When a client cannot pay in cash, may an attorney accept other forms of payment such as an equity stake in the client’s business? Isn’t this a classic “win-win” scenario?

In a warning for attorneys looking at creative ways to implement alternative fee arrangements, the Court of Appeals held Tuesday that an attorney’s violation of the North Carolina Rules of Professional Conduct can, under appropriate circumstances, relieve a client from its obligation to pay for legal services provided. In Law Offices of Peter H. Priest v. Coch, the Court held that an attorney who enters into a business transaction with a client as compensation for legal representation can be barred from enforcing the terms of the agreement if he or she failed to provide written advice to seek independent counsel or to obtain informed consent from the client before entering the transaction.

This dispute started ten years ago when a technology start-up and the three partners who formed it hired a law firm to file a patent application, agreeing to pay the lawyer’s hourly rate up to $10,000 for drafting and filing the application. The clients paid this amount early in the representation.  Nearly four years into the representation, which extended beyond drafting and filing, the Patent and Trademark Office issued a “non-final rejection,” at which point the clients indicated they might be financially unable to proceed with the patent registration.  The law firm then proceeded with the representation at its own expense, ultimately obtaining the patent.  After the patent was issued, the attorney and one of the three partners met to discuss how to generate revenue through licensing the patent and how to best compensate the law firm for the work it had performed without pay.  They agreed in principle that the law firm would continue to prosecute and maintain the patent and pay 25% of the actual costs of doing so, with the remainder to be split by the other three partners.  In exchange, they agreed that the firm would receive 25% of the proceeds from the patent.  Although the agreement was reduced to writing, it was apparently never signed.  Nevertheless, both the clients and the attorney seem to agree that the written contract accurately reflected the deal.

Things went south between the parties when the law firm was unable to successfully obtain licenses for the patent. Ultimately, the clients hired a third party to sell the patent who quickly arranged a $1 million sale.  The law firm demanded its quarter of the proceeds.  When the clients refused to pay it, the law firm filed suit alleging breach of contract, among various other claims.

The trial court granted the defendants summary judgment on the breach of contract claim because the attorney had failed to comply with Rule 1.8(a) of the Rules of Professional Conduct. Rule 1.8(a) states in relevant part:

A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest directly adverse to a client unless:

(1) the transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client;

(2) the client is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel on the transaction; and

(3) the client gives informed consent, in a writing signed by the client, to the essential terms of the transaction and the lawyer’s role in the transaction, including whether the lawyer is representing the client in the transaction.

Because there was no evidence that the attorney had advised the clients in writing to have independent counsel review the agreement or that he had obtained informed written consent of the clients, the trial court held that the attorney’s violation of Rule 1.8(a) barred him from enforcing the contract.

On appeal, the Court of Appeals agreed, holding that whether an attorney’s violation of a Rule can be used defensively will depend upon the public policy that a given Rule aims to promote or the harm it seeks to prevent. In analyzing this question, it held that courts should look at the Rule’s plain language, the Comments to the Rule, and any related precedent.

Applying this test to the case at hand, the Court held that Comment [1] to Rule 1.8, highlighting the relationship of trust and confidence between lawyer and client, illustrates a strong public policy rationale for allowing violations of Rule 1.8 to be used defensively. Noting that other jurisdictions who have reviewed the issue have reached the same conclusion, the Court stated:

“[W]e agree with the trial court’s observation that the Rule itself reflects the special obligation the attorneys of this State have when dealing with their clients, and we share the trial court’s conclusion that, for the sake of maintaining the public’s trust, attorneys should be held to abide by Rule 1.8(a)’s explicit requirements as a condition of their own recovery when that recovery is based on business transactions with their clients.”

Although the Court’s analysis seems intuitive in retrospect, it was probably less clear to the attorney on the front end that he hadn’t complied with his obligations. For one thing, the attorney seemed to believe that his conduct was covered by Rule 1.5, which relates to fee arrangements, not Rule 1.8, which relates to business transactions with a client.  (The Court, on the other hand, viewed the contract at issue as a “fundamental shift in the nature and objective of the representation” that the defendants’ expert characterized as unusual for patent and trademark lawyers, and therefore held was more appropriately characterized as a business transaction.)  Furthermore, it appears to be undisputed that the lawyer met with the client, acknowledged his role in drafting the written contract for a share of the proceeds, and orally encouraged the client to obtain independent counsel; he had not, however, reduced this advice to writing.  Additionally, although the attorney had not been paid for his services for several years and the parties agreed that he should be compensated for prior work, the Court went so far as to hold that his violation of Rule 1.8 likewise barred any claim for quantum meruit.

The implications of this opinion could be broad given the Court’s holding that any given Rule violation could be used defensively in a fee dispute, depending on the policy implications behind the rule. The lesson here:  before you get too creative in your next fee arrangement, stop and assess your risks under the Rules of Professional Conduct.  Otherwise, like the plaintiff here, you could end up having worked for several years on a matter only to have your fee arrangement declared unenforceable.

–Liz Hedrick