Lawyer’s Ethics in Real Estate Transactions

Roger Bernhardt and Robert L. Kehr

In the past few months, two California decisions have made strong statements to lawyers about improper behavior in handling real estate matters for their clients, one on going into business while representing the client and the other on supporting the other side after the termination of the representation of a client .

Fair v Bakhtiari

In the first of these cases, Fair v Bahktiari, 195 Cal App 4th 1135 (2011), a lawyer who had been representing a client for about six months then went into business with him, the two of them making real estate investments together and sharing the[profits, with the client providing the money and the lawyer doing the negotiating and document drafting.  Their enterprise lasted about ten years (although the lawyer stayed with his old firm for the first four years of their joint venture), but it then ended badly when the client terminated their business relationship. The lawyer filed suit against the client for the value of his interest in their jointly-owned business and for other claims, including assault and battery, and the client cross-complaining for, inter alia, breach of fiduciary duty. After a bifurcated trial, the court found that the lawyer had violated two California standards.  One was California Rule of Professional Conduct 3-300, which, like ABA Model Rule 1.8(a), requires a lawyer – before entering into a business transaction with a client -- to advise him in writing and give him the opportunity to get advice from independent counsel on the situation.  The second is the statutory presumption, found in California Probate Code §16004, that the lawyer (or other fiduciary) who enters into a transaction with a client (or beneficiary) has the burden of proving that the transaction lawyer was fair and reasonable to the client.  The lawyer failed to make this showing although the investment venture was very profitable.  In light of those findings, the trial court then rejected the lawyer’s request to amend his complaint against the client to seek a monetary recovery from him on a quantum meruit basis for all of the services he had performed during their shared career (over and above what he already taken out of the venture as previous compensation, profit sharing, and benefits).  The appellate opinion affirmed that conclusion, holding that the lawyer’s misconduct disqualified him from demanding any further compensation from the client.

Does this decision mean that a lawyer cannot invest in a business deal with his or her real estate client? No, but it is a cautionary tale about what the civil consequences can be for a lawyer who gets the rules wrong. Because this lawyer failed to meet his burden of showing that his transactions with his clients were fair and reasonable to the clients, the result was that he lost his ownership interest in the business (a series of real estate investments in which the lawyer was a partner) despite the fact that he had done years of work as an active partner in the business.  He was permitted to retain all of his prior compensation (which the former clients did not seek to recover), but he was denied the right to obtain quantum meruit compensation for the services he provided to the investment entities.

Is this a standard peculiar to California? The rule now stated in California Probate Code §16004 long has been part of California statutory law, but it is based on common law considerations that exist even where there is no such codification.  For example, the Indiana Supreme Court said: “Indiana case law recognizes that transactions entered into during the existence of a fiduciary relationship are presumptively invalid as the product of undue influence. Transactions between a lawyer and client are presumed to be fraudulent, so that the lawyer has the burden of proving the fairness and honesty thereof. Matter of Smith, 572 N.E.2d 1280, 1285 (Ind.1991), cited with approval in Liggett v. Young, 877 N.E.2d 178, 184 (Ind. 2007).  Another example of this can be found in In the Matter of the Disciplinary Proceedings Against McMullen, 896 P.2d 1281, 1290 (Wash. 1995), and much the same standard is provided by Restatement Third, The Law Governing Lawyers § 126.

Suppose the lawyer doesn’t invest funds in the client’s project but instead agrees to take a piece of the action in lieu of fees for doing the legal work? It is widely recognized that the business transaction rules don’t apply for either civil or disciplinary purposes when a client hires a lawyer under a traditional hourly, flat, contingency, or mixed fee arrangement.  However, a lawyer’s fee agreement is subject to the business transaction rules when the lawyer obtains an ownership, possessory, or security interest adverse to the client.  One example of this is when the lawyer obtains an ownership interest in the client company or in a client’s asset as compensation for legal services. This is explicit in Restatement Third, The Law Governing Lawyers §126, Comment a, which cites several published appellate opinions to that effect.  The same conclusion has been reached in a number of advisory ethics opinions, including ABA Formal Opinion 00-418 (7/7/00).  The Fair decision does not rely on any distinction between investing with a client and obtaining an ownership interest in return for providing legal services.

Will the Lawyer Always Go Unpaid?

