Breach of Fiduciary Duty for Failure to Disclose Conflict of Interest Could Result in Disgorgement of Fees, Even Absent Damages

By Jeffrey P. Lewis

A recent 3rd U.S. Circuit Court of Appeals opinion raises the specter that a lawyer may have to disgorge his/her fee to his/her client for breach of fiduciary duty, even if the client sustained no damages. In Huber v. Taylor, 469 F.3d 67 (3rd Cir. 2006), a three-judge panel considered this issue in the context of a mass tort case, but it can have ramifications anywhere that a conflict of interest exists.

In Huber, plaintiffs in three states (including Pennsylvania) retained various local counsel in their home states to prosecute asbestos claims against manufacturers. They entered into a 40 percent contingent fee agreement. Local counsel then engaged Texas counsel to prosecute these claims — preferably in Louisiana, which is historically a plaintiff-friendly venue. Local counsel entered into co-counsel agreements with Texas counsel, who would serve as lead counsel. Texas counsel would receive between 95 percent and 97.5 percent of local counsels’ fees if they were to recover in a state other than local counsels’ home state and a lesser amount or various amounts, depending on the circumstances, if they were to recover in a local counsel’s home state. Texas counsel, however, also had his own “inventory” of asbestos clients, also located in Texas and Louisiana.

In the clients’ view, this created conflicts on multiple levels. The modest percentages going to each local counsel meant that they could generate a profit only if involved in a high volume of cases that required only rote work. Many of the cases generated only a few thousand dollars, which resulted in a small recovery to local counsel on a case-by-case basis. As a consequence, local counsel had little incentive to concentrate on any particular case. Moreover, with Texas counsel standing to recover a greater percentage in his own cases — those in which local counsel did not participate — he had an incentive to favor clients in those cases over cases involving local counsel. Further, Texas counsel had incentive not to file suits in any local counsel’s home state because he would receive a smaller percentage. Finally, local counsel as a group (not necessarily individually), notwithstanding the 1-2 percent cut, stood to recover a substantial amount because these claims in the aggregate generated hundreds of millions of dollars. Complicating matters, Texas counsel had entered into his own upstream co-counsel agreements with counsel, who then entered into their own upstream agreements.

Adding to the conflicts, the terms of the various settlements varied based upon both the seriousness of injury and the claimant’s home state. This resulted in the Texas counsel’s clients (those solely represented by him) recovering between 2.5 and 18 times more than the northern clients, whom he shared with local counsel. To justify this result, Texas counsel contended that the northern clients still recovered more than they would have in their home states.

Here is the rub: None of the counsel disclosed these upstream fee arrangements to their clients. Moreover, the clients in their subsequent action for breach of fiduciary duty and related claims contended that Texas counsel’s incentive to favor his clients in the allocation and the southern venue prompted the disparity in payments between northern and southern clients.

The court found that disclosures to the clients did not state the settlements’ material terms or the various lawyers’ involvement in the cases. Therefore, counsel had failed to place their clients in a position to appreciate the existence and nature of the conflicts. Each disclosure included a written statement averring that further details were available upon request and inviting the clients to come to counsel’s office to read the entire settlement agreement, as well as a list identifying the amounts offered to each client. The court found these offers to be inadequate disclosure. Unfortunately, according to plaintiffs, not even local counsel and a paralegal service retained to coordinate settlements with the clients fully understood “the full terms of the settlements or had access to the complete settlement agreement.”

The district court granted summary judgment in favor of the lawyers, finding that disgorgement of fees for conflict of interest can only occur when the client can demonstrate actual harm. The 3rd U.S. Circuit Court, in a 2-1 decision, found that Texas law applies and that under Texas law the client need not show actual harm to recover disgorgement of fees. The court also noted that Pennsylvania case law has not addressed this issue, although it observed that Pennsylvania case law does not appear to require actual damages for aiding and abetting breach of fiduciary duties, citing Thompson v. Glenmede Trust Co., 1993 WL 197031 (E.D. Pa. 1993). The court observed the irony that a claim for disgorgement of fees in contingency fee cases can result in a greater recovery to the client than the amount of the actual damage.

The court had no difficulty in granting disgorgement under Texas law, absent any actual damages, because the remedy “focuse[s] on regulating the behavior of the fiduciary, not remedying the harm to the client” and Texas has the interest in regulating Texas lawyers.

The clients did not sue their local counsel or the local paralegal service; they only sued the upstream lawyers, who argued that they owed no fiduciary duty to the clients. In finding this argument “preposterous,” the court held that “[e]ven though the duty of disclosure is itself delegable, the duty of loyalty is inherently not, and in this case disclosure was necessary to fulfill the duty of loyalty.”

The court concluded: “Indeed, we are embarrassed to have to explain a matter so elementary to the legal profession that it speaks for itself: all attorneys in a co-counsel relationship individually owe each and every client the duty of loyalty. For it to be otherwise is inconceivable.”

Granting disgorgement for conflict of interest can have devastating consequences to the lawyer. For example, the failure of a lawyer to disclose a conflict — even though he or she contends that no such conflict exists — may later disgorge, even absent actual harm, because a court finds that an actual conflict exists that counsel did not disclose. This becomes even more hazardous when the matter involves a third party, such as beneficiaries to an estate, who have standing to raise the conflict. The lawyer may have raised the potential conflict to the administrator (his or her client) who was satisfied that no conflict existed, but later a beneficiary and the court may not agree. That would suggest that a lawyer must proceed with caution whenever any potential conflict appears.

Jeffrey P. Lewis is a shareholder in the West Chester office of the Philadelphia-based law firm of McKissock & Hoffman P.C., with offices also in Harrisburg, Doylestown and Westmont, N.J. He serves on the PBA Professional Liability Committee and is a PBA Zone 9 delegate.