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Let’s suppose your law firm is deciding whether to accept stock in payment for its legal services. It knows that many other firms have done so (usually at the client’s request), but it wants to make a checklist of the legal and business issues to be faced in such an arrangement. Also, in the current “depressed” Nasdaq market, it wants to focus on any additional legal risks it may face. The following topics belong on any such list. The first and easiest problem to be faced involves legal ethics. Under both Formal Opinion 00-418 (2000) of the American Bar Association Committee on Ethics and Professional Responsibility and Formal Opinion 2000-3 (2000) of the Association of the Bar of the City of New York’s Committee on Professional and Judicial Ethics, an agreement under which the client pays for legal services with its securities will probably be deemed to constitute a business transaction with the client and thereby will require that the firm provide special written disclosure to the client about potential conflicts of interest that may arise and that it obtain the client’s written agreement thereafter. In addition, the client should be formally advised to consult with independent counsel (although few clients are likely to do so). CONFLICTS THAT COULD ARISE FROM PAYMENTS WITH STOCK What potential conflicts could arise from such a compensation arrangement? Two stand out. First, initial public offerings (IPOs) tend to be significantly underpriced by the underwriters and thus to run up substantially on their first day of trading. Often, new issuers look to their counsel to assist them in negotiating with the underwriter to limit the amount of such underpricing. But if counsel is paid with stock priced at the initial offering price, then counsel has exactly the opposite incentive from its client: that is, it gains to the extent that underpricing is maximized. The second conflict involves the decision to sell. All the empirical evidence shows that IPO stocks, on average, underperform the equity market for the year after the initial offering. Economically, this implies that a rational investor would logically do what most institutional investors in fact d i.e., flip the stock as early as possible. But dumping your client’s stock can sour the relationship and, in some limited settings, may even create a conflict of interest between the attorney and the client. For example, the law firm may prefer that favorable news be disclosed so that it can sell at a higher price; yet the client may have legitimate reasons for resisting disclosure. As a practical matter, the law firm that receives stock for its services will quickly find itself holding an undiversified and volatile portfolio of securities. Unless it has confidence that the stock market will always rise, it needs to focus on how and when it can liquidate this portfolio. Here, the principal problem for the firm is that it faces significant exposure under recently revised insider trading rules. New Rule 10b5-1, which became effective in October 2000, creates liability for the firm “if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.” ( SeeRule 10b5-1(b)). Potentially, the firm “was aware” of all information that any of its partners knew. Yet, suppose that only Partner X knew the material, nonpublic information,” while Partner A made the investment decision. Here, Rule 10b5-1(c)(2) provides a limited safe harbor: “A person other than a natural person also may demonstrate that a purchase or sale of securities is not ‘on the basis of’ material nonpublic information if the person demonstrates that: (i) The individual making the investment decision on behalf of the person to purchase or sell the securities was not aware of the information; and (ii) The person had implemented reasonable policies and procedures, taking into consideration the nature of the person’s business, to ensure that individuals making investment decisions would not violate the laws prohibiting trading on the basis of material nonpublic information.” This is an affirmative defense. Hence, unless the law firm can demonstrate the implementation of such “reasonable policies and procedures,” the good faith and innocence of the individual exercising the investment discretion will be insufficient to avoid liability. As a practical matter, it may be impossible to insulate any partner, or committee of partners, exercising investment discretion from the possession of material nonpublic information because that partner’s activities may be too central to the firm (i.e., he or she is the “star” of M&A or a big-time litigator, and he or she also wants to supervise investment decisions). In this light, it may be prudent to consider another option: Rule 10b5-1(c)(1) provides an affirmative defense if “before becoming aware of the information,” the person had: “(2) instructed another person to purchase or sell the security for the instructing person’s account, or (3) adopted a written plan for trading securities.” Any such instruction or written plan must meet some very specific criteria specified in the rule, including (1) being irrevocable, and (2) no deviation from the plan having previously occurred. This approach could kill three birds with one stone. Not only does it protect the firm from direct insider-trading liability, it also reduces the firm’s vicarious liability under � 21A(b)(1) of the 1934 act for trading by its employees and partners, and finally, it may minimize the client’s dismay at its stock being sold. For example, suppose a law firm deposits its stock received from an IPO issuer with its broker and instructs the broker to sell 10 percent of the stock so deposited on the first day of each month beginning after the expiration of any lock-up restriction. It is, of course, necessary that those giving this instruction not then be in possession of inside information, but ideally such an instruction could be given during a “clean” period immediately after the client’s filing of