Institutional investors have come under intense pressure to find creative solutions to deal with serious funding challenges. Many have taken proactive measures to reduce their administrative budgets and cut expenses; for example, negotiating discounts and fee concessions from third party service providers such as consultants and money managers, reducing the size of their investment staff, restricting investment staff and board members from attending educational seminars, and reducing use of outside legal counsel to review and negotiate fund documents.
To help institutional investors drive down investment related costs and become more competitive on fees in general, in addition to providing recommendations with respect to appropriate levels of allocation to different financial products and conducting due diligence prior to recommending specific investments, some consulting firms package the legal review of fund documents together with their investment management and advisory services. This is particularly attractive to those investors who do not have sufficient legal in-house support or expertise for advising on these investments. Instead of the investor clients hiring their own outside legal counsel to review and negotiate the fund documents, legal review is provided on behalf of an investor client or a group of investor clients to whom the consultant has recommended a particular investment by either using the consultant's own in-house staff counsel to review the investment documents, or by a single outside counsel selected and retained by the consultant to conduct such legal review. It should be noted that this practice is more often seen with private equity investments, such consulting practices are not limited to a particular asset class.
In our view, the use of the consultant's legal counsel presents serious concerns for the institutional investors involved. The institutional investors may not be receiving unbiased legal advice when the counsel is retained by the consultant. In addition, this practice may trigger conflicts of interest issues with respect to the consultant and also the consultant's other investor clients. Although the institutional investor may believe that the counsel represents its interests, the parties may not have an effective attorney-client relationship nor be subject to the attorney-client privilege. Furthermore, often the institutional investor may not even know what they are paying in legal fees.
In most cases where in-house counsel or a single outside counsel is engaged to advise a group of investors, the lawyer negotiates a single form of side letter for the whole group of clients that are making an investment in a particular vehicle irrespective of the fact that the clients may not be similarly situated and may have different legal needs. In fact, in certain circumstances, such investor counsel inevitably finds itself negotiating with fund counsel to address a particular issue perceived to be impacting one but not another client. Often the instructions to counsel come directly from the consultant, not from a specific investor. Regardless of whether the outside counsel is employed directly or indirectly by the consultant, it seems clear to us that the consultant is controlling the legal review process.
The institutional investor clients are not usually aware of the exact amount of fees paid for such legal services because the fees are either packaged into the overall compensation paid to the consultants for their services or invoiced pro rata among the client group. Certainly, there is no legal cost break-out where the review is done with the consultant's own in-house staff counsel who are directly employed and salaried by the consulting firm since the clients are not privy to the employment contract between the consultancy firm and its in-house counsel. Furthermore, there is often no break-out for legal fees paid to an outside counsel retained or paid by the consultant to provide legal services to a group of clients investing in the same investment product or fund.
The use of the consultant's counsel has developed from the practice of many consultants today advising clients as a group in an attempt to reduce third party fees for their clients. There is no denying that for many institutional investors, the group review process has resulted in cheaper consulting fees and lower outside counsel legal fees for each investment. But what has been forgotten in an attempt to save legal fees is that legal vetting, or due diligence, as well as legal advice, involves a review and evaluation of the proposed investment, including its contractual commitments and obligations, from the specific investor's perspective. Every investor faces legal requirements specific to it (no matter how similarly situated a group of investors may seem to be). A lawyer who is retained only by one investor will review the investment from that investor's perspective. If the lawyer is asked to perform the same or related functions for more than one party with respect to a single investment, he or she must look at the engagement from the respective perspectives of each of the separate clients, who may face different legal requirements for permitted investments or may have different economic objectives. However, as the case of Buehler v. Scarbellati (1995) 34 Cal. App.4th 1527 explains, it is possible for a single lawyer or firm to represent disparate investors in a single real estate investment; but such lawyer functions essentially as a scrivener and he or she cannot act as advocate for a single client's objectives over those of another. If problems develop downstream, the law firm cannot represent any of its original clients in the matter and the investor must retain new counsel.
Even when outside counsel is used and legal fees are shared pro rata among a group of clients and passed through to each investor client separately from the consultant's advisory fees, such arrangement is still problematic and not conflict-free. There still exists an inherent conflict of interest in allowing the consultant's in-house staff counsel or outside counsel to review and negotiate the investment documents on behalf of the consultant's client or group of clients, whether or not such counsel also reviews the documents on the consultant's behalf. This scenario equally applies in circumstances of investments commonly referred to as "discretionary" or "discretion in a box" in which the consultant recommends to its clients those investment opportunities that meet identified investment criteria and has a certain level of discretion to invest in such funds on behalf of its clients. What may seem as an effective way for the institutional investors to cut down on legal fees may in fact taint the legal review process and potentially jeopardize the investments.
