Firm’s Stake in Client’s Business Will Fall Unless Jury Finds It Is ‘Fair and Reasonable’

By Joan C. Rogers

Sept. 5 — A written contract giving a law firm an ownership interest in a business as a fee for previous legal services will crumble on public policy grounds unless a jury finds that the arrangement is fair and reasonable to the client as required by Kentucky's ethics rule on lawyer-client business deals, a Kentucky federal judge decided Aug. 25.

To help jurors decide whether the agreement was aboveboard, ethics experts may give their opinions about standards that apply when lawyers acquire a stake in a client's business, according to Chief Judge Joseph H. McKinley Jr. of the U.S. District Court for the Western District of Kentucky.

The court also held that the lawyer who provided the underlying services in this matter did not engage in the unauthorized practice of law when he advised the client on federal labor law issues relating to a Kentucky transaction without being admitted to practice in that state.

Rules Reflect Policy

McKinley issued his rulings at the summary judgment stage in a legal wrangle over the enforceability of a fee agreement between Allied Resources Inc., owned by Chester Thomas, and Institutional Labor Advisors LLC, a consulting firm co-founded by attorney David S. Smith.

Thomas had hired Smith and ILA to deal with federal labor law issues in a potential acquisition; they orally agreed that ILA's fee would be contingent on the transaction's successful closing. After the deal went through, ILA and Allied reached a written agreement in which ILA would receive 5 percent of Allied's distributions to stockholders as compensation for ILA's services in the underlying acquisition.

On a threshold issue, the court held that the Kentucky Rules of Professional Conduct reflect the state's public policy and that “courts applying Kentucky law will not enforce an attorney's fee agreement that violates the Rules of Professional Conduct.”

“[C]ontracts that violate the Rules of Professional Conduct are unenforceable,” McKinley declared. Courts in other states have likewise refused to enforce contracts that violate their professional conduct rules, he noted, citing cases from New Jersey and Massachusetts.

Disclosure Obligations Met

The court focused on Rule 1.8(a), which governs lawyers' financial transactions with clients. It found clear evidence that ILA and Smith fully disclosed to Thomas “the transaction and terms on which the lawyer acquires the interest” as required by Rule 1.8(a)(1).

The terms of the agreement were in writing and were extensively negotiated between the parties' independent counsel for seven months in which multiple drafts of the contract were exchanged, the court noted.

Under these circumstances, the court said, it was not necessary for ILA and Smith to disclose possible risks of the transaction and alternatives to it. Moreover, Thomas was advised by his own counsel about the risks of having a lawyer involved in his business, McKinley said.

The court also held that Allied “was given a reasonably opportunity to seek the advice of independent counsel” as required by Rule 1.8(a)(2). In fact, Allied did consult separate counsel, McKinley noted.

In addition, the court found that as a matter of law Smith and ILA complied with Rule 1.8(a)(3), which requires written client consent to a lawyer-client business transaction. Allied gave consent when it signed the compensation agreement, and that consent was “informed” because the terms of the agreement were agreed upon after a lengthy negotiation process in which both parties were represented by counsel, the court said.

But Is It Fair?

Nevertheless, McKinley concluded that a jury question exists as to whether the transaction and the terms of the compensation agreement were “fair and reasonable” to Allied as required by Rule 1.8(a)(1).

When assessing fairness and reasonableness under Rule 1.8(a), he said, the factors listed in Rule 1.5 for determining a reasonable fee are relevant.

A jury considering those factors could find that the agreement was fair and reasonable to Allied, the court said.

On the other hand, it said, a jury could find that it was not fair and reasonable for ILA to claim a 5 percent fee by the time the written agreement was negotiated. At that point the transaction had closed and Smith already knew how many hours he had spent on the transaction, the court observed.

McKinley also pointed out that according to the parties' experts, Smith violated Rule 1.8(a) when he entered into the oral contingent fee agreement with Thomas. In light of that violation, the court said, “there is a factual issue as to whether Thomas entered the parties' negotiations based on some misunderstanding that he was obligated to enter a percentage fee contract with ILA—and, in turn, whether this misunderstanding caused the agreement to be unreasonable or unfair.”

Experts May Opine on Rule Violations

The court decided that ethics expert W. William Hodes may give his opinion that ILA and Smith violated their obligations under the Kentucky Rules of Professional Conduct and the standard of care required of lawyers when they take a stake in a client's business.

His proposed testimony does not address a pure issue of controlling law but rather explains relevant legal principles and may assist the jury in determining whether the compensation agreement was fair and reasonable to Allied under Rule 1.8(a)(1), the court said.

Similarly, McKinley decided that two law professors may give their opinions that Smith and ILA did not violate Rule 1.8. “To determine whether the written Compensation Agreement was ‘fair and reasonable' to Allied, the jury will need to understand the applicable rules, as well as how the parties' transaction fits therein,” he stated.

But no expert may testify about the enforceability of the compensation agreement, as a contract's enforceability on public policy grounds is a question of law for the court, McKinley said.

No Unauthorized Practice

Allied also contended that the compensation agreement is unenforceable due to Smith's alleged unauthorized practice in giving legal advice about a Kentucky transaction without being admitted to the Kentucky bar. Kentucky did not amend its Rule 5.5 to permit cross-border practice until years later, Allied pointed out.

The court held that as a matter of law Smith and ILA did not engage in UPL in Kentucky. “Smith's advice was limited to federal labor law issues, which certainly related to his practice in Virginia,” the court said, noting that Thomas's Kentucky-licensed counsel worked on all other aspects of the transaction.

“It is a common practice among transactional attorneys to advise clients in other states as to the federal implications of contract language,” McKinley said.

The court also held that Allied could not raise ILA's alleged malpractice in the underlying transaction as an affirmative defense to offset amounts allegedly due under the compensation agreement. The claim amounted to a time-barred counterclaim for malpractice, McKinley said.

ILA was represented by Blackburn Domene & Burchett PLLC, Venable LLP and Murnane Brandt. Allied Resources was represented by Frost Brown Todd LLC and Dinsmore & Shohl LLP.

To contact the reporter on this story: Joan C. Rogers in Washington at

To contact the editor responsible for this story: Kirk Swanson at

Full text at

The ABA/BNA Lawyers’ Manual on Professional Conduct is a joint publication of the American Bar Association Center for Professional Responsibility and Bloomberg BNA.

Copyright 2014, the American Bar Association and The Bureau of National Affairs, Inc. All Rights Reserved.