United States: California Supreme Court Holds That Conflict Invalidates Firm's Engagement Letter But Says Firm Still May Be Able To Get Paid

Last week, the California Supreme Court issued its decision in Sheppard, Mullin, Richter & Hampton, LLP v. J-M Manufacturing Co., Inc., a decision which lawyers and law firms anxiously awaited for months. The case involved a lower court's refusal to enforce a law firm's advance conflict waiver and - to add insult to injury - an order to disgorge its entire legal fee as a result. The wait is now over. On August 30, 2018, the California Supreme Court affirmed the lower court's ruling as to the advance conflict waiver, which should result in firms across the country re-evaluating their use and implementation of those waivers.  Indeed, the court went so far as to void the retainer agreement containing the waiver entirely, including the arbitration clause. Nevertheless, in a surprising move, the Court reversed the disgorgement award and, contrary to the law of most U.S. jurisdictions, said that fee disgorgement is not automatic in a conflict situation, but will depend on particular circumstances.

The Facts

Sheppard Mullin represented J-M Manufacturing Company ("J-M") in defending against a qui tam (whistle blower) lawsuit. When J-M approached Sheppard Mullin, the firm did a conflict check and found it had done unrelated work for a company called South Tahoe, which was an intervenor (represented by separate counsel) in the qui tam lawsuit. South Tahoe had provided Sheppard Mullin with a broad advance conflict waiver as part of its standard retainer. That waiver -- not much different than the standard boilerplate currently found in many firms' retainer agreements -- allowed Sheppard Mullin to represent "another client in a matter in which we do not represent [South Tahoe], even if the interests of the other client are adverse to [South Tahoe]," as long as "the other matter is not substantially related to our representation of [South Tahoe]," and Sheppard Mullin had not obtained confidential information from South Tahoe relevant to the adverse representation. Not only had South Tahoe given an advance waiver, but at the time J-M sought to retain Sheppard Mullin South Tahoe had not used the firm for five months.

After reviewing these circumstances, Sheppard Mullin agreed to represent J-M in the qui tam lawsuit. Sheppard Mullin had J-M sign a retainer and advance waiver identical in form to that signed by South Tahoe -- a waiver that did not, however, specifically mention South Tahoe. Nor did Sheppard Mullin seek South Tahoe's consent, or even inform either J-M or South Tahoe about its representation of the other. Sheppard Mullin began working for J-M on the qui tam lawsuit (accruing approximately $3M in fees), and also later performed 12 hours of additional, unrelated work for South Tahoe.

Eventually, South Tahoe's counsel in the qui tam lawsuit found out about the conflict, alerted Sheppard Mullin and demanded its withdrawal. Sheppard Mullin refused, citing the advance waivers. Years of litigation ensued, with the California intermediate appellate court ultimately refusing to honor the advance waiver because of its vagueness and failure to disclose the existing conflict to both clients, while overturning an arbitration award for fees in Sheppard Mullin's favor on the ground that prevailing case law required a firm with a conflict of interest to disgorge all fees earned while the conflict existed. 

The Court's Decision

This set up a showdown in the California Supreme Court. In last week's decision, the majority skirted the advance waiver issue, but nevertheless excoriated Sheppard Mullin for failing to properly disclose what the Court viewed as a current client conflict with South Tahoe when it undertook J-M's representation. More precisely, it said that the firm's boilerplate advance waiver was inadequate because although it suggested that conflicts might arise in the future, it did not disclose that a conflict actually did exist. It voided the retainer agreement entirely, including the arbitration clause. 

The majority, however, was not entirely unforgiving. Far from it, as it reversed the disgorgement award, finding that "the degree to which [fee] forfeiture is warranted as an equitable remedy that will vary with the equities of the case." It remanded to the trial court --not the arbitrators-- to evaluate such equitable factors as the willfulness of the conflict breach, the degree to which the firm worked against the client's interest, and the amount of client harm. "[T]he trial court must then exercise its discretion to fashion a remedy that awards the attorney as much, or as little, as equity warrants, while preserving incentives to scrupulously adhere to the Rules of Professional Conduct." This ruling came in the face of a stinging dissent, which focused on the firm's breach of its duty of loyalty to J-M, and how a bright-line rule on disgorgement is the best way to enforce that duty of loyalty. 

The Takeaways

Sheppard Mullin serves as a reminder about the risks of using boilerplate advance waivers. Here are some practice points:

(a) The standard advance waivers appearing in many firms' retainer letters -- particularly those that include litigation matters -- are not necessarily enforceable.

(b) Regardless of whether a client has signed an advance waiver, if a conflict arises later with another firm client it should be analyzed to determine if it is waivable.

(c) If the conflict is waivable, but involves an adversarial situation - a litigation or a contentious transaction - both affected clients should be notified in writing, and preferably provide a specific written waiver. 

(d) Any advance waiver must be as detailed as possible, and identify any known or likely future conflicts involving the client signing it.

(e) When dealing with a client claiming a conflict, take a hard look at your firm's own conduct and determine whether it makes financial or reputational sense to litigate.

(f) Firms facing claims of fee disgorgement due to conflicts may want to use Sheppard Mullin to challenge the existing body of New York law -- not unanimous -- that fee disgorgement is automatic in for the period the conflict exists. 

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This alert provides general coverage of its subject area. We provide it with the understanding that Frankfurt Kurnit Klein & Selz is not engaged herein in rendering legal advice, and shall not be liable for any damages resulting from any error, inaccuracy, or omission. Our attorneys practice law only in jurisdictions in which they are properly authorized to do so. We do not seek to represent clients in other jurisdictions.

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Authors
Ronald C. Minkoff
Nicole I. Hyland
Tyler Maulsby
 
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