To explain the subject of our concern briefly, the courts have stated that "a conflict of interest is present where the circumstances of a particular case present ‘a substantial risk that the lawyer's representation of the client would be materially and adversely affected by the lawyer's own interests or by the lawyer's duties to another current client, a former client, or a third person.'" Vapnek, et al., Professional Responsibility, § 4:1. Although the outside counsel is providing legal review on behalf of the investor clients, it is unclear whom the counsel really represents. This is especially the case with a consultant's in-house staff counsel, but also true in the case of an outside law firm retained by the consultant and paid for by the group of clients separately from the consultant fees. It is still questionable whether the counsel is able to stay impartial vis-à-vis the investment recommendations made by the consultant, given that legal counsel was retained by such consultant to provide the legal services in support of the investment recommendations provided by the consultant's firm. It is questionable whether counsel in that position can recommend against key provisions of the proposed transaction if the consultant, which engaged counsel, favors those terms or perhaps failed to sufficiently address the terms in its recommendation to the clients? We are not aware of any statistics as to what percentage of investments are considered but ultimately not made by an institutional investor group, or by at least some of the investor clients in a group, due to information uncovered by the outside legal counsel, nor of any studies of the ability of such counsel to negotiate terms on behalf of a specific investor, despite the recommendation by the consultant. We would venture to suggest, however, that though there are many examples of a single investor pulling out because of legal concerns, few investments fall through where outside legal counsel, retained in some form or another by the consultant, conduct the review and the negotiation process for a group of investors. In addition, consider when a group of the consultant's clients who are represented by a single outside counsel have conflicting interests or objectives, which illustrates another problem with having the same attorney represent the investor group.
The institutional investor may wrongly believe it is saving the pension system legal fees by using the consultant's counsel, but there are real dangers in this practice. It is questionable whom such counsel represents. Just who are such counsel's clients; and who gives such counsel instructions from the client's perspective? In most cases, the consultant's in-house staff counsel does not have a direct attorney-client relationship with the clients. It is certainly unlikely that such counsel would perform a conflict check prior to commencement of the representation, although it is standard practice, and a requirement under state rules of professional conduct and the American Bar Association (ABA) guidelines, for any attorney to ensure that there is no conflict of interest between the institutional investor clients it represents. Nor does such counsel in the majority of cases obtain conflict waivers for any potentially conflicting representations, as those rules require. At the very least, in order to comply with the ABA requirements as well as the particular state ethics rules governing attorney-client relationships, such counsel acting on behalf of more than one investor, or on behalf of the consultant and one or more investors, needs to obtain conflict waivers from all of the investor group clients, and for each separate investment negotiation, prior to representing them.
In addition, while the attorney client privilege exists in the case of multiple clients, the privilege disappears as to any part of the subject matter if the clients become at odds about the engagement. That may seem a remote issue at the time the due diligence is performed and the investment documents are negotiated; but any one of the clients can disclose privileged material at will, and the material will then lose its privileged status for all. Moreover, an arrangement seems unwise whereby the confidences of any one client can be shared – and under ethical rules for joint representation, must be shared at another client's request – between multiple clients. Moreover, since the consultant is often privy to all of the communications between the investors and the consultant-retained common counsel, the communications between the parties are not subject to the basic confidentiality standards which typically exist between counsel and its client.
Those of us who regularly prepare and review investment documents understand that the investment terms contained in summary form in a term sheet or a private placement memorandum may look different by the time they are written into the investment documents. It is not the consultant's role to carefully review the legal terms contained in the investment documents after the consultant has made the recommendation to invest with a particular manager and, in fact, in many cases the investment agreements have not yet been drafted at the time that the consultant may be performing its due diligence. It is the responsibility of each investor to review the legal terms and confirm that the documents say exactly what the manager or the consultant claims they say, and that they reflect the specific investor's needs. In addition, it is the legal counsel's duty, whether in-house or outside counsel, to not only review and negotiate the investment documents but also check them against the recommendations made by the consultant and, when appropriate, make sure that the terms the consultant has relied upon to make its recommendations are properly documented in the investment documents. In some cases, it may be necessary for legal counsel to question the basis of a consultant's recommendation or the sufficiency of the initial or follow-on due diligence performed by the consultant in connection with a particular investment. We believe that the level of independent review and vigilance in reviewing the consultant's recommendation and the clients' individual needs is compromised when the outside counsel who performs that task has been retained by the consultant – and that this money-saving compromise clearly becomes improper where the same counsel represent both the consultant and the investors.
Many of the consultants we regularly work with understand the inherent conflict of interest and the potential liability to themselves. The more prudent consultants do not package their advisory services together with the legal review, and avoid facilitating the use of their in-house staff counsel or the retention of outside counsel for their clients. In fact, many of these consultants, in an attempt to reduce any liability and remain conflict free, include express language in their written recommendations stating that the investment documents remain subject to independent legal review. Even those consultants who have their in-house staff counsel assist clients with the initial review of the investment documents should still, if they are prudent, encourage their clients to conduct an independent legal review of the investment documents.
Regardless of whether the consultant's in-house staff or outside counsel performs an initial review of the investment documents, and even negotiates a basic side letter on behalf of a group of investors, each investor should ultimately have its own independent counsel review the investment documents. Whether that review is carefully conducted by the city attorney, county counsel, staff attorney, or an outside law firm, such independent review for each and every investment is critical to protecting the investment. Institutional investors who, in an attempt to save on investment related expenses, have come to rely on their consultants for legal review should re-evaluate their practices to ensure that doing so does not compromise the legal advice they are receiving from counsel. Independent outside counsel should be carefully vetted, selected and retained directly by the institutional investors themselves, not their consultants. The attorney-client relationship and the investment document review process are too important to be compromised. There is simply too much at stake for the investors and their beneficiaries.