Changing Fee Agreement in Midstream

By Roy Simon

[Originally published in NYPRR May 2004]

Suppose your firm begins representing the corporate plaintiff in a commercial dispute on an hourly rate basis. When your firm accepted the matter, you and the client thought the dispute could be worked out pretty quickly and reasonably, but the dispute won’t die. Instead, it has escalated. The defendant refused to settle on reasonable terms; you had to file suit to force the defendant’s hand; and the legal fees are mounting much more rapidly than the plaintiff expected — or can afford. Consequently, your client has fallen months behind (and tens of thousands of dollars behind) in paying your fees, and the CFO says the company doesn’t have the money to pay right now. May you ethically take steps to protect your firm’s financial interests? Specifically: (a) May you convert the fee arrangement from an hourly fee to a contingent fee, or to a hybrid fee arrangement with a discounted hourly rate plus a relatively low contingent fee? or (b) May you demand security for past and future bills before continuing with the case? or (c) May your firm charge interest on overdue bills?

All of these situations raise one overarching question: Is a material change to a retainer agreement during the attorney client relationship a “business transaction with a client” that must satisfy the stringent standards of DR 5-104(A) of the New York Code of Professional Responsibility? This article addresses that important question.

Background

Every lawyer knows that business transactions with clients are risky ventures. Things like borrowing money from a client, investing money in a client’s business, or selling real estate to a client are fraught with peril and are subject to the stringent provisions of DR 5-104(A), which provides as follows:

DR 5-104: Transactions Between Lawyer and Client

A. A lawyer shall not enter into a business transaction with a client if they have differing interests therein and if the client expects the lawyer to exercise professional judgment therein for the protection of the 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 to the client in a manner that can be reasonably understood by the client;

2. The lawyer advises the client to seek the advice of independent counsel in the transaction; and

3. The client consents in writing, after full disclosure, to the terms of the transaction and to the lawyer’s inherent conflict of interest in the transaction.

(DR 5-104(B) concerns acquisition by a lawyer of literary and media rights relating to the representation and does not concern us here.)

Although the initial retainer agreement is, in the most literal sense, a “business transaction with a client,” conventional wisdom is that entering into a retainer agreement is not covered DR 5-104(A). Why not? Maybe it’s a kind of “Catch-22” because the transaction is not with a “client” until the person signs the retainer agreement — but that is not a very good answer when the new engagement is for an existing client, especially if the fee terms are different from those in prior matters. Maybe we don’t think the client expects the lawyer to exercise professional judgment “for the protection of the client” when bargaining for legal fees — but surely most clients (especially existing clients) don’t expect their lawyers to take advantage of them, do they? Or maybe we realize that it would border on the ridiculous to tell clients to hire “independent counsel” to advise them about our fee agreements — and then the independent counsel would have to advise the client to retain independent counsel to advise the client about his fee agreement, and so on to infinity. Whatever the reason, it is well established that most fee agreements do not constitute business transactions with clients. DR 2-106(A) provides that fees must not be “excessive” (unhelpfully defined in DR 2-106(B) as a fee “in excess of a reasonable fee”) or “illegal,” but lawyers do not have to comply with the arduous and sometimes treacherous provisions of DR 5-104(A).

Of course, lawyers are always looking for exceptions, and during the dot.com boom of the late 1990’s the New York City Bar’s Committee on Professional and Judicial Ethics found one. In those days, many lawyers were accepting stock in lieu of fees from start-up companies that couldn’t afford hourly rates now but would one day be worth a fortune (or so we thought). In N.Y. City Op. 2000-3 (2000), the Committee held that taking stock in lieu of fees may turn a retainer agreement into a business transaction with a client. The details of the opinion are unimportant, but the big message is vital: in some circumstances, fee agreements with clients may indeed be governed by DR 5-104(A).

Judicial Approaches to Midstream Changes in Fee Agreements

That brings us to the main question of this article: Does DR 5-104(A) apply to midstream changes in the terms of a fee agreement?

