[*PG1203]WHEN BUSINESS DECISIONS OF A CLIENT CREATE A CURRENT CLIENT CONFLICT OF INTEREST: IMPLICATIONS IN A COMPLEX ETHICAL LANDSCAPE
Abstract: Lawyers have an ethical duty to be loyal to their clients. Conflict of interest questions involving loyalty are increasingly at issue in the modern climate of mergers and acquisitions. When there is a traditional client conflict the courts favor disqualification, finding the risk to loyalty values too extreme. Yet, when there is a corporate affiliate situation, or when the conflict is created by client business decisions and not the law firm, the balance may and should be shifted. This Note argues that courts should follow the flexible, practical, balancing of facts and circumstances approach instead of a strict per se rule. This balancing of facts and circumstances must consider all facts that implicate loyalty, including the law firm’s fault in creating the conflict. This Note concludes that a more flexible balancing approach, which includes whether the law firm is at fault in creating the conflict, adequately protects loyalty values while preventing the misuse of disqualification motions as a litigation tactic.
In 1985, Gould, Inc. filed a lawsuit against Pechiney and Tremfimetaux (“Pechiney”).1 In the lawsuit, Gould, Inc. v. Mitsui Mining & Smelting Co., Gould was represented by the law firm of Jones, Day, Reavis & Pogue (“Jones, Day”).2 Jones, Day also represented IG Technologies, Inc. in various contractual matters.3 Unfortunately, in 1989, Pechiney acquired IG Technologies, putting Jones, Day in the position of suing the subsidiary of a current client.4
Lawyers have an ethical duty to be loyal to their clients.5 One component of the duty of loyalty is that a lawyer cannot be directly [*PG1204]adverse or materially adverse to the interest of a current client, such as the position in which Jones, Day found itself.6 This duty of loyalty is the basis for the attorney-client relationship, a relationship in which clients reveal their most intimate confidences.7 A law firm’s undivided and uncompromising loyalty to its clients is fundamental to the integrity of legal representation.8 Just as important, it is vital to the layman’s perception of justice.9 Four general policies, therefore, drive the duty of loyalty and the conflict of interest rules that accompany this duty: (1) maintaining professional judgment and thereby effective representation; (2) maintaining confidentiality; (3) protecting the client’s expectations; and (4) “furthering broader societal objectives.”10
Conflict of interest and loyalty issues can occur in a variety of situations. A traditional current client conflict can arise if a law firm that represents two clients, A and B, sues Client B on behalf of Client A.11 Even if the suit on behalf of A against B is unrelated to the law firm’s representation of B, the basic ethical rule is that adversity is prohibited as a breach of loyalty to a current client.12 Traditionally, jurisdictions have used either a per se rule of disqualification or a prima facie rule to prohibit such representation.13 Yet, as the legal [*PG1205]environment has shifted in the last twenty years, these strict rules are increasingly challenged as out of date and unduly formalistic.14
Conflict of interest questions are increasingly at issue in the modern climate of mergers and acquisitions, as in the case of Gould.15 In this situation, courts must decide what rules apply when a law firm suddenly finds itself adverse to a client’s affiliate because of a business action of a client, such as a merger or an acquisition.16 There is a breach of loyalty when a law firm is adverse to a current client, even when there is no relationship between the two representations, but, of course, there is no loyalty issue when a law firm is adverse to a non-client.17 Therefore, the key question when a law firm is adverse to a corporate affiliate of a client, known as a corporate family conflict, is whether the affiliate should be treated as a client or non-client for conflict of interest purposes.18 Various courts and commentators have advocated approaches ranging from per se treatment of an affiliate of a client as an actual client to considering corporate family members as completely separate entities.19
State and federal ethical codes ultimately define and regulate the attorney’s duty of loyalty and attempt to address these questions.20 The American Bar Association’s (“ABA”) Model Code of Professional Responsibility and its replacement, the Model Rules of Professional Conduct, both address conflicts of interest by emphasizing loyalty to the cli[*PG1206]ent.21 Additionally, there has been substantial development of the duty of loyalty in both case law and ethics opinions.22
