By Mary C. Daly [Originally published in NYPRR March 2001]
Just about every lawyer in the United States who practices in the private sector counts business organizations among her clients. In New York, a lawyer who represents a business organization is required to advise the constituents of that organization (e.g., directors, officers, employees, stockholders, members) that she is the lawyer for the organization and not the constituents whenever their interests appear to differ. [DR 5-109.] This principle is called the entity theory of representation.
This article explores not only how the entity theory of representation regulates the ethical aspects of the professional relationship between lawyer and business organization, but, also, how it plays a critical role in liability regimes, such as in actions for malpractice or breach of fiduciary duty. Typically, these actions are brought by a constituent of the organization, usually a shareholder or partner, against a lawyer who provided legal services to the entity. In some instances, the constituent will allege that a client-lawyer relationship also existed between the constituent and the lawyer in connection with some element of the entity’s representation. Although the courts will generally dismiss an action filed by a constituent for lack of standing, it’s incumbent upon every lawyer to take specific concrete measures to lessen the threat of such a lawsuit. We offer some suggestions for improving law office management practices to avoid any confusion about the lawyer’s role.
In 1999, DR 5-109 of the New York Lawyer’s Code of Professional Responsibility (Code) was substantially amended to delineate with greater clarity the ethical obligations that a lawyer owes to an organizational client. Animating DR 5-109 is the principle that an organization is an entity separate and distinct from its constituents. Consequently, a New York lawyer owes to the organization the duty to preserve client confidences and secrets and to avoid conflicts of interest, not to its shareholders, officers, directors or employees. The lawyer who ignores this duty should not be surprised when she faces both a disciplinary complaint and a claim of malpractice by one of the organization’s constituents.
Confusion Greatest in Small Businesses
As we discussed in two earlier articles in NYPRR, the application of the entity principle of representation to questions of ethics makes a great deal of sense when the entity involved is a large company of the Fortune-500 type. In theory, the more the management and ownership of a business are separate and independent from its constituents, and the more the ownership is dispersed among a large number of individuals, the easier it is for a lawyer to remember that the entity has a distinct legal existence of its own. This also makes it easier for an entity’s constituents, such as its shareholders and directors, to understand that they do not personally have a professional relationship with the lawyer.
Correspondingly, the more the management and ownership are concentrated in a small number of individuals, the easier it is for a lawyer to lose sight of the entity principle of representation and to treat those individuals as her clients. From the individuals’ perspective, it becomes equally, if not more, difficult, to appreciate the distinction between the entity and its constituents. They forget that the lawyer’s client is the entity, not they themselves. This is especially true when the lawyer has undertaken from time to time to represent the individuals in matters which are independent of the entity’s business interests — e.g., the purchase of a house or the drafting of a will. The most problematic of all issues arises when the lawyer is asked to advise the owners of a business on the distribution of the entity’s profits — is it better for the income to remain in the entity or to be distributed to its stockholders? How does the specter of income taxes affect this decision?
Just as the confusion over the identity of the lawyer’s client raises ethical issues, so it also raises liability issues. Generally speaking, the liability rules that are applicable to individual clients are equally applicable to organizational clients. Incompetent representation can trigger malpractice liability. The relationship between an entity and its lawyer is one of agency. Therefore, the lawyer for a business entity owes a fiduciary duty to the entity, and the violation of that duty is actionable. The entity may recover damages for its lawyer’s fraudulent conduct. [See, generally, Catizone v. Wolff, 71 F.Supp.2d 365 (S.D.N.Y. 1999).]
When the entity has a claim against the lawyer, do its constituents also have a claim based upon the same facts? Can they assert the claim as individuals who have also been damaged by the lawyer’s conduct? This is a dilemma with which the courts have had to grapple. The general rule in New York is that liability must be premised on the existence of a client-lawyer relationship. Unless unusual circumstances are present — e.g., fraud or a lawyer’s expressed assumption of a special duty to a non-client — the absence of privity is a fatal obstacle to recovery of damages by a non-client. Privity remains an indispensable requirement in the overwhelming majority of cases. [See, e.g., Deni v. Air Niagara, 190 A.D.2d 1011, 594 N.Y.S.2d 468 (4th Dept. 1993).]
Courts Hostile to Suits By Constituents
Consistently, the New York courts have dismissed a shareholder malpractice action on the ground that for “a wrong against a corporation a shareholder has no individual cause of action, though he loses the value of his investment or incurs personal liability in an effort to maintain the solvency of the corporation.” [See, e.g., Schaeffer v. Lipton, 243 A.D.2d 969, 970, 663 N.Y.S.2d 392, 393 (3d Dept. 1997); see, generally, Malpractice, N.Y. Jurisprudence 2d §36 (Supp. 1999). These dismissals are rooted, in major part, in the fundamental corporate law principle that derivative actions are the appropriate vehicle for redressing wrongful conduct inflicted on an organization. [See generally, N.Y. General Corp. Law §626 (McKinney 2000).] The shareholder must therefore observe the legal formalities associated with a derivative action. [See, Walker v. Saftler, Saftler & Kirschner, 239 A.D.2d 252, 657 N.Y.S.2d 187 (1st Dept. 1997), dismissing a shareholder’s malpractice claim on the ground that he lacked standing and the derivative claim on the ground that the shareholder had “failed to plead with particularity his efforts to secure board action or the reasons why such efforts would have been futile.”] [Id. at 252, 657 N.Y.S.2d at 187.]