Will it always be the case that a lawyer who goes into business with a client will not be able to obtain compensation for services provided to the client or to the client’s business entity? The opinion in Fair provides a definite starting point for answering in California.  This is because the issue on appeal was whether the trial court abused its discretion in denying the lawyer’s motion to amend its complaint in order to seek compensation for the reasonable value of his services.  However, Fair does not provide a definite answer to other factual situations that might be raised in later cases.  Fair found that the trial court had not abused its discretion in denying the motion to amount under the aggravated factual situation presented.  Among other things, the lawyer failed to document many of the transactions he sought to enforce, and the parties had disagreed over time as to what their deal was.  In addition, the lawyer failed to provide any advice to his clients regarding the transactions despite the continued existence of a lawyer-client relationship, and the lawyer had unresolved conflicts.  One conflict was that the lawyer represented multiple clients (including the individual client and numerous business entities), and another was that the lawyer’s ownership interests gave him a financial interest in the transactions on which he provided legal services.  The lawyer failed to comply with the conflict disclosure and consent requirements of California’s Rules of Professional Conduct as to both sets of conflicts.  Because the situation was extreme, it is possible that a lawyer might succeed in obtaining compensation in other settings even though the lawyer fails to meet the burden of showing the transactions were fair, reasonable, and fully explained to the client.  Still, a lawyer seeking quantum meruit compensation will have an uphill battle.  The reason is that the court refused to apply the doctrine of severance (a common law principal, codified in California in Civil Code §1599, that permits a court to sever the invalid part of a contract and enforce the portions that are valid) because the lawyer’s failure to prove that the transactions were fair, reasonable, and fully explained permitted the clients to void them in their entirety.  The result of voiding the agreements in their entirety was that there was no valid part to be severed from an invalid part.  The trial court’s key finding was that all of the lawyer’s services were “part and parcel of those unenforceable business transactions.”  There might be situations in which a court would permit a client to void a transaction but nevertheless see at least some of the lawyer’s legal or non-legal services as being distinguishable from the void transaction and therefore compensable.

Is the client’s right to void the transaction peculiar to California, or will lawyers in other jurisdictions face the same potential outcome? The client’s right to void the transaction comes from the common law and is not unique to California.  Cases from elsewhere apply the same policy.  See, e.g., DiLuglio v. Providence Auto Body, Inc., 755 A.2d 757, 770-71 (R.I. 2000); Tyson v. Moore, 613 So.2d 817, 823-24 (Miss. 1992); and Security Federal Sav. & Loan Ass’n of Nashville v. Riviera, Ltd., 856 S.W.2d 709 (Tenn. Ct. App. 1992). This can be seen as an expression of the norms that a fiduciary ordinarily may not retain any of the profits that arise from a breach of fiduciary duty, and that an agent may be required to deliver to the principle any benefit acquired through the misuse of the agent’s position.  See Restatement Second, The Law of Torts § 874, Comment b (1979), Restatement Third, The Law of Agency § 8.02, Comment e (2006), and Note, Sanctions for Lawyer’s Representation of Conflicting Interests, 57 Colum. L. Rev. 994, 1004-06 (1957)

Does this mean that, outside California, lawyers will face the same problem in attempting to obtain compensation for services when a transaction is held to be void? We are not aware of any case from outside California that directly addresses whether a lawyer can secure compensation for services to a business with a client although the lawyer cannot enforce a related transaction.  The opinion in Fair analyzes this from a contract standpoint, but other starting points might be used by different courts.  The issue might be viewed from the standpoint of agency, fiduciary duty, or lawyer’s conflict of interest.

So is there any way for a lawyer to safely go into business with a client and be certain of being able to enforce the compensation features of the deal? The safest course is for the lawyer to fully comply with the business transaction rule.  This is Rule 3-300 in California and Rule 1.8(a) under the Model Rule numbering system.  Doing so should allow the lawyer to meet the burden of proving that the transaction was fair and reasonable to the client. Compliance means that (1) the agreement will be fully stated in writing in a form that the client reasonably should be able to understand, (2) the lawyer advises the client in writing to seek independent counsel and gives the client time to seek that advice, (3) the client agrees to the deal in writing, and (4) the lawyer provides the client all the advice the lawyer would have given if not a party to the deal. The obligation to competently advise the client about the transaction long has been part of California law and received its most famous statement in Felton v Le Breton, 92 Cal. 457, 469 (1892).  This also probably is the law elsewhere, at least when the client reasonably relies on the lawyer for advice regarding the transaction.  One example is In the Matter of the Disciplinary Proceedings Against McMullen, 896 P.2d 1281, 1290 (Wash. 1995).

