Leaving South Tahoe: Will Your Advance Conflict Waiver Survive Sheppard Mullin v. J-M Manufacturing?

On Friday, August 30, 2018, the California Supreme Court ruled that a blanket advanced conflict waiver signed by two current clients, which purported to authorize lawyers from Sheppard Mullin to accept an unrelated representation of one client adverse to another, was void against public policy because the firm failed to obtain informed consent.  Even though the engagement agreement was legally unenforceable, the Court stated that the firm may still be entitled to recovery some of its fees, reversing the lower court’s decision which had barred Sheppard Mullin from any recovery due to its ethical breach.  The Court remanded the case for trial on the law firm’s claim for recovery in quantum meruit.

Factual Background

In 2006, a qui tam action was filed against J-M Manufacturing, a paper company.  The suit alleged that J-M had misrepresented the strength of its PVC pipe it had sole to approximately 200 entities around the country.  One of those entities was the City of South Tahoe.

In 2010, J-M sought Sheppard Mullin to represent it in the qui tam action.  The attorneys ran a conflict check against the named qui tam relators and discovered that one of those entities was a current client of the Firm.  Specifically, a Sheppard Mullin partner had been representing the City of South Tahoe “on and off” since 2002 for employment-related work.  As recently as 2009, South Tahoe and the Firm had entered into an advance waiver of conflicts for matters unrelated to the employment matters on which the Firm had provided assistance.

In 2010, Sheppard Mullin and J-M signed an engagement agreement.  The engagement agreement provided that J-M agreed the Firm could represent other clients in unrelated matters.  The J-M engagement agreement stated the Firm:

has many attorneys and multiple offices” and that “we may currently or in the future represent one or more clients . . . in matters involving [J-M].  We undertake this engagement on the condition that we may represent another client in a a matter in which we do not represent [J-M] (including appearance on behalf of another client advere 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.

The agreement with J-M further provided that “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.”

The general counsel of J-M reviewed the agreement and made specific changes to part of it but made no changes to the conflict waiver provision.  Sheppard Mullin did not inform J-M about its representation of South Tahoe before or at the time the engagement agreement was signed.

As noted above, the Firm also had an engagement agreement with South Tahoe.  The Firm’s agreement with South Tahoe included a similarly worded advanced waiver of conflicts for unrelated matters, which purported to permit the Firm to take a position adverse to South Tahoe, including in litigation.

At the time the South Tahoe engagement agreement was signed the Firm had not been engaged by J-M.  After it was contacted by J-M to represent it adverse to the 200 parties in the qui tam action (one of which was South Tahoe), the Firm did not disclose to J-M anything about its existing representation of South Tahoe.  The law firm’s general counsel and others concluded that the advanced waiver South Tahoe had agreed upon one year earlier was all that was required and the Firm did not need another waiver from South Tahoe after having received the broad, general blanket waiver.

Shortly after the engagement agreement with J-M was signed, the partner at South Tahoe who had been representing South Tahoe in employment matters began actively working for South Tahoe.  Over the course of the following year, the Firm billed South Tahoe for 12 hours of work.

South Tahoe’s attorneys in the qui tam action learned that Sheppard Mullin was representing J-M adverse to South Tahoe.  Sheppard Mullin informed South Tahoe, through South Tahoe’s qui tam litigation counsel, of the Firm’s position that the advanced waiver South Tahoe had signed permitted the Firm to represent J-M adverse to South Tahoe. In other words, by executing the broad general advanced conflict waiver, it was the Firm’s position that another waiver was unnecessary.

In 2011, South Tahoe moved to disqualify Sheppard Mullin as litigation counsel in the qui tam action.  The basis for the DQ motion was that the Firm was simultaneously representing South Tahoe when it was directly adverse to South Tahoe in another matter.  Moreover, South Tahoe argued that the advanced waiver signed by South Tahoe legally was ineffective because South Tahoe had not given its “informed consent.”  The court agreed with South Tahoe and Sheppard Mullin was disqualified from further representation of J-M.

Prior to its disqualification, Sheppard Mullin performed approximately 10,000 hours of work in the qui tam action and a related state court action.  The firm’s billings totaled more than $3 million, of which approximately $1 million remained unpaid as of the date of the disqualification.

