Fairness and Written Disclosure

Fairness and Written Disclosure

Rule 1.8(a) forbids a lawyer to enter a business transaction with a client, or knowingly acquire an ownership, possessory, security, or other pecuniary interest adverse to a client, unless a list of conditions is met.¹ The first condition, paragraph (a)(1), requires that “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 That one sentence imposes two duties. The first governs the bargain: the price and every other term must be fair and reasonable to the client. The second governs communication: the client must receive the transaction and its terms in a writing the client can reasonably understand.

The duties guard against different dangers, and neither can do the other’s work. A lawyer who deals with a client is both the client’s adviser and the client’s counterparty. The fairness duty limits what that lawyer may demand; the disclosure duty lets the client see what is being demanded. A clear letter describing a lopsided price tells the client exactly how badly the deal treats them, and the deal stays unfair. A fair price offered on a handshake leaves the client unable to check anything, and the disclosure stays deficient. The rule asks for both, so a deal that fails either one fails the rule.

Fair and Reasonable Terms

The fairness clause measures the deal from the client’s side of the table. The question is what the client gives up and what the client gets, and the lawyer’s own view of the bargain does not answer it. The comment to the rule confirms that paragraph (a)(1) requires that the transaction itself be fair to the client.³

Fairness also stands apart from the client’s agreement. In Cotton v. Kronenberg, the court stressed that compliance with the rule requires adherence to all three of its subparts. It held that the lawyer breached his fiduciary duty by failing to comply with (a)(1) alone, never reached (a)(2) or (a)(3), and ruled that the fee agreement violated the rule as a matter of law.⁴ A deal that fails (a)(1) therefore violates the rule whatever the client agreed to. The reason is structural: the client’s trust is what makes the lawyer’s proposal easy to accept, so acceptance cannot be the only test of its fairness.

When a dealing is questioned, the lawyer carries the burden of showing it was fair. In Mershon, an Iowa disciplinary case decided under the earlier rule DR 5-104(A), the court reasoned that because of the fiduciary relationship the attorney must show that the transaction “was in all respects fairly and equitably conducted.” The attorney must also show that he discharged his duties to the client “not only by refraining from any misrepresentation or concealment of any material fact, but by active diligence to see that his client was fully informed of the nature and effect of the transaction proposed and of his own rights and interests in the subject matter involved.” And the client must either have had independent advice or have received the advice the lawyer would have given had the deal been with a stranger.⁵

The facts of Mershon show what a lawyer must be ready to answer. No one discussed or investigated whether it was reasonable or wise to tie the lawyer’s fee for future services to a present twenty percent interest in the corporation. Nothing assured the client, Miller, of getting his farm back if either Schenk or the lawyer failed to perform or the development never went forward, and nothing protected Miller or his estate if a party died. The promissory notes could hardly have been on more favorable terms to the debtors.⁶ The court disciplined the lawyer because the record did not show full disclosure, a point the next subsection takes up. Still, the omissions it listed are the questions a lawyer must be able to answer: why the deal is reasonable, and what protects the client if things go wrong.

Cotton applied the same scrutiny to the amount of the fee. The lawyer had estimated $30,000 to take the matter through trial, yet soon after the agreement he sold the property for $42,000, 40 percent more than was reasonable under his own estimate. He was also disqualified before trial. In light of both facts, the court held the transaction not “fair and reasonable” within Rule 1.8(a)(1).⁷

Nothing in the rule limits the fairness inquiry to the moment of signing, the Cotton court added. As Professor Hazard explains, a fee agreement that seemed fair when signed must be reevaluated when later events change the circumstances of the relationship. The court’s example is a client who pays a lawyer with an interest in a fledgling company: if its value unexpectedly rises greatly, the fee may become unreasonably large in proportion to the work performed.⁸ The logic is simple. A cash fee is fixed on the day it is agreed, but an ownership interest moves with later events, and a test frozen at signing would let the lawyer keep any later gain, however large.

The reasoning in Cotton calls for the fee to be reevaluated at that point. The appraisal and the review by the client’s counsel remain relevant evidence that the deal began on fair terms, because the comment states that the client’s independent representation is relevant in determining whether the agreement was fair and reasonable to the client.⁹ Independent representation is evidence on fairness, and it does not replace the fairness requirement. A later section explains how it changes the rule’s other conditions.

Full Written Disclosure

Paragraph (a)(1) also requires that the transaction and terms be “fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client.”¹³ The comment restates the duty: the transaction’s essential terms must be communicated to the client, in writing, in a manner the client can reasonably understand.¹⁴ Three qualifiers do the work. Fully governs what the disclosure contains, in writing governs its form, and reasonably understood by the client governs who must be able to follow it. Omit any one and the gap between what the lawyer knows and what the client knows stays open: a disclosure that leaves out something material, exists only as a conversation, or exceeds the client’s grasp leaves the client unable to judge the deal. A writing also gives the client something to study and to show another lawyer.

