California has historically been one of the stricter jurisdictions when it comes to the forfeiture and disgorgement of attorneys’ fees for conflicts of interest violations. If the latest decision to address the issue is any indication, that status is unlikely to change anytime soon. In Sheppard Mullin Richter & Hampton LLP v. J-M Manufacturing Co. Inc., 198 Cal.Rptr.3d 253 (Cal. App.4th 2016), a California court of appeals relied on long-standing precedent to overturn a trial court decision and find that the law firm of Sheppard Mullin must disgorge and forfeit millions of dollars in legal fees based on the firm’s failure to disclose an actual conflict of interest.

The appeals court reached this severe and somewhat surprising conclusion despite the fact that, in the underlying litigation, the client had stipulated it did not challenge the value and quality of the work provided or that it suffered any actual damages from the conflict of interest. Id. at 260; see also Resp’t’s Br. at 38, Case No. B256314 (Cal. App. Mar. 30, 2015) (“Here, J-M stipulated that it did not challenge the quality of Sheppard Mullin’s work and suffered no damages.”). At the same time, the allegations create a somewhat murkier picture about the firm’s failure to disclose and the egregiousness of the ethics violation. Thus, the decision provides an important cautionary tale on securing informed waivers and weighing the risks of potentially adverse representations.

Sheppard Mullin had billed over $3.8 million in fees defending its client, J-M Manufacturing Co. Inc., the world’s largest manufacturer of polyvinyl chloride (PVC) pipe, in a large qui tam lawsuit involving numerous parties. Id. at 257. Prior to its engagement, the firm ran a standard conflicts check that indicated Sheppard Mullin had represented one of the adverse intervening parties in the qui tam action, South Tahoe Public Utility District, on certain unrelated employment matters. Id. Several weeks later, the firm also undertook a new minor and unrelated matter for South Tahoe, but failed to disclose the existing conflict with J-M or obtain an informed waiver of the conflict from either of its clients. Id. at 258.

The limited scope of work Sheppard Mullin undertook for South Tahoe is notable. Neither J-M nor the court disputed the firm’s description of that work:

At the time Sheppard Mullin agreed to represent J-M in the Qui Tam Action, it had done no work for South Tahoe for five months. After J-M engaged [two partners in the firm’s LA office], South Tahoe reemerged and engaged [a partner] in the Santa Barbara office to provide discrete labor and employment advice, totaling 16 hours over 16 months. None of the lawyers who had done work for South Tahoe did any work for J-M, and vice versa. There was not even an allegation ... and certainly no evidence, that Sheppard Mullin had any confidential information about South Tahoe that it used in (or that even was relevant to) the Qui Tam Action. Likewise, there was no allegation or evidence that Sheppard Mullin had any confidential information about J-M that it used to J-M’s detriment in any way.

Resp’t’s Br. at 9, Case No. B256314 (Mar. 30, 2015).

At the same time, Sheppard Mullin plainly failed to disclose its ongoing, adverse representation of South Tahoe in a timely fashion. Indeed, J-M claimed that it only learned about the adverse representation when Sheppard Mullin had to oppose motion to disqualify the firm in the qui tam action filed by South Tahoe. 198 Cal.Rptr.3d at 259. And Sheppard Mullin was disqualified from its representation of J-M in the qui tam action. Id. at 260.

After Sheppard Mullin was disqualified, J-M refused to pay approximately $1.3 million in outstanding legal fees. Id. at 260. Sheppard Mullin then sued JM to recover those outstanding fees and compelled an arbitration in which the arbitral panel awarded the firm a majority of its attorneys’ fees. Id. at 261. The arbitrators found that “Sheppard Mullin’s conduct was not so serious or egregious as to make disgorgement of fees appropriate” where the representation of the adverse client “was unrelated to the subject of the J-M representation, and therefore the conflict did not pervade the whole relationship with J-M ...” Id. A California trial court affirmed the arbitration award, but J-M appealed, arguing that the violation of California’s Rule of Professional Conduct 3-310 on conflicts of interest rendered the engagement contract illegal or void as a matter of public policy. Id. at 261.

First, the appeals court determined that, under the applicable arbitration agreement and California law, the court should make a de novo determination as to whether the engagement contract was enforceable. Id. at 262-265. Second, the court determined that, despite standard waivers of both current and future conflicts contained in their client’s engagement agreements, Sheppard Mullin had failed to obtained informed written consent as required by Rule 3-310(C)(3). Id. at 266-267. Third, the court found that the “attorney’s duty of undivided loyalty that forms the basis of Rule 3-310 constitutes the very foundation of an attorney-client relationship” and, thus, the engagement agreement was invalid and unenforceable because it “violated an expression of public policy.” Id. at 272-273.

