In-House Counsel Sanctions: Recent Trends

By: Devika Kewalramani, Moses & Singer LLP

Disgorgement of legal fees is a harsh, but not unusual, penalty. Although this unforgiving sanction is more frequently imposed on outside counsel, it is not uncommon for in-house counsel to be required to disgorge and forfeit their compensation due to ethical violations.

CALIFORNIA HAS HISTORICALLY BEEN ONE OF THE stricter jurisdictions regarding disgorgement of outside counsel’s legal fees. For example, in 2016, the California Court of Appeals required a law firm to disgorge $3.8 million based on the firm’s failure to adequately disclose an actual conflict of interest between two existing clients.¹ California courts have also held fee forfeiture to be an appropriate remedy where outside counsel’s personal conflict involving business transactions with his client permeated their entire relationship, leading to egregious ethical misconduct.²

Similarly, the U.S. Court of Appeals for the District of Columbia Circuit ordered outside counsel to pay their former client nearly $500,000—an amount representing a portion of the legal fees the attorney collected from the client, plus interest—due to an undisclosed current client conflict.³ Likewise, New York courts have held that “[a]n attorney who engages in misconduct by violating the Rules of Professional Conduct [] is not entitled to legal fees for any services rendered.”⁴

In-house counsel, like their outside counsel counterparts, are not shielded from being compelled by courts to disgorge their compensation as a remedy for violation of their ethical duties. For example, in 2015, the Supreme Court of New Jersey held that a corporate employer may seek disgorgement of a disloyal general counsel’s compensation as a remedy for breaching the duty of loyalty, regardless of a finding of economic loss.⁵

Taking center stage in 2016 was another disgorgement case involving in-house counsel’s ethical breaches, where the court engaged in an in-depth comparative analysis of the ethical issues impacting in-house counsel in the corporate setting. In Chism v. Tri-State Constr., Inc., 193 Wn. App. 818 (Wash. Ct. App. 2016), the Court of Appeals of Washington addressed whether the general counsel violated his ethical obligations to his corporate client by examining the key distinctions between lawyer/employee–client/ employer arrangements on the one hand and conventional attorneyclient relationships on the other, with a particular focus on wages and legal fees.

In the Chism case, a lawyer who formerly acted as outside counsel for a closely-held construction company became its general counsel in 2008 and was compensated with an annual salary of $190,000. Around that time, he admitted to spending only an average of 7.5 hours per week on legal work for the company and worked primarily from home. In 2011, he proposed being paid a $500,000 bonus, and the company’s president, who was suffering from Alzheimer’s disease, agreed. Ultimately, the company refused to pay the requested bonus and an additional bonus of $250,000, and the general counsel sued the company.

At trial, the jury found that the general counsel’s bonus agreements were not the product of undue influence, and awarded him $750,000 for breach of compensation contracts by his former employer, plus $750,000 as exemplary damages for unlawful wage withholding. However, following the jury verdict, the judge ruled that the general counsel had violated his ethical and fiduciary duties when he negotiated his bonus payments with the company’s Alzheimer’s-stricken principal. The judge ordered him to disgorge $1.1 million of his award, premised on violations of Rule 1.5 (fees), Rule 1.7 (current client conflicts of interest), Rule 1.8 (business transactions with clients), and Rule 8.4 (misconduct) of the Washington Rules of Professional Conduct (which are based on the ABA Model Rules).

On appeal, the Court of Appeals of Washington reviewed the ethics rules individually to determine whether in-house counsel are bound by ethical and fiduciary obligations when negotiating compensation arrangements with their corporate employers and whether in-house counsel may be ordered to disgorge wages the same way outside counsel are required for breach of ethical or fiduciary duties to clients, as discussed below.

