New Jersey’s attitude toward business transactions between attorneys and clients is clear—while not prohibited, avoid them. The current rule on the subject, RPC 1.8(a), provides that an attorney 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 list of conditions are met.
As originally adopted in 1984, RPC 1.8(a) imposed far more restrictions on counsel than its predecessors DR5-101 (Refusing Employment when the Interest of the Lawyer May Impair His Independent Professional Judgment) and DR5-104 (Limiting Business Relations with a Client). Rule 1.8(a) was amended in 2003 with additional preconditions to afford clients even greater protections. The reason for this trend of increased protections is obvious: the dual role as attorney and investor presents an inherent conflict between client service and personal profit. Public policy dictates that the former must give way to the latter and otherwise “require[s] a strict adherence to an attorney’s duty of fidelity and good faith” even if such conduct would appear to put the attorney at a business disadvantage. See Petit-Clair v. Nelson, 344 N.J. Super. 538 (App. Div. 2001) (invalidating mortgages given on clients’ personal residence to secure the payment of fees for attorney’s representation).
Fairness, Reasonableness and Attorney Overreach
Before doing business with a client, the attorney must ensure the deal is fair, reasonable and fully disclosed in writing “in a manner that can be understood by the client”; advise the client to seek independent legal advice and give the client a chance to do so; and obtain written informed consent signed by the client “to the essential terms of the transaction and the lawyer’s role in the transaction.” RPC 1.8(a)(1)-(3).
The rule has been applied to a variety of transactions. See Mroz v. Handler, No. A-3957-15T2, 2017 WL 3221744 (App. Div. July 31, 2017) (real estate transaction); In re Frost, 171 N.J. 308 (2002), and Moorehead v. Luhn, No. A-3829-04T2, 2007 WL 135903 (App. Div. Jan. 22, 2007) (loans made to or received from a client); Milo Fields Tr. v. Britz, 378 N.J. Super. 137, 141 (App. Div. 2005) (services exchanged for interest in client’s businesses). There is a presumption of invalidity to these transactions, and the attorney bears the heavy burden to overcome the presumption with only “the clearest and most convincing evidence.” P & M Enters. v. Murray, 293 N.J. Super. 310, 314 (App. Div. 1996). Because of the difficulties in determining whether a deal is fair and reasonable, courts generally focus on the level of compliance with each of RPC 1.8(a)’s technical steps rather than whether the transaction is fair and reasonable to the client.
Although each step is critical, particularly important is the requirement that the client be “advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel of the client’s choice concerning the transaction.” RPC 1.8(a)(2). Independent legal advice is needed because the attorney’s judgment may be impaired by self-interest. An attorney is well-advised to resist the fear of sending his clients elsewhere. Instead, the attorney may take comfort in the fact that such advice sends a message to the client that the attorney is committed to the client’s best interests.
A client will certainly regret her decision to trust the attorney if it turns out that he had an upper hand in a deal, and a jury in a malpractice case is often influenced by the presence of an ethics violation. It is not enough that the attorney simply mentions in passing the prudence of retaining independent counsel’s advice; rather, the attorney must carefully and clearly explain—in writing—the reason outside counsel is necessary, and the attorney should consider whether to insist on it or refuse to be a part of the transaction. As an added benefit, once independent counsel is retained and is advising on the fairness and reasonableness of the terms of the transaction, the investor-attorney is relieved of the need to speak directly with the client about the risk in the transaction. While this may seem frustrating to the attorney, in fact, independent counsel acts as a safeguard for him because it becomes the independent counsel’s professional responsibility to adequately advise the client regarding any issues.
Former Clients and Non-Practicing Attorneys
Although the RPCs permit transactions with former clients, the courts will still look for compliance with RPC 1.8(a). See Spadoro v. Gentile, No. A-0971-07T1, 2009 WL 1685171 (App. Div. June 18, 2009) (attorney loaned former client money in exchange for an interest in real property, and because attorney followed RPC 1.8(a), the contract was not void). In the same vein, RPC 1.8(a) will apply even to attorneys who are generally not practicing if they act, in part, as an attorney for the transaction.
