Ethics Rules, Conflicts, Waivers and Money

On August 30, the California Supreme Court decided Sheppard, Mullin, Richter & Hampton, LLP v. J-M Manufacturing Company, Inc. (2018) 6 Cal.5th 59. On all issues but one, the Court was unanimous; five justices, however, held that the law firm should be allowed to develop a record that it might be entitled to a quantum meruit fee award; Justice Chen and the Chief Justice disagreed and would have disallowed the firm any fees, including disgorgement of fees already paid.

The Facts

The facts, at least for the ethics analysis, are relatively straightforward. J-M Manufacturing, a defendant in a federal qui tam action numerous public entities brought, was changing counsel. The law firm’s conflict check showed that one of its lawyers represented one of the plaintiff public entities in employment matters, most recently some four months before the firm began representing J-M Manufacturing in the qui tam action. The law firm did not disclose that representation either to the public entity or to J-M Manufacturing. It concluded such disclosure was unnecessary because the public entity had signed, and J-M Manufacturing was about to sign, an engagement agreement with an advance conflict waiver that provided, in effect, because the firm might currently or in the future represent another client with interests adverse to the client signing the waiver, the client waived any such conflict so long as the matters for each client were not the same or substantially related. The firm did further legal work for the public entity client within a few weeks after the firm’s engagement with J-M Manufacturing. A year later, the public entity learned of the dual representation of it and J-M Manufacturing and successfully moved for the law firm’s disqualification to represent JM Manufacturing in the federal action. The fee dispute followed. The law firm was successful in arbitration, which the engagement agreement required, and in the superior court. The Court of Appeal reversed, voided the fee agreement, found the waiver ineffective and held that the firm was entitled to no compensation, requiring disgorgement of fees already paid. The Supreme Court took the case.

The Ethics Violation Voided the Firm’s Engagement Agreement
First, the Court held that the firm’s violation of the Rules of Professional Conduct, rule 3- 310(C), by concurrently representing two clients with adverse interests—although in different matters—without the informed written consent of each client, voided the engagement agreement and its arbitration provision. To reach this conclusion the Court held that the Rules of Professional Conduct constitute the public policy of California, and 2 that an engagement contract that has as its object conduct constituting a violation of the Rules—here representing two clients with conflicting interests—is contrary to public policy and unenforceable. It rejected the firm’s contention only the Legislature can declare the state’s public policy.

The Conflict and the Waiver
Next, the Court addressed the conflict and the waiver in the J-M Manufacturing engagement agreement. The Court held that the firm’s representation of the public entity was ongoing—rejecting the firm’s “framework” agreement argument, under which the relationship would be renewed each time the client had a new assignment for the firm— and that the law firm had agreed to represent, and was representing two current clients with conflicting interests, without the informed written consent of either. That violated rule 3-310(C) and the firm’s duty of loyalty to each client. Because the representations were in separate matters, the firm’s conflicted representation did not involve its duty of confidentiality. The Court also rejected the law firm’s argument J-M Manufacturing had waived both current and future conflicts. Rather, because the law firm had known the conflict, the Court held that the firm had a duty to disclose it to J-M Manufacturing, and could not rely on the general language in its waiver. Further, the Court held that the whole engagement agreement was void and unenforceable as contrary to public policy; hence, the law firm was not entitled to any contractual fee for its services—about 10,000 hours.

No Contractual Fee But Quantum Meruit Possible
The five-Justice majority, however, reversed the Court of Appeal determination that the firm was not entitled to any quantum meruit payment for the services it had rendered, relying on a series of cases in which courts had denied compensation in the face of serious ethical breaches. Rather, the Court held that the rule barring compensation even when serious ethical breaches occur is not categorical and remanded the case to the trial court for the firm, which will have the burden of proof, to be allowed to develop facts to support some equitable recovery. Thus, the Court said, while forfeiture of compensation is often an appropriate response to conflicted representation, quantum meruit recovery is not categorically barred. Further, the Court observed that, although a 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 Concurring, Dissenting Opinion
Justice Chen, joined by the Chief Justice, agreed with the majority on every issue except for the firm’s ability to seek quantum meruit compensation. He based his analysis primarily on one of the Court’s decisions, Huskinson & Brown v. Wolf (2004) 32 Cal.4th 453. He argued that permitting such a recovery here would be contrary to what the violated rule itself seeks to accomplish; rule 3-310’s purpose precludes lawyers from simultaneously representing clients with conflicting interests absent informed written consent. He also argued that quantum meruit recovery here was inconsistent with case 3 law, including that discussed in Huskinson, and that the Legislature had made no policy determination that a quantum meruit recovery was available in these circumstances, as it has, for example, when a lawyer does not comply with Business & Professions Code sections 6147 and 6148. Finally, Justice Chen felt the Court had sufficient facts and law in the record before it to make the determination about quantum meruit recovery, such that remand was unnecessary. The Chief Justice joined in his concurring and dissenting opinion.

Some Observations
What do we learn from the Court’s opinion? First, Rules of Professional Conduct establish California’s public policy, such that a rule violation that affects the very object of the representation is sufficient to void a fee agreement and deprive a lawyer of any contractual fee. Second, while the Court expressly stated it was not addressing all advance conflict waivers, it made clear that when lawyers know of conflicts at the time the client is executing an advance conflict waiver, the lawyer has the obligation to make specific disclosure of the other representation, the language in the fee agreement notwithstanding. Third, the Court reaffirmed established law that concurrent representation of clients with conflicted interests, even though the matters may be separate, violates both rule 3-310 and the duty of loyalty. Had the matters been the same or substantially related, the duty of confidentiality would have been implicated as well. Fourth, while a lawyer may be entitled to some quantum meruit compensation, the lawyer will have to address the factors the Court set forth and face the arguments in Justice Chen’s dissent that the lawyer’s conduct precludes any such recovery. Fifth, the district court, in disqualifying the law firm and rejecting its waiver arguments in the underlying qui tam action, also focused on the firm’s lack of transparency and its failure to give J-M Manufacturing all the known facts when it presented the fee agreement with the advance conflicts waiver. Finally, the opinions of the Supreme Court, the Court of Appeal and the district court in the underlying qui tam action underscore a lawyer’s obligation of complete transparency to a client in relation to conflicts of interest. How that transparency mandate may apply to the new conflict of interest rule, rule 1.7, that becomes effective November 1, will be the subject of a future Ethics in Brief or other ethics article.

Edward J. McIntyre is an attorney at law.

**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.**