Posted March 6, 2016; ©David Jargiello 2016 All Rights Reserved.
“Wilson, Sonsini and the Venture Law Group were staggering. Predictably, these portfolios became recruitment and retention devices designed to attract lawyers and keep them from choosing in-house jobs, positions with investment banks, or venture capital firms.”
Langevoort (When Lawyers and Law Firms Invest in Their Corporate Clients’ Stock), at 569.
Investing in clients remains an important topic in risk management circles, albeit with a lower press profile than in days past. While much of the literature on this topic sources to the dot com era or otherwise deals with the topic as a practice somewhat unique to that period, in my view nothing could be farther from the truth. In fact I would say that the practice remains common, particularly in the technology startup area. Said another way, and generally speaking, “those that can, do.” Some thoughts follow.
PART I – DEFINITION
Lawyers can and do engage in a variety of business transactions with clients, and it is therefore important to clarify that by “investing in clients” or “client investment(s)” in this post I mean the acquisition, by a lawyer, of an equity security or a convertible security, of a corporate client. Again, for purposes of this post, the clients in question are typically, but not necessarily, venture-backed emerging growth companies and the lawyers are the ones representing the entity in general corporate and securities matters. The latter is a generalization, of course, but it is a fact that the venture-backed startup space is the one in which the opportunity for counsel to invest in clients most commonly presents itself.
PART II – RISKS
A – Ethics Risk. In my judgment there is nothing untoward about client investments provided that (1) the client is sophisticated and understands the transaction, (2) the lawyer gets the requisite, informed written consent (as opposed to a broadly or vaguely applicable form consent), and (3) the lawyer pays cash-for-stock at the same price and on the same terms as same-point-in-time purchasers of the same security. On the narrow ethics point, the need for a properly drafted, timely waiver is self-evident; investing without one is almost certainly a breach of the duty of loyalty under any applicable rules of professional conduct. While I have found that most lawyers and law firms that engage in client investing have “form waivers” for such situations caution is the order of the day because such instruments are, well ….. forms.
As noted in ABA Formal Opinion 00-418 (Acquiring Ownership in a Client in Connection with Performing Legal Services) (still an excellent resource on the topic):
“The terms of the transaction also must be fully disclosed in writing to the client in a manner that can be reasonably understood by the client. Full disclosure includes, for example, discussions of the consequences of any rights by virtue of the lawyer’s stock ownership that may limit the client’s control of the corporation under special corporate by-laws or other agreements and the possibility that the lawyer’s economic interests as a stockholder could create a conflict with the client’s interest that might necessitate the lawyer’s withdrawal from representation in a matter. The client also must be afforded a reasonable opportunity to consult independent counsel concerning the transaction and its terms. Finally, the client’s consent must be in writing.” ABA Formal Opinion 00-418, at 12 (emphasis added).
My point is not that there is anything problematic about using conflict waiver forms, templates or exemplars. Rather, I would simply say that counsel should always remember that doing so creates the potential for error … legal document “forms” of any type can be wrong, out of date, badly drafted in the first instance or nuanced to suit specific facts. Conflict waivers are not immune from this risk. For example, I have seen many investment waivers characterized as “standard” or “the letter we have always used without incident” or “the same as [big firm] uses so it must be right” that nevertheless failed to set forth an adequete explanation of the transaction at hand, or that glossed over key facts out of embarrassment over the extent of the conflict. None of that is to say that technically proper disclosure is impossible. In my judgment it is perfectly feasible but requires diligence on a client investment by client investment basis, i.e., does this particular waiver letter meet the applicable standard for informed consent for this particular investment?
Sound Bite: Thoughtful, intelligent waiver practice consistent with the applicable rules of professional conduct on a firm wide basis is a prerequisite to any client investment activity.
B – Claims Risk.
“If you’re explaining, you’re losing.” Rep. J.C. Watts, Jr. (R–Oklahoma) NPR Morning Edition, July 22, 2002
As to actual loss experience, in my view professional liability claims that arise from client investments fall into four broad categories as set forth below. Note that the terminology is mine and colloquial, and does not imply any technical cause(s) of action.