The Law Firm Sues The Client for Fees

Sheppard Mullin sued J-M to recover the unpaid fees.  J-M countersued for breach of contract, fraudulent inducement and breach of fiduciary duty and sought both relief from the unpaid fees and a return (disgorgement) of the $2 million it had already paid to Sheppard Mullin.

Sheppard Mullin sought to move the dispute to arbitration based on the engagement agreement, which provided that disputes between the parties had to be resolved in that forum.  J-M asserted that the Firm’s conflict of interest rendered the entire engagement agreement—including the arbitration provision—unenforceable.

The state trial court granted Sheppard Mullin’s petition to compel arbitration, and the arbitrators ruled in favor of Sheppard Mullin and awarded it more than $1.3 million in unpaid fees (and denied the demand for disgorgement of the $2 million plus already paid).  The arbitrators found that the Firm’s representation of South Tahoe involved matters that were unrelated to the qui tam action; the conflict did not cause J-M any damage and did not prejudice its defense to the qui tam action, it did not result in any confidential information being disclosed to South Tahoe, and it did not render Sheppard Mullin’s representation less effective or valuable.  The lower court confirmed the arbitration award.

The California Court of Appeals reversed.  The intermediate appellate court held that the concurrent conflict rendered the engagement agreement unenforceable and the advanced waiver was invalid because Sheppard Mullin failed to obtain consent that was “informed”—particularly, Sheppard Mullin failed to get renewed consent from South Tahoe after it learned about the proposed representation of J-M, and it failed to get “informed” consent from J-M because it never disclosed to J-M the known fact of the Firm’s simultaneous representation of South Tahoe.

The appeals court further found as a result of the ineffective waiver that Sheppard Mullin was not entitled to any of the legal fees it had incurred during the representation of J-M—it was both: (a) not entitled to unpaid fees that were still owed by J-M; and (b) required to disgorge the fees it had already collected from J-M.

The California Supreme Court Affirms Illegality of Fee Agreement

The Supreme Court of California affirmed in part and reversed in part the decision of the Court of Appeal.

The first question addressed was the standard for judicial review of an arbitration award.  Despite the strong public policy in favor of arbitration, the California Supreme Court found that arbitrators exceed their authority when the arbitration has been undertaken to enforce a contract that is illegal or against public policy.  The Court held that contracts involving attorneys may be found unenforceable if it violated the Rules of Professional Conduct.  The Court held that where the entire contract was void for illegality, so too was a provision in the contract mandating arbitration. The Court noted that an attorney-client fee agreement is not necessarily illegal in its entirety simply because it contains a provision that conflicts with an attorneys’ obligation under the ethics rules.   Thus, the Court affirmed this part of the Court of Appeal’s ruling.

The second question was whether the Sheppard Mullin – JM engagement agreement was only partially illegal or whether it was illegal in its entirety.  The Supreme Court held that the agreement was void in toto for violating the conflicts of interest rule that provides that an attorney “shall not, without the informed consent of each client . . . represent 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.”  The term “informed written consent” means “written agreement to the representation following written disclosure,” and “disclosure” means “informing the client . . . of the relevant circumstances and of the actual and reasonably foreseeable adverse consequences to the client.”

The Supreme Court held that “because Sheppard Mullin knew of” its conflicting interest with South Tahoe and failed to inform J-M about it, J-M’s advanced blanket conflict waiver was not supported by consent that was “informed” within the meaning of the Rules of Professional Conduct.  Furthermore, since the consent was not informed, the entirety of the engagement agreement with J-M was unenforceable.

For a conflict waiver to be “informed,” the Court reasoned, “the client’s consent to dual representation must be based on disclosure of all material facts the attorney knows and can reveal.”  The Court stated that “An attorney or law firm that knowingly withholds material information about a conflict has not earned the confidences and trust the rule is designed to protect.”

Applying this standard, the Court noted that the Sheppard Mullin advanced waiver to J-M “did not disclose any particular conflict, or even any area of potential conflict, and did not mention” the Firm’s concurrent representation of South Tahoe.  Accordingly, the Firm’s advanced waiver was insufficient to inform J-M’s consent to the representation where, as here, the Firm was aware of a more specific and concrete conflict that already existed when the engagement agreement was executed.  The representation of South Tahoe “was not merely a future possibility; it was a present reality.”  Informed by this legal standard, the Court had no trouble concluding “the conflicts waiver here was inadequate.”