• Legal Fees (Rule 1.5) Under Rule 1.5, a lawyer is prohibited from agreeing to, charging, or collecting an unreasonable fee. The Court of Appeals rejected the company’s claim that the general counsel violated the rule by negotiating substantial compensation in addition to his salary and benefits. The Court concluded that there is an absence of authority from Washington and elsewhere to support expanding Rule 1.5’s application to “fees” to “wages contracts” in order to allow disgorgement.
• Current Client Conflicts of Interest (Rule 1.7) Rule 1.7 bars a lawyer from representing a client if there is a significant risk that the representation will be materially limited by the lawyer’s personal interest. The Court of Appeals disagreed with the trial court’s ruling that it was a conflict of interest for the general counsel to negotiate his $500,000 bonus withthe company, without fully disclosing his self-interest in the transaction and the potential risks to the company. The Court observed that for a conflict to exist, the general counsel had to have “represented [the company] in its negotiations over his own wages” which would “cast doubt on the wage negotiations of scores of Washington attorneys—not only in-house corporate counsel…but also government attorneys and numerous nonprofit attorneys.” The Court held that the trial court exceeded its authority by issuing a disgorgement order for a lawyer-employee's negotiation of a wage increase, noting its “unprecedented application of [Rule] 1.7 to in-house counsel” and the absence of supporting authority.
• Business Transactions with Clients (Rule 1.8) Under Rule 1.8, a lawyer is forbidden from entering into a business transaction with a client, unless the transaction is fair and reasonable to the client, after making full disclosure and advising it to consult separate counsel on the transaction. The Court of Appeals rejected the trial court’s finding that the general counsel violated the rule by improperly negotiating his bonus arrangement and payment with the company without full disclosure and advice to confer with outside counsel. The Court clarified that there are “essential differences between fee agreements and wage contracts” and that if the rule were interpreted to include compensation agreements between a lawyer-employee and a current client-employer, then every agreement increasing a lawyer-employee’s wages or benefits would fall within the rule. Given the lack of authority, the Court of Appeals declined to extend application of Rule 1.8 to the general counsel’s conduct.
• Misconduct (Rule 8.4) Finally, Rule 8.4(c) proscribes a lawyer from engaging in conduct involving misrepresentation. The trial court held that the general counsel violated the rule by making numerous misrepresentations and providing “unreliable estimates” to the company regarding the hours he worked during specific time periods relating to his bonus arrangement and compensation package. The Court of Appeals disagreed with the trial court, noting that he supplied a “best estimate” of hours worked, and left to the company’s discretion how to ascertain the bonus amount, without breaching the rule.

Ultimately, the Court of Appeals of Washington held that while a court has the authority to disgorge outside counsel’s legal fees for breaches of ethical duties, courts are not empowered to disgorge in-house counsel’s wages as a sanction for ethical violations. The Court noted that there are “important differences in the treatment of attorney fees versus wages” and observed that “whereas our Supreme Court has actively regulated attorney fees…it has not at all regulated attorney wages,” and eventually concluded that “lawyer-employees are protected by the same wage and hour laws that apply to employees in comparable positions.” Accordingly, the Court of Appeals reversed the trial court’s ruling based upon novel interpretations of the ethics rules and remanded the case for entry of judgment consistent with the jury’s verdict.

Disgorgement for ethical violations, while historically rare for in-house counsel, nonetheless appears to be an emerging trend as courts are more frequently awarding this form of remedy as a result of ethical violations. Review of Chism was sought and denied by the state’s highest court. Chism v. Tri-State Constr., Inc., 186 Wn.2d 1013 (Wash. 2016).

The Chism case has been closely watched with mixed reactions from a cross-section of the legal community. The case underscores some important considerations for in-house counsel to keep in mind whenever they negotiate compensation packages or other agreements with their corporate clients. When wearing different hats as legal/business advisors and corporate employees, in-house counsel may need to consider paying special attention to the context and content of their interactions with their companies, including making appropriate disclosures and obtaining written consents, advising their companies to consult separate counsel where necessary, and clarifying the nature, scope, and implications of any employer/employee agreements they may enter into.

Undoubtedly, Chism is a unique case that sheds light on a number of important issues involving in-house counsel’s relationship with a client-employer that appear to not have been addressed as closely by a U.S. court before. For example, what is the nature of in-house counsel’s role; how is in-house counsel to be compensated; what ethical duties are owed to a corporate employer; and are in-house counsel akin to outside counsel who are regulated by the ethics rules and have a fiduciary relationship with their clients, or are in-house counsel comparable to corporate executives who are not governed by the ethics rules, but may owe certain fiduciary type duties to the client-employer? These questions may arise for in-house counsel in jurisdictions around the country, regardless of where they are admitted or licensed and who their corporate employer is. The answers are not always clear. 

1. Sheppard Mullin Richter & Hampton LLP v. J-M Mfg. Co., 244 Cal. App. 4th 590 (Cal App. 4th 2016). 2. Fair v. Bakhtiari 195 Cal. App. 4th 1135 (Cal App. 2d 2011). 3. So v. Suchanek, 670 F.3d 1304 (D.C. Cir. 2012). 4. Shelton v. Shelton, 151 A.D.2d 659 (2d Dept. 1989), citing Brill v. Friends World Coll., 133 A.D.2d 729 (N.Y. App. Div. 1987). 5. Kaye v. Rosefielde, 223 N.J. 218 (N.J. 2015).

Devika Kewalramani is a partner at Moses & Singer LLP and co-chair of its Legal Ethics & Law Firm Practice. Ms. Kewalramani focuses her practice on legal ethics, professional discipline, risk management, and compliance. She serves as the chair of the Committee on Professional Discipline of the New York City Bar Association.

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