McDERMOTT v. SUPERIOR COURT, LOS ANGELES COUNTY

Citation Codes

Equivalent Citations

citation codes

Docket Number

B137829

Attorney(S)

John H. Sharer and Kevin S. Rosen for Petitioner. No appearance for Respondent. Browne Greene, Christine D. Spagnoli, Ralph B. Wegis and Stuart B. Esner for Real Parties in Interest.

Judges

N. Fred Woods

See more information ...

Smart Summary

Factual and Procedural Background

Petitioner McDermott, Will Emery ("MWE") served as outside legal counsel for Memorial Healthcare Systems, Inc. ("MHSI"), a nonprofit parent company of Bakersfield Memorial Hospital. In 1994, MHSI negotiated an affiliation agreement with Mercy Healthcare Bakersfield, with MWE representing MHSI during these negotiations. Following execution of the agreement, five shareholders of approximately 1,200 (the real parties in interest) filed a direct action against MHSI and others, alleging procedural irregularities and seeking to void the affiliation agreement. The court denied their preliminary injunction motion, reasoning they likely lacked standing to pursue direct claims.

While this direct action was pending, the real parties initiated a derivative malpractice action against MWE, alleging malpractice related to drafting ballots and assisting in the election implementation, as well as making false and misleading representations. Before discovery commenced, MWE moved for judgment on the pleadings, arguing the derivative action was an impermissible assignment of a legal malpractice claim and contrary to public policy because it prevented MWE from defending itself due to attorney-client privilege constraints. The trial court denied this motion, prompting the present petition for writ of mandate.

Legal Issues Presented

Whether a shareholder may maintain a derivative legal malpractice action against the corporation’s outside counsel arising from counsel’s representation of the corporation when the corporation refuses to commence the action.
Whether such a derivative action constitutes an impermissible assignment of the corporation’s malpractice claim.
Whether attorney-client privilege issues preclude outside counsel from mounting a meaningful defense in a shareholder derivative malpractice action.
Whether the business judgment rule bars a derivative action against an extracorporate third party such as outside counsel.

Arguments of the Parties

Petitioner’s Arguments

The derivative malpractice action against outside counsel is effectively an assignment of the corporation’s legal malpractice claim to shareholders, prohibited under California law and public policy.
The action circumvents the business judgment rule by allowing shareholders to sue outside counsel directly instead of pursuing remedies against management or the board.
The attorney-client privilege prevents MWE from disclosing privileged communications needed to mount a defense, effectively denying a meaningful defense.

