by Paul A. Stewart

The California Supreme Court does not often address questions of legal ethics in its opinions, but it spoke loudly on the subject in the very recent case of Sheppard, Mullin, Richter & Hampton, LLP v. J-M Mfg. Co., Inc., 6 Cal. 5th 59 (2018). The Sheppard decision announced a number of important holdings relating to conflicts of interest and waivers of those conflicts, whether or not a representation has terminated, attorney engagement agreements, and attorney-client arbitration agreements.

First, an engagement agreement entered by a law firm with a conflict of interest is void, at least with respect to the matter for which the conflict exists. Accordingly, the conflicted law firm cannot enforce an arbitration clause or fee provisions in the engagement agreement. Second, a blanket advance waiver of conflicts of interest granted by a client in an engagement agreement is ineffective if the law firm is aware of an actual conflict at the time it seeks the advance waiver and the law firm fails to disclose the actual conflict to the client. Third, a conflicted lawyer with no enforceable engagement agreement may be able to recover some, but not all, of its fees by pursuing an equitable quantum meruit claim.

Some background on the facts underlying the Sheppard case is helpful in placing these holdings in context. In 2006, an action was filed in federal court against J-M Manufacturing, alleging that J-M had misrepresented the strength of pipes it had sold to approximately 200 public entities for use in their water and sewer systems. Id. at 68. The complaint sought to recover $1,000,000,000 from J-M. Id. at 97. In early 2010, many of the public entities intervened in the case, including the South Tahoe Public Utility District, which effectively became a plaintiff in the action against J-M. Id. at 69.

Shortly thereafter, in February 2010, J-M interviewed the law firm of Sheppard, Mullin, Richter & Hampton to replace its defense counsel. Id. Sheppard Mullin ran a conflict check and learned that it had represented South Tahoe in employment matters on and off since 2002, and most recently in November 2009. Sheppard Mullin concluded, however, that it was free to take on the matter for J-M because South Tahoe had signed an advance waiver of conflicts for matters unrelated to the employment matters that Sheppard Mullin had been handling. Id.

In early March 2010, Sheppard Mullin and J-M signed an engagement agreement. This agreement, too, contained an advance waiver provision that stated that Sheppard Mullin may “currently or in the future” represent other clients adverse to J-M. Id. Sheppard Mullin, however, did not inform J-M of its unrelated representation of South Tahoe, which was an adverse party to J-M in the J-M litigation. Id. The engagement agreement also included an arbitration clause, requiring the parties to submit any disputes to binding, mandatory arbitration. Id. Less than a month after Sheppard Mullin signed the engagement agreement with J-M, a Sheppard Mullin attorney took on a new matter for South Tahoe. Sheppard Mullin billed a total of twelve hours to that matter. Id.

Different Sheppard Mullin attorneys worked on the J-M matter. They billed approximately 10,000 hours to the matter, charging over $3,000,000. Id. at 70. When South Tahoe realized that its employment counsel was adverse to it in the J-M litigation, South Tahoe moved to disqualify Sheppard Mullin from the case. The federal court granted that motion. The court held that Sheppard Mullin’s simultaneous representation of South Tahoe and its adversary, J-M, had been undertaken without adequately informed waivers and thus violated Rule 3-310(C)(3) of the California Rules of Professional Conduct. Id. at 69-70.

Sheppard Mullin then filed suit in state court against J-M for unpaid legal fees, which totaled approximately $1,000,000. Id. at 70. J-M counterclaimed for disgorgement of all previously paid fees, among other things. Id. Over South Tahoe’s objection, the court referred the matter to arbitration, pursuant to the arbitration provision in the engagement agreement. The arbitrators ruled in favor of Sheppard Mullin, awarding the law firm $1,300,000 in fees and interest. The arbitrators concluded that any ethical violation by Sheppard Mullin was not sufficiently egregious to warrant forfeiture of fees or disgorgement. Id.

The trial court confirmed the award, concluding that any violation of the Rules of Professional Conduct did not render the engagement agreement unenforceable. Id. The court of appeal then reversed. The court held that Sheppard Mullin’s simultaneous representation of South Tahoe and J-M was a conflict of interest, and that this conflict voided the engagement agreement in its entirety. The court further held that Sheppard Mullin was not entitled to any compensation for its conflicted representation, and remanded for a calculation of how much money Sheppard Mullin would be required to refund to J-M. Id.

The California Supreme Court granted review. The threshold issue faced by the Supreme Court was whether the court of appeal should have reviewed the substance of the arbitrators’ award at all. Under the California Arbitration Act, an arbitrator’s decision “is ordinarily final and thus is not ordinarily reviewable for error by either the trial or appellate courts.” Id. at 60. However, an exception exists for contracts that are “illegal and against the public policy of the state.” Id. Thus, the threshold question of whether the arbitrators’ award was reviewable merged with the ultimate question of whether Sheppard Mullin’s engagement agreement was unenforceable for violating public policy.

The Supreme Court began its analysis by rejecting Sheppard Mullin’s argument that only those agreements that violate public policies enacted by the legislature may be held unenforceable. The Supreme Court had previously held in Chambers v. Kay, 29 Cal. 4th 142 (2002), that a fee-splitting agreement between attorneys was unenforceable in its entirety because it violated the California Rules of Professional Conduct, which are not adopted by the legislature. Accordingly, the court held, “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.” Sheppard, 6 Cal. 5th at 74. “It would be absurd,” the court added, “for a court to aid an attorney in enforcing a transaction prohibited by the rules.” Id.