1 – “Aiding and Abetting” Claims: In such cases, the allegation is that client was engaged in civil or criminal misconduct and that lawyer’s investment blinded him or her to the bad acts. The lawyer is thus drawn into civil (and/or criminal) claims as a deemed facilitator of the client’s misconduct.
2 – “Impaired Judgment” Claims: In such cases, the allegation is that the lawyer’s investment impaired his or her ability to be objective, disinterested, and independent, as a result of which there was poor lawyering and actionable malpractice.
– “Unfair Advantage” Claims: In such cases, the allegation is that the lawyer’s investment was obtained under duress or on otherwise unfair terms, as a result of which a demand for disgorgement (and/or other claims of damage) is made.
4 – “Indirect” Claims: In such cases, while there is nothing “wrong” with the investment per se, the lawyer in fact makes an unrelated mistake (e.g., he or she misses a filing deadline). The fact of the investment is then used to paint the lawyer as “bad” such that (i) allegations of self-dealing factually and legally complicate the defense precluding summary judgment, or (ii) the attorney has an excessive amount of “explaining” to do thus giving the jury (or arbitrator or mediator) something to think about, or (iii) the jury (or arbitrator or mediator) takes undue notice the elephant in the room – that lawyers invest in clients because it is lucrative – with bad results.
Of the four, “indirect” claims are in my experience the most common by an overwhelming margin. It bears noting that proper management of the investment process, among other things, reduces what I think of as the “target size” of the investment in an indirect claims context, i.e., a law firm investment that is properly documented, properly waived, properly vetted by an investment committee, and of a size-price-nature fixed by third party investors is simply harder to “drag into” a factually unrelated claim against the law firm.
Sound Bite: The proverbial elephant in the room is that lawyers invest in clients because it is lucrative. Regardless of the technical niceties of waivers or the mistake-cause-damages calculus, this fact will often be used against the firm in a claims context … “Your fees weren’t enough?” This risk is mitigated by thoughtful process consistently applied.
C – Insurance Risk. I personally know a large number of law firms that invest in clients and each of them is able to purchase lawyers’ professional liability insurance of some sort. Thus, based on my own limited data set I would say that the practice does not make one uninsurable per se. However, being able to purchase insurance is different than being able to purchase it on reasonable terms, and, from having a carrier that is comfortable with your practice.
My experience in the LPL market suggests that underwriters tend to rely on the advice of experts in evaluating the risk of client investing, including actuaries, ethics lawyers, and the analyses and results of captive insurance groups (such as AIMRRG, ALAS, BAR, and MPC) and risk purchasing groups (such as PilotLegis). While opinions among such parties vary, I believe it is fair to say that their input to the underwriting process is rarely comforting, i.e., it is rarely suggestive of low or minimal risk. Thus, while in practical terms investing in clients probably will not make a lawyer or law firm uninsurable, it will likely have a number of effects that may or may not be apparent. For example, some underwriters will simply shy away from the account and decline to offer terms as a result of which the available capacity in the market for coverage may be smaller. Conversely, underwriters that offer coverage may do so on tougher terms … higher premiums, lower limits, higher retentions and more rigorous exclusions.
Sound Bite: Know every aspect of your LPL policy as it relates to client investments and adopt internal procedures to ensure compliance therewith. Know your reputation in the market as it relates to your investment activity and how it affects your purchasing power.
PART III – RISK MANAGEMENT STRATEGY AND PROCESS
In the dot-com era law firm of which I was both a partner and firm wide general counsel, we systematically invested in almost literally every client of the law firm over a ten year period yet suffered no direct or indirect claims losses from this activity.
This was the result of process, not luck. More specifically, we had detailed procedures for (i) handling “direct” investments by lawyers, (ii) handling “indirect” investments by our affiliated investment partnerships, (iii) managing our “behavior” as stockholders (when to vote and when to abstain, for example), and (iv) dealing with “directed shares” and like opportunities. Expressly forbidden at all times were “stock-for-fees” deals. Note that there is a difference between “process” and “bureaucracy.” Our risk management processes surrounding client investment were engineered to convert a profitable, perceived high-risk activity into a profitable, in fact low-risk activity. Said another way, the purpose of “risk management” procedures should be to intelligently manage risk to the competitive advantage of the law firm, nothing more, nothing less.
