United States: Paying A Lawyer With Stock; Tales Of The SEC And Form S-8.

Article by Gregory C. Yadley and Julio C. Esquivel

You are a general business practitioner acting as primary counsel to a small public company that has been suffering with some cash flow problems. One day the CFO approaches you with an innovative idea that will allow the company to pay your fees while simultaneously relieving some of the pressure on its diminishing cash reserves: He wants you to take stock in the company!

Well, you may know from your general business law experience that if the issuance of the stock to you is not registered under Securities Act of 1933 (the "Securities Act"), the stock will be "restricted," and you will not be able to liquidate your position through the public markets for at least one year under Securities and Exchange Commission ("SEC") Rule 144. That is a bit unsettling in today’s bearish market. "But wait!" your client says. "We’ll register the stock under SEC Form S-8. This way it will be freely tradable the day that you receive it."

True, generally. But do you even qualify to receive S-8 stock? And what are the ramifications if you accept such stock in a situation where you are not eligible?

Let’s first consider why your client wants to use Form S-8 to register the stock instead of any other registration form adopted by the SEC. Form S-8 was created by the SEC to provide a simplified form of registration for securities issued to employees in a compensatory or incentive context. As such, it allows for incorporation of required disclosure information by reference from the public company’s reports filed pursuant to the Securities Exchange Act of 1934 (the "Exchange Act") (e.g., the company’s annual report on Form 10-K and quarterly reports on Form 10-Q). And, unlike SEC Form S-3 (the form used most frequently for incorporating previously registered information by reference in "shelf" registrations), Form S-8 may be used without regard to the length of the issuer’s reporting history or the aggregate market value of its securities held by non-affliates (thus providing a luxury that your client may not otherwise have been afforded). This allows for a much simpler and condensed registration statement.

In addition, a Form S-8 registration statement is not reviewed by the SEC staff and "goes effective" immediately upon filing. Furthermore, Form S-8 generally allows for the delivery of regularly prepared materials regarding the benefit plans pursuant to which the shares are to be issued in satisfaction of the Securities Act prospectus delivery requirements, eliminating the need to file and deliver a separate prospectus that duplicates this information. All of this results in substantially reduced costs and time savings to the issuer, thus allowing registration of shares where such registration might otherwise have been impractical.

The SEC allows for this limited disclosure and prospectus delivery procedure because employees and other eligible recipients are deemed to have sufficient knowledge of the issuer’s business by virtue of their relationship with the company. As the SEC stated in its release revising Form S-8 in February 1999 (Securities Act Release No. 7646), "The compensatory purpose of the offering and employees’ familiarity with the issuer’s business through the employment relationship justify the use of abbreviated disclosure that would not be adequate in a capital-raising transaction."

"Well, that’s great," you say, "but we’re the company’s lawyers, not their employees." That’s right, but in 1990 the SEC expanded the availability of Form S-8 to encompass "consultants and advisors," concluding that so long as the stock is paid as compensation for bona fide services, there is no reason to discriminate based solely on the title of such individuals. So lawyers, as "consultants and advisors," may very well qualify to receive freely tradable stock registered on Form S-8.

Unfortunately, when the SEC expanded Form S-8 to include consultants and advisors, they opened the door for abuse of this simplified registration form. Over the past several years, certain companies have attempted to circumvent the SEC’s full-blown registration procedure by masking public stock offerings as S-8 offerings. These companies have, for example, issued S-8 stock to a purported class of "consultants and advisors," who, upon the company’s instructions, subsequently have sold the stock to the public and either returned the proceeds to the company or used them to pay the company’s expenses, including expenses completely unrelated to any service provided by the consultant or advisor. Often, in these cases, the consultants or advisors performed limited or no services for the issuer.

The SEC unequivocally has taken the position that the foregoing scenario is capital raising in nature, and not compensatory, and thus a violation of Section 5 of the Securities Act. As stated in Securities Act Release No. 7646:

Registration of the shares on Form S-8 does not accomplish Section 5 registration of these public sales. The transaction that takes place (a capital-raising transaction with the public) is a different transaction from the transaction registered on Form S-8 (a compensatory transaction with employees, including consultants). Although the issuer purports to sell securities to employees, the securities instead are sold to the public. The "employees" act as conduits by selling the securities to the public and distributing the proceeds (or their economic benefit) to the issuer. This public sale of securities by the issuer has not been registered, although the Securities Act requires registration. The failure to register this sale of securities deprives public investors of the protections afforded by the Securities Act.

More troubling to the lawyer who is considering his client’s offer to pay him or her in S-8 stock is the fact that, under the foregoing fact pattern, the SEC will consider the "consultants and advisors" who served as conduits for the unregistered public offering to be "statutory underwriters," as defined in Section 2(a)(11) of the Securities Act, each of them guilty of violating Section 5 of the Securities Act.