How difficult that will be depends on the nature of the transaction.  Imagine, as an example, that a lawyer wants to buy a client’s used car for the use of the lawyer’s teenager.  It would not be complicated for the lawyer to satisfy all of the requirements of the applicable business transaction Rule in an isolated transaction of that sort.  The documentation would be simple and the fair value of the used car easy to determine.  The transaction in Fair was pretty far toward the opposite end of the spectrum.  There, the lawyer and his client entered into a real estate investment business.  Rather than a simple, isolated transaction, the lawyer and client entered into a series of complex and interrelated business transactions with one another for which they formed a series of entities over time.  Anyone with any real estate experience can picture what this meant in practice because buying, financing, operating, and selling real estate breaks down into a great number of individual but interrelated transactions.  A lawyer in that situation would need to comply with the business transaction Rule each time the lawyer and client enter into a new transaction with one another or modify an existing agreement.  When the lawyer and client work side by side day after day in an active real estate investment or development program, the compliance burden on the lawyer would be extraordinary.

Quitting as Counsel First?

Would the lawyer be able to avoid the business transaction requirements by terminating the lawyer-client relationship before going into the venture? That is something for the lawyer to consider, but it has practical problems because the lawyer might have been invited into the real estate project because the lawyer would contribute legal services.  This is what happened in Fair.  The client testified that he agreed to give the lawyer a 30% ownership interest because the lawyer was contributing his legal expertise, and the lawyer was found to have represented both the business entities and the individual client thereafter.

It would be a significant protective step for the lawyer to clearly and unambiguously terminate the lawyer-client relationship before entering into any business transaction with a client, and then to carefully avoid any conduct that the former client reasonably might understand to mean that the lawyer-client relationship has been reestablished.  However, by itself that does not provide the lawyer with immunity.  The reason for this is that, although the business transaction Rule by its terms applies to business transactions “with a client,” case law in California has applied it to situations in which the relationship of trust and confidence has continued after the termination of a lawyer-client relationship.  This is more likely to occur when the business transaction is related to the subject of the former relationship or involves information that the lawyer obtained as a result of the former representation.  There is some similar authority on this from outside California.  The application of ABA Model Rule 1.8(a) to transactions with former clients is explicit in the Connecticut version of the Rule, and the same result might be obtained through trust concepts.  See Restatement Second, Trusts § 170, Comment g.

Obtaining “Independent Approval”

Can lawyer number one recommend the name of a prospective lawyer number two to satisfy the independent approval requirement; would she or he have to be in a different law firm: and who pays the fees of the second lawyer? California Rule 3-300 and Model Rule 1.8(a) require the lawyer to recommend to the client that the client seek independent advice, and to give the client time to obtain that advice.  In a situation of any complexity or magnitude, such as in Fair, it would be prudent for the lawyer to refuse to proceed unless the client actually obtains independent legal advice.  Model Rule 1.8(a) and Restatement Third, The Law Governing Lawyers § 126, do not address when a lawyer is “independent”.  Common sense would say that the lawyer should not be in the same law firm with or paid by the first lawyer, and should not have a close personal or professional relationship with the first lawyer that might cause independence to be questioned.  It probably would be best if the client selects the independent lawyer without any input from the first lawyer, but this is not required.  California’s proposed new Rules of Professional Conduct (on which the sSupreme cCourt has not yet ruled) have the following explanation: “An independent lawyer is a lawyer who (i) does not have a financial interest in the transaction or acquisition, (ii) does not have a close legal, business, financial, professional or personal relationship with the lawyer seeking the client’s consent, and (iii) represents the client with respect to the transaction or acquisition.”