its Form 10-K or on the IPO offering date. This procedure facilitates an orderly liquidation with little price impact, and the explanation could be given to the client that Securities and Exchange Commission rules made it infeasible for the firm to itself hold any investment discretion over the stock’s disposition. Note, however, that once this plan is put into effect, it cannot be changed or slowed at the client’s request without sacrificing the availability of the exemption. In addition to the risk of insider trading liability, the law firm may also face heightened liability under the Securities Act of 1933 if it receives a significant block of stock for its legal services in connection with an IPO. In particular, there is an increased risk that a law firm could be found to be a “statutory underwriter” with resulting adverse consequences under both �� 11 and 12(a)(1) of the act. Sec. 2(11) of the 1933 act defines an underwriter to include both a person who “offers or sells for an issuer in connection with, the distribution of any security” and one who “participates or has a direct or indirect participation in any such undertaking.” The obvious implication of this phrasing is that a “participant” can be an underwriter, even though it does not offer or sell securities for the issuer. And so the cases have held. The most frightening case from the standpoint of a law firm serving an issuer is probably Harden v. Raffensperger, Hughes & Co. Inc., 65 F.3d 1392 (7th Cir. 1995). There, in connection with a debt offering by Firstmark Corp., a member of the National Association of Securities Dealers, NASD rules required that the offering be priced by a “qualified independent underwriter.” This limited role was performed by the defendant, who neither sold securities, solicited customers or had any equity stake in the offering. Nonetheless, in a subsequent suit under � 11, both the district court and the U.S. Court of Appeals for the 7th Circuit (on an interlocutory appeal) found that a “qualified independent underwriter” could be held liable as a statutory underwriter based on this theory that it was a “participant” in the distribution. The test, according to the 7th Circuit’s opinion, was whether the alleged participant was a “necessary participant” and a “substantial factor” in the offering whose “services were essential to the distribution.” ‘UNDERWRITER’ IS A TERM THAT’S BEEN READ BROADLY Nor does Hardenstand alone. Earlier, well-known cases, such as SEC v. Chinese Benevolent Association, 120 F.2d 738 (2d Cir. 1941), have read the term “underwriter” equally broadly, to include persons, such as fund custodians, who play a far more ministerial role than does the securities attorney. As a policy matter, why should it make any difference whether the attorney is paid in cash or stock? Here, the answer could be that the attorney receiving stock has a greater stake in the offering’s success and, in particular, has an interest in seeing the stock price climb in the immediate aftermarket (either as a result of optimistic statements in the prospectus or of underpricing by the underwriters). Hence, a person in such a position may be a less zealous gatekeeper and watchdog. If so, the logical response is to increase the liabilities faced by the attorney for the issuer in order to add countervailing pressure on that attorney to perform the gatekeeper role. At least one other trap for the unwary exists for the firm regularly receiving stock in IPOs and other transactions: Potentially, it could become an “inadvertent” investment company. Because law firms pay out most of their cash revenues to partners while retaining less liquid noncash assets (i.e., securities), it is surprisingly easy for a law firm’s balance sheet to show investment securities “having a value exceeding 40 percent per centum of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.” If so, the definition of an “investment company” in � 3(a)(1) of the Investment Company Act of 1940 is at least partially satisfied. Of course, exemptions are available, and the most obvious one is in � 3(c)(7)(B) of that act, which exempts an issuer whose securities are “beneficially owned by not more than 100 persons who are not qualified purchasers.” This 100-person test may exempt the small firm, but obviously many firms exceed this level. ’98 SEC NO-ACTION LETTER IS A MODEL FOR LARGER FIRMS What should such larger firms do? One model has been suggested by Boston’s Ropes & Gray, which in 1998 obtained an SEC no-action letter for a Delaware limited liability company that it had established to hold such securities. SeeRopes & Gray, 1998 SEC Lexis 560 (March 30, 1998) (For details of this plan, seeRopes & Gray 1998 SEC Lexis 340 (1998)). Under the Ropes & Gray model, an exemption is applied for under � 6(b) of the 1940 act for an “employee’s security company,” which application the commission is authorized to grant “if and to the extent that such exemption is consistent with the protection of investors.” The Ropes & Gray model has been followed by many other firms, in part because it easily permits associates, nonlawyers and retired persons to share in the securities pool and to make individual decisions as to which offerings to participate in. There may be a storm cloud on the horizon, however. The SEC is growing concerned that the size of these pools is in some cases increasing to 1,000 or more participants and that young associates are participating; thus, it is beginning to doubt whether such broad pools are consistent with � 6(b)’s criterion relating to the “protection of investors.” The bottom line is that the firm that decides to hold a securities portfolio needs to engage in candid, detailed discussions with its clients, partners and, probably, an investment adviser. Finally, the firm that thinks it can manage its portfolio on an ad hoc basis may have a fool for its client. Mr. Coffee is Adolf A. Berle Professor of Law at Columbia University Law School.

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