For example in the recently decided matter of Chernalis v. Taylor, No. A-3461-14T3, 2018 WL 2921814 (App. Div. June 7, 2018), the investor-attorney had retired from practice when she was asked to assist with an acquisition by providing transactional expertise and legal advice in exchange for an interest in the clients’ company. Her role was multifaceted—she at once served as a financial adviser, attorney, and spokesperson with “substantial real estate experience.” The court noted that an attorney-client relationship may be formed even in the absence of formal agreements and may be inferred by the conduct of the parties. The Appellate Division keyed in on the clients’ belief that she was acting as their attorney either because she allowed them or led them to believe that she was willing and able to provide legal advice. The court required her to follow RPC 1.8(a) as a result of the attorney-client relationship that had been formed, even though she was technically retired from practice. Because she failed to do so, her interest in the investment was voided.
Chernalis serves as a good example of how attorneys—even non-practicing attorneys—are perceived by the public. They are believed to be “uniquely” qualified and experienced in issue spotting and in the preparation of legal documents, thus making them attractive business partners and, when things go wrong, perfect targets for a malpractice suit from which to recover losses. Chernalis also serves as a reminder that retaining co-counsel will not shield any attorney from the consequences of his own failure to follow the rules of professional responsibility. In Chernalis, the attorney recommended and onboarded other professional service providers to assist with the venture, including an experienced real estate attorney. Despite the retention of real estate counsel, the attorney was still held liable. Further, Chernalis demonstrates how failing to follow the proscriptions of RPC 1.8(a) may invalidate an otherwise enforceable agreement, leaving an investor-attorney high and dry. The attorney in Chernalis apparently received no compensation for the services she had rendered. These remedies are harsh but are in line with New Jersey’s strong public policy against such arrangements.
While the ethical responsibilities of an attorney in entering into a transaction with a client has received most of the attention, there are also ethical limitations on the same attorney’s ability to represent the client after the transaction takes place. The financial interest the attorney has in the entity in which he has invested may create a conflict of interest between the attorney and the client. For example, an investor-attorney holding shares in a company may be asked to defend it in a litigation. Absent a financial stake in the outcome, the attorney would ordinarily advise his client that the business has several defenses available and the litigation should proceed in the normal course, but the attorney’s investment may benefit by settling early on, thus pitting his professional responsibilities against his personal gain.
Similarly, there may be a conflict posed by a potential acquisition by the client company when the investor-attorney disagrees with the strategy but the other investors want to move forward with it. If the acquisition does not take place because the parties cannot reach an agreement or another problem arises, the other investors may accuse the attorney of using his position as the company attorney to sabotage the transaction because of his opposition to the transaction. In either of these scenarios, the attorney may be accused of violating RPC 1.7(a)(2) (concurrent conflicts) and of not representing the client’s best interests.
Where the attorney is going to represent a client in which he holds an interest, the potential conflict or limitation on his impartiality should be disclosed in writing and the client’s written consent obtained. RPC 1.7(b). If the potential conflict is serious, and the transaction or litigation is fraught with potential problems, the attorney should consider stepping aside or seeking co-counsel to minimize the risk.
Practical Advice for Attorneys and Law Firms
Any multi-lawyer firm should adopt rules for the type and scope of client transactions in which its attorneys may enter as well as procedures for subsequent representation after the initial transaction. It is insufficient to assume each attorney will comply with the RPCs generally or RPC 1.8(a) and 1.7 specifically. Rather, any potential investor-attorney should be required to present firm management with the details of the transaction and terms and obtain prior firm approval. The firm should also identify what (if any) firm resources may be utilized for the endeavor, and put in place any other rules that would shield the firm from vicarious liability for the acts of one of its attorneys. See Moorehead v. Luhn, 2007 WL 135903 at *8-11. Many larger law firms in this country prohibit such investments by their attorneys, and those that do permit it, require compliance with specific protocols due to the potential problems and conflicts that this creates.
In light of the risk of conflicts and attendant claims from any investment in a client, attorneys are well advised to avoid business transactions with clients and proceed with the greatest caution if they decide to entertain a deal. Where the attorney decides to proceed, RPC 1.8(a) and 1.7 should be followed to the letter.
Michael Furey is a partner with Day Pitney in Parsippany. He represents clients in commercial litigation, including matters involving legal malpractice, ethics and partnership disputes.
Sylvia-Rebecca Gutierrez is an associate at the firm, representing corporations in matters involving legal malpractice, torts, creditors’ rights, and real estate litigation.