Courts and bar associations around the county are mixed and sometimes unclear regarding whether DR 5-104(A) (or its ABA Model Rules equivalent, Rule 1.8(a)), governs these situations. In In re Stamell [252 B.R. 8 (Bankr. E.D.N.Y. 2000)], the court said that “New York case law applies DR 5-104(A)” to midstream changes in a retainer agreement. Among other cases, the Stamell court cited Baye v. Grindlinger [78 A.D.2d 690, 432 N.Y.S.2d 624 (2d Dept. 1989)], in which a divorce lawyer sued his former matrimonial client for refusing to pay on two promissory notes that the client had executed at her lawyer ‘s demand to cover attorney fees when the trial of her matrimonial action was “imminent.” The trial court granted summary judgment on the notes in favor of the attorney, but the Second Department reversed, stating:

The rule is well established that as to contracts made between an attorney and his client subsequent to employment which are beneficial to the attorney, it is incumbent on the attorney to show that the terms are fair and reasonable and fully known and understood by the client.

The Baye court therefore remanded for factual findings on various issues, including “whether, under the circumstances, the defendant was unfairly put in a position by the plaintiff in the litigation pending in Massachusetts that she might be without counsel in the trial shortly to be held, and whether the defendant understood the import of the transactions with the plaintiff at the time of the making and delivery of the notes.” The Baye court relied partly on a musty old New York Court of Appeals case, In re Howell [215 N.Y. 466, 109 N.E. 572 (1915)], in which the court considered an attorney’s lien based on a post-engagement modification to the original retainer agreement. The Howell court (which included the great Justice Cardozo) said:

The rule of law relating to original contracts of retainer is not applicable in the case at bar. Here we have the alleged contract made at the close of a trial at a time when the relation of attorney and client had existed for a long period of time and was still in force. In determining the validity and conclusiveness of such contracts, in view of the confidential relation between the parties, the same will be carefully scrutinized by the courts.

The Howell court then surveyed the approaches that had been taken by various jurisdictions around the country. The most extreme jurisdictions, the court said, had held that fee agreements modified in the middle of an attorney-client relationship were “void.” Other states, taking a slightly more liberal approach, had held that such contracts were presumptively “invalid on the ground of fraud,” and placed the burden on the attorney to show “the fairness of the transaction,” meaning that the fees did “not exceed a reasonable compensation for the services rendered or to be rendered.” In New York, the courts had held that “as to contracts made between the attorney and his client, subsequent to the employment which are beneficial to the attorney, it is incumbent upon the latter to show that the provisions are fair and reasonable, and were fully known and understood by the client.”

In the Howell case itself, the referee had enforced the attorney’s lien based on the modified contract, pointing out that it saw “no evidence in the case of fraud or undue influence” by the attorney. The Court of Appeals rejected that finding as irrelevant. The referee’s approach implied that the client had to show fraud or undue influence on the part of the attorney to void the modification to the fee agreement, but “[s]uch is not the law.”

DR 5-104(A) in its present form did not appear in the New York Code of Professional Responsibility until 1999, so obviously neither the Baye court nor the Howell court cited it. But the criteria the Baye court demanded — that changes in a retainer agreement beneficial to the attorney must be “fair and reasonable and fully known and understood by the client” — parallel the requirements of DR 5-104(A)(1) that the “transaction and terms … are fair and reasonable to the client and are fully disclosed and transmitted in writing to the client in a manner that can be reasonably understood by the client.”

Differences Between Code and Courts

However, DR 5-104(A) also differs significantly from the conditions that courts have imposed on post-engagement changes to a retainer agreement.

First, DR 5-104(A)(1) requires that disclosures to the client be “in writing.” The courts have not imposed that requirement, though nearly all of the relevant cases concern written modifications, and an attorney would have to be downright reckless not to get such a modification in writing.

