You’re Outta Here! Avoiding Disqualification When Representing Small Organizational Clients
LACBA Update, November/December 2015
By Ellen A. Pansky, Pansky Markle Ham LLP, California State Bar Certified Legal Malpractice Specialist. She has served continuously as a member of LACBA’s Professional Responsibility and Ethics Committee since 1992. The opinions expressed are her own.
Disputes between shareholders or partners in closely held organizations are not uncommon. When there are only two 50% shareholders in a corporate entity, or two equal partners in a partnership, the question often arises whether the organization and one of its members can be represented by the same lawyer, whether there is a conflict of interest between the organization and the individual member, and if there is, can the conflict be waived and by whom?
As a preliminary matter, in California as in most states, every time a lawyer represents more than one client in a particular matter or in related matters, a potential conflict of interest exists. Under California Rule of Professional Conduct 3-310(C), a written disclosure of the potential conflict and a written consent to the concurrent representation of the multiple clients are mandatory, even if there is no direct or actual conflict between the multiple clients. The concept is that there is always a possibility that the interests of two or more clients may diverge in the future. Additionally, multiple clients give up certain rights by agreeing to be represented by one lawyer rather than by independent, separate counsel, most notably, preserving privilege for communications.
These concepts apply equally when the lawyer is concurrently representing an organizational entity and one or more of its constituent members. A lawyer is not ethically precluded from representing both an entity and one or more of its members, assuming that the potential conflict is not so direct and irreconcilable that the conflict is unwaivable. See Rule 3-600(E). Again, sufficient written disclosure and informed written consent must be obtained from both the organizational client and the individual affiliated client(s). Conversely, if the interests of the entity and an individual shareholder are seriously contradictory, the conflict of interest is unwaivable.
In some situations, a lawyer is precluded from concurrently representing both an organizational entity and its individual member(s). Forrest v. Baeza (1997) 58 Cal. App. 4th 65 held that in a derivative action in which the corporate entity is a necessary party, an attorney is disqualified from concurrently representing both the shareholders and the corporation from which the defendant-shareholders are accused of embezzling funds. In such situations, there is direct adversity between the interests of the corporate entity and the interests of the individual defendants who are alleged to have acted in a manner that damaged the corporation; the lawyer cannot represent both. As the Forrest court held at p. 76:
The referee's view on this issue was succinctly stated in its order: "[I]n the face of a derivative cause of action, to permit the Forrests to waive the conflict on behalf of the corporations would be the equivalent of denying Mr. Ricetti's derivative claim out of hand--a legally impermissible action." Clearly, under rule 3-600, the Forrests could not consent to the representation on behalf of the corporations in their capacity as directors of the corporations. In the circumstances here, where the only shareholders of the corporations are also the directors involved in the controversy, to allow the shareholders to consent on behalf of the corporation would render rule 3-600 meaningless.
Similarly, in Gong v. RFG Oil, Inc. (2008) 166 Cal. App. 4th 209, an action for involuntary dissolution of a closely held corporation, the minority shareholder of a two-member corporation, Jeffrey, moved to disqualify opposing counsel who was representing both the corporation and the majority shareholder, David. Finding an abuse of discretion, the appellate court reversed the lower court’s order denying disqualification and found that the majority shareholder was using the corporation as a pawn in his dispute with the minority shareholder, so that opposing counsel simply could not fulfill the duty of loyalty owed to each client by continuing to represent both the majority shareholder and the corporation. The Gong court concluded that the majority shareholder, David, could not provide disinterested consent to waive the conflict between the corporation and the majority shareholder, and that the corporation was required to hire new counsel “without previous connections to it, David or Jeffrey” to “preserve the duty of loyalty and the public trust in the administration of justice."
