Advance Conflict Waivers, Arbitration–and Fees–Tossed for Conflicts

The recent Second District Court of Appeal opinion in Sheppard, Mullin, Richter & Hampton, LLP v J-M Manufacturing Co., Inc. sent a shock wave through California law firms.  The case started when a firm sued a former client for $1.3 million in unpaid fees, after it had been disqualified from a matter for that client because of conflicts.  The case ended (at least for now) with an order from the Court of Appeal that rejected the firm’s advance conflict waivers and neutered the arbitration provision in its fee agreement.  Instead of collecting an additional $1.3 million in fees, the firm has to refund nearly all of the $3.8 million in fees it collected for the underlying matter.  Among other things, the case illustrates the limited application of advance conflict waivers and what happens when they are not effective to prevent or to cure conflicts.  It also may portend a much more difficult landscape for analyzing conflicts of interest, and what is now at stake if that analysis turns out to be incorrect.

J-M approached Sheppard Mullin in March 2010 to replace its defense counsel in a qui tam action against J-M and others in the Central District of California.  The firm ran a conflicts check and discovered that another partner at the firm had done labor and employment work for municipality South Lake Tahoe, one of the intervenors in the J-M qui tam action.  South Lake Tahoe had signed a fee agreement with the firm that contained an advance conflict waiver, and the firm had done no work for that company for five months, so the firm concluded it could handle the qui tam action, although the attorneys did not discuss South Lake Tahoe with J-M.

J-M also signed a fee agreement with an advance conflict waiver provision.  Shortly after the firm began working on the J-M qui tam action, the other partner began actively working again for South Lake Tahoe on unrelated labor and employment matters.  Sixteen months passed, and counsel for South Lake Tahoe in the J-M qui tam action moved to disqualify Sheppard Mullin from that action because of the conflict.  The district court granted the motion to disqualify, holding that the advance conflict waiver by South Lake Tahoe was ineffective because the client was not fully informed about the conflict with J-M.

After the firm’s disqualification, J-M refused to pay the firm’s unpaid fees for the qui tam action, and demanded the return of the fees it had already paid to the firm.  The firm sued J-M in state court to collect the $1.3 million balance of unpaid fees.  The Court granted the firm’s motion to compel arbitration, and a three-arbitrator panel sided with the firm, awarding the unpaid fees and costs, plus interest.  The trial court confirmed the arbitration award and entered judgment for the firm.  J-M appealed.

On appeal, the Court began its analysis with the issue of arbitration itself.  It first held that California law governed the arbitration provision.  Since J-M had challenged the validity of the entire fee agreement, the question of whether the arbitration provision was enforceable was for the court, not the arbitrators, to decide.  The Court then turned to the conflict issue, and held that the firm’s simulteaneous representation of J-M and South Lake Tahoe violated California Rules of Professional Conduct 3-310(C)(3).  The Court rejected both advance conflict waivers, holding that neither client received enough information from the firm at the time of execution to make an informed written consent to the conflict.  Specifically, the Court held that the firm “(1) failed to inform J-M about any potential or actual conflict with South Tahoe, and (2) did not obtain J-M’s informed, written consent to continued representation despite the actual conflict that occurred while Sheppard Mullin was working for J-M and South Tahoe at the same time.”

More generally, the Court held that the firm’s violation of Rule 3-310(C) made the entire fee agreement unenforceable, and that the firm was not entitled to any fees related to the matter from the date of the conflict forward.  The Court remanded the case for a factual determination of the date the actual conflict occurred.

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