Could Your Law Firm Forfeit Its Fees Due to an Undisclosed Conflict?

The Facts

J-M Manufacturing Co. retained Sheppard, Mullin, Richter & Hampton, LLP, to represent the company in a federal qui tam action involving several public entity intervenors, including the South Tahoe Public Utility District. Prior to being retained, Sheppard Mullin ran a conflict check and discovered that another Sheppard Mullin attorney did a small amount of employment counseling for South Tahoe. Sheppard Mullin’s retainer agreements with J-M and South Tahoe contained a blanket waiver of all current and future conflicts. As a result, Sheppard Mullin concluded it could concurrently represent both clients and, as it will later regret, did not disclose the conflict to either J-M or South Tahoe. After Sheppard Mullin had performed 10,000 hours of work for J-M in the qui tam action, South Tahoe discovered the conflict and successfully moved to disqualify Sheppard Mullin. During that same time, Sheppard Mullin performed 12 hours of unrelated employment counseling for South Tahoe.

After the disqualification, Sheppard Mullin sued J-M for $1.2 million in unpaid legal fees. J-M countersued, seeking disgorgement of nearly $2 million in fees it had already paid. Sheppard Mullin petitioned to compel arbitration, and the arbitrator found in Sheppard Mullin’s favor. The superior court confirmed the award. J-M appealed, and an intermediate appellate court reversed, finding the undisclosed conflict required the arbitration award to be vacated, and further required Sheppard Mullin to disgorge roughly $2 million in fees. Sheppard Mullin appealed to the California Supreme Court.

Lesson No. 1: Ethical Violations May Render an Entire Attorney Retainer Agreement Unenforceable, Including an Arbitration Provision

The California Supreme Court agreed with the lower appellate court holding that the undisclosed conflict of interest rendered the entire fee agreement, including the arbitration provision, illegal and unenforceable. The court reaffirmed prior precedent holding that a contract or transaction with attorneys may be declared unenforceable for violating the California Rules of Professional Conduct. The determination of whether the entire agreement is an unenforceable illegal contract rests with the court and not the arbitrator.

The court ultimately concluded Sheppard Mullin’s concurrent representation of J-M and South Tahoe rendered the entire fee agreement between Sheppard Mullin and J-M unenforceable. In reaching this decision, the court put great emphasis on the fact that Sheppard Mullin knew of, but did not disclose, the conflict before it started representing J-M. The court, stating the obvious, held that

[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. . . . An attorney or law firm that knowingly withholds material information about a conflict has not earned the confidence and trust the rule is designed to protect.

Applying this standard, the court held that the conflict waiver was inadequate. While it put J-M on notice that there might be a conflict, Sheppard Mullin did not advise J-M that a conflict actually existed and thus did not disclose all the relevant circumstances within its knowledge.

The court further rejected Sheppard Mullin’s argument that its blanket waiver was sufficient because J-M was a sophisticated purchaser of legal services, stating: “Whether the client is an individual or a multinational corporation with a large law department, the duty of loyalty demands an attorney or law firm provide the client all material information in the attorney or firm’s possession.” The court also rejected the notion that clients should have to investigate their attorneys, holding: “Simply put, withholding information about a known, existing conflict is not consistent with informed consent.” The court, however, stopped short of holding that blanket conflict waivers are per se invalid, 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.”

Finally, Sheppard Mullin also argued that even if it violated the conflict-of-interest rules, such a violation would not render the entire retainer agreement void because the agreement encompassed other matters. The court disagreed, finding the object of the agreement was representation in the qui tam action and, therefore, the entire transaction was entered into under terms that undermined an ethical rule designed to protect clients, as well as public confidence in the legal profession.

The court nevertheless cautioned not to read its holding too broadly: “[N]or do we today hold[] that an attorney-services contract may be declared illegal in its entirety simply because it contains a provision that conflicts with an attorney’s obligations under the Rules of Professional Conduct.”

The opinion leaves many questions unanswered. It is unclear, for example, how the results would have been different if Sheppard Mullin discovered the conflict immediately after J‑M signed the retainer agreement. Would it have mattered if Sheppard Mullin performed 1,000 hours of work before discovering the conflict but kept working without disclosing the conflict to its clients? What if Sheppard Mullin never did the conflict check and thus could argue it did not have actual knowledge of the conflict? What if Sheppard Mullin missed the conflict through an honest mistake or simple negligence? Time will tell how future courts will answer these and many other open questions.

Lesson No. 2: A Conflicted Law Firm May Forfeit Its Fees—Or It May Not

In the last portion of its analysis, the court addressed the $3 million question: Was Sheppard Mullin entitled to any compensation for the 10,000 hours it worked in the qui tam case, or would it have to forgo its fees and disgorge the $2 million it had already received? The lower appellate court ordered forfeiture and disgorgement. But the California Supreme Court punted, finding the question was not “ripe for our resolution.”

The court refused to find the ethical violation categorically disentitled Sheppard Mullin from recovering the value of services rendered to J-M. Instead, the court left open the possibility Sheppard Mullin could recover under a quantum meruit theory. The court found Sheppard Mullin could potentially show its conduct was not willful and its departure from the ethical rules was not so severe or harmful that its legal services had no value to J-M. Sheppard Mullin may attempt to show the value of its 10,000 hours of work despite the harm done to J-M and “to the relationship of trust between attorney and client.” The trial court must then exercise its discretion to fashion a remedy as equity warrants, while preserving attorneys’ incentive to scrupulously adhere to the Rules of Professional Conduct.

In asserting a quantum meruit claim, the law firm has the burden. Relevant considerations include the gravity and timing of the ethical violation, its willfulness, its effect on the value of a lawyer’s work for the client, any other threatened or actual harm to the client, and the adequacy of other remedies. And, before awarding compensation, courts must be satisfied the award does not undermine incentives for complying with the Rules of Professional Conduct. For this reason, the court held, absent exceptional circumstances (not guidance on what this may include), the agreed-upon hourly rates should not be the measure of value in quantum meruit. “Although the law firm may be entitled to some compensation for its work, its ethical breach will ordinarily require it to relinquish some or all of the profits for which it negotiated.”

The court concluded its opinion by emphasizing that by leaving open the possibility of quantum meruit recovery, it “in no way condone[s] the practice of failing to inform a client of a known, existing conflict of interest before asking the client to sign a blanket conflicts waiver.”

It remains to be seen how future courts will handle the quantum meruit analysis, particularly where, as here, the consequences of denying compensation would be severe. Nevertheless, the opinion exposes firms to a substantial risk in the event of an undisclosed conflict or other violation of the Rules of Professional Conduct. At the very least, firms should expect an uptick in disgorgement claims, fee disputes, and challenges to arbitration provisions.

Michael S. LeBoff, P.C., is a partner at Klein & Wilson in Newport Beach, California.

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