California Supreme Court Rules Law Firm’s Fee Arbitration Clause With Its Client Unenforceable

The Supreme Court of California (“California Supreme Court”), in its opinion filed on August 30, 2018, decided a case in which a large law firm agreed to represent a manufacturing company in a federal qui tam action brought on behalf of a number of public entities. During the same time period, the same law firm represented one of these public entities in matters unrelated to the qui tam suit. Both clients had executed engagement agreements that purported to waive all such conflicts of interest, current or future, but the agreements did not specifically refer to any conflict and the law firm did not tell either client about its representation of the other. This arrangement fell apart when the public entity discovered the conflict and successfully moved to have the law firm disqualified in the qui tam action. A fight over the manufacturer’s outstanding law firm bills followed, and the dispute was sent to arbitration in accordance with an arbitration clause in the parties’ engagement agreement.

The engagement agreement’s arbitration clause provided that any dispute over fees or charges that was not resolved through voluntary arbitration under the auspices of the California State Bar, and any other type of dispute between the parties, would be settled by “mandatory binding arbitration” conducted in accordance with the California Arbitration Act (CAA; Code Civ. Proc., § 1282 et seq.). The arbitration clause also stated the agreement would be governed by California law.

The arbitrators ruled in the law firm’s favor and the superior court confirmed the award, but the Court of Appeal reversed. That court concluded that the matter should never have been arbitrated because, notwithstanding the broad conflict waiver in the engagement agreement, the law firm’s undisclosed conflict of interest violated rule 3-310(C)(3) of the Rules of Professional Conduct (i.e., an attorney “shall not, without the informed written consent of each client . . . [¶] . . . [¶] . . . [r]epresent 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.”). This ethical violation, the court ruled, rendered the parties’ agreement, including the arbitration clause, unenforceable in its entirety. The Court of Appeal further held that the conflict of interest disentitled the law firm from receiving any compensation for the work it performed for the manufacturer while also representing the utility district in other matters.

The California Supreme Court held: “We agree with the Court of Appeal that, under the framework established in Loving & Evans v. Blick (1949) 33 Cal.2d 603, the law firm’s conflict of interest rendered the agreement with the manufacturer, including its arbitration clause, unenforceable as against public policy. Although the manufacturer signed a conflicts waiver, the waiver was not effective because the law firm failed to disclose a known conflict with a current client. But we conclude, contrary to the Court of Appeal, that the ethical violation does not categorically disentitle the law firm from recovering the value of the services it rendered to the manufacturer; whether principles of equity entitle the law firm to some measure of compensation is a matter for the trial court to address in the first instance.”

In Loving & Evans v. Blick, the California Supreme Court had held that the excess-of-authority exception applies, and an arbitral award must be vacated, when a court determines that the arbitration has been undertaken to enforce a contract that is “illegal and against the public policy of the state.” In the present case, the California Supreme Court held that “an attorney contract that has as its object conduct constituting a violation of the Rules of Professional Conduct is contrary to the public policy of this state and is therefore unenforceable” (“California law holds that a contract may be held invalid and unenforceable on public policy grounds even though the public policy is not enshrined in a legislative enactment” – “violation of a Rule of Professional Conduct in the formation of a contract can render the contract unenforceable as against public policy”).

The California Supreme Court stated in the present case: “We conclude that Sheppard Mullin’s concurrent representation of J-M and South Tahoe violated rule 3-310(C)(3) and rendered the engagement agreement between Sheppard Mullin and J-M unenforceable. Our conclusion rests on three subsidiary points: First, at the time Sheppard Mullin agreed to represent J-M in the qui tam action, the law firm also represented a client with conflicting interests, South Tahoe; second, because Sheppard Mullin knew of that conflicting interest and failed to inform J-M of it, J-M’s consent was not “informed” within the meaning of the Rules of Professional Conduct; and third, Sheppard Mullin’s unconsented-to conflict of interest affected the whole of its engagement agreement with J-M, rendering it unenforceable in its entirety.”

The California Supreme Court further stated that “[a]n 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.” In the case it was deciding, the California Supreme Court stated: “Assessed by this standard, the conflicts waiver here was inadequate. By asking J-M to waive current conflicts as well as future ones, Sheppard Mullin did put J-M on notice that a current conflict might exist. But by failing to disclose to J-M the fact that a current conflict actually existed, the law firm failed to disclose to its client all the “relevant circumstances” within its knowledge relating to its representation of J-M. (Rules Prof. Conduct, rule 3-310(A)(1).)”

The California Supreme Court went on to state: “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. No matter how large and sophisticated, a prospective client does not have access to a law firm’s list of other clients, and cannot check for itself whether the firm represents adverse parties. Nor can it evaluate for itself the risk that it may be deprived, via motion for disqualification, of its counsel of choice, as happened here. In any event, clients should not have to investigate their attorneys. Simply put, withholding available information about a known, existing conflict is not consistent with informed consent … We conclude, rather, that without full disclosure of existing conflicts known to the attorney, the client’s consent is not informed for purposes of our ethics rules. Sheppard Mullin failed to make such full disclosure here.”

The California Supreme Court held: “Because Sheppard Mullin’s ethical breach renders the engagement agreement unenforceable in its entirety, the rule of Loving & Evans means that Sheppard Mullin is not entitled to the benefit of the arbitrators’ decision awarding it unpaid contractual fees. The final question before us is whether Sheppard Mullin may receive any compensation for its services at all …  contrary to the Court of Appeal, [ ] California law does not establish a bright-line rule barring all compensation for services performed subject to an improperly waived conflict of interest, no matter the circumstances surrounding the violation.”

The California Supreme Court continued: “When a law firm seeks compensation in quantum meruit for legal services performed under the cloud of an unwaived (or improperly waived) conflict, the firm may, in some circumstances, be able to show that the conduct was not willful, and its departure from ethical rules was not so severe or harmful as to render its legal services of little or no value to the client. Where some value remains, the attorney or law firm may attempt to show what that value is in light of the harm done to the client and to the relationship of trust between attorney and client. Apprised of these facts, the trial court must then exercise its discretion to fashion a remedy that awards the attorney as much, or as little, as equity warrants, while preserving incentives to scrupulously adhere to the Rules of Professional Conduct … When a law firm seeks fees in quantum meruit that it is unable to recover under the contract because it has breached an ethical duty to its client, the burden of proof on these or other factors lies with the firm. To be entitled to a measure of recovery, the firm must show that the violation was neither willful nor egregious, and it must show that its conduct was not so potentially damaging to the client as to warrant a complete denial of compensation. And before the trial court may award compensation, it must be satisfied that the award does not undermine incentives for compliance with the Rules of Professional Conduct. For this reason, at least absent exceptional circumstances, the contractual fee will not serve as an appropriate measure of quantum meruit recovery … 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 … By leaving open the possibility of quantum meruit compensation for the 10,000 hours that Sheppard Mullin worked on J-M’s behalf, we in no way condone 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. Trust and confidence are central to the attorney-client relationship, and maintaining them requires an ethical attorney to display all possible candor in his or her disclosure of circumstances that may affect the client’s interests. Sheppard Mullin’s failure to exhibit the necessary candor in this case has rendered its contract with J-M unenforceable and has thus disentitled it to the benefit of the unpaid contract fees awarded by the arbitrators in this case. Whether Sheppard Mullin is nevertheless entitled to a measure of compensation for its work is, along with the other unresolved noncontract issues raised by the pleadings, a matter for the trial court to consider in the first instance.”

Source Sheppard, Mullin, Richter & Hamilton, LLP v. J-M Manufacturing Company, Inc., S232946.

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