On August 30, 2018, the California Supreme Court rendered a long-awaited decision in Sheppard, Mullin, Richter & Hampton, LLP v. J-M Manufacturing Co., Inc. Primarily, the case considers what disclosures are required under California law to make a client’s “advance” conflict waiver enforceable. The decision also addresses when a dormant client is a “current” client and the extent to which a law firm may be entitled to payment for legal services rendered even in the face of a violation of the Rules of Professional Conduct.
J-M Manufacturing Co., Inc. (J-M) was sued in a qui tam lawsuit alleging misrepresentations about products sold to approximately 200 public entities nationwide. When the qui tam complaint was unsealed, some of those entities intervened as plaintiffs in the lawsuit.
During the litigation, J-M decided to replace its litigation counsel with Sheppard, Mullin. A conflicts check revealed that an attorney in a different Sheppard Mullin office had represented one of the plaintiffs, South Tahoe Public Utility District (South Tahoe), periodically over the previous eight years but only on employment matters.
The 2002 South Tahoe engagement letter, renewed in 2006, contained a prospective or “advance” waiver provision similar to what the court quoted from the J-M engagement letter:
Conflicts with Other Clients: Sheppard Mullin . . . has many attorneys and multiple offices. We may currently or in the future represent one or more other clients (including current, former, and future clients) in matters involving [J-M]. We undertake this engagement on the condition that we may represent another client in a matter in which we do not represent [J-M], even if the interests of the other client are adverse to [J-M] (including appearance on behalf of another client adverse to [J-M] in litigation or arbitration) and can also, if necessary, examine or cross-examine [J-M] personnel on behalf of that other client in such proceedings or in other proceedings to which [J-M] is not a party provided the other matter is not substantially related to our representation of [J-M] and in the course of representing [J-M] we have not obtained confidential information of [J-M] material to the representation of the other client. By consenting to this arrangement, [J-M] is waiving our obligation of loyalty to it so long as we maintain confidentiality and adhere to the foregoing limitations. We seek this consent to allow our Firm to meet the needs of existing and future clients, to remain available to those other clients and to render legal services with vigor and competence. Also, if an attorney does not continue an engagement or must withdraw therefrom, the client may incur delay, prejudice or additional cost such as acquainting new counsel with the matter.
Sheppard Mullin’s general counsel analyzed the work the law firm had done for South Tahoe and determined that such employment-law-related legal work was not “substantially related” to the qui tam litigation. This standard, mentioned in the advance waiver provision, might be relevant under the Model Rules of Professional Conduct if South Tahoe had been a former, not a current, client (a question litigated in the case).
Note also that the language at the beginning of the quoted conflicts provision accomplishes nothing: Model Rule 1.10(a) (and now new California Rule 1.10(a)) provides that if one attorney in a law firm has a disqualifying conflict of interest, that attorney’s conflict is imputed to every other lawyer in the firm, regardless of how many attorneys and how many offices the law firm may have.
Sheppard Mullin’s general counsel also concluded that that the advance conflict waiver signed by South Tahoe would authorize the firm to undertake a representation adverse to South Tahoe. The firm did not, at that time, disclose its representation of South Tahoe to J-M but assured J-M that there were no conflicts preventing it from undertaking the proposed representation.
After commencing its representation of J-M, Sheppard Mullin provided additional employment-law-related legal services to South Tahoe. Thereafter, attorneys representing South Tahoe in the qui tam litigation became aware of Sheppard Mullin’s representation of South Tahoe, and in March 2011 wrote Sheppard Mullin to assert the conflict. Sheppard Mullin responded by invoking the advance conflict waiver provision and arguing the adequacy of the firm’s screening procedures (which apparently were established only after being contacted by South Tahoe’s attorneys about the conflict).