Real Parties in Interest’s Arguments

Shareholders have standing to bring derivative actions against outside counsel to recover for harm to the corporation.
Precedents from other jurisdictions support shareholder derivative actions against corporate counsel as a matter of standing and do not raise privity concerns.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Kracht v. Perrin, Gartland Doyle (1990) 29 Cal.App.3d 1019, 1023	Prohibition on assignment of legal malpractice claims due to public policy and defense difficulties.	Supports the principle that attorneys cannot be forced to defend malpractice claims by non-clients without waiver of privilege; analogous reasoning applied to derivative actions.
Baum v. Duckor, Spradling Metzger (1999) 72 Cal.App.4th 54, 66-67	Reinforces the prohibition on assignment of malpractice claims and highlights privilege issues.	Used to affirm that derivative actions against outside counsel raise the same privilege concerns as assignments.
Jackson v. Rogers Wells (1989) 210 Cal.App.3d 336, 341-342	Legal malpractice claim assignment impermissibility.	Supports public policy against assignment of malpractice claims.
Goodley v. Wank Wank, Inc. (1976) 62 Cal.App.3d 389, 393	Prohibition on assignment of malpractice claims.	Supports the court’s reasoning on public policy grounds.
Fireman's Fund Insurance v. McDonald, Hecht, Solberg (1994) 30 Cal.App.4th 1373, 1381	Definition of assignment of a cause of action.	Distinguishes assignment from derivative action, emphasizing the cause of action remains with the corporation in the latter.
Jones v. Ahmanson Co. (1969) 1 Cal.3d 93, 107	Clarifies nature of shareholder derivative suits as actions brought on behalf of the corporation.	Supports the principle that derivative suits do not transfer claims but are brought in the corporation’s right.
United Copper Securities Company v. Amalgamated Copper Company (1917) 244 U.S. 261, 263-264	Business judgment rule and internal management discretion regarding litigation decisions.	Establishes that courts ordinarily defer to directors’ decisions unless misconduct is alleged.
Findley v. Garrett (1952) 109 Cal.App.2d 166, 178	Requirement to allege director misconduct or dual interest to proceed with derivative action against third parties.	Used to explain the prerequisites for shareholder derivative suits when corporation refuses to act.
Katz v. Chevron Corp. (1994) 22 Cal.App.4th 1352, 1366	Business judgment rule protects directors’ decisions if any rational business purpose exists.	Supports deference to board decisions barring bad faith or misconduct.
National Football League Properties, Inc. v. Superior Court (1998) 65 Cal.App.4th 100, 109	Corporation holds attorney-client privilege; shareholders do not have standing to waive it in derivative suits.	Court relied on this to hold privilege bars disclosure by corporate counsel in derivative malpractice actions.
Pacific Tel. Tel. Co. v. Fink (1956) 141 Cal.App.2d 332, 335	Filing malpractice suit generally waives attorney-client privilege to the extent necessary for defense.	Distinguishes direct malpractice actions from derivative ones where privilege is not waived.
Robertson v. Gaston Snow Ely Bartlett (Mass. 1989) 536 N.E.2d 344, 350	Derivative nature of shareholder claims against corporate counsel for harm to corporation.	Referenced by real parties to support standing but court found privilege issues unaddressed.
Palmer v. Fox Software (6th Cir. 1997) 107 F.3d 415, 420	Malpractice claims resulting in injury to corporation are derivative, not direct.	Supports standing argument but not privilege concerns.
Ohman v. Kahn (S.D.NY 1988) 685 F. Supp. 1302, 1310	Derivative suits do not raise privity concerns because shareholders assert corporation’s rights.	Supports standing but not privilege waiver.
Karris v. Water Tower Trust Savings Bank (Ill.App. 1979) 389 N.E.2d 1359, 1370	Derivative actions against third parties do not raise privity issues.	Supports standing argument.
Hoiles v. Superior Court (1984) 157 Cal.App.3d 1192, 1198	California courts refuse to create shareholder exception to attorney-client privilege in derivative actions.	Supports court’s holding that privilege bars derivative malpractice actions against outside counsel.
Dickerson v. Superior Court (1982) 135 Cal.App.3d 93, 99	Strict application of attorney-client privilege precludes judicial exceptions.	Supports refusal to allow shareholder waiver of privilege.
Garner v. Wolfinbarger (1970) 430 F.2d 1093, 1103-1104	Federal courts allow case-by-case access to privileged information in derivative suits.	Not adopted by California courts due to Evidence Code restrictions.

Court's Reasoning and Analysis

The court began by clarifying the nature of shareholder derivative actions, emphasizing that such suits do not constitute an assignment of the corporation’s cause of action to shareholders, but rather are brought on the corporation’s behalf to enforce its rights. Consequently, the argument that the derivative malpractice suit is an impermissible assignment was rejected.

The court rejected the contention that the business judgment rule bars derivative suits against third parties, noting that shareholders may proceed where directors act in bad faith or have conflicts preventing an unbiased decision to enforce the corporation’s rights.

However, the court identified a critical obstacle: the attorney-client privilege. Because the corporation holds the privilege and has not waived it, shareholders cannot access privileged communications necessary for the attorney defendant to mount a meaningful defense. Unlike direct malpractice claims, where privilege waiver is automatic upon filing suit, derivative actions do not effect such waiver.

This privilege barrier places outside counsel in an untenable position, forced to defend against malpractice allegations without the ability to disclose communications that are central to the defense. The court found this situation analogous to the rationale behind prohibiting assignments of malpractice claims, where attorneys would be unable to defend themselves adequately.

While acknowledging cases from other jurisdictions that permit derivative suits against outside counsel, the court distinguished California’s strict adherence to attorney-client privilege under the Evidence Code, which forecloses judicial exceptions allowing shareholders to waive the privilege.

Accordingly, the court concluded that, absent legislative action creating a shareholder right to waive privilege in derivative actions, such lawsuits against corporate outside counsel cannot proceed.

Holding and Implications

The court granted the writ of mandate and ordered the trial court to vacate its denial of MWE’s motion for judgment on the pleadings, directing entry of judgment in favor of MWE.

