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Ethics & Professional Responsibility FLASHPOINTS January 2019

January 15, 2019Print This Post Print This Post

Terrence P. McAvoy & Thomas P. Sukowicz
Lawyers for the Profession, Hinshaw & Culbertson LLP, Chicago
312-704-3000 | E-mail Terrence McAvoy | E-mail Thomas Sukowicz

Requirements for Waivers of Existing Conflicts and Potential for Fee Disgorgement

On March 4, 2010, Sheppard, Mullin, Richter & Hampton LLP (Sheppard Mullin) agreed to take over the representation of J-M Manufacturing in a federal qui tam suit brought against J-M on behalf of over 200 public entities for the alleged sale of faulty PVC pipes. J-M faced an exposure of over $1 billion in damages. Sheppard, Mullin, Richter & Hampton, LLP v. J-M Manufacturing Co., 6 Cal.5th 59, 425 P.3d 1, 237 Cal.Rptr.3d 424 (2018).

Sheppard Mullin’s conflict check revealed that another Sheppard Mullin attorney in a different office previously represented one of the plaintiffs, South Tahoe Public Utility District, in unrelated employment matters on and off since 2002 and most recently in November 2009.

Because South Tahoe had signed an advance conflict waiver in nonemployment matters, Sheppard Mullin concluded that it could take on the representation of J-M. The engagement agreement between Sheppard Mullin and J-M was negotiated, and while J-M’s general counsel revised certain portions of the agreement, she made no changes to the conflict waiver provision. Moreover, the provision did not refer specifically to South Tahoe. Sheppard Mullin did not tell J-M about its representation of South Tahoe before or at the time the engagement agreement was signed. The engagement agreement provided for arbitration of any dispute arising under the agreement.

The waiver provision provided:

Conflicts with Other Clients. Sheppard, Mullin, Richter & Hampton LLP has many attorneys and multiple offices. We may currently or in the future represent one or more other clients (including current, former, and future clients) in matters involving [J-M]. We undertake this engagement on the condition that we may represent another client in a matter in which we do not represent [J-M], even if the interests of the other client are adverse to [J-M] (including appearance on behalf of another client adverse to [J-M] in litigation or arbitration) and can also, if necessary, examine or cross-examine [J-M] personnel on behalf of that other client in such proceedings or in other proceedings to which [J-M] is not a party provided the other matter is not substantially related to our representation of [J-M] and in the course of representing [J-M] we have not obtained confidential information of [J-M] material to representation of the other client. By consenting to this arrangement, [J-M] is waiving our obligation of loyalty to it so long as we maintain confidentiality and adhere to the foregoing limitations. We seek this consent to allow our Firm to meet the needs of existing and future clients, to remain available to those other clients and to render legal services with vigor and competence. Also, if an attorney does not continue an engagement or must withdraw therefrom, the client may incur delay, prejudice or additional cost such as acquainting new counsel with the matter. 425 P.3d at 6.

After J-M engaged Sheppard Mullin, the firm billed South Tahoe for about 12 hours of work. Although the court called South Tahoe a “ ‘dormant’ client,” Sheppard Mullin had, in fact, worked for the client in the preceding year. 425 P.3d at 14. Unfortunately for the firm, the amount of hours worked was irrelevant to the court’s analysis concerning whether South Tahoe was a current or former client, because the representation had not been terminated and thus there was a reasonable expectation that it was ongoing at the time J-M retained the firm.

In 2011, South Tahoe discovered Sheppard Mullin’s representation of both parties and filed a motion to disqualify Sheppard Mullin in the qui tamaction. The district court granted the motion, ruling that the simultaneous representation was undertaken without adequately informed waivers in violation of Rule 3-310(C)(3) of the California Rules of Professional Conduct.

