Ethics in Brief

Ethics in Brief is designed to present ethical issues that practitioners might well face on a daily basis. It is a service of the Legal Ethics Committee of the San Diego County Bar Association.

Successive Representation and Closely Held Corporations: Normal Disqualification Rule Doesn’t Apply. 

Your client Bob is a successful entrepreneur who founded, and now is the sole manager of, several related businesses — we'll call them Company A, B and C (the "Companies"). Your firm helped him set up the Companies, all closely held corporations, and helped him negotiate with some investors when he brought them in as shareholders. You've assisted him from time to time since then as various minor disputes cropped up between the Companies and their vendors or employees.

Last month Bob came to you with a new problem. A shareholder in Company C — Sam — is claiming that Bob has been breaching his duties to the shareholders of Company C, because (Sam claims) Bob is diverting resources from Company C to Companies A and B. You assisted Bob in responding to Sam's letters threatening litigation and requesting information on Bob's and Company C's behalf.           

Now Sam has filed a shareholder derivative action against Bob. Bob asked you to represent him, and you filed an answer on his behalf. You don't represent Company C. Now, however, Sam has threatened to bring a disqualification motion against you unless you withdraw. He claims that you can't represent Bob because you represented Company C in relation to Sam's letters, and now that there is a derivative lawsuit pending (which technically pits Company C against Bob), you can't represent Bob because the matters are substantially related. In short, he claims you have a successive representation problem.

Should you withdraw?

At first blush, it looks like Sam has a point. The Rules of Professional Conduct prohibit an attorney from accepting "employment adverse to the client or former client where, by reason of the representation of the client or former client, the member has obtained confidential information material to the employment." Rule 3-310(E). Case law makes clear that where a former client shows a "substantial relationship" between the subjects of the former and current representations, it is presumed the attorney obtained confidential information during the prior representation that is material to the current matter. In such cases, disqualification is mandatory.

Here, there is no dispute that you did, in fact, represent Company C in relation to Sam's letter. There also can be no dispute that there is a substantial relationship between the letter and the current litigation. It seems like disqualification would be automatic.

But a different rule applies for closely held corporations. In Beachcomber Management Crystal Cove, LLC v. Douglas L. Salisbury, the Fourth District explained that in shareholder derivative lawsuits involving closely held corporations, "[s]uccessive representation rules ... generally do not prevent an attorney from continuing to represent the insiders in a derivative lawsuit even though a substantial relationship exists between the attorney's previous representation of the company and the attorney's current representation of the insiders in the company's lawsuit against them." "This separate rule for derivative lawsuits derives from a recognition that the insiders are the true sources and possessors of a closely held company's confidential information."

When you represented Company C and Bob in relation to Sam's letters, all of your information came from Bob, who you now represent. Indeed, all of the relevant information for Company C could only come from Bob, because he's the sole manager. As the Fourth District pointed out, "As the repositories and source of the company's confidential information, the insiders would be able to provide their new attorney with the same information their previous attorney had, and therefore disqualifying the original attorney would be a futile act that merely generates attorney fees as the new attorney gets up to speed."

Thus, you can probably feel comfortable that a disqualification motion will not be successful. However, be aware that despite the case law supporting counsel's continued representation of the insider, the trial court in Beachcomber disqualified the insider's counsel and had to be reversed by the Court of Appeal.

Moreover, the same rule may not hold true for larger corporations. Thus, if there could be any question on whether the corporation qualifies as "small," or whether there are sources of confidential information that don't involve the alleged insiders, proceed with caution.

Discussing Beachcomber Mgmt. Crystal Cove, LLC v. Superior Court, No. G054078, 2017 Cal. App. LEXIS 664, at *1 (Ct. App. June 28, 2017).

-- Leah Strickland

**No portion of this summary is intended to constitute legal advice. Be sure to perform independent research and analysis. Any views expressed are those of the author only and not of the SDCBA or its Legal Ethics Committee.**