing investment in clients in addition to fees, provided that the transaction is fair and reasonable; the terms of the transaction, as well as their potential consequences, are disclosed and reasonably understood by the client; the client is given a fair chance to seek a second opinion; and the client furnishes written consent to the transaction in advance.Recently, in New York City, the home of Wall Street and Silicon Alley, the Association of the Bar's Committee on Professional and Judicial Ethics also weighed in on the subject, releasing Formal Opinion 2000-3. In a lengthy and careful examination, the Committee did not completely prohibit the practice of accepting stock, either in lieu of or in addition to traditional compensation. Instead, it was again subject to guidelines for fairness, potential to give rise to conflicts of interest, and for concerns about excessive fees.To be sure, there are some things that can be done to minimize some of the feared consequences of lawyer equity participation in their clients. Committees, made up of lawyers not directly working for the client, can be organized to handle the firm's investments. Also, there can be limits to how much stock is taken from a particular client, so the lawyer or firm can argue that the amounts weren't enough to cloud or influence their judgment to the client's detriment.

What to Do

So, what should a client do in evaluating whether to give lawyers stock, either as fees or in addition to hourly rates? Well, the obvious first answer is that, unless you're a client that thinks it's an advantage to have your lawyers as partners, you could try to avoid it and go down the block to the next firm. In areas such as Silicon Valley, this may not be so easy, but it is not impossible.Another avenue for exploration would be to try to measure what the estimated cost of the contemplated legal services are and back into a stock allocation that, at present value, is somewhat less than the full value of services, with the lawyer taking the risk that good work will lead to appreciation and, ultimately, the equivalent of full compensation with a reasonable bonus.Yet another thing to consider is how many of your present or anticipated competitors are represented by the law firm you are interviewing. Clearly, if there is any potential or actual opportunity for mixed loyalties, you should consider going elsewhere.

As the formal ethical opinions indicate, though, the best bet is to obtain appropriate disclosures from the contemplated law firm, then to invest in independent advice from a disinterested lawyer so that you know what you are getting into. Then, whichever choice you make, it will be a reasonably well-informed one.

Copyright © Jay Hollander, 2007. All Rights Reserved.

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