When South Tahoe’s counsel moved to disqualify Sheppard Mullin, the firm informed J-M about the alleged conflict for the first time. The disqualification motion argued that a general advance waiver was inadequate under California ethics rules because it did not constitute informed consent. Sheppard Mullin countered that (1) South Tahoe did not carry its burden of proving that it was a “current” client when Sheppard Mullin accepted the representation of J-M; (2) even if South Tahoe was a “current” client, it had signed a prospective waiver to future litigation against it; and (3) even absent the prospective conflict waiver, laches and waiver should preclude South Tahoe from succeeding on its disqualification argument. Sheppard Mullin also noted that in retaining its current law firm in the qui tam litigation, South Tahoe had agreed to a similar prospective waiver provision.
South Tahoe replied that it remained a current client. The scope of the engagement letter encompassed general employment matters, and the attorney-client relationship thereunder terminated only upon (1) written notice from either party or (2) completion of the “Matter,” which by its nature was recurring. Notably, whether Sheppard Mullin’s representation of South Tahoe is properly viewed as continuous or as a series of discrete, sequential engagements, there were many times when the firm was simultaneously representing both, including the representation of J-M adverse to South Tahoe. Furthermore, the putative waiver was arguably inapplicable to the qui tam matter in that Sheppard Mullin had pursued a California Public Records Act (CPRA) request against South Tahoe, while simultaneously providing legal advice to South Tahoe about how to respond to CPRA requests, thereby constituting a “substantially related representation.”
On July 14, 2011, the federal court granted, without opinion, South Tahoe’s motion to disqualify Sheppard Mullin.
Meanwhile, Sheppard Mullin had billed J-M approximately $3 million in the qui tam matter, with approximately $1 million uncollected. When the firm sued to collect the outstanding amount, J-M counterclaimed for breach of contract, breach of fiduciary duty, and fraudulent inducement and sought both an accounting and disgorgement of the $2 million already paid to Sheppard Mullin. Pursuant to the engagement letter, Sheppard Mullin sought compulsory arbitration. J-M resisted, arguing that Sheppard Mullin’s conflict of interest rendered the engagement letter illegal and unenforceable, but the trial court ordered the parties to arbitration, where Sheppard Mullin prevailed.
The arbitrators concluded that the firm’s failure to disclose its representation of South Tahoe and to obtain a specific waiver from J-M was an ethics violation, but not sufficiently serious or egregious to warrant forfeiture or disgorgement of Sheppard Mullin’s fees. The conflict had not caused J-M any damage, and the services Sheppard Mullin rendered to J-M were not “less effective or less valuable.” The arbitrators accordingly awarded Sheppard Mullin $1.3 million in fees and interest.
The Superior Court rejected J-M’s objections and, holding that a violation of the ethics rules does not render a retainer agreement unenforceable, confirmed the award. The California Court of Appeals reversed, however, holding that concurrent representation of J-M and South Tahoe violated Rule 3-310(C)(3), notwithstanding the scope of the conflict waivers in the parties’ respective engagement agreements, and this violation rendered the entire engagement agreement unenforceable. The Court of Appeals remanded the case for a finding as to when that concurrent representation began.
The California Supreme Court Decision
Sheppard Mullin petitioned for review on the following issues: (1) whether a court may invalidate an arbitration award on grounds that the agreement containing the arbitration agreement violates the public policy of the state as expressed in the Rules of Professional Conduct, as opposed to statutory law; (2) whether Sheppard Mullin violated the Rules of Professional Conduct in view of the broad conflicts waiver signed by J-M; and (3) whether any such violation automatically disentitles Sheppard Mullin from any compensation for the work it performed on behalf of J-M. The California Supreme Court granted review and rejected most of Sheppard Mullin’s arguments. “California law holds that a contract may be held invalid and unenforceable on public policy grounds even though the public policy is not enshrined in a legislative enactment.”
Addressing the advance waiver provision, the court interpreted Rule 3-310(C)(3)’s requirement (essentially comparable to Model Rule 1.7(a)(1)) of informed written consent, confirmed in writing, to mean “informing the client of the relevant circumstances and of the actual and reasonably foreseeable adverse consequences to the client. . . .”
