Fee Disgorgement (Special Credit)
Attorneys who fail to disclose conflicts to clients may lose their right to collect fees—and may have repay fees already collected.
Plaintiffs do not typically seek disgorgement of attorneys’ fees in attorney legal malpractice suits. The reason most likely is of the rigorous malpractice causation requirement which forces clients to prove that but-for the attorney’s misconduct, the client would have obtained a better outcome (either in litigation or in the transaction the attorney worked on). Under this rubric, the measure of damages is typically the difference between the outcome the client received and the one he should have obtained but-for his attorney’s error. See, e.g., Herrington v. Super. Ct. (2003) 107 Cal.App.4th 1052, 1057.
Despite this general rule, claims for disgorgement of fees already paid (or forfeiture of fees owed) are on the rise. Attorneys should be cognizant of potential risks and shield themselves as effectively as possible from possible fee disgorgement and/or forfeiture, especially since most professional liability policies exclude fee-based damage claims.
Sheppard Mullin Case
The recent upward trend in disgorgement and forfeiture claims is best represented by a recent case decided by the second district court of appeal. See Sheppard, Mullin, Richter & Hampton, LLP v. J-M Manufacturing (2016) 244 Cal.App.4th 590. In the Sheppard Mullin case, the appellate court found that a law firm’s failure to adequately disclose a conflict of interest between two existing clients was sufficient to deny the firm $3.8 million in fees billed for more than a year of work in a litigation matter.
The underlying dispute stemmed from competing claims asserted between the Sheppard Mullin law firm and its former client, J-M, whom Sheppard Mullin represented in litigation for sixteen months. Before J-M retained Sheppard Mullin to assist it in litigation, the firm ran a conflicts check and learned that, as recently as five months prior, the firm had represented the South Tahoe Public Utility District, which was one of J-M’s adversaries in the pending case.
Sheppard Mullin’s work for South Tahoe was unrelated to the litigation matter involving J-M, and the firm did not reveal its representation of South Tahoe to J-M. Instead, it had J-M sign a retainer agreement containing a boilerplate advance conflict waiver provision which did not identify any specific potential or actual conflicts. Three weeks into the representation of J-M, Sheppard Mullin resumed actively working for South Tahoe (again, on an unrelated matter) even though South Tahoe was directly adverse to J-M in the pending litigation.
As a result of the actual conflict of interest between South Tahoe and J-M, Sheppard Mullin was later disqualified from representing J-M in the litigation.
Void Fee Agreement
Ultimately, the court of appeal was asked to consider whether the entire fee agreement between Sheppard Mullin and J-M was void as a result of the actual conflict of interest. It was undisputed that there was an actual conflict between J-M and South Tahoe; however, Sheppard Mullin argued that the boilerplate advance conflict waiver contained in its retainer agreement was sufficient to comply with California Rule of Professional Conduct 3-310 (Avoiding Representation of Conflicting Interests).
The court of appeal disagreed, finding that Rule 3-310(C)(3) requires “informed written consent,” meaning that the firm was obligated to inform both J-M and South Tahoe of the actual conflict when it arose and obtain a knowing waiver following full disclosure. Finding that the actual conflict of interest began, at the latest, three weeks into Sheppard Mullin’s representation of J-M, the court of appeal found that the conflict had pervaded the entire relationship between the parties and denied the firm all of its fees.
On April 27, 2016, the California Supreme Court accepted review of Sheppard Mullin. Although Sheppard Mullin has piqued the interest of the California legal malpractice community, it did not alter the fundamental rules applicable to disgorgement or forfeiture of attorneys’ fees. Rather, relying on cases such as Goldstein v. Lees (1975) 46 Cal.App.3d 614, and Jeffry v. Pounds (1977) 67 Cal.App.3d 6, the court of appeal explained that California courts have long “drawn a line between cases involving serious ethical violations such as conflicts of interest, in which compensation is prohibited, and technical violations or potential conflicts, in which compensation may be allowed.” Sheppard Mullin, 244 Cal.App.4th at 617. The Sheppard Mullin opinion therefore serves as a good reminder of the types of attorney misconduct that can result in the loss of fees. As we await the Supreme Court’s decision, it would be wise to consider those rules already in play, which are unlikely to be affected by the pending review.
Attorneys in California risk disgorgement or forfeiture of their fees where they have engaged in violations of the Rules of Professional Conduct. However, California has no bright-line rule for determining whether a particular rule violation will result in disgorgement or forfeiture. Rather, it is a question which must be addressed on a case-by-case basis. It is therefore important to understand the cases on this subject and avoid the types of misconduct which the courts have highlighted as a basis for denial of fees.
The last time the California Supreme Court offered its views on the subject of fee forfeiture was in Huskinson & Brown v. Wolf (2004) 32 Cal.4th 453. There, the Court observed that an attorney may be denied fees as a result of a violation of the Rules of Professional Conduct, but recognized that disgorgement is reserved for those cases in which the attorney violated “a rule that proscribed the very conduct for which compensation was sought, i.e., the rule prohibiting attorneys from engaging in conflicting representation or accepting professional employment adverse to the interests of a client or former client without the written consent of both parties.” Huskinson & Brown, 32 Cal.4th at 463 (citing Jeffry v. Pounds (1977) 67 Cal.App.3d 6 and Goldstein v. Lees (1975) 46 Cal.App3d 614). Thus, the Supreme Court recognized that a technical violation of the RPC will not lead to automatic disgorgement. Rather, the attorney’s breach of loyalty to the client must go to the heart of the representation.