Second, DR 5-104(A)(2) requires an attorney to “advise[] the client to seek the advice of independent counsel in the transaction,” but this may often be impractical or just plain overkill. The courts have not required attorneys to advise their clients to retain independent counsel in connection with midstream retainer agreement changes.

Third, DR 5-104(A)(3) makes a transaction between lawyer and client unethical unless the client “consents in writing, after full disclosure, to the terms of the transaction and to the lawyer’s inherent conflict of interest in the transaction.”(Emphasis added.) Courts have not expressly required written consent, and they have not required attorneys to disclose their “inherent conflict of interest in the transaction.”

Fourth, DR 5-104(A) does not apply at all unless “the client expects the lawyer to exercise professional judgment therein for the protection of the client…” Many lawyers would argue that a client who is negotiating a fee agreement with an attorney, whether at the outset of the relationship or in the middle of it, knows that the attorney is inherently at odds with the client and is not seeking to exercise professional judgment on the client’s behalf. [See N.Y. State Bar Op. 755 (2002), “A central limitation of DR 5-104(A) is that it applies only to transactions if ‘the client expects the lawyer to exercise professional judgment therein for the protection of the client.’”] If clients seldom expect their lawyers to exercise professional judgment to protect them when negotiating initial or amended retainer agreements, then, then DR 5-104(A) will seldom apply to a modified retainer agreement.

But the question of whether and when DR 5-104(A) applies remains unsettled, and various courts and bar associations continue to debate the issue. In Matter of Thayer, [745 N.E.2d 207 (Ind. 2001)], for example, the lawyer for a personal injury plaintiff had negotiated a settlement offer that the client told the attorney to accept. Before telling the insurance company that the client wanted to accept the offer, however, the attorney persuaded the client to sign an agreement raising the contingent fee from 40% to 50%. The attorney told the client that increasing the attorney’s fee would prevent the medical provider or others from attaching the proceeds. The client signed the agreement and the lawyer retained 50% of the settlement as his fee. In a subsequent disciplinary proceeding, the lawyer admitted that his “ex post facto” act of raising his contingent fee after settlement negotiations concluded was “a business transaction with the client… ” Consequently, the court applied Indiana Rule 1.8(a), which is almost identical to New York’s DR 5-104(A). The court said:

… The manner and timing by which the respondent exerted the change upon his client were not fair and reasonable. After settlement negotiations had concluded, the respondent presented his client with a new agreement calling for a 10% hike in the contingency fee. The respondent advised his client that the increased fee was t protect the money from attachment, although the respondent failed to explain how his own increased fee would provide that protection. The client testified that she felt she had no choice but to accept the new agreement. The respondent did not advise the client to consult independent counsel nor did he obtain her express written consent to his self-serving amendment to the contingency fee agreement. Accordingly, we find that the respondent violated Prof. Cond. R. 1.8(a).

But the Thayer court immediately dropped a footnote that carefully straddled the fence. The plight of an “unsophisticated client” in “unique circumstances” activated the need for the protections required for lawyer-client business transactions, the court said. “By this holding today, however,” the court continued, “we do not mean to require that all modifications to contingency fee agreements under any circumstances be subject to the client protections contained in” Rule 1.8(a). (Emphasis added.) Thus, we are left to wonder where to draw the line between midstream changes to retainer agreements that will trigger DR 5-104(A) and those that will not.

Many Policy Arguments Support Applying DR 5-104(A)

From a policy perspective, there are some strong arguments for applying DR 5-104(A) to all material post-engagement changes in retainer agreements. Clients invest substantial time and energy choosing attorneys. They often bare their souls to attorneys they scarcely know, and they engage an attorney only after learning the key details of the proposed fee agreement. An attorney is in almost total control of the terms of the retainer agreement, and is therefore in a position to protect against nearly every contingency. An attorney may not know whether a particular client will attempt fraud, make the representation unreasonably difficult, or deliberately refuse to pay the fee, but the attorney knows that some clients will cause problems during the representation. An attorney should therefore draft a letter of engagement or a retainer agreement to take the adverse possibilities into account. An attorney who fails to do so should, as a policy matter, bear the risk of changing circumstances.