Full disclosure requires more than delivering paper. The Mershon court demanded that the lawyer refrain from misrepresentation or concealment and also use “active diligence to see that his client was fully informed of the nature and effect of the transaction proposed and of his own rights and interests in the subject matter involved.”¹⁵ The duty therefore has an affirmative half. A client who does not know the risks does not know which questions to ask, so a lawyer who answers only what is asked leaves the client informed about only what the client thought to raise. A signature shows that the client signed. Whether the client learned what the deal does and where the lawyer’s interest lies is a separate question, and the lawyer must be able to answer it.

Full disclosure also covers the conflict itself. In Cornell v. Wunschel, the court contrasted the disclosure a fraud claim looks for with the disclosure the professional code requires. Disclosure for scienter purposes reaches all material facts; the code requires full disclosure of the facts and also of the conflict of interest between lawyer and client, after which it is for the client to decide whether to retain additional counsel.¹⁶ The two kinds of information do different jobs. The terms tell the client what the deal is. The disclosure of the conflict tells the client that the person explaining the deal sits on the other side of it. Mershon, citing a Wisconsin decision, put the content in two parts: the lawyer’s adverse interest, and the effect that interest will have on the exercise of professional judgment.¹⁷ The ethical considerations quoted in Cornell explain why. A lawyer’s ownership of property in which the client also has an interest may interfere with free judgment on the client’s behalf, and the lawyer’s personal interests should neither influence advice about bringing in additional counsel nor deter the lawyer from suggesting it.¹⁸

Mershon shows a disclosure that fell short. The lawyer had tied his fee for future services to a present twenty percent interest in a corporation, and no one discussed or investigated whether that was reasonable or wise. He chose to enter the transaction without recommending that Miller obtain independent advice, so he was obliged to make full disclosure. Instead, nothing was done to protect Miller if a party failed to perform or died. The record did not show whether Miller was told of the difficulty the corporation might have in enforcing the lawyer’s obligation, and, so far as it showed, Miller was never told how the lawyer’s differing interests might affect his professional judgment.¹⁹ Because the record did not show that full disclosure preceded Miller’s consent, the court found a violation of DR 5-104(A), although the lawyer neither acted dishonestly nor made a profit. It reprimanded him.²⁰ The duty concerns what the client was told before agreeing, so honesty and the absence of gain cannot fill the gap left by an unexplained deal.

The lawyer in Mershon owed full disclosure because he had not recommended independent advice. The modern rule does not treat the two as alternatives. Its conditions are joined by and, and paragraph (a)(2) separately requires the lawyer to advise the client in writing of the desirability of seeking independent counsel and to give a reasonable opportunity to do so.²¹ Cotton likewise requires adherence to all of the rule’s subparts.²²

Each element of the letter answers a gap in Mershon. The explanation of how value was set answers the silence about whether tying future fees to a present stake was wise. The account of what the lawyer will do and of the early-end terms answers the missing protection if a party fails to perform. The statement of the lawyer’s interest and its possible effect on advice supplies what Miller was never told. The letter is in plain language and arrives in time to be used, so it meets the writing and understandability qualifiers as well. It says nothing about whether the price is fair or whether the founder was advised about independent counsel, and those conditions remain to be satisfied.

The last qualifier sets the yardstick at the client the lawyer actually has. The rule says “by the client,” not by a reasonable lawyer or a typical reader. A letter that a public company’s general counsel can follow at a glance may be opaque to the owner of a family business who has never read a stock agreement, so one document can satisfy the requirement for one client and fail it for another. A lawyer facing the less experienced client should plan for more explanation in plainer words, because boilerplate recited at length gives that client nothing to evaluate. The point matches the wider law of conflict waivers, which conditions a party’s ability to waive conflict-free counsel on the waiver being “knowing and intelligent.”²³

A client who has counsel in the transaction changes where the disclosure can come from. When the client is independently represented, paragraph (a)(2) is inapplicable, and the (a)(1) requirement of full disclosure is satisfied either by a written disclosure from the lawyer involved in the transaction or by the client’s independent counsel.²⁴ The reason follows from what disclosure is for. The client needs to evaluate the deal, and a lawyer with no stake in it can explain the terms without the self-interest that makes the dealing lawyer’s own explanation suspect. The substitution reaches only the disclosure requirement. Independent representation remains merely relevant to whether the terms were fair and reasonable, and a later section takes up how the carve-out from (a)(2) operates.²⁵