The questions that should, in my view, guide firm management as it considers whether or not to allow client investing follow.
A – Question: Stock-for-Fees? The threshold risk management question is whether to take stock in lieu of fees, or pay cash for the stock just like any other investor in the client enterprise. In general, it is my view that lawyers should pay cash, just like other investors and rarely, if ever, exchange legal services for equity.
1 – Tax Implications. Generally speaking, the receipt of stock for legal services results in taxable ordinary income regardless of whether the stock is saleable. Thus, absent careful tax planning in concert with a “stock-for-fees” strategy, a law firm can find itself wrestling with . . . . (a) how to pay a current tax liability arising from the receipt of nonsaleable, restricted stock, (b) how to value such stock for the firm’s tax purposes without contravening the company’s valuation algorithm, and (c) whether, when and how to distribute stock so received to the firm’s partners. Of course, the structure of the law firm (LLP, LLC, PLLC, PC or sole proprietorship) affects the tax analysis in each case.
2 – Reasonableness of the Fee. Taking stock for fees opens the door to the question of whether the lawyer’s fee is reasonable:
“One danger [to the lawyer who accepts stock as a fee] is that the business will so prosper that the fee will later appear unreasonably high. Of course, instead of increasing in value, the stock may become worthless, as occurs frequently with start-up enterprises. The risk of failure and the stock’s nonmarketability are important factors that the lawyer must consider, along with all other information bearing on value that is reasonably ascertainable at the time when the agreement is made.” Formal Opinion 00-418, at 5 (quoting Hazard and Hodes, The Law of Lawyering).
3 – Practice of Law vs. Investing. Finally, in my view, by paying cash for stock a lawyer is able to mechanically and administratively separate the practice of law from his or her investment activity. For example, key to “paying cash” in my view is that the lawyer should never negotiate terms with the client; rather, the lawyer just buys stock on the same terms, at the same price and with the same rights as arms-length investors. In that way, the board of directors (assuming the client is a corporation) determines the price and the terms of the security in question, as a result of which the key terms of the lawyer’s investment are dictated by someone else.
Sound Bite: There are many pitfalls to accepting stock for fees and the practice should, in my view, be assiduously avoided. For the lawyer wishing to invest in a client, paying cash for stock alongside third party investors who, along with the company’s board of directors, sets the terms, facilitates the lawyer’s ability to maintain his or her professional independence.
B – Question: Pooled Investments or Direct Investments? The second risk management question is whether to invest via a central, pooled fund (”pooled investing” or “pooled investment(s)”) or whether to allow individual lawyers to directly and personally invest (”direct investing” or “direct investment(s)”), or …. both? The answer lies in a balancing of pros and cons in accordance with a firm’s culture, risk tolerance and administrative capacity.
1 – Pooled Investing. From a risk management standpoint, pooled investing has many advantages relative to direct investing:
+++ As a matter of customary practice, pooled investing involves the creation of an investment entity (an LLC or LP) that is affiliated with the law firm but separate from it for tax, accounting and governance purposes.
+++ In a pooled investing system, it is easy to implement administrative controls to reduce risk (e.g., no check is released for the purchase of client stock without a signed conflict waiver).
+++ For insurance or other risk management purposes, pooled investing makes it relatively easy to maintain an accurate central record of all investments made by the firm (e.g., (company, type of security, dates, amounts, terms).
2 – Direct Investing. Conversely, direct investing has pros and cons as to which reasonable minds can differ in practice:
+++ Direct Investing can be more lucrative for individual lawyers than a pooled investing system and can therefore facilitate attorney retention as a business matter. In a law firm at risk of losing key lawyers to in-house stock opportunities (e.g., technology startup opportunities), direct investing is an essential retention tool.
+++ Because the lawyer has a personal stake, it can in some cases advance the attorney client relationship by demonstrating the attorney’s willingness to advance risk capital.
— Direct Investing can be more lucrative for individual lawyers than a pooled investing system and can therefore create a greater appearance of impropriety.