Three years after Huskinson & Brown, the Court of Appeals sought to further clarify matters in Mardirossian & Assoc., Inc. v. Ersoff (2007) 153 Cal.App.4th 257. There, an attorney agreed to represent two clients in litigation. Prior to taking the representation, the attorney identified various potential conflicts of interest which might arise. Both clients signed separate, comprehensive documents consenting to the attorney’s joint representation despite the identified potential conflicts. Id. at 262. When the attorney sought his fees from one of the clients, however, the client argued that the attorney should be prohibited from recovering fees because there had been an actual (rather than just potential) conflict of interest at the inception of representation in violation of Rule 3-310(C).
The trial court ruled against the client, finding that, at most there had been a potential conflict of interest. Id. at 278. The court further found, however, that even if there had been an actual conflict, “any violation of rule 3-310 was not sufficiently egregious under the circumstance to justify a total forfeiture of fees.” Id. The court of appeal agreed, recognizing that the attorney had provided valuable services and that a denial of fees to the attorney would result in “an unjust enrichment” of the client. Id. at 279.
How Egregious Was It?
The court’s opinion in Mardirossian recognized that an attorney’s violation of the RPC—including those rules pertaining to conflicts of interest—will not automatically result in disgorgement or forfeiture of fees. Rather, the question of whether an attorney has forfeited his fees “depends on the egregiousness of the violation.” Id. at 278. When considered alongside Huskinson & Brown, Mardirossian therefore gives us a two part test for determining whether an attorney’s misconduct may result in disgorgement:
- Does the attorney’s violation of the RPC go to the “very conduct for which compensation was sought,” and
- Is the conduct “sufficiently egregious” such that the attorney should be denied his fees?
The Fair Case
Four years after Mardirossian, the court of appeal issued its decision in Fair v. Bakhtiari (2011) 195 Cal.App.4th 1135. In that case, the court considered whether an attorney’s own conflict with his client (as opposed to a conflict among clients) may also be grounds for fee forfeiture. It answered the question in the affirmative.
In Fair, the attorney and clients entered into multiple real estate business arrangements over a ten-year period. When the attorney sought to collect fees owed to him, the client alleged that the attorney had violated RPC 3-300, which prohibits attorneys from entering into business transactions with their clients without first obtaining the client’s informed, written consent.
The trial court found that the attorney failed to comply with rule 3-300 because he had never disclosed his potential conflict of interest or obtained his clients’ written consent to the actual conflicts that arose in the course of their business dealings. Id. at 1135. As a result of the attorney’s rule violation, the trial court denied the attorney the ability to recover his outstanding fees on a quantum meruit theory. Applying the two-part test developed in Huskinson & Brown and Mardirossian, the court of appeal affirmed, finding that (1) the attorney’s ethical breach was one which “permeated” his entire relationship with the clients and (2) the trial court’s “express findings of undue influence and breaches of fiduciary duty” demonstrated the attorney had engaged in egregious misconduct warranting the denial of his requested fees. Id. at 1163 & 1166.
Importantly, the court in Fair rejected the contention that fees may only be denied where the attorney has engaged in actual fraud. Rather, Fair recognized that certain acts, short of fraud, but which effectively prevent the attorney from discharging his duties, may serve to deny an attorney his fees. Id. at 1168. The Fair opinion therefore adds to the previously announced two-part test by clarifying that “egregious” misconduct need not rise to the level of actual fraud.
Forfeiture of All Fees, or Just a Portion?
Though not referenced in the Supreme Court’s 2004 Huskinson & Brown opinion, the courts of appeal often cite to Cal Pak Delivery, Inc. v. UPS, Inc. (1997) 52 Cal.App.4th 1, to answer the question of whether an attorney must forfeit all, or only a portion, of the fees earned as a result of a conflict of interest. In Cal Pak, class counsel “admitted he had offered to sell out his client and the class which the client was seeking to represent for a payment to himself personally of approximately $8 to $10 million dollars.” Id.at 5-6. Despite the admittedly egregious conflict between the attorney and his clients, the court of appeal acknowledged that the attorney may have a “right to recover fees for services rendered before his breach of duties to his client.” Id. at 16.
While not a license to engage in violations of the RPC, Cal Pak serves to prevent unjust enrichment by clients who, despite an error by their attorney, enjoyed at least some benefit from the representation prior to the breach. It remains to be seen whether Cal Pak or its progeny will have any effect on the pending Supreme Court review in Sheppard Mullin, particularly given the short three-week period the firm represented its client before the admitted conflict arose.
The court of appeal’s Sheppard Mullin opinion cited each of the above-discussed cases with approval and concluded that the firm had breached a duty of loyalty by engaging in conflicting representation. The court also concluded that the firm’s breach permeated the entire sixteen-month representation, and the firm’s conduct was sufficiently egregious to warrant denial of all fees. The question therefore remains whether the Supreme Court will maintain the existing rules announced in these cases or whether, after a twelve-year silence, the state high court will provide further insight into the rules on disgorgement and fee forfeiture.
Regardless of the eventual Supreme Court ruling in Sheppard Mullin, attorneys practicing in California would do well to examine their fee agreements, as well as their active litigation and transactional matters, to ensure there are no underlying potential or actual conflicts which have not been properly disclosed or documented with the clients’ written consent. Precedent teaches a powerful lesson: Failure to diligently follow the rules for disclosing such conflicts can be costly.
Kate G. Kimberlin is Senior Counsel and Jessica R. MacGregor is a partner at Long & Levit in San Francisco, where they both defend lawyers and other professionals.