This decision means the derivative legal malpractice action against corporate outside counsel cannot proceed due to attorney-client privilege constraints. The ruling does not establish a new exception to the privilege nor alter the business judgment rule but enforces existing privilege protections strictly. Consequently, shareholders cannot pursue derivative malpractice claims against outside counsel unless the corporation waives privilege or the legislature provides otherwise. Each party was ordered to bear its own costs in this writ proceeding.

Show full summary ...

McDERMOTT, WILL EMERY, Petitioner, v. THE SUPERIOR COURT OF LOS ANGELES COUNTY, Respondent DONNA SMITH JAMES, et al., Real Parties in Interest.

WOODS, J.

INTRODUCTION

May a shareholder sue its corporation's outside counsel in a derivative action for legal malpractice arising out of counsel's representation of the corporation, where the corporation refuses a proper demand to commence the action? Under the procedural posture of this case (a denial of a motion for judgment on the pleadings), we are not called upon to address the merits of this lawsuit or whether such a suit would subsequently be dismissed under the business judgment rule. Rather, we are asked to decide whether, assuming all procedural requirements have been met and the directors' bad faith is properly alleged, such a derivative suit against outside counsel may go forward.

Although shareholders, upon meeting certain prerequisites, may proceed in a derivative action against a third party to recover for harm done to the corporation, a derivative lawsuit for malpractice against corporate outside counsel raises unique attorney-client privilege issues. Because the shareholders are not the holder of the privilege, they do not effect a waiver of that privilege merely by filing their action on the corporation's behalf. As a result, in the absence of a waiver by the corporate client, the third party attorney is effectively foreclosed from mounting any meaningful defense to the shareholder derivative action. Accordingly, and for the reasons expressed herein, we hold such a derivative action against the corporation's outside counsel, necessarily brought in equity, cannot proceed.

FACTS AND PROCEDURAL HISTORY

Petitioner, McDermott, Will Emery ("MWE"), is outside legal counsel for Memorial Healthcare Systems, Inc. ("MHSI"), a nonprofit parent company of Bakersfield Memorial Hospital ("Bakersfield Memorial"). Real parties in interest are five of approximately 1,200 shareholders of MHSI.

In 1994, MHSI entered into negotiations with Mercy Healthcare Bakersfield ("Mercy") to effect an "affiliation" between Bakersfield Memorial and Mercy. MWE represented MHSI in these negotiations. After the Affiliation Agreement was executed, real parties filed a direct action against MHSI and the other parties to the Affiliation Agreement ("Kern County Action.") Real parties alleged, among other things, the written ballot was misleading, the election was not fair because MHSI members were not provided with a membership list, and MHSI acted improperly in implementing the Affiliation Agreement. Real parties sought to void the Affiliation Agreement, and sought a preliminary injunction and damages. The court denied real parties' motion for preliminary injunctive relief, reasoning real parties likely lacked standing to pursue direct claims against MHSI.

While the Kern County action was still pending, real parties sued MWE in this derivative action, claiming MWE committed malpractice in drafting the ballots and assisting in the implementation of the election, and made false and misleading representations about the affiliation in order to effect the Affiliation Agreement.

Before any discovery was conducted, MWE filed a motion for judgment on the pleadings, arguing, inter alia, this derivative action against outside counsel constituted an "assignment" of a legal malpractice action in violation of California law, and was contrary to public policy because it required MWE to defend a malpractice action without an ability to disclose privileged information in connection with such a defense. The trial court denied the motion. This petition followed.

DISCUSSION

I. A SHAREHOLDER DERIVATIVE ACTION AGAINST AN EXTRACORPORATE THIRD PARTY IS NOT AN ASSIGNMENT OF THE CORPORATION'S CLAIM TO THE SHAREHOLDERS NOR AN END-RUN AROUND THE BUSINESS JUDGMENT RULE.

MWE contends this derivative lawsuit is akin to an assignment of the corporation's malpractice claim to dissident shareholders, and as such, is in violation of a long line of California precedent prohibiting the assignment of legal malpractice claims. (See e.g. Kracht v. Perrin, Gartland Doyle (1990) 29 Cal.App.3d 1019, 1023 [assignment of legal malpractice claims is impermissible as a matter of public policy because, among other things, it would force attorneys to defend themselves against persons to whom no duty was ever owed.); see also Baum v. Duckor, Spradling Metzger (1999) 72 Cal.App.4th 54, 66-67); Jackson v. Rogers Wells (1989) 210 Cal.App.3d 336, 341-342; Goodley v. Wank Wank, Inc. (1976) 62 Cal.App.3d 389, 393.)