— Direct investing carries with it the issue that different lawyers will have different access to the opportunity, i.e., the corporate transactional lawyers will almost always have better and more access to such opportunities than litigators or specialists. This fact can create perceived and actual differences in “compensation” leading to strife within the firm.
— Direct investing carries with it a meaningful risk of decentralized conflicts management and record keeping. For example, it may be difficult for a firm to say, with certainty, exactly how many client investments it may have at any one point and whether appropriate waivers were obtained.
Sound Bite: Generally speaking, pooled investing is preferable because it is relatively easy to manage. In my view, direct investing is not inappropriate, it is just more complex to manage and requires greater process and greater diligence by the firm.
C – Question: Who … Partners, Associates, Staff? The third risk management question is whether to allow participation by anyone other than firm partners, and, under what conditions. For example … Should only firm partners be allowed to participate in a central, pooled investment fund? Should only firm partners be allowed to make direct investments, while both partners and associates can participate in a central, pooled investment fund? Should there be any distinctions between or among partners (equity vs. nonequity), associates (based on seniority or performance), Of Counsel, or staff?
These are extraordinarily difficult questions, and answering them requires a balancing of (1) the firm’s culture, (2) the bona fide need of the firm to offer such opportunities as retention imperative, (3) the firm’s practical ability to manage the additional risk posed by increasing the number of individuals involved, (4) whether non-partner involvement is permissible in any particular transaction or at all as an “accredited investor” matter, and (5) the risk of perverse incentives arising from non-partner involvement (e.g., associates will prefer to work on clients with investment opportunities to the disadvantage of clients otherwise positioned)
Sound Bite: Generally speaking, “partner-only” systems are preferable from a risk management standpoint. Participation by others in the firm is neither improper nor impossible per se, however it is again more complex to manage and requires greater process and greater diligence by the firm.
D – Process: Making Client Intake Decisions. Client intake is not directly related to client investing, but a firm that permits client investing must be diligent about several aspects of the intake process, including, without limitation, whether there are conflicts of interest arising from other than the investment, and whether the firm has the requisite expertise and bandwidth for the representation.
Sound Bite: It is imperative to avoid even the appearance of taking on a representation you otherwise would not because of the investment opportunity.
E – Process: Making the Investment Decision. With respect to the decision to make a particular client investment, I would articulate the key decision-making elements as follows:
1 – Committee. Appoint an investment committee of relatively senior partners with sufficient gravitas to control the activity on a firm wide basis. Members should include experts in the following disciplines … corporate securities and venture capital, personal and corporate tax, and legal ethics.
2 – Independent Decision Making. In a pooled investing system, lawyers not involved with the client should make the investment decision in accordance with the objectives/policies set forth in the charter documents for the fund. In a direct investing system, the committee should play an oversight role, tracking and monitoring direct holdings, and ensuring the propriety of such activity in each case.
3 – Systems. Set up internal systems to ensure compliance with the applicable rules of professional conduct. For example, releasing the check for the investment is a natural choke point in a pooled investment process; therefore, no check should be released without (a) a signed conflict waiver, (b) a signed engagement letter containing arbitration clause, (c) confirmation that that investment does not trigger an LPLI exclusion, and (d) appropriate committee vetting and approval.
4 – Investment Size. Decide on the size of the firm’s investments and stick to it, no exceptions. Some rules of thumb:
(a) Percentage Amount Rule. <1% of a firm’s pooled fund should take no more than 1% to 3% of any one client company.
(b) Dollar Amount Rule. No more than $25,000 to $75,000 per investment.
(c) Cardinal Rule. No one investment should be material to the firm or to any lawyer. In this respect, systematic investing is preferable to occasional, “one-off” investing.
5 – “Founder” Investments vs. “Venture” Investments. In the venture backed startup space, know the difference between (and abide by the respective customs appurtenant to) investments in founders’ stock as opposed to securities issued to third party professional investors.