Sheppard Mullin had billed nearly $3.8 million in fees in representing J-M, and over $1 million was outstanding when it was disqualified. Sheppard Mullin filed a lawsuit for the unpaid fees and sought specific performance of the arbitration provision in their agreement. J-M filed a cross-complaint for breach of contract, breach of fiduciary duty, and fraudulent inducement and sought disgorgement of previously paid fees and exemplary damages. The trial court granted Sheppard Mullin’s request to compel arbitration. The arbitrators ruled in favor of Sheppard Mullin, noting that the conflict of interest did not cause J-M damage, prejudice J-M’s defense in the qui tamaction, result in communication of J-M’s confidential information to South Tahoe, nor did it render Sheppard Mullin’s representation less effective or valuable to J-M. Sheppard Mullin petitioned to confirm the award, and J-M petitioned to vacate it on the basis that the engagement agreement was unenforceable due to the violation of Rule 3-310(C)(3). While the trial court confirmed the award, the court of appeal reversed, holding that the matter never should have been arbitrated because Sheppard Mullin’s undisclosed concurrent conflict violated the Rules, rendered the engagement agreement with J-M unenforceable, and disentitled it to any fees from J-M while it represented South Tahoe in other matters. Sheppard Mullin appealed.

The California Supreme Court affirmed in part and reversed and remanded in part. The court agreed that Sheppard Mullin’s failure to inform J-M of its attorney/client relationship with South Tahoe constituted a conflict of interest that rendered its engagement agreement with J-M unenforceable as against public policy. In California, Rule 3-310(C)(3) prohibits the concurrent representation of adverse parties, even if the subject matters of the respective representations are substantially unrelated. This is because the Rule’s paramount concern is grounded in the duty of loyalty, not confidentiality. Sheppard Mullin did not dispute this general premise but, rather, argued that it had properly obtained both clients’ informed written consent by way of the conflict waiver in both clients’ engagement agreements.

The court rejected this argument because J-M’s consent could not have been “informed” when Sheppard Mullin concealed the identity of a known, current client and thus an actual conflict. “ ‘ “Informed written consent” ’ is defined to mean ‘written agreement to the representation following written disclosure,’ and ‘[d]isclosure’ is defined as ‘informing the client . . . of the relevant circumstances and of the actual and reasonably foreseeable adverse consequences to the client.’ ” 425 P.3d at 13.

The undisclosed “relevant circumstance” was the firm’s relationship with South Tahoe, which J-M characterized as a “present reality” at the time of the engagement with J-M, and the firm characterized as a “former” or “dormant” attorney-client relationship. The court agreed with J-M. In so holding, it examined the terms of the engagement between Sheppard Mullin and South Tahoe:

South Tahoe’s operative engagement agreement, executed in 2006, provided that Sheppard Mullin would represent the utility district “in connection with general employment matters (the ‘Matter’).” The agreement further provided that South Tahoe could terminate the representation at any time, as could Sheppard Mullin (subject to its ethical obligations), but that otherwise the representation would terminate “upon completion of the Matter” unless the firm agreed to render other legal services to the agency. The parties’ agreement thus established an attorney-client relationship that, absent earlier termination by one of the parties, would endure so long as Sheppard Mullin continued to work on “the Matter,” which was defined in the agreement as “general employment matters.” [Emphasis added.] 425 P.3d at 14.

Thus, although the work for South Tahoe was sporadic between 2002 and 2009, and presumably, there was no work pending on March 4, 2010, when J-M retained the firm, by operation of the South Tahoe engagement agreement, the representation had not ended. The broadly defined scope of work — “general employment matters” — meant that the relationship could not automatically terminate by completion of the assignment under the agreement. Id. And neither party instigated the termination provision. The court also rejected Sheppard Mullin’s argument that its arrangement with South Tahoe was akin to a “framework” agreement under which “the relationship would be renewed, on the same terms, each time the client had a new assignment for the firm — and, critically, one that would end when the assignment was completed.” 425 P.3d at 15. The court said:

The terms of the agreement do not, however, bear out the characterization. The agreement provided that Sheppard Mullin’s representation of South Tahoe would continue for the length of “the Matter,” which the agreement defined as general employment matters, in the plural. The definition belies the suggestion that the parties intended to terminate the attorney-client relationship after each individual general employment matter was completed. And unlike the framework agreement . . . the agreement contained no language reserving to the law firm the right to decline work requested by the client. Nor did the agreement include any other explicit statement that Sheppard Mullin and South Tahoe would maintain an attorney-client relationship only during times when the law firm was actually performing work for the utility district. Id.