No Bright Line Rule on Fee Disgorgement

The final question addressed by the Supreme Court was whether the Firm may receive any compensation at all for its thousands of hours of legal services, or whether J-M gets a free ride because of the ineffective conflict waver.

The Firm argued it should still be entitled to the value of its services under the equitable doctrine of quantum meruit.  The Firm asserted it acted in good faith reliance on the blanket conflict waivers both clients signed, there was no evidence the Firm acted contrary to J-M’s interest, or that it violated J-M’s confidences.  And J-M stipulated it was not challenging the quality or quantity of the work Sheppard Mullin performed on its behalf.  Denying all compensation, the Firm argued, would disproportionately punish Sheppard Mullin and result in a “massive windfall” for J-M.

The Court agreed that a bright line rule of disgorgement of fees was not appropriate, although it decided not to decide the question of whether or to what extent Sheppard Mullin was entitled to fees.  The Court found that there should be no automatic rule on fee forfeiture for every breach of a lawyer’s ethical duty.  The Court stated that the court below should consider as part of its decision “the egregiousness of the attorney’s conduct, its potential and actual effect on the client and the attorney-client relationship, and the existence of alternative remedies.”

The Court explained that the firm may be able to show its conduct was not willful and the violation of the ethical rule was not so sever or harmful “as to render its legal services of little or no value to the client.”  If it is found that the Firm’s breach of its ethical duty was “flagrant” that might justify a complete forfeiture even in the absence of proof of harm to the client.  On the other hand, for “less egregious” cases, a complete forfeiture may be an “excessive sanction.”

The case was remanded for a trial on the Firm’s equitable claims for recovery.

Takeaways from Sheppard Mullin v. J-M

The Court’s decision serves as a warning to law firms—particularly those operating in California—that attempt to rely upon a blanket advanced waiver to take on an otherwise impermissible representation.  Guessing wrong can result in a significant penalty.

For starters, the Supreme Court’s decision makes clear that firms have an affirmative obligation to inform their clients of specific facts regarding known conflicts and cannot hide that information and accept the representation under the guise of a blanket advanced waiver.  By withholding known conflict information, a firm runs the risk that a court will subsequently invalidate any supposed advanced waiver.

The Sheppard Mullin decision limits the reliability of blanket advanced waivers and may cause law firms to think hard about how much they need to disclose to their clients when considering an advanced waiver.  In fact, counsel may want to consider regular updates of such advanced waivers when the firms learn of new information such as when the firm learns about the specifics of a prospective representation adverse to another firm client.

The Court in Sheppard Mullin did not address the question of whether blanket advanced conflict waivers generally are unenforceable.  Courts have divided on this issue.  The Supreme Court of California concluded that it need not reach this issue because, in its view, the failure to disclose material information to J-M regarding the firm’s then-present representation of South Tahoe itself was a failure to give J-M the information it was entitled to receive to inform its consent.

Another important takeaway from this decision is knowing whether your clients are current or former clients.  The Firm characterized South Tahoe as a “dormant” former client because even though there had been periodic representation over the years, it was not currently representing South Tahoe at the time of the J-M representation.  The Court rejected this characterization of South Tahoe.  The Court found the parties had a course of dealing of periodic representation followed by periods of dormancy.  The Court considered law from California and other jurisdictions that support the proposition that “where a law firm and client have had a long-term course of business calling for occasional work on discrete assignments, courts have generally held the fact that the firm is not performing any assignment on a particular date and may not have done so for some months—or even years—does not necessarily mean the attorney-client relationship has been terminated.”

In light of this holding, law firms may wish to consider modifying terms of their standard engagement agreements to clarify the nature of the relationship–particularly where the firm takes on a periodic representation and anticipates that there may be significant downtime between billable assignments.  In such situations, it may be wise to indicate the representation ends when the stated assignment is completed or delivered, as opposed to an open-ended engagement that does not identify any clearly marked point at which the representation ends.

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