Subsequently, in Blue Water Sunset, LLC v. Markowitz (2011) 192 Cal. App. 4th 477, a motion was brought to disqualify the attorney who briefly represented both a limited liability company and one of the two members of the LLC. The other member of the LLC moved for disqualification (notwithstanding the fact that he had never been a client of the attorney) on the ground that the lawyer could not ethically jointly represent the LLC and the member accused of having defrauded the LLC. The court found that the other member had standing to bring the motion and granted the disqualification motion precluding the lawyer from continuing to represent the LLC, finding that disqualification is “automatic.” The court relied on Flatt v. Superior Court (1994) 9 Cal. 4th 275 and Forrest v. Baeza:
"…[t]he paradigmatic instance of…prohibited dual representation—one roundly condemned by courts and commentators alike—occurs where the attorney represents clients whose interests are directly adverse in the same litigation.” (Flatt, supra, 9 Cal. 4th at 284, fn. 3.) Moreover, in the context of a derivative action, “[c]urrent case law clearly forbids dual representation of a [company] and [company insiders]…, at least where…the [company insiders] are alleged to have committed fraud. [Citations.]" (Forrest, supra, 58 Cal. App. 4th at 74–75.) (Id. at 489.)
In the recent case of Coldren v. Hart, King & Coldren (2015) 239 Cal. App. 4th 237, the Fourth Appellate District of the Court of Appeal distinguished Blue Water Sunset and Gong, and reversed a trial court’s order of disqualification of a law firm that was concurrently representing both the closely held corporate entity and one 50% shareholder, who were plaintiffs in an action against the other 50 % shareholder, seeking involuntary dissolution and damages for inter alia, breach of contract and alleged conversion. In concluding that there is no conflict of interest when a lawyer is representing both the entity and one of its constituents against the alleged wrongdoer defendant/shareholder, the Coldren opinion noted that there must be actual evidence that the plaintiff is using the entity as “pawn” and that it does not suffice to speculate that the jointly represented shareholder is acting contrary to the interests of the entity client. Coldren further explained that, unlike the facts in both Blue Water Sunset and Gong, where the plaintiffs alleged that the individual shareholder defendant had acted in contravention of the interests of the entity, and therefore the same lawyer is ethically precluded from concurrently representing both the alleged wrongdoer and the entity who was damaged by the alleged wrongful acts, in an involuntary dissolution action, a corporate entity’s interest is in its continued existence. However, when one owner decides to buy the shares of the other owner (as permitted by the California Corporations Code), the corporation’s interests are “whatever [the purchasing shareholder] chooses to do,” and the other shareholder’s interests are “irrelevant.” On this basis, the Coldren court concluded that there was no conflict of interest that would prevent the law firm from currently representing both the corporation and the remaining shareholder in the involuntary dissolution case.
Read together, these cases support a conclusion that a lawyer cannot represent a minority shareholder as a plaintiff in a lawsuit where, in addition to derivative claims, the minority shareholder is directly suing the corporation, asserting direct claims against the corporation and majority shareholders. If the attorney were to do so, a conflict would exist by virtue of the concurrent claims being asserted for the benefit of the corporation in the derivative cause of action, while at the same time the lawyer is suing that same corporation for damages.
Before undertaking to concurrently represent both an organizational entity and one or more of its constituents, a lawyer must carefully analyze whether the interests of the individual are aligned with those of the entity. If not, a motion for disqualification will likely ensue.
In conclusion, it may or not be ethically permissible for a lawyer or law firm to currently represent an organizational entity and its member(s) in a matter. Careful consideration must be given to how the parties’ interests align, and one lawyer may not represent both the entity and the individual who is alleged to have undertaken wrongful acts to the entity’s detriment. Finally, consent to the dual representation must be given by a disinterested member of the entity or, in some circumstances, by the member empowered by the bylaws or partnership agreement to act on behalf of the entity.
LACBA's Professional Responsibility and Ethics Committee welcomes new inquiries from LACBA members regarding ethical issues or concerns about professional responsibilities. The identity of the inquirer is kept confidential within the committee. The committee, however, does not publish formal opinions that are the subject of any pending litigation involving the inquirer. If you have an ethical question that you would like the committee to consider, you can mail your written inquiry to Los Angeles County Bar Association, Professional Responsibility and Ethics Committee, P.O. Box 55020, Los Angeles, CA 90055-2020, or e-mail your inquiry marked “Confidential” to Member Services at firstname.lastname@example.org.