Moreover, once a representation is underway, an attorney is likely to have a significant advantage over a client in negotiating changes to an existing retainer agreement, especially where the attorney’s withdrawal would have a “material adverse effect on the interests of the client” — see DR 2-110(C) — and this advantage will increase as the matter moves closer to trial, or to the closing, or to whatever the culminating event in the representation may be. In the same way as the Indiana Supreme Court in Thayer, New York courts are likely to cast a harsh eye on midstream changes to a retainer agreement where the client “felt she had no choice but to accept the new agreement.” Indeed, in the Baye case, where the attorney demanded promissory notes to secure his fees on the eve of trial, the Second Department remanded partly to determine “whether, under the circumstances, the defendant was unfairly put in a position by the plaintiff [her attorney] … that she might be without counsel in the trial shortly to be held …” If so, the promissory notes would be unenforceable.

In short, as the representation progresses, a client is more and more like a passenger on a ship who is faced with a choice between paying a higher fare or being thrown overboard. Seldom if ever is that a fair choice. Thus, especially where clients are relatively unsophisticated or inexperienced in dealing with attorneys, courts may be persuaded that an attorney who seeks to increase the amount of the fee, or to change the fee from hourly to contingent (or vice versa), or to obtain additional security for payment of the fee, or to charge interest on unpaid fees, or to otherwise to modify the fee agreement, must abide by DR 5-104(A), including advising the client to obtain independent counsel to review the proposed changes.

… But Other Policy Arguments Oppose Applying DR 5-104(A)

Yet we can also develop strong arguments for demanding only what the Howell court demanded nearly a century ago — that post-engagement changes in retainer agreements be “carefully scrutinized by the courts” and that the new terms “are fair and reasonable, and were fully known and understood by the client.” Such a “strict scrutiny” standard will give courts flexibility to take into account all of the facts and circumstances, including such things as:

The nature of the changes. For example, increasing a contingent fee is a far more troubling change than increasing an hourly rate at the beginning of each new calendar year.

The timing of the changes. A lawyer’s demand for changes on the eve of trial or on the eve of a closing is more disturbing than a post-engagement announcement that interest will be charged on late payments.

The sophistication of the client. Courts ought to be much less sympathetic to midstream changes in retainer agreements with unsophisticated personal injury plaintiffs than to midstream changes in agreements with sophisticated corporate clients that regularly engage lawyers — especially if the change is negotiated with a corporate client’s in-house counsel.

The extent of the disclosures to the client. A lawyer should have to fully disclose the nature and purpose of any changes. If a lawyer deceives a client by making material false statements about the changes or by omitting material facts, the changes should be considered unreasonable per se.

The overall fairness and reasonableness of the changes. Changes should be permitted only if either (1) the client has done something that would entitle the lawyer to withdraw from representation pursuant to DR 2-110(C), such as deliberately disregarding the fee agreement or engaging in conduct that renders it unreasonably difficult for the lawyer to carry out the representation, or (2) the changes benefit the client, such as by giving a client a discounted hourly rate or forgiving some or all past-due hourly rate bills in exchange for a reasonable contingent fee. If the client rather than the lawyer initiated discussions about the changes, that should weigh on the fairness side of the scale, though it is not dispositive, especially if the client did not suggest a change in the fee terms until the lawyer threatened to withdraw.