[T]hese people act as conduits for unregistered offers and sales of securities to the public for which no exemption is available. In these circumstances, we have charged both issuers and consultants acting as nominees with violating Sections 5(a) and 5(c) of the Securities Act. We also have charged violations of the antifraud provisions of the Securities Act and the Exchange Act for misrepresentations in the Form S-8 that the securities are issued as compensation for consulting services rather than to raise capital for the issuer.

Securities Act Release 7646. Clearly, the civil and criminal penalties which could be applied under the Securities Act require that the lawyer recipient of S-8 stock take all possible steps to avoid such statutory underwriter status and the potential liability associated therewith.

OK, so how do you avoid statutory underwriter status? Well, in Securities Act Release No. 7646, the SEC attempted to clarify this issue by setting forth guidelines on who is and who is not eligible to receive Form S-8 stock. As adopted, the amended Form S-8 permits consultants and advisors to be treated in the same fashion as employees only if:

• the consultants and advisors are natural persons;
• the consultants and advisors provide bona fide services to the issuer; and
• the services provided by the consultants and advisors are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market for the registrant’s securities.

Furthermore, the SEC has announced that it will continue to take the view that Form S-8 is not available to register offers and sales of securities to either traditional employees or consultants and advisors where:

• by pre-arrangement or otherwise, the issuer or a promoter controls or directs the resale of the securities in the public market; or
• the issuer or its affiliates directly or indirectly receive a percentage of the proceeds from such sales.

Thus, a company will be disqualified from using Form S-8 where the issuer or its affiliates receive an economic benefit from the resale proceeds, such as when the proceeds are used to pay the issuer’s operating expenses or are paid to the issuer’s control persons.

So, how does this apply to legal services? Well, the SEC has specifically stated (in Securities Act Release No. 7646) that:

Attorneys who represent an issuer in matters that are not related to its securities, such as litigation defense, securing U.S. Food and Drug Administration approval of a drug, or obtaining a patent, will be eligible [to receive S-8 stock]. Attorneys who prepare the issuer’s Exchange Act reports and proxy statement will be eligible whether or not these documents are incorporated into a Securities Act registration statement. However, any consultant or advisor, including an attorney, who prepares or circulates an Exchange Act report or proxy statement that is part of a promotional scheme that violates federal securities laws will not be eligible. Attorneys serving as counsel to the issuer, its underwriters or any participating broker-dealer in a securities offering will not be eligible. Attorneys and other consultants who assist an issuer in identifying acquisition targets or in structuring mergers or other acquisitions in which securities are issued as consideration, will be eligible, unless the acquisition takes a private company public . . . So, as you can see, the substantive nature of your representation is central to the determination of whether you qualify to receive S-8 stock. Unfortunately, while the SEC has provided much needed guidance in this area, gray (and potentially problematic) areas remain. Take, for example, the rather simple hypothetical wherein you are retained to draft a stockholders agreement which the issuer will require each of its preferred stockholders to sign, including all future investors. Is your service in connection with the company’s capital raising efforts? And what would happen in a situation where you represent a public company in a joint venture, the sole purpose of which is to develop and market the products developed by your cash-poor client with the cash provided by a silent partner. Imagine further that, in lieu of receiving its share of the revenues from the joint venture, the silent partner has the option of converting its accrued revenues into equity of your client. If you take stock for your services in this transaction, is it a violation of the S-8 rules?

And then there is the issue of costs and expenses. Can S-8 stock be used to reimburse your in-house copying costs? Probably. But which third-party expenses can you pay with the S-8 shares you receive? Long distance telephone charges? A $300 fee charged by a state to incorporate a subsidiary? A $2,000 legal research fee charged by an electronic information provider? A $30,000 fee charged by the issuer’s financial printer? Remember, the shares are supposed to be compensation for bona fide services rendered to the issuer.

Of course, even if you qualify to receive shares registered on Form S-8, you will need to deal with the SEC’s requirement that the S-8 stock be issued only to individuals (unless, of course, you are a solo practitioner). The consulting contract (i.e., engagement letter) can be between the issuer and an entity (such as a law firm), but the securities must be issued to the natural persons (individual attorneys) who actually provide the bona fide services to the issuer. Currently, it is not clear whether an individual consultant (lawyer) can then either transfer the stock to his or her firm or sell the stock and remit the proceeds to the firm. The SEC has not spoken officially on this issue. A conservative reading of General Instruction A.1.(a)(1)(i) to Form S-8, however, would lead one to assume that the SEC may very well conclude that transferring either the stock or cash to your firm is an attempt to do something indirectly which cannot be done directly. Accordingly, lawyers accepting S-8 stock will need to proceed with caution as they consider means of allocating profits among their partners, some but not all of whom may have received S-8 stock in lieu of fees. However, since most firms’ compensation systems typically are based upon subjective factors and discretion is generally exercised by executive or compensation committees, the decision of a law firm manager to reduce a partner’s bonus or otherwise limit distributions to a lawyer may be a viable alternative when that partner has received S-8 stock directly from one of the firm’s clients. Of course, where associate attorneys are involved, the situation would be substantially more complicated.