In contending this derivative action is tantamount to an assignment of the corporation's malpractice claim, MWE misconstrues the nature of a derivative action. An assignment of a claim "pass[es] title to a cause of action from one person to another." ( Fireman's Fund Insurance v. McDonald, Hecht, Solberg (1994) 30 Cal.App.4th 1373, 1381.) A derivative action, in contrast, does not transfer the cause of action from the corporation to the shareholders. Rather, the cause of action in a shareholder derivative suit belongs to and remains with the corporation. Such a lawsuit is derivative, i.e., brought in the "corporate right," to recompense the corporation for injuries done to it. ( Jones v. Ahmanson Co. (1969) 1 Cal.3d 93, 107.) Though it is named as a defendant, the corporation is "the real plaintiff and it alone benefits from the decree; the stockholders derive no benefit therefrom except the indirect benefit resulting from a realization upon the corporations' assets." ( Ibid.)

MWE further contends such a derivative lawsuit against an extracorporate third party must be precluded because it accomplishes an end-run around the business judgment rule. MWE contends the only remedy is a derivative suit against management or the board. Certainly, this is not the case. As our Supreme Court made clear, a shareholder derivative action may be brought to enforce a cause of action the corporation itself possesses against management, the board, or some third party when management fails to redress the wrong. ( Jones v. Ahmanson Co., supra, 1 Cal.3d at p. 107.)

That is not to say a shareholder may proceed against a third party in a derivative action every time the corporation refuses a demand to commence the action. As the Supreme Court noted nearly a century ago, "whether or not a corporation shall seek to enforce in the courts a cause of action for damages, is like other business questions, ordinarily a matter of internal management, and is left to the discretion of the directors." ( United Copper Securities Company v. Amalgamated Copper Company (1917) 244 U.S. 261, 263-264.) To proceed with a lawsuit against a third party in a derivative action after the corporation refuses to do so, the derivative action must allege the directors are guilty of misconduct or otherwise stand in a dual relation which prevents an unprejudiced exercise of judgment. ( Findley v. Garrett (1952) 109 Cal.App.2d 166, 178.) The "court will not substitute its judgment for that of the board if the latter's decision can be attributed to any rationale business purpose." ( Katz v. Chevron Corp. (1994) 22 Cal.App.4th 1352, 1366.)

II. A DERIVATIVE LAWSUIT AGAINST OUTSIDE COUNSEL RAISES ATTORNEY-CLIENT PRIVILEGE ISSUES WHICH FORECLOSE THE ATTORNEY FROM MOUNTING A MEANINGFUL DEFENSE TO THE ACTION.

Having held shareholders have standing to pursue a derivative action against an extracorporate third party to enforce the rights of the corporation provided certain prerequisites are satisfied, we must still confront the attorney-client privilege issues necessarily raised by a derivative malpractice action against corporate outside counsel. In holding a shareholder derivative action not to be tantamount to an assignment, we have reasoned that shareholders in such an action essentially "stand in the shoes" of the corporation. While this is true for most purposes, the one notable exception is with respect to the attorney-client privilege.

It is the corporation, and not the shareholder, who is the holder of the privilege. ( National Football League Properties, Inc. v. Superior Court (1998) 65 Cal.App.4th 100, 109.) Shareholders do not enjoy access to such privileged information merely because the attorney's actions also benefit them. ( Ibid.) Nor do shareholders obtain the right to waive the privilege simply by virtue of filing the action on the corporation's behalf. ( Ibid.)

This distinction makes a derivative malpractice action far different from a direct malpractice action. Generally, the filing of a legal malpractice against one's attorney results in a waiver of the privilege, thus enabling the attorney to disclose, to the extent necessary to defend against the action, information otherwise protected by the attorney-client privilege. (Evid. Code § 958; Pacific Tel. Tel.. Co. v. Fink (1956) 141 Cal.App.2d 332, 335.) However, because a derivative action does not result in the corporation's waiver of the privilege, such a lawsuit against the corporation's outside counsel has the dangerous potential for robbing the attorney defendant of the only means he or she may have to mount any meaningful defense. It effectively places the defendant attorney in the untenable position of having to "preserve the attorney client privilege (the client having done nothing to waive the privilege) while trying to show that his representation of the client was not negligent." ( Kracht, supra, 219 Cal.App.3d at p. 1024, fns. omitted.)