The courts’ blanket pronouncements in dismissing shareholder malpractice suits should not be taken entirely at face value, however. Some courts have concluded that the smaller the entity (e.g., a close corporation with only two shareholders), the more it is “reasonable for each shareholder to believe that the corporate counsel is in effect his own attorney.” [Steinfeld v. Marks, 1997 WL 563340 (S.D.N.Y. 1997).] Discussions of a lawyer’s ethical obligations frequently make the same point. [ABA Comm. on Ethics and Professional Responsibility, Formal Op. 91-361 (1991).]
At least one court has held that if the constituent-plaintiff originally retained the lawyer with respect to the matter alleged in the complaint, the court should permit the joinder of the corporation as plaintiff rather than dismiss the complaint. [See, e.g., Schleidt v. Stamler, 106 A.D.2d 264, 482 N.Y.S.2d 481 (1st Dept. 1984).] Even if joinder is not allowed, a court may permit the action to proceed. For example, in Schaeffer, supra, the plaintiff filed a malpractice action in connection with the purchase of real estate that an S corporation of which he was 95% owner was unable to use for its intended purpose. The Appellate Division dismissed that part of the complaint asserted in the plaintiff’s name as shareholder of the S corporation, which was established to develop the real estate. However, it refused to dismiss that part of the complaint which alleged that the lawyer’s malpractice had resulted in the shareholder ‘s inability to expand the business of the corporation. The plaintiff had originally engaged the lawyer to represent him individually in connection with the realty purchase and had taken title to the property in his own name.
How to Avoid Confusion
What steps should a lawyer take to lessen the likelihood that a court will find that an attorney-client relationship exists between the lawyer and a shareholder or partner who initially retains the lawyer to form a business entity, or who asks the lawyer to represent the business on a continuing basis? The engagement letter and the lawyer’s bills and statements are the obvious places to start. The engagement letter should identify the client with precision. It should state, for example: “ABC Corporation has engaged [lawyer] to deliver legal services in connection with [state business or matter].” Ideally, it should contain an express statement that ABC Corporation alone is the lawyer’s client, and not its individual shareholders or partners. If the individuals retain the lawyer specifically to form and organize ABC Corporation, the engagement letter should state: “A, B and C hereby engage [lawyer] to form and organize the ABC Corporation and to perform related legal services which shall be solely for the benefit of the Corporation. Upon its incorporation, ABC Corporation will be deemed [lawyer’s] client from the time of the initial engagement.”
The lawyer should confirm his commitment only to the corporate entity by submitting all bills to the corporation, not to the individual shareholders. [Cf. C.K. Industries Corp. v. C.M. Industries Corp., 213 A.D.2d 846, 623 N.Y.S.2d 410 (3rd Dept. 1995); Benedek v. Heit, 139 A.D.2d 393, 531 N.Y.S.2d 266 (1st Dept. 1988).] If the lawyer also represents a shareholder or partner individually on other matters, she should keep careful billing records that make a clear distinction between the two clients.
In dismissing malpractice actions brought by individual directors or shareholders, the courts have weighed heavily both (1) whether there is a retainer agreement with the individuals describing work for the organization, and (2) what the lawyer’s billing records show about the delineation and separation of services between the individuals and the business organization. [See, e.g., Catizone v. Wolff, supra.] A lawyer should refrain from offering individual legal advice to the principals of a corporation or partnership in connection with any transaction or litigation in which the firm is representing the entity. [Gupta v. Rubin, 2001 WL 59237 (S.D.N.Y. 2001).] To the extent that a shareholder can prove that the law firm “advised me directly on aspects of the negotiations that were particular to my individual interests’ such as [my] salary, stock options, and the nonrecourse nature of the bridge loan” the shareholder may be able to demonstrate an implied client-lawyer relationship or the existence of a fiduciary duty. [Id.]
Finally, a lawyer should consider carefully whether to provide representation to an entity in connection with a business transaction when there is a familial relationship between the lawyer and a shareholder of that entity. [McLenithan v. McLenithan, 710 N.Y.S2d 674 (3rd Dept. 2000).] The relationship may make it easier for the family-member shareholder to form a reasonable belief that the lawyer was representing the shareholder personally in the transaction
Mary C. Daly is James H. Quinn Professor of Legal Ethics at Ford ham Law and past Chair, Committee of Professional and Judicial Ethics, Association of the Bar of the City of New York.
DISCLAIMER: This article provides general coverage of its subject area and is presented to the reader for informational purposes only with the understanding that the laws governing legal ethics and professional responsibility are always changing. The information in this article is not a substitute for legal advice and may not be suitable in a particular situation. Consult your attorney for legal advice. New York Legal Ethics Reporter provides this article with the understanding that neither New York Legal Ethics Reporter LLC, nor Frankfurt Kurnit Klein & Selz, nor Hofstra University, nor their representatives, nor any of the authors are engaged herein in rendering legal advice. New York Legal Ethics Reporter LLC, Frankfurt Kurnit Klein & Selz, Hofstra University, their representatives, and the authors shall not be liable for any damages resulting from any error, inaccuracy, or omission.