There Are No Small Conflicts: Due to Undisclosed, Known Conflict, Supreme Court Agrees that Engagement Agreement Is Unenforceable but Keeps Door Open to Law Firm Receiving Compensation Under Equitable Principles

In Sheppard Mullin Richter & Hampton LLP v. J-M Manufacturing Co., Inc. (8/30/2018 No. S232946), the California Supreme Court held that the conflict of interest of the law firm (“Sheppard Mullin”) rendered its engagement agreement, including an arbitration provision, with its client (“J-M”) unenforceable because the agreement violated the California Rules of Professional Conduct (“RPC”). Although the agreement included an “advance” conflict waiver, the Court deemed it ineffective because Sheppard Mullin failed to disclose a known conflict with its existing client the South Tahoe Public Utility District (“South Tahoe”), an adverse party in the matter involving J-M. Despite vacating the firm’s arbitration award of $1.3 million in unpaid legal fees for services rendered to J-M, the Court instructed the trial court to determine whether principles of equity (i.e., quantum meruit) nevertheless entitled Sheppard Mullin to some measure of compensation.

In 2006, a whistleblower filed a qui tam action against J-M in federal court alleging that J-M had misrepresented the strength of its PVC pipe sold to hundreds of public entities. In 2010, numerous public entities sought to intervene. J-M then approached Sheppard Mullin about taking over its defense. Sheppard Mullin’s conflicts check revealed employment work performed for one of the public entity interveners, South Tahoe, on and off since 2002 and most recently in 2009. In its engagement agreement with Sheppard Mullin, South Tahoe had agreed to an advance waiver of conflicts in cases unrelated to employment matters. In March 2010, J-M signed an engagement agreement with Sheppard Mullin for representation in the qui tam action. In relevant part, the agreement included a conflict waiver stating that Sheppard Mullin, currently or in the future, might represent clients in matters involving J-M provided the other matter was not “substantially related” to the qui tam action and the firm had not obtained confidential information from J-M material to the other client. Sheppard Mullin did not disclose to J-M its concurrent representation of South Tahoe before J-M executed the agreement.

Weeks later, Sheppard Mullin’s employment partner began working for South Tahoe on a new matter, which involved a total of only 12 hours of time incurred by the firm. In 2011, South Tahoe filed a motion to disqualify Sheppard Mullin in the qui tam action. The District Court granted the motion, ruling that Sheppard Mullin’s concurrent representation of South Tahoe and J-M had been undertaken without adequate informed conflict waivers in violation of RPC Rule 3-310(C)(3), which provides that an attorney “shall not, without the informed written consent of each client . . . [¶] . . . [¶] . . . [r]epresent a client in a matter and at the same time in a separate matter accept as a client a person or entity whose interest in the first matter is adverse to the client in the first matter.” By that point, Sheppard Mullin had performed approximately 10,000 hours of work in the qui tam action and a related state court case.

After being disqualified, Sheppard Mullin sued J-M for approximately $1.3 million in unpaid fees. J-M cross-complained for, inter alia, breach of fiduciary duty and sought disgorgement of $2.7 million in paid fees. Sheppard Mullin petitioned for an order compelling arbitration, which J-M opposed, but which the trial court granted. The arbitrators ruled in Sheppard Mullin’s favor, holding that the ethical violation was not sufficiently serious or egregious to warrant forfeiture or disgorgement of fees. They found that the firm’s representation of South Tahoe was unrelated and had, thus, caused J-M no damage and awarded Sheppard Mullin $1.3 million in unpaid fees. Sheppard Mullin petitioned the court to confirm the award, which J-M sought to vacate, renewing its contention that Sheppard Mullin’s ethical breach rendered the engagement agreement unenforceable. However, the trial court confirmed the award.

The Court of Appeal reversed, explaining that Sheppard Mullin’s concurrent representation of J-M and South Tahoe violated the RPC notwithstanding the advance conflict waivers in the respective engagement agreements. It reasoned that this violation rendered the agreement with J-M unenforceable and disentitled Sheppard Mullin from receiving any fees (including previously paid fees) in the qui tam action while concurrently representing South Tahoe in another matter. The appellate court reasoned that Sheppard Mullin’s ethical breach meant that it was not entitled to any compensation even under principles of quantum meruit.