The court rejected Sheppard Mullin’s argument that when it began representing J-M, South Tahoe was a “former client” or a “dormant client” of the law firm, and that South Tahoe did not again become a “current client” until after its representation of J-M began. Sheppard Mullin’s engagement letter with South Tahoe was open-ended, with the scope of the representation being described as “in connection with general employment matters (the ‘Matter’)” and, absent an earlier termination by either South Tahoe or Sheppard Mullin, the representation of South Tahoe would terminate “upon completion of the Matter.” Sheppard Mullin had provided employment-law-related legal services to South Tahoe since 2002 and had done so as recently as November 2009, and again on March 29, 2010, less than a month after taking on the qui tam matter.
Under comparable circumstances, where a law firm and a client have had a long-term course of business calling for occasional work on discrete assignments, courts have generally held the fact that the firm is not performing any assignment on a particular date and may not have done so for some months—even years—does not necessarily mean the attorney-client relationship has been terminated. . . . Absent any express agreement severing the relationship during periods of inactivity, South Tahoe could reasonably have believed that it continued to enjoy an attorney-client relationship with its longtime law firm even when no project was ongoing.
This conclusion became the linchpin for the rest of the decision.
This result creates practical difficulties. Applying the current client conflict rules and the rule with respect to imputation of such conflicts makes enforceability of “advance” waiver provisions in engagement letters in the context of the realities of contemporary law practice a matter of grave concern.
The typical “advance” waiver—similar to the one in both the South Tahoe and J-M engagement letters—provides that the client is agreeing, at the outset of representation, that the law firm may undertake other representations adverse to the client so long as that other adverse representation is not “substantially related” to the matter for which the client is retaining the firm. This “substantially related” caveat is not adventitious; rather, it allows a firm to treat a “current client” as a “former client” for conflict-of-interest purposes vis-à-vis ABA Model Rule 1.9, whereby lawyers can be directly adverse to a former client without the need separately to secure the latter’s consent, if the new matter adverse to the former client is not “substantially related” to the matter for which the attorney previously represented the former client. As such, an “advance” waiver is, and should be, a reasonable compromise between the attorney and the occasional or “dormant” client.
Nonetheless, if the California Supreme Court’s conclusion that South Tahoe remained a “current client” of Sheppard Mullin from 2002 to May 2011 is accepted, the court’s rejection of the application of the “advance” conflict waiver in the J-M engagement letter makes sense. That waiver provision attempted to cover both ongoing and future matters adverse to J-M; however, more disclosure was necessary to satisfy the requirements of informed consent.
The court’s assessment of what constitutes informed consent had consequences of long-range significance:
- First, the Sheppard Mullin advance waiver provision was inadequate. By not apprising J-M that a conflict was not merely possible in the abstract, but actually existed at the very moment the firm was asking J-M to waive any current or future conflicts, Sheppard Mullin had failed to disclose all relevant information. Disclosure that an actual conflict might exist but not that a concurrent conflict of interest actually exists is inadequate. “Simply put, withholding available information about a known, existing conflict is not consistent with informed consent.”
- Second, the court held that “Sheppard Mullin’s concurrent representation of J-M and South Tahoe violated rule 3-310(C)(3) and rendered the engagement agreement between Sheppard Mullin and J-M unenforceable.” The court rejected the argument that violation of ethics rules regarding the obtaining of informed consent did not invalidate the entire engagement letter, which addressed many other issues.
It is true that Sheppard Mullin rendered J-M substantial legal services pursuant to the agreement, and J-M has not endeavored to show that it suffered damages as a result of the law firm’s conflict of interest. But the fact remains that the agreement itself is contrary to the public policy of the state. 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.
- Third, the arbitral award was null and void because it arose from a mandatory arbitration provision in an unenforceable contract.
