A prominent law firm, Sheppard, Mullin, Richter & Hampton (Sheppard), failed to inform the world’s largest PVC pipe manufacturer, J-M Manufacturing (J-M), that it had an ongoing relationship with a municipality that was a party to a whistleblower suit the firm was hired to handle. The California Supreme Court held that an engagement agreement (including the arbitration clause) and advance conflict waiver were unenforceable on public policy grounds where there was a concurrent conflict of interest that was known and not disclosed at the time of the engagement. The Court remanded the matter for trial to determine entitlement to the $3.3 million in fees at stake.
In 2006, a qui tam action was filed against J-M. The suit alleged that J-M had misrepresented the strength of PVC pipe it had sold to approximately 200 entities around the country. One of those entities was the City of South Tahoe (Tahoe), which Sheppard had represented since 2002 in employment matters. In 2009 Sheppard and Tahoe entered into another “advance waiver of conflict” agreement for unrelated matters, which professed to permit Sheppard to take a position adverse to Tahoe in litigation. In 2010 J-M asked Sheppard to represent it in the qui tam action. Shepard and J-M entered into an engagement agreement which also included an advance waiver of conflicts such as the one signed by Tahoe in 2009.
At that time, Sheppard did not disclose to J-M its existing representation of Tahoe. Sheppard assumed that Tahoe’s 2009 broad advance waiver agreement was all that was required. Thereafter, Sheppard billed Tahoe for some 12 hours of work in an unrelated matter. But the attorneys representing Tahoe in the qui tam action discovered that Sheppard was also representing J-M, and they confronted Sheppard. Sheppard contended that another advanced waiver from Tahoe was not necessary. In 2011 Tahoe moved to disqualify Sheppard in the qui tam action. Tahoe argued that the advance waiver was ineffective because Tahoe had not given its “informed consent.” The court agreed with Tahoe and Sheppard was disqualified from further representation of J-M.
Prior to its disqualification, Sheppard had billed J-M for more than $3 million in fees, of which approximately $1.3 million remained unpaid. Sheppard sued J-M to recover those fees and J-M countersued for breach of contract, fraudulent inducement and breach of fiduciary duty. Further, J-M sought the return (disgorgement) of the $2 million in fees already paid to Sheppard. Over J-M’s objection, the dispute proceeded to arbitration pursuant to the parties’ engagement agreement. The arbitrators found that Sheppard’s representation of Tahoe involved matters that were unrelated to the qui tam action. They also found the conflict did not cause any damage to J-M, did not prejudice its defense in qui tam action, and did not render Sheppard’s representation less effective or valuable. The trial court confirmed Sheppard’s arbitration award of an addition $1.3 million. J-M appealed.
The California Court of Appeals reversed, finding that the concurrent conflict rendered the engagement agreement unenforceable and the advance waiver was invalid because Sheppard did not obtain “informed consent”. Sheppard had failed to obtain consent from Tahoe before its representation of J-M. Sheppard also failed to obtain consent from J-M, since it never disclosed the firm’s representation of Tahoe in other matters. Therefore, Sheppard was not entitled to any of the legal fees it had incurred during the representation of J-M and was required to disgorge the fees it had already collected from J-M. Sheppard appealed.
The California Supreme Court affirmed the illegality of the fee agreement and advance conflict waiver. The Court held that the agreement was void for violating the conflicts of interest rule which 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.” Sheppard knew of its conflict of interest with Tahoe and did not inform J-M. Further, the advance blanket conflict waiver was not supported by consent that was “informed” within the meaning of the Rules of Professional Conduct. Since the consent was not informed, the entire engagement agreement with J-M was unenforceable.
With regard to Sheppard’s fees, the court found that a “bright line rule of disgorgement of fees” was not appropriate although it did not decide the question of whether or to what extent Sheppard 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.” Sheppard may be able to show its conduct was not willful and the violation of the ethical rule was not so damaging “as to render its legal services of little or no value to the client.”
The Court also held that, where the entire contract was void for illegality, the arbitration provision in the contract was void. Therefore, the case was remanded for a trial on Sheppard’s equitable claims for recovery of fees.
It is imperative that law firms take conflicts into account at the beginning of a matter. A violation of the conflict rules can void the entire agreement. In addition, the attempt to rely upon a blanket advance waiver to take on an otherwise impermissible representation can lead to significant penalties.
For a copy of the complete decision, see: Sheppard, Mullin etc. v. J-M Manufacturing Co., Inc.