The first lawyer certainly may provide the client with the names of other lawyers to provide needed advice about the proposed transaction, but the first lawyer should not even appear to have selected the second lawyer.  Any such suggestion might prevent the second lawyer from being seen as independent.  The first lawyer can explain to the second lawyer the reason for the consultation, and it is to be expected that the dealings between the two lawyers might go beyond that.  The reason is that the role of independent counsel is to provide competent and unbiased advice to the client about the proposed transaction.  For the second lawyer to counsel the client about the pros and cons of the proposed transaction, and the reasonably available alternatives and their pros and cons, the second lawyer quite likely will want to discuss the situation with the first lawyer to better understand how the nature and form of the proposed transaction was developed.  It also is possible that this will lead to negotiations between the two lawyers as to the substance or form of the transaction.

Should the original lawyer consult with an ethics expert about the deal while the client is off visiting the independent lawyer? The business transaction rules set out protocols that any lawyer should be able to follow.  The greater problem is that the lawyer might not recognize the need to comply with the rule.  Some lawyers are influenced by their personal interests to not recognize the application of the business transaction rule, a requirement that might have been apparent if they were observing the conduct of another lawyer.

Further Obligations?

If a business agreement is ultimately worked out and been approved by independent counsel, is the original lawyer subject to any ongoing further restraints because of his former status? That will depend on the nature of the transaction.  If the lawyer had purchased a used car from a client, it is difficult to see how there would be any later interaction between the lawyer and client with respect to that transaction.  When a lawyer is in business with a current client, the lawyer must be mindful of the obligation to comply with the business transactions requirements each time the lawyer and client enter into a new agreement with one another or modify an existing agreement.  The lawyer also must be certain that the business relationship and the lawyer’s financial interests do not affect the full performance of all of the lawyer’s duties to the client, and must be certain to comply with any other conflict rules that might apply because of multiple clients or because of the lawyer’s financial interest in the subject of his representations.

Is the relative sophistication of the lawyer and the client important in a business transactions situation? In determining whether a business transaction is fair and reasonable to the client and therefore is enforceable by the lawyer, there is a long case-law tradition of examining the client’s sophistication.  The less sophisticated the client, the heavier the burden on the lawyer to demonstrate the procedural and substantive conscionability of the transaction. The lawyer’s relative sophistication was mentioned by the court in Fair, but that is unusual because the fiduciary nature of the relationship creates a presumption of the lawyer’s relative sophistication. iIt is possible the court gave some added weight to the fact that the lawyer was a licensed real estate broker, but it is hard to imagine that the outcome would have been any different if the lawyer had not also been a licensed broker.  The decision hinged on the lawyer’s status as lawyer, his lawyer-client relationships with the individual and with the various entities they formed, and the lawyer’s failure to meet the burden of showing that the transactions were fair and reasonable and fully explained to the clients.

The obvious civil risks for a lawyer who goes into business with a client are the possible inability to enforce the transaction and the possible inability to be compensated for services to the business.  But additionally, there is the danger that when a lawyer obtains an ownership interest in a business, at least in part because the lawyer promises to provide legal services to the business, the lawyer might feel obligated to provide services outside the lawyer’s area of experience.  There is a real potential for malpractice liability in situations of this kind.  A lawyer might think of himself only as one of the principals in a business but nevertheless owe all of the duties that lawyers owe to clients.  Related to this are the questions of whether the lawyer will think to carry malpractice insurance and whether the insurance will protect the lawyer who is doing business with a client.  It also is important to remember that some jurisdictions have malpractice insurance disclosure requirements. One example is California’s recently adopted Rule 3-410 that requires lawyers to tell their clients if they don’t have malpractice coverage.  The insurance issue easily could morph into a disciplinary issue.

Oasis West. v Goldman

The second recent decision was by the California Supreme Court.  Oasis West v Goldman, 51 Cal.4th 811 (2011), which involved a lawyer who turned against his client on a project on which the lawyer previously had represented the client.  In 2004, the client retained the lawyer’s firm to obtain all the necessary approvals for a luxury hotel and condominium development in Beverly Hills; in 2006, shortly before the project went before the city council, the firm withdrew from the matter, and then, in 2008, after the council had approved the project, its lead lawyer on the deal, joined the citizen’s group seeking to overturn the approval, including soliciting signatures for a referendum petition.  This conduct led the lawyer and his law firm to be sued for breach of contract and fiduciary duty and for professional negligence.