Nevertheless, the California Supreme Court rejected the conclusion of the court of appeals that because of the ethics violation Sheppard Mullin was “categorically barred” from recovering any fees. Although the Restatement contemplates that violating a duty to a client may require fee forfeiture, not all violations of the rules of professional conduct rise to that level. “The Restatement instructs, and we agree, that 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.” Despite the stigma of an ethics violation, the decision allowed that recovery in quantum meruit might be possible if Sheppard Mullin could “show that the conduct was not willful, and its departure from ethical rules was not so severe or harmful as to render its legal services of little to no value to the client.” Accordingly, the case was remanded to the trial court with these admonitions:
To be entitled to a measure of recovery, the firm must show that the violation was neither willful nor egregious, and it must show that its conduct was not so potentially damaging to the client as to warrant a complete denial of compensation. And before the trial court may award compensation, it must be satisfied that the award does not undermine incentives for compliance with the Rules of Professional Conduct. For this reason, at least absent exceptional circumstances, the contractual fee will not serve as an appropriate measure of quantum meruit recovery. 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.
The Sheppard Mullin litigation is not a repudiation of “advance” waivers generally, as some might have apprehended. It is, however, a reminder that any client consent to waive a conflict must be an informed one. Thus, when asking a client to sign an engagement letter with an “advance” waiver, lawyers should scrupulously disclose any known conflicts upfront.
Some uncertainty remains as to the treatment of “dormant” clients. Such dormant clients may or may not have a reasonable belief that they are still “current” clients. That places a premium on adequate disclosure to ensure enforceability of engagement letters in general and advance waivers in particular.
 425 P.3d 1 (Cal. 2018).
 The facts set forth herein are derived from the California Supreme Court’s majority opinion, the concurring and dissenting opinions, the underlying California Court of Appeals decision, 244 Cal. App. 4th 590, 198 Cal. Rep. 2d 253 (Cal. Ct. App. 2016), and pleadings in the qui tam action, U.S. v. J-M Manuf., Inc. d/b/a JM Eagle, et al., Case No. 5:06-cv-00055-GW-PJW (C.D. Cal., filed Jan. 17, 2006). Except for key holdings of the California Supreme Court, citations to these documents will, in the interests of space, generally be omitted.
 The “substantially related” language appears in Model Rule 1.9 (Duties to Former Clients) but not in Model Rule 1.7 (Conflicts of Interest: Current Clients). The same dichotomy holds true under Rules 1.7 and 1.9 of the new California Rules of Professional Conduct adopted in November 2018. No “substantially related” language appeared in the language of the prior California Rules of Professional Conduct in force at the time this matter arose (Rule 3-310(C)(3)).
 Sheppard Mullin, 425 P.3d at 7.
 Id. at 12.
 Id. at 13 (quoting Cal. R. Prof. Conduct 3-310(A)(2), (1)).
 Id. at 14.
 Id. at 14–16. The California high court expressly linked an attorney’s duty of loyalty to a current client to the requirement that a conflict waiver, to be informed, requires the attorney to disclose “all material facts the attorney knows and can reveal.” Id. at 16. “An attorney or law firm that knowingly withholds material information about a conflict has not earned the confidence and trust the rule is designed to protect.” Id.
 But cf. Ky. Bar Assoc. Ethics Op. E-148 2–3 (July 1976) (internal citations omitted) (expressing doubt whether, absent special circumstances, frequency or length of time of prior employment of a lawyer should be dispositive of current versus former client status, unless the client pays a continuing retainer).
 Sheppard Mullin, 425 P.3d at 17.
 Id. at 14 (emphasis added).
 Id. at 18.
 See Restatement (Third) of the Law Governing Lawyers § 37.
 Sheppard Mullin, 425 P.3d at 20.
 Id. at 20. The court went on to say, “The law firm may have been legitimately confused about whether South Tahoe was [Sheppard Mullin’s] current client when it took on J-M’s defense, or it may in good faith have believed the engagement agreement’s blanket waiver provided J-M with sufficient information about potential conflicts of interest, there being at the time no explicit rule or binding precedent regarding the scope of required disclosure. The conflict was, moreover, not one in which Sheppard Mullin represented another client against J-M.” Id. at 24 (internal citations omitted).
 Id. at 23–24 (internal citations omitted).