On review, the Supreme Court considered the threshold issue of the proper scope of judicial review of an arbitration award. It explained that such an award may be vacated where the arbitration was “undertaken to enforce a contract that is illegal and against the public policy of the state.” By way of example, “an attorney contract that has as its object conduct constituting a violation of the Rules of Professional Conduct is contrary to the public policy of this state and is therefore unenforceable.” Because J-M was challenging the enforceability of the entire agreement, the Court determined that it could review the validity of the arbitration award. The Court, however, emphasized that it was not holding that an agreement may be declared unenforceable in its entirety merely because it contains a provision that conflicts with an attorney’s obligations under the RPC.

The next issue was whether the subject engagement agreement was, in fact, illegal and, thus, unenforceable (including the arbitration provision) because it violated RPC Rule 3-310(C)(3). In answering this question in the affirmative, the Court first reasoned that at the time that Sheppard Mullin agreed to represent J-M in the qui tam action, the firm also represented South Tahoe, a client with conflicting interests in the same action. The Court explained that South Tahoe was not a “former” or “dormant” client at the time J-M signed the agreement even though Sheppard Mullin was not working on a pending matter for South Tahoe at that time. Instead, the parties had established an attorney-client relationship that would endure so long as Sheppard Mullin continued to provide services in “general employment matters.” Where a firm and a client have had “a long-term course of business calling for occasional work on discrete assignments” but no pending assignments, the Court reasoned that this does not necessarily mean the attorney-client relationship has been terminated. Instead, “[a]bsent 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.”

Second, the Court held that because Sheppard Mullin failed to inform J-M of the known, conflicting interest, J-M’s consent was not “informed” within the meaning of Rule 3-310(C)(3). It explained that the purpose of this rule is to enforce the attorney’s duty of loyalty, rather than confidentiality. The rule, thus, applies “even in unrelated matters where there is no risk that confidential information will be transmitted.” As a result, “[t]o be informed, the client’s consent to dual representation must be based on disclosure of all material facts the attorney knows and can reveal.” By failing to advise J-M about the current conflict with South Tahoe, Sheppard Mullin did not discharge its duty to disclose “all relevant circumstances” relating to the representation of J-M as required under Rule 3-310(C)(3). As a result, Sheppard Mullin’s “blanket waiver” in the engagement agreement was ineffective.

Third, the Court concluded that Sheppard Mullin’s failure to comply with Rule 3-310(C)(3) affected the whole of its engagement agreement with J-M, rendering it unenforceable in its entirety. It reasoned, “The transaction was entered under terms that undermined an ethical rule designed for the protection of the client as well as for the preservation of public confidence in the legal profession.” As a result, the Court determined that Sheppard Mullin was not entitled to the benefit of the arbitrators’ decision awarding $1.3 million in unpaid fees.

The Court then considered whether Sheppard Mullin could receive any compensation for its services rendered to J-M in the qui tam action. Sheppard Mullin maintained that the circumstances did not warrant an outright denial of fees because: (1) the arbitrators found that the firm acted in good faith reliance on the blanket conflict waivers to which both clients agreed; (2) there was no suggestion that Sheppard Mullin worked against J-M’s interests; (3) there was no evidence of any breach of confidentiality; and (4) J-M had stipulated during the arbitration that it was not challenging the “value or quality” of Sheppard Mullin’s work in the qui tam action or seeking “transition” costs incurred in replacing the disqualified firm. The Court found that this issue was not ripe for resolution and returned the matter to the trial court for further consideration. Significantly, it stated that California law does not establish a bright-line rule barring all compensation for services performed subject to an improperly waived conflict of interest. Instead, “[t]o be entitled to a measure of recovery, the firm must show that the violation was neither willful nor egregious, and it must show that its conduct was not so potentially damaging to the client as to warrant a complete denial of compensation.”

This case serves as a cautionary tale for law firms that use advance conflict waivers in their engagement agreements. In particular, it reinforces the obligation that law firms advise a client about any known, existing conflict with a concurrent client even where, as the Supreme Court observed was the situation here, the law firm could represent both clients if appropriate informed consent had been obtained. As a result, a blanket waiver such as the one used by Sheppard Mullin is insufficient to satisfy RPC Rule 3-310(C)(3). Another important takeaway is that fee agreements may be voided in their entirety in the face of a violation of the Rules of Professional Conduct, including an arbitration clause in such agreements. On the other hand, there is some good news for law firms, as the Supreme Court did not foreclose the possibility of recovery of fees under an equitable theory even where there has been an ethical breach so long as it was neither willful nor egregious and caused little or no harm to the affected client.

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September 6, 2018