In any event, strict scrutiny by the courts arguably gives clients as much protection as DR 5-104(A) — perhaps more. If DR 5-104(A) applies to all midstream changes in fee agreements, many lawyers will begin writing lengthy boilerplate retainer agreements that give the lawyer the right to impose certain penalties (like interest) or to implement certain changes (like conversion to a contingent fee) if the client engages in specified conduct, or if certain events occur while a matter is pending. These boilerplate agreements will at some point, maybe in the middle of 37, advise the client to “seek the advice of independent counsel” before agreeing to amend the fee agreement (which almost no clients will do), and will advise the client that the lawyer has an “inherent conflict of interest” in entering into any amended retainer agreement because the lawyer wants to earn as much as possible and obtain as much protection as possible whereas the client wants to pay as little as possible and give the lawyer as little protection as possible (duh!). These multi- page retainer agreements will ensure that post-engagement amendments will comply with DR 5-104(A) but will be of little help to clients, who are unlikely to read the retainer agreements any more carefully than they read automobile leasing agreements, software licenses, or credit card agreements. Clients may well be better off if lawyers use simple fee agreements when a relationship begins and propose specific changes to respond to changed circumstances as they arise.

Moreover, the literal language of DR 5-104(A) may take midstream retainer agreement changes beyond the reach of the rule. DR 5-104(A) applies only if the lawyer and client have “differing interests” and “the client expects the lawyer to exercise professional judgment therein for the protection of the client …” The lawyer and client will usually (though not always) have “differing interests” when they negotiate a change in an existing fee agreement, but the client will seldom expect the lawyer to exercise professional judgment to protect the client (unless the lawyer claims to be doing so, as in the Thayer case, where the lawyer told the client that increasing the lawyer’s fee would protect the client’s recovery from the claims of creditors). The client will nearly always understand that the lawyer is changing the fee agreement to protect the lawyer, not “for the protection of the client” — especially if the lawyer is threatening to withdraw because the client has not been paying the bills.

Implied Terms in Every Fee Agreement?

Even if DR 5-104(A) applies to midstream modifications in a fee agreement, lawyers can argue that certain terms of every fee agreement are implied, including that clients will not engage in conduct that “renders it unreasonably difficult for the lawyer to carry out employment effectively” and will not “[d]eliberately disregard” the fee agreement (i.e., will pay their bills on time if they can afford it) — see DR 2-110(C)(1)(d), (f). These terms certainly appear to be implied in DR 2-110, which permits an attorney to withdraw if a client acts unreasonably or deliberately refuses to pay the bills, even if a fee agreement is silent about withdrawal rights and even if withdrawal will cause “material adverse effect on the interests of the client …” If the Disciplinary Rules give a lawyer the right to withdraw from a representation in certain circumstances even though withdrawal may significantly harm the client, shouldn’t the Disciplinary Rules permit a lawyer to modify a fee agreement on fair and reasonable terms that the client understands and agrees to in those same circumstances, without requiring the lawyer to advise the client to seek the advice of independent counsel and without demanding that the changes comply with the letter of the business transaction rule?

Conclusion: It’s a Tough Call

The strong competing arguments on both sides of the DR 5-104(A) issue make it difficult to reach a firm conclusion. For now, given the sparse law in New York, we can at most say what the Indiana Supreme Court said and implied in Thayer: Sometimes DR 5-104(A) will apply to midstream fee agreement modifications, but sometimes it won’t. At a minimum, however, New York courts are likely to agree with D.C. Bar Ethics Op. 310 (2001), which said: “A change in a fee arrangement in an ongoing representation is subject to strict scrutiny for overreaching by the lawyer …” The strict scrutiny will ensure that post-engagement changes in retainer agreements are “fair and reasonable” and were “fully known and understood by the client,” as New York courts have insisted for nearly a hundred years. Thus, whether or not all of the terms of DR 5-104(A) apply to all post-engagement changes retainer agreements, many changes are unlikely to survive the strict scrutiny to which they will rightfully be subjected by the courts.

Roy Simon is the Howard Lichtenstein Distinguished Professor of Legal Ethics and Director of the Institute for the Study of Legal Ethics at Hofstra University School of Law, and is the author of Simon’s New York Code of Professional Responsibility Annotated.

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.

Roy Simon