The defendants responded with a special motion to strike under California’s “Anti-SLAPP” statute, restricting lawsuits designed to discourage citizens from asserting their rights to petition the government. The trial court denied the motion, holding that the suit was based on claimed breaches of the lawyers’ duties of loyalty and confidentiality, but the intermediate appellate court reversed, ruling that the lawyer’s actions did involve protected petitioning activity and that the client could not show that it was likely to prevail on its claims. The Supreme Court then took the case and unanimously ruled in favor of the client.  A presumption of confidential knowledge arose from the existence of the attorney-client relationship and the’s lawyer’s duties of loyalty and confidentiality continue even after representation of the client ends. Those duties were not confined – as the cCourt of aAppeals had believed – to cases involving subsequent representations or employment or the disclosure of confidential information; a breach can be damaging “even if the attorney is not working on behalf of a new client and even if none of the information is actually disclosed.”  An attorney’s right to free speech does not include using confidential information to the detriment of a former client.

Does Oasis West v. Goldman tell lawyers whether they can go into business against rather than going into business with a former client? As a general principle, the duty of undivided loyalty prevents a lawyer from being adverse to a current client on any matter, whether or not related to the subject of the current representation. The opinion in Oasis West is a reminder that the duty of loyalty generally ends with the termination of a lawyer-client relationship.  What remains of it after the termination of the lawyer-client relationship is a prohibition on being adverse to the former client with regard to the subject of the former representation.  This is the first California opinion that applies the continuing duty of loyalty to a situation in which the lawyer’s conduct was not part of the representation of a new client.  California law previously was thought to be generally consistent with Model Rule 1.9(a), which prohibits a lawyer who has formerly represented a client in a matter from thereafter representing another person “in the same or a substantially related matter in which that person's interests are materially adverse to the interests of the former client unless the former client gives informed consent, confirmed in writing.”

Oasis West also is a reminder that a lawyer may neither use nor disclose the former client’s confidential information obtained by the lawyer as a result of the former lawyer-client relationship. The opinion suggests that a lawyer may engage in a business that is competitive with that of a former client, but not if in doing so the lawyer violates either the narrow continuing duty of loyalty or the continuing duty of confidentiality.

Can she join a firm that represents someone who is a competitor to that old client? Yes, but with some important limits. First, without the consent of the former client, a lawyer cannot be adverse to a former client with respect to a matter that is the same or substantially related to a matter on which the lawyer represented the former client (this is Model Rule 1.9(a)). Second, the same is true if the former representation was by the former firm, but not by the lawyer personally, but only if the lawyer while at the former firm obtained confidential information of the former client (this is Model Rule 1.9(b)).  Third, the lawyer may not use or disclose confidential information of the former client (this is Model Rule 1.9(c)).

So if a lawyer knows that she is leaving her old firm or old client, must she advise that client about any adverse potential in her new situation? No. There is no general requirement that a lawyer who is leaving a law firm must give notice to or obtain consent from a former client when the lawyer’s new firm represents the former client’s competitor or is adverse to the former client.  However, consent from the former client will be needed if the lawyer will be adverse to the former client with respect to the subject of the former representation.  Even if the individual lawyer won’t be adverse to the former client, the lawyer must be aware that any information held by any firm lawyer is presumed to have been shared with all firm lawyers.  This means that if the lawyer has pertinent confidential information, the lawyer’s new firm might be subject to disqualification even when the individual lawyer is not adverse to the former client.  Applicable state law might permit the lawyer to institute an ethics screen to prevent disqualification of the firm when the migrating lawyer brings pertinent confidential information.

If a lawyer switches to another firm that presents some potential for conflicts, can you suggest any proper steps for her to take to help her keep out of trouble? The vital first step is to attempt to identify potential conflicts before the lawyer moves to another firm.  The lawyer and the new firm must know of the conflict to be able to manage it.   No two lawyer-client business transactions are the same, and all together they make up a wide spectrum of situations.  At one extreme is a plain-vanilla transaction, the fairness of which is obvious and about which there is little or nothing for the lawyer to explain to the client.  It is hard to imagine there being any civil or disciplinary risk to the lawyer in that kind of situation.  The further one moves across the spectrum, the more difficult it becomes for the lawyer to defend, after the fact, that the transaction was fully explained and fair and reasonable to the client.  A major step along the spectrum occurs when moving from a single transaction to a business relationship, as happens when a lawyer goes into a real estate development or investment relationship with a client.  This is something of real risk to the lawyer, and something to be done – if at all – only with great caution.

Reprinted with the permission of the ABA