Generally speaking, “founders’ stock investments” are purchases of Common Stock at the price paid by founders. The price of such shares can be very, very low (perhaps pennies per share), and three things follow as a result: (a) because the aggregate cash purchase price can be so low on a relative scale (hundreds or a few thousands of dollars), such shares can carry the appearance of being essentially “free” stock given to counsel, (b) the opportunity to receive that essentially “free stock” can carry with it an obligation (express or implied) to perform legal services at a discount, or to defer or forgive the payment of fees, and (c) because cash-for-stock at the same price and on the same terms as same-point-in-time purchasers of the same security should be the order of the day, it is appropriate for such stock to carry with it any vesting or other transferability restrictions applicable to the founders.
In my view, there is nothing per se improper or untoward in purchases of founders’ stock by counsel. What is essential in such cases, however, is to understand and properly articulate the complete business transaction in writing, e.g., “for a deferment of legal fees until time [x], counsel will be provided the opportunity to purchase [y] shares of Common Stock at the founders’ price of [z] per share.”
On the other hand, by “venture investments” I mean purchases of the company’s securities by professional, third party investors such as angels, venture capitalists or private equity funds. A number of things distinguish these investments from purchases of founders’ stock. For example, such investments generally involve the purchase of Preferred Stock or similar securities at much higher price per share and therefore require a greater expenditure of capital by the firm. Further, because such transactions involve the purchase of the company’s securities by outside investors in an arm’s length transaction, there is somewhat greater comfort that the lawyer’s purchase (on the same terms at the same time) is objectively fair to the client.
6 – Establish Investment Criteria. Decide on your investment criteria and stick to them. For example, investments made parallel to well established, sophisticated venture capital investors are likely to carry less risk than investments made alongside friends/family or other investors of unknown pedigree.
7 – Corporate Formalities. For pooled investing, the creation of an investment entity or entities separate from the law firm is an essential risk management strategy. As a generalization, such entities are LLC’s or LP’s comprised of law firm partners who contribute their personal after tax dollars as capital contributions for both fund operations (accounting and the like), and investment. It is imperative that those entities observe all applicable corporate formalities and are run as the affiliated but standalone businesses they are.
F – Process: Managing the Investment.
1 – Shareholder Behavior. Without exception, lawyers and law firms who invest in their clients should be passive investors. For example, counsel should vote along with management and the Board on matters brought before the shareholders, and abstain from voting on matters where there is controversy among management, the Board or the shareholders. In the highly unlikely event that abstention is impossible, then counsel should be prepared to disgorge the shares in a manner that does not alter the voting dynamic or otherwise affect the outcome of the dispute.
2 – Effect of Ending the Client Relationship. As noted above, founders’ stock investments should vest at the same rate as founders or other key management. A “norm” in this regard would be perhaps 4 to 5 years tied to continued service as legal counsel. By contrast, “venture investments” by their nature are never subject to vesting and counsel should take the same deal (no vesting) as the professional investors.
3 – Liquidity. When client stock held by a lawyer or law firm becomes liquid (e.g., after an IPO or upon an M&A event), all blackout periods, lock ups and other restrictions applicable to insiders should be observed. As a business matter, in pooled investing structures, the general practice is to mirror the behavior of professional venture capital funds by distributing only cash or fully liquid stock to individual member lawyers.
PART IV – TAKE AWAYS
#1 – Pay cash-for-stock at the same price and on the same terms as same-point-in-time purchasers of the same security.
#2 – Take firmwide control; do not leave either the decision to invest or the process for doing so up to individual lawyers.
#3 – Make pooled investments through an investment vehicle other than the firm (e.g., an LP or LLC comprised of lawyers who contribute their own after tax dollars into the pool).
#4 – Direct investing is not problematic per se, it just requires greater diligence by firm management.
#5 – Create an investment committee with securities, tax and ethics expertise to approve every investment, direct or pooled.
#6 – Adopt procedures to minimize risk and ensure rules compliance then stick to them.
#7 – Avoid stock-for-fees arrangements.
#8 – Keep it small in any one case.
#9 – Make sure that your investment does not void your client’s S-Corporation election, 33 Act exemption or other legal right.
#10 – Be a passive investor, no exceptions.
#11 – The LPLI underwriting risk is manageable, but requires a knowledgeable broker, diligent risk management, and thoughtful, personal marketing of the firm to the underwriting community.
#12 – If using a pooled investment vehicle or fund, know and abide by the corporate formalities and securities law requirements applicable thereto.
| | | | |