In Reilly v. Greenwald & Hoffman, LLP (2011) 196 Cal. App. 4th 891, the court held that a minority shareholder could not bring a derivative action against the corporation’s outside counsel for misrepresentation, malpractice, or breach of contract.
In March 2003, Mark Reilly and Lena Brion agreed to operate Brion Reilly, Inc. (BRI), to provide architectural and design services. Reilly’s and Brion’s interests in the corporation were 49% and 51%, respectively, but they agreed to equal compensation and profit-sharing. Brion was the president, director and chief financial officer of BRI. Reilly was also a director and officer of BRI.
In April 2004, Reilly and Brion agreed to terminate their business relationship and dissolve BRI. Five years later, in 2009, Reilly sued BRI, Brion, and the corporation’s outside counsel, Greenwald & Hoffman, LLP, and Paul Greenwald, who was BRI’s outside counsel. A bank and other persons were also named as defendants. The first cause of action, titled “Shareholder Derivative Action,” named all defendants and alleged that between June 2006 and the end of 2008, Brion had excluded Reilly from BRI’s premises and had misappropriated to herself the monies, receivables, personal property, and work in progress of BRI and that Brion engaged in this misconduct with the cooperation and assistance of the other defendants.
The seventh through ninth causes of action were solely against Greenwald and his firm. The seventh cause of action, for constructive fraud and negligent misrepresentation, alleged that Greenwald, while acting as BRI’s counsel, advised BRI that Brion had no duty, in connection with the dissolution of BRI, to account for the monies, receivables, personal property, and work in progress of BRI as of the date of the termination of business. Further, it alleged that Greenwald counseled BRI that Brion was entitled to appropriate such assets of BRI to her own use without any duty to distribute to plaintiff his proportionate share of the assets.
The eighth cause of action, for legal malpractice, alleged that Greenwald breached the standard of care owed BRI and that he violated the State Bar’s Rules of Professional Conduct by facilitating Brion’s misconduct.
The ninth cause of action, for breach of contract, alleged that Greenwald’s conduct was a breach of his written agreement with BRI for legal services.
The trial court dismissed the complaint in response to Greenwald’s objection that BRI had not waived the attorney-client privilege covering communications between him and Brion during his representation of BRI, and so under McDermott, Will & Emery v. Superior Court (2000) 83 Cal.App.4th 378, the claim was barred as to him.
In McDermott, Will & Emery, the court explained that while shareholders “stand in the shoes” of the corporation for most purposes of a derivative action, a 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. Shareholders do not enjoy access to information protected by the attorney-client privilege merely because the attorney’s actions also benefit them. Nor do shareholders obtain the right to waive the privilege simply by virtue of filing the action on the corporation’s behalf. Thus a derivative malpractice action is quite different from a direct malpractice action.
Generally, the filing of a legal malpractice action 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. But because a derivative action does not, of itself, result in the corporation’s waiver of the privilege, such a lawsuit against the corporation’s outside counsel can deprive the attorney defendant of the only means he or she may have to mount a 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.
A theoretical solution would be to carve out an exception to the attorney-client privilege for disclosure to shareholders of the attorney’s client, but Californiacourts have refused to carve out a shareholder exception to the attorney-client privilege, even in a derivative action. In McDermott, Will & Emery, the court rejected the case-by-case approach some federal courts have adopted, which allows a shareholder access to privileged information in a shareholder derivative action on a finding of good cause.California case law does not permit it.
Because the corporation’s lawyer is placed in an untenable position, unless the corporation waives the attorney-client privilege (which the suing shareholders don’t have the power to do on behalf of the corporation), McDermott, Will & Emery holds that shareholders may not maintain a malpractice action against the corporation’s attorney in a derivative action.
Reilly contended McDermott, Will & Emery was inapplicable because a dissolved corporation such as BRI may not assert the attorney-client privilege, but that argument was recently rejected in Favila v. Katten Muchin Roseman LLP (2010) 188 Cal.App.4th 189. The appellate court here agreed with Favila‘s analysis.
Corporations Code section 2010(a) provides:
A corporation which is dissolved nevertheless continues to exist for the purpose of winding up its affairs, prosecuting and defending actions by or against it and enabling it to collect and discharge obligations, dispose of and convey its property and collect and divide its assets, but not for the purpose of continuing business except so far as necessary for the winding up thereof.
Citing Penasquitos, Inc. v. Superior Court (1991) 53 Cal.3d 1180, the court said that the effect of dissolution is not so much a change in the corporation’s status as a change in its permitted scope of activity. Thus, a corporation’s dissolution is best understood not as its death, but merely as its retirement from active business.
And indeed, Reilly was able to bring this action only because BRI’s existence continued for purposes of litigation. It is therefore logical that if a dissolved corporation continues to exist for litigation, it remains the holder of the attorney-client privilege during the litigation.
Reilly asserted, that notwithstanding Favila, BRI cannot assert the attorney-client privilege because there is “no functioning management of the corporation” to assert the privilege on its behalf. But he had it backwards. Absent a waiver of the attorney-client privilege by someone authorized to make it on BRI’s behalf, the privilege is not waived, and the attorney is duty-bound to claim the privilege.
Reilly also argued that under Evidence Code section 953(d) the successor to a dissolved corporation holds the attorney-client privilege. That section provides that the holder of the attorney-client privilege is a “successor, assign, trustee in dissolution, or any similar representative of a… corporation…that is no longer in existence.” (Italics added.) According to the court, BRI remained in existence to wind up its affairs, including litigating the derivative action brought by the shareholder.
Because of the fundamental unfairness of allowing a suit against an attorney for alleged misconduct arising out his representation of corporation while effectively prohibiting him from telling his side of the story, the claims against the attorney had to be dismissed.
The court assumes, but does not explain why, McDermott, Will & Emery should apply to misrepresentation and breach of contract claims. This seems like a correct result but the absence of analysis of the issue is not helpful.
The court’s treatment of Evidence Code section 953(d) seems facile. Clearly the text of the section was intended to apply to a dissolved corporation. If under Corporations Code section 2010(a) a corporation always continues to exist for the purpose of winding up, there can be no such thing as a corporation “that is no longer in existence.” Rather than treat the Evidence Code section as saying something that effectively means nothing, the court should have reconciled the two sections. The result seems correct, however.