Accordingly, the court concluded that although the engagement agreement was not a true retainer (i.e., when a retainer is paid for access to the firm), “it was not a simple framework agreement, either. It was, rather, an agreement governing a continuing engagement involving occasional work on employment matters as needed. . . . Absent any express agreement severing the relationship during periods of inactivity, South Tahoe could reasonably have believed that it continued to enjoy an attorney-client relationship with its longtime law firm even when no project was ongoing.” 425 P.3d at 15 – 16.

The sophistication of the client is immaterial when a known conflict exists and is undisclosed. Sheppard Mullin and various amicus curiae argued that many corporate clients (such as J-M) are large and sophisticated with bargaining power equal to or exceeding that of the firm. Such clients, and in particular their general counsel, understand and accept that large national and international firms may currently or in the future represent clients with potentially conflicting interests, but the firms can maintain loyalty and confidentiality to both clients.

Sheppard Mullin asserted that J-M was clear-eyed about its risks and agreed to accept them when entering into the engagement agreement containing the blanket conflict waiver. The court rejected this notion simply because Sheppard Mullin knew of the existing and conflicting relationship with South Tahoe and did not disclose it. “By asking J-M to waive current conflicts as well as future ones, Sheppard Mullin did put J-M on notice that a current conflict might exist. But by failing to disclose to J-M the fact that a current conflict actually existed, the law firm failed to disclose to its client all the ‘relevant circumstances’ within its knowledge relating to its representation of J-M.” [Emphasis in original.] 425 P.3d at 16. Thus, “[i]f a conflict of interest is known to an attorney at the time he seeks a waiver, the attorney is not allowed to hide that conflict, regardless of whether the client is sophisticated or not.” 425 P.3d at 17.

In short, the client’s level of sophistication does not come into play if there is an actual conflict to disclose:

No matter how large and sophisticated, a prospective client does not have access to a law firm’s list of other clients, and cannot check for itself whether the firm represents adverse parties. Nor can it evaluate for itself the risk that it may be deprived, via motion for disqualification, of its counsel of choice, as happened here. In any event, clients should not have to investigate their attorneys. Simply put, withholding available information about a known, existing conflict is not consistent with informed consent. Id.

The court did not reject the use of advance conflicts waivers in future cases under the revised California Rules of Professional Conduct, but sidestepped whether advance waivers — in which the clients waive potential conflicts in advance — comply with the Rules, stating: “Because this case concerns the failure to disclose a current conflict, we have no occasion here to decide whether, or under what circumstances, a blanket advance waiver . . . would be permissible.” Id. Nevertheless, the court addressed the comprehensive amendments to California’s Rules of Professional Conduct approving, in part, language from Rule 1.7 of the Model Rules of Professional Conduct regarding conflicts. In a footnote, the court said that with respect to advance conflict waivers, “the client’s experience and sophistication and the presence of independent representation in connection with the [informed] consent are ‘relevant’ to the effectiveness of that consent, and that the new rule ‘does not preclude an informed written consent[ ] to a future conflict in compliance with applicable case law.” 425 P.3d at 17 n.7. The court also stated in a footnote that “[s]everal federal courts applying California law have declined to enforce blanket advance waivers on grounds they insufficiently disclosed the conflicts of interest.” 425 P.3d at 17 n.9.

The court also ruled, contrary to the court of appeal, that the ethical violation does not categorically disentitle the law firm from recovering the value of its services under a quantum meruit theory.

For more information about ethics and professional responsibility, see ATTORNEYS’ LEGAL LIABILITY — 2018 EDITION. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.

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