Turning to the merits, the court held that Sheppard Mullin “is not entitled to its fees for the work it did for J-M while there was an actual conflict with [its other client].” Id. at 274. In reaching this conclusion, the court relied primarily on two California appeals court cases from the 1970’s. See id. at 272 (analyzing Goldstein v. Lees, 120 Cal.Rptr. 253 (Cal. App. 1975) and Jeffry v. Pounds, 136 Cal.Rptr.373 (Cal. App. 1977)). The Goldstein court found an engagement contract “void for reasons of public policy” where counsel represented a minority shareholder and director in a proxy fight to gain control of a company for which the attorney had served as in-house counsel several years prior to the proxy fight. 120 Cal.Rptr. at 254-255. Central to the decision was the fact that the attorney possessed “corporate secrets that [were] material to the proxy fight.” Id. at 255 (emphasis added). In Jeffry, a small law firm’s lead partner represented both a husband in a personal injury action and his wife in her divorce proceeding against the husband. 67 Cal.App 3d at 374-375. There, the court denied any fees for work performed after the conflict arose even though the representations involved “unrelated matters” and the law firm did not have a “dishonest purpose” or engage in “deliberately unethical conduct.” Id. at 377.

The Sheppard Mullin court also noted that “a number of cases followed Goldstein and Jeffry,” including a 2011 case in which a California appeals court noted that “attorneys are not entitled to fees where the ethical violation is ‘one that pervades the whole relationship.’” 198 Cal.Rptr.3d at 273 (citing Fair v. Bakhtiari, 125 Cal.Rptr.3d 765, 776(Cal. App. 2011). The court found that the same principle applied to Sheppard Mullin’s violation:

As in Fair, the conflict here pervaded the entire relationship between Sheppard Mullin and J–M. Even if, as Sheppard Mullin argues, it was not working for [the intervenor] at the time the Agreement was signed, it nonetheless began working for [the intervenor] three weeks later, thereby representing adverse clients without telling either client about the actual conflict. The violation caused Sheppard Mullin to be disqualified from representing J–M in the Qui Tam Action — the very purpose for which J–M had hired it. It is clear, therefore, that Sheppard Mullin’s ethical breach went to the very heart of its relationship with J–M.

198 Cal.Rptr. 3d at 273.

The court, however, declined to engage in any analysis of the gravity of the violation in Fair, which involved an attorney allegedly abusing his position as counsel to gain partial ownership of his client. 125 Cal.Rptr.3d at 778.

To some extent, the court’s reluctance to engage in a detailed analysis of the egregiousness of the violation stands at odds with other California precedent. For example, the appeals court in Pringle v. LaChappelle stated that there was no support for the “proposition that a violation of a rule of professional conduct automatically precludes an attorney from obtaining fees.” 87 Cal.Rptr.2d 90, 94(Cal. App. 1999); see also Sullivan v. Dorsa, 27 Cal.Rptr.3d 547, 561 (Cal. App. 2005) (finding clients failed to show “any violation of the rules governing representation of adverse interest was serious enough to compel a forfeiture of fees”). The appeals court attempted to distinguish this line of cases by suggesting that “none of them involved an actual conflict.” While the distinction is technically accurate, the precedent certainly suggests that courts should consider the egregiousness of the violation in determining whether to deny fees. See also Rest. 3d, Law Governing Lawyers, §37 (listing balancing factors, including “the gravity and timing of the violation, its willfulness, its effect on the value of the lawyer’s work for the client, any other threatened or actual harm to the client, and the adequacy of other remedies”); Rodriguez v. Disner, 688 F.3d 645, 655 (9th Cir. 2012) (“The egregiousness of the violation is often the critical factor.”); Fair, 125 Cal.Rptr.3d at 785, n. 19 (pointing to Restatement factors).

The court also engaged in a somewhat cursory rejection of the firm’s argument that forfeiture and disgorgement should be disallowed where the client suffered no injury from a violation. 198 Cal.Rptr.3d at 619 (“J-M’s actual damages as a result of Sheppard Mullin’s breach are irrelevant.”). At least some courts have suggested that such a remedy should be unavailable when the client is unable to “satisfy the damages element of [a breach of fiduciary duty] claim.” See, e.g., Tethys Bioscience Inc. v. Mintz Levin Cohn Ferris Glovsky & Popeo PC (N.D. Cal. June 4, 2010) (relying on Slovensky v. Friedman, 49 Cal.Rptr.3d 60 (Cal. App. 2006)). The appeals court was swayed, however, by the Fair decision, in which the court found disgorgement appropriate regardless of any proof of damages when a conflict of interest is involved. See Fair, 125 Cal.Rptr.3d at 779. The decision did recognize a potentially important exception based on the timing of when the actual conflict arose. Thus, the court left open the possibility that the firm may be entitled to fees incurred during the three weeks prior to the active adverse engagement on remand. 198 Cal.Rptr.3d at 274. While this nominal amount of fees no doubt provides little solace to a firm that stands to lose millions, it could be an important factor in other cases.

Overall, the Sheppard Mullin decision arguably sets precedent for the automatic disgorgement of all fees incurred while a conflict of interest violation exists. The court was no doubt swayed, in part, by allegations that Sheppard Mullin failed to disclose the adverse representation until the client had reviewed the firm’s opposition to a motion to disqualify. But there is no way to predict whether the decision would have been different if the factual circumstances were arguably more innocuous.

Likewise, law firms can never predict exactly how a court will rule as to the existence of a conflict of interest or the efficacy of a client waiver. In light of this uncertainty, law firms would be wise to go beyond a technical examination of the conflict rules and consider the risks and benefits of potentially adverse representations in general. In this case, Sheppard Mullin risked its lucrative representation of a major client for a little more than a dozen hours of work for a smaller, occasional client. For Sheppard Mullin, the consequences were extreme.

Law360