The reader should also be aware that the SEC currently is considering additional changes to Form S-8 in an attempt to further curb ongoing abuses relating to the registration form, including proposals that would require:

• the issuer to be timely in its Exchange Act reports during the 12 calendar months and any portion of a month before the Form S-8 is filed;
• an issuer formed by merger of a nonpublic company into an Exchange Act reporting company with only nominal assets at the time of the merger to wait to file a Form S-8 until it has filed an annual report on Form 10-K containing audited financial statements;

• certification that any consultant or advisor who receives securities registered on the form has not been hired for capital-raising or promotional activities; and
• disclosure of the names of any consultants or advisors receiving securities under Form S-8, the number of securities to be issued and the services that were rendered by each of them.

At this time, it remains unclear whether the SEC will adopt any of these proposals. However, any attorney considering whether to accept S-8 stock for his or her legal fees would be well advised to stay abreast of the resolution of these pending proposals.

In addition, any attorney accepting compensation in the form of S-8 stock should be aware of the rules of professional conduct governing his or her practice. The Model Rules of Professional Conduct of the American Bar Association, for example, state that a lawyer is not prohibited from acquiring an ownership interest in a client in lieu of a cash fee for providing legal services as long as the lawyer complies with Rule 1.8(a), governing business transactions with clients, and, when applicable, with Rule 1.5, requiring that a fee for legal services be reasonable. To comply with Rule 1.8(a), the transaction by which the lawyer acquires the interest and its terms must be fair and reasonable to the client, and fully disclosed and transmitted in writing in a manner that can be reasonably understood by the client. The client also must be given a reasonable opportunity to seek the advice of independent counsel in the transaction and must consent to the transaction in writing. In addition, in providing legal services to the client’s business while owning its stock, the lawyer must take care to avoid conflicts between the client’s interest and the lawyer’s personal economic interests as an owner, as required by Rule 1.7(b), and must exercise independent professional judgment in advising the client concerning legal matters, as required by Rule 2.1.

Finally, once an attorney owns the stock of his public company client, he or she will need to be mindful of SEC prohibitions on insider trading, including those imposed by Rule 10b-5. Generally, Rule 10b-5 prohibits a person from trading "on the basis of" material, nonpublic information. Subject to the affirmative defenses in paragraph (c) of Rule 10b5-1, a purchase or sale is "on the basis of" material nonpublic information if the person making the purchase or sale was "aware" of the material nonpublic information when the person made the purchase or sale. To satisfy the affirmative defenses of paragraph (c) of Rule 10b5-1, a person must establish that:

• before becoming aware of the information, he or she had entered into a binding contract to purchase or sell the security, provided instructions to another person to execute the trade for the instructing person's account, or adopted a written plan for trading securities;
• with respect to the purchase or sale, the contract, instructions, or plan either: (1) expressly specified the amount, price, and date; (2) provided a written formula or algorithm, or computer program, for determining amounts, prices, and dates; or (3) did not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales; provided, in addition, that any other person who did exercise such influence was not aware of the material nonpublic information when doing so; and

• the purchase or sale that occurred was pursuant to the prior contract, instruction, or plan. (A purchase or sale is not pursuant to a contract, instruction, or plan if, among other things, the person who entered into the contract, instruction, or plan altered or deviated from the contract, instruction, or plan or entered into or altered a corresponding or hedging transaction or position with respect to those securities.)

Taken as a whole, these affirmative defenses are designed to cover situations in which a person can demonstrate that the material nonpublic information was not a factor in the trading decision.

Accordingly, if, through your representation of your client, you become "aware" of material, nonpublic information, you will either need to comply with the affirmative defense provisions of paragraph (c) of Rule 10b5-1 or you will need to refrain from trading until such time as that information is publicly disclosed. Additionally, you should also be aware that, in an attempt to limit violations of the insider trading regulations, many companies impose trading restrictions on their insiders through internally created trading procedures. These procedures typically limit an insider’s trading activity to specific trading windows of time (e.g., immediately following the release of the company’s quarterly report on Form 10-Q). Such restrictions may further increase the market risk to which you are exposed as a result of holding your client’s stock, especially in highly volatile markets. However, you may be able to offset this risk through a contractual arrangement with your client pursuant to which your client will make up the difference between the amount of your fees and the amount you received through the sale of your stock. This could be done either through the payment of cash or the delivery of additional shares.

Despite the foregoing cautions, there may be times when it is both appropriate and necessary for an attorney to accept compensation in the form of S-8 stock. The decision to accept this form of compensation, however, requires careful consideration of the many factors involved, both legal and otherwise. So long as the rules are followed and the stock is not part of a capital-raising effort, an attorney may safely take stock in lieu of fees and protect himself or herself from legal risk and, through the use of Form S-8 registration and contractual arrangements with the client, some of the market risk involved.