Calif. Supreme Court Breaks New Ground on Arbitrability, Future Waivers and Quantum Meruit

HIGHLIGHTS:

• In Sheppard, Mullin, Richter & Hampton, LLP v. J-M Manufacturing Company, Inc., the Supreme Court of California held that an attorney-client engagement agreement that is arguably tainted by an unwaived or inadequately waived conflict of interest is not subject to arbitration and must be litigated in court.
• The court also held that in order to be effective, a future conflicts waiver must expressly address any presently existing conflicts.
• In addition, the court said that the existence of an unwaived or inadequately waived conflict of interest does not necessarily require full fee disgorgement. The firm may still be entitled to quantum meruit recovery.

After J-M Manufacturing Co. (J-M) parted company with prior counsel, it hired the Sheppard Mullin firm to defend it in federal qui tam litigation brought on behalf of a number of entities. After the firm had done an extraordinarily large amount of work for J-M in the qui tam litigation, Sheppard Mullin was disqualified as a result of a motion filed by a small defendant in that litigation from whom Sheppard Mullin believed it had obtained an enforceable future conflicts waiver.

Over J-M's objection, the resulting fee dispute between J-M and Sheppard Mullin was initially sent to arbitration in accordance with the arbitration provision in the engagement agreement between the two parties. After a panel of three arbitrators held unanimously that Sheppard Mullin was entitled to collect its full fee and that J-M was not entitled to any offset or fee disgorgement, J-M sought judicial relief. In Sheppard, Mullin, Richter & Hampton, LLP v. J-M Manufacturing Company, Inc., 2018 WL 4137013 (Cal. Sup. Ct. Aug. 30, 2018)¹, the Supreme Court of California accepted review after the California Court of Appeal held that the conflict of interest claim rendered the arbitration provision unenforceable and that the conflict of interest found by the Appeals Court required full fee disgorgement.

Arbitrability

The California Supreme Court first addressed the question whether the arbitration provision was enforceable notwithstanding the arguably contrary public policy regarding attorney conflicts of interest reflected in the California Rules of Professional Conduct (RPC). The court found no difference for this purpose between public policy as reflected in statutes and public policy as reflected in the court's own rules. The court then went on to hold that the conflict of interest charge went to the entirety of the engagement agreement between J-M and Sheppard Mullin. In the court's view, this was sufficient to distinguish the present case from partial illegality situations in which arbitrability would be upheld. Examples of situations given by the court where arbitrability would be upheld in spite of claims of partial illegality included disputes over engagement agreements that allegedly contain an impermissible fee-splitting provision and engagement agreements that call for services to be provided by non-California lawyers outside of California (for which the firm can collect) and within California (for which the firm cannot collect).

It remains, of course, to be seen how future cases and courts will draw the line between partial versus full illegality in California. Nonetheless, the right or ability of a law firm or a client to rely upon the enforceability of a California arbitration provision has plainly been reduced.

Future Conflicts Waivers

Consistent with holdings throughout the country and with Comment [9] to the new California RPC 1.7, which takes effect on Nov. 1, 2018, the court did not dispute that future conflicts waivers could be legally effective if the conflict was one that could be waived and if the waiver was based on informed consent. The court held, however, that because it found that Sheppard Mullin had had a current client relationship with the small qui tam plaintiff when it undertook representing J-M, and because Sheppard Mullin had not expressly disclosed that conflict to J-M as a part of obtaining the company's informed consent, Sheppard Mullin could not rely upon J-M's waiver.

One can certainly say that it is preferable to make express reference to present representations that can be said to give rise to conflicts rather than stating, as Sheppard Mullin did, that it may then or in the future represent one or more of the qui tam plaintiffs. Nonetheless, one can also ask how much detail is required for an effective conflicts waiver where, among other things, J-M was a sophisticated client who had the conflicts waiver provision reviewed by counsel who claimed a great deal of knowledge about conflict of interest issues.

Quantum Meruit Recovery

Over a strongly worded partial dissent, the majority held that its opinion that a conflict of interest existed did not require that Sheppard Mullin be denied recovery of any and all legal fees. The court stated that because the trial court had not fully developed the record below, it would remand the case to the trial court to consider the extent to which fee disgorgement was warranted as an equitable remedy. On remand, the trial court was directed to consider, inter alia, the egregiousness or willfulness of Sheppard Mullin's conduct, the fact that Sheppard Mullin had sought to obtain a waiver (even though the court held that it fell short), the fact that Sheppard Mullin never represented a client adversely to J-M, and the value of the work to J-M. As the court noted, however, J-M was not required to prove actual harm in order to pursue a disgorgement claim.

There is no doubt but that when ruling on a claim or motion for fee disgorgement, a court of equity can and should consider all traditional equitable aspects. The majority holding is thus on far more solid ground than the partial dissent which would have used the existence of the conflict to require 100 percent disgorgement. A failure to allow any recovery or retention of fees received as an automatic or virtually automatic result of a conflict of interest provides a windfall to clients and may promote baseless demands for disgorgement. Full disgorgement can also punish a firm severely since, among other things, disgorgement is typically based on the firm's total gross receipts and not on its profits.

Notes

¹ Holland & Knight and one of the authors of this alert filed an amicus brief in this case supporting Sheppard Mullin's positions.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.