On The Case

California justices to law firms: If you have a conflict, tell your client. Or risk your fees

(Reuters) - If you’re a big law firm, the good news from Thursday’s hotly-anticipated ruling from the California Supreme Court in Sheppard, Mullin, Richter & Hampton v. J-M Manufacturing is that the state justices did not hold advance conflict waivers to be categorically unenforceable. These waivers, as you know, have become a mainstay of the practice at big firms whose client base sprawls across practice areas and time zones. The Sheppard Mullin case could have spelled an end to the waivers, which is why more than two dozen big firms appeared as amici, asking the state high court not to prohibit engagement agreements in which clients assent, in advance, to conflict waivers.

The Supreme Court, in an opinion by Justice Leondra Kruger, stopped well short of banning advance conflict waivers. The justice found that at the time J-M hired Sheppard Mullin to defend the pipe maker in a qui tam action back in 2010, the law firm was already representing one of the qui tam plaintiffs, the South Tahoe Public Utility District, in unrelated employment matters. Sheppard Mullin did not tell J-M about its relationship with South Tahoe, which subsequently got the firm bounced from the qui tam case.

That failure to disclose, the California Supreme Court said, made J-M’s advance client waiver unenforceable. “The agreement itself is contrary to the public policy of the state,” the Supreme Court said. “The transaction was entered under terms that undermined an ethical rule designed for the protection of the client as well as for the preservation of public confidence in the legal profession. The contract is for that reason unenforceable.”

But the circumstances of the case also meant that it was not the right vehicle to decide whether advance conflict waivers are, as a rule, impermissible, the justices said. As they noted, several federal trial courts have held that blanket advance waivers are unenforceable under California law. Those rulings contrast with a 2013 ruling by U.S. District Judge Ed Kinkeade of Dallas, who held in Galderma Laboratories v. Actavis that Vinson & Elkins’ blanket advance waiver constituted informed consent from a sophisticated client represented by in-house counsel. The Sheppard Mullin case, the California Supreme Court said, did not present the same factual scenario.

“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 like the one at issue in Galderma would be permissible,” the court said. “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.”

That’s a key sentence from the court’s ruling, and it’s why law firms should read the opinion as a warning, not as an all-clear signal. The state justices do not regard advance conflict waivers as a magic wand that will eliminate firms’ ethical duties to clear conflicts with their clients. If there’s a chance you have a conflict, the court said, you’d better tell your prospective client – even if the client is a big corporation with its own lawyers – or else risk losing your fees.

Fee forfeiture isn’t automatic, the state justices said. Sheppard Mullin doesn’t have a right to contractual fees, the court said, because its disclosure failure voided its engagement agreement with J-M. The firm may be entitled to some of the more than $3 million it claims it is due for its work on behalf of J-M under the equitable doctrine of quantum meruit. But the burden is now on Sheppard Mullin to prove it’s owed anything. The Supreme Court ordered a remand hearing in Superior Court to determine a fair fee for the firm. (An arbitration panel previously ruled Sheppard Mullin was due a total of about $3 million, of which J-M had already paid about $2 million; because arbitration was part of the now voided contract, the quantum meruit case will be heard in court.)

J-M intends to argue on remand that Sheppard Mullin should pay back some or all of the money J-M already paid its onetime lawyers, according to J-M counsel Kent Richland of Greines, Martin, Stein & Richland, who said his client was “really pleased its position was validated,” if a little disappointed that the Supreme Court majority did not adopt the dissenting view of Justice Ming Chin, who argued Sheppard Mullin isn’t entitled to any fees at all because it broke an ethical rule.

“The court doesn’t want to incentivize law firms to take a chance,” Richland said. “The opinion makes clear that in order to uphold the concerns behind the ethical rules, law firms can’t make a profit when they don’t disclosure a conflict.”

Sheppard Mullin sent an email statement via its lead lawyer, Kevin Rosen of Gibson, Dunn & Crutcher. “Sheppard Mullin previously established before a panel of three distinguished arbitrators and the trial court that the firm acted in good faith at all times, and we anticipate a similar outcome upon remand,” the statement said. “Indeed, J-M stipulated that it had no issues with ‘the value or quality of Sheppard Mullin’s work.’ As such, we fully expect that the undisputed quality and value of Sheppard Mullin’s work, based on effective and laudable advocacy for J-M in the qui tam action, will be confirmed once again.”

At least one California general counsel believes the Supreme Court’s J-M decision didn’t do enough to recalibrate the balance of power between big firms and their clients. Matt Fawcett, GC at the cloud computing company NetApp, said in a blog post last year that he was disappointed to find many of his company’s outside counsel among the Sheppard Mullen amici urging the state justices to bless advance conflict waivers. (Fawcett described the law firms’ amicus briefs as “an aggressive attempt by Biglaw to prioritize its own bottom line over the interests of its clients.”) After Thursday’s ruling, Fawcett said in an email that the Supreme Court seemed to have taken the course of least resistance to big law firms.

“The one finding the court made that was in any way favorable to the client was that the firm should disclose current conflicts at the time of engagement, even to sophisticated purchases on legal services,” Fawcett said. “But that is not new - and apparently the only consequence of not doing so would be that the fee agreement would be rendered invalid, but still the firm could recover the ‘reasonable value of its services’ by suing under doctrines of equity.”