To support their right to pursue this action, real parties draw our attention to cases in other jurisdictions, which they claim recognize the validity of a shareholder derivative action against outside corporate counsel. All of the cases cited by real parties view the issue as one of standing. Some focus on the harm alleged, noting any action against corporate counsel to recover for harm to the corporation would be a derivative, as opposed to a direct action. (See e.g. Robertson v. Gaston Snow Ely Bartlett (Mass. 1989) 536 N.E.2d 344, 350, fn. 5 ["the plaintiff cannot assert, in this personal action, any alleged breach of duty [the attorney] owed to the corporation. Any claim made by a shareholder based on [the attorney's] failure to disclose to the corporation the voting agreement . . . must be through a derivative action."]; see also Palmer v. Fox Software (6th Cir. 1997) 107 F.3d 415, 420 ["we agree Palmer is not entitled to recover [directly] for acts of malpractice that resulted in injury to the corporation, and are therefore solely derivative claims"].)

Other cases uphold the action against challenges of absence of privity between the shareholder and the corporate counsel. These cases correctly note such derivative lawsuits do not raise privity concerns since the shareholders are simply asserting the rights of the corporation. (See e.g., Ohman v. Kahn (S.D.NY 1988) 685 F. Supp. 1302, 1310; Karris v. Water Tower Trust Savings Bank (Ill.App. 1979) 389 N.E.2d 1359, 1370.)

We do not disagree with the rationale in any of these cases so far as standing is concerned. As we previously explained, we agree any lawsuit by a shareholder against corporate counsel for damage to the corporation must be derivative in nature. We also agree that as such, there is no issue of privity, since the shareholder sues on behalf of the corporation.

Where we depart from these cases, if at all, is in their failure to address the attorney-client privilege issues necessarily raised by such a lawsuit. Unlike some courts, California courts have refused to carve out a shareholder exception to the attorney-client privilege, even in a derivative action. ( National Football League Properties, Inc., supra, 65 Cal.App.4th at p. 107; Hoiles v. Superior Court (1984) 157 Cal.App.3d 1192, 1198.) We simply cannot conceive how an attorney is to mount a defense in a shareholder derivative action alleging a breach of duty to the corporate client, where, by the very nature of such an action, the attorney is foreclosed, in the absence of any waiver by the corporation, from disclosing the very communications which are alleged to constitute a breach of that duty. Thus, while we decline to view a shareholder derivative action in the same vein as an assignment, the rationale used to prohibit all assignments of legal malpractice actions, on the ground attorneys would be unable to defend such actions in the absence of a waiver of the privilege by their own client, applies with equal force here. ( Kracht, supra, 219 Cal.App.3d at p. 1024; Baum v. Duckor, Spradling Metzger (1999) 72 Cal.App.4th 54, 67.)

It has been suggested, and indeed adopted by some federal courts, that a case-by-case finding of good cause, including a likelihood that the corporate decision would be outside the protections of the business judgment rule, could be grounds for allowing the shareholders access to privileged information in any lawsuit they brought on the corporation's behalf. (See, e.g. Garner v. Wolfinbarger (1970) 430 F.2d 1093, 1103-1104.) However, long-standing California case authority has rejected this application of the federal doctrine, noting it contravenes the strict principles set forth in the Evidence Code of California which precludes any judicially-created exceptions to the attorney-client privilege. ( Dickerson v. Superior Court (1982) 135 Cal.App.3d 93, 99; Hoiles, supra, 157 Cal.App.3d at p. 1198.) In light of this history, the creation of any shareholder right to waive the privilege in a derivative action should be left to the California Legislature. And, in the absence of such a right, this derivative action, necessarily brought in equity, cannot go forward.

DISPOSITION

Let a peremptory writ of mandate issue directing respondent court to vacate its order of November 17, 1999, denying MWE's motion for judgment on the pleadings, and enter a new judgment granting MWE's motion for judgment on the pleadings consistent with the reasons set forth herein.

Each party to bear its own costs in this writ proceeding.

We concur:

LILLIE, P.J.

NEAL, J.

The petition of real parties in interest for review by the Supreme Court was denied December 13, 2000. Werdegar, J., was of the opinion that the petition should be granted.