The court then turned to whether Sheppard Mullin’s engagement agreement with J-M violated the Rules of Professional Conduct and, therefore, violated public policy. The court noted that “without informed written consent, an attorney (and his or her firm) cannot simultaneously represent a client in one matter while representing another party suing that same client in another matter.” Id. at 63. Any such representation would violate Rule 3-310(C)(3). Id. Sheppard Mullin agreed that its concurrent representation of J-M and South Tahoe fell within the scope of Rule 3-310(C)(3). Id. Thus, the engagement agreement violated this Rule unless Sheppard Mullin obtained the informed written consent of both J-M and South Tahoe.

Sheppard Mullin relied on the advance waiver of conflicts that J-M had signed as part of its engagement agreement. The Supreme Court expressly chose not to decide the broad and important question of whether an advance waiver of this type is ever adequate to obtain a client’s informed consent. Id. at 83. Instead, the court held that such a waiver is necessarily ineffective when the law firm knows of an existing conflict of interest, but fails to disclose that conflict before obtaining the advance waiver. To be effective, “the client’s consent to dual representation must be based on disclosure of all material facts the attorney knows and can reveal.” Id. at 84. “Simply put, withholding available information about a known, existing conflict is not consistent with informed consent.” Id. at 86.

Here, the court held, Sheppard Mullin knew of its representation of South Tahoe and the existing conflict when Sheppard Mullin and J-M signed the engagement agreement. Id. at 83. Sheppard Mullin argued that no actual conflict existed when J-M signed its engagement agreement because South Tahoe was merely a former client at that time. The court, however, rejected this argument. Id. at 83-84. The South Tahoe engagement agreement provided that the attorney-client relationship endures “so long as Sheppard Mullin continued to work on ‘the Matter,’ which was defined in the agreement as ‘general employment matters.’” Id. at 83. Thus, the attorney-client relationship would not end until Sheppard Mullin ceased all work for South Tahoe on its employment matters. Moreover, the court held, Sheppard Mullin had performed employment work for South Tahoe on and off from 2002 through November 2009, and again starting in late March 2010. This pattern of conduct, the court held, established that the parties had an ongoing, continuous attorney-client relationship that existed when J-M signed its engagement agreement in early March 2010. Id.

Consequently, Sheppard Mullin had an actual, undisclosed conflict at the time it entered into the engagement agreement with J-M, and therefore could not rely upon the advance waiver to avoid the conflict. As a result, the engagement agreement with J-M violated the public policy expressed in the Rules of Professional Conduct, and was unenforceable. Accordingly, the arbitration proceedings were a nullity because no enforceable agreement authorized any arbitration with J-M. And Sheppard Mullin had no right to collect any fees under the engagement agreement because, again, that agreement was unenforceable.

The final issue before the court was whether Sheppard Mullin was entitled to pursue an equitable claim to recover a portion of its fees under the doctrine of quantum meruit. “Quantum meruit refers to the well-established principle that the law implies a promise to pay for services performed under circumstances disclosing that they were not gratuitously rendered.” Id. at 88 n.11. “To recover in quantum meruit, a party need not prove the existence of a contract, but it must show the circumstances were such that the services were rendered under some understanding or expectation of both parties that compensation therefore was to be made.” Id.

The court of appeal held that an attorney may never recover compensation in quantum meruit for services rendered while laboring under a conflict of interest. On this point, however, the Supreme Court reversed. Id. at 88-93. The court held that “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.” Id. at 89. Instead, “the egregiousness of the attorney’s conduct, its potential and actual effect on the client and the attorney-client relationship, and the existence of alternative remedies are all also relevant to whether and to what extent forfeiture of compensation is warranted.” Id.

When a law firm seeks to recover compensation in quantum meruit, it bears the burden of proving that these factors favor compensation. Id. at 90. In particular, the law firm must show that its services to the client had some value, despite the conflict of interest. Id. at 89. “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.” Id. “[T]he 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.” Id. “[A]bsent exceptional circumstances, the contractual fee will not serve as an appropriate measure of quantum meruit recovery.” Id. at 96. “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.” Id. The court remanded to the trial court to determine what amount, if any, Sheppard Mullin was entitled to recover on the specific facts of this case.

The Sheppard decision is a reminder that the consequences of signing an engagement agreement while laboring under a conflict of interest are severe. Such an agreement may be unenforceable. As a result, the conflicted law firm will be entitled to no compensation under the agreement, and will be left to the equitable vagaries of pursuing a recovery of some lesser amount in quantum meruit. Moreover, the court, not an arbitrator, will decide the law firm’s entitlement to any recovery at all, and the amount of any such recovery. Avoiding conflicts of interest has always been important, but the financial incentives to avoid conflicts have never been stronger.

Paul A. Stewart is a partner in the law firm of Knobbe, Martens, Olson & Bear, LLP, based in Irvine, California. Mr. Stewart’s practice focuses on intellectual property litigation. In addition, he serves as Chairman of the firm’s Ethics Committee, and is a member of the Orange County Bar Association Professionalism and Ethics Committee. He can be reached at Paul.Stewart@knobbe.com.