This Note addresses the duty of loyalty, and the prohibition against suing or otherwise acting adversely to your own client, in the context of mergers and acquisitions.23 Furthermore, it examines what rules should govern given the complex interaction of three paradigms: current conflicts between traditional clients, conflict with a former client, and the hot potato rule, which prohibits a law firm from dropping one client to undertake representation of another client.24 Part I of this Note addresses the current state of the Model Code of Professional Responsibility (“Model Code”), Model Rules of Professional Conduct (“Model Rules”), Restatement (Third) of the Law Governing Lawyers (“Restatement”), and ethical opinions in resolving current client and corporate affiliate conflicts.25 Part II discusses the general case history and the differences between the per se rule and the facts and circumstances test.26 Part III addresses how a conflict caused by the actions of the client should be addressed in the context of the per se rule and the facts and circumstances test.27 Part IV argues for a practical approach that looks for real, instead of imaginary, conflicts.28
The American Bar Association’s (“ABA”) Model Rules of Professional Conduct (“Model Rules”) and Model Code of Professional Responsibility (“Model Code”) embody the basic doctrine on conflicts of interest.29 Although the Model Rules and the Model Code have formed the basis for state ethics rules, both of these documents were meant to have force [*PG1207]only within the membership of the ABA.30 An increasing number of states have adopted the Model Rules with various modifications, although a significant minority have adopted modified Model Codes.31 The state rules of professional conduct are followed by the state courts.32 Meanwhile, the federal courts try to apply a national standard of ethics by relying on the state ethics codes, as well as the Model Code and the Model Rules.33
The Model Code is made up of Canons, Ethical Considerations (“EC”) and Disciplinary Rules (“DR”).34 Canons are general directives, while Ethical Considerations are more specific guidelines that are not binding.35 In contrast, Disciplinary Rules are binding on legal professionals.36 Canons 4, 5 and 9 apply generally to concurrent representation, although Disciplinary Rule 5–105 is the controlling provision.37
Embedded in the Model Code is a preoccupation with maintaining public confidence in attorneys and upholding the legal profession’s integrity.38 Canon 4, for instance, addresses the former by preserving the confidences of clients, thus encouraging clients to speak freely to their lawyers without fear of disclosure.39 Canon 5 addresses the latter by imposing a duty to exercise independent professional judgment on behalf of a client.40 EC 5–1 further states that the professional judgment of a lawyer should be exercised solely for the benefit of his cli[*PG1208]ent, and the interests of other clients should not “be permitted to dilute his loyalty to his client.”41
Within this framework, Disciplinary Rule 5–105 specifically mandates that lawyers may not accept or continue employment if their independent professional judgment is likely to be adversely affected or if it would likely involve them in representing differing interests.42 There is an exception if it is obvious that a lawyer could adequately represent the interest of each client and if both consent.43 The consent provision is important because occasionally a client will not consent to the adverse representation, but the law firm or the opposing party will believe that consent should not be necessary because there is no real conflict.44 Furthermore, Canon 9 of the Model Code embodies a concept courts liberally use to reject representation adverse to a current client: “a lawyer should avoid even the appearance of impropriety.”45 This concept is increasingly rejected by Model Rules jurisdictions.46
The Model Rules deal with adverse representation against a current client or its affiliate through Model Rule 1.7.47 Rule 1.7 states:
A lawyer shall not represent a client if the representation of that client will be directly adverse to another client, unless:
[*PG1209] the lawyer reasonably believes that representation will not adversely affect the relationship with the other client; and
each client consents after consultation.
A lawyer shall not represent a client if the representation of that client may be materially limited by the lawyer’s responsibilities to another client or to a third person, or by the lawyer’s own interests, unless:
the lawyer reasonably believes the representation will not be adversely affected; and
the client consents after consultation . . . .48
The rule emphasizes that representation “directly adverse” to another client is prohibited unless the lawyer reasonably believes that the representation will not be adversely affected and each client consents.49 The comment to Rule 1.7 states that “a lawyer ordinarily may not act as advocate against a person the lawyer represents in some other matter, even if it is wholly unrelated.”50 On the other hand, simultaneous representation, in unrelated matters, of clients whose interests are only generally adverse instead of directly adverse, such as competing economic enterprises, “does not require consent of the respective clients.”51 The Rules, therefore, distinguish between impermissible and permissible representation according to the degree of adverse impact, emphasizing the difference between specific and generalized, and direct and indirect adversity.52 Although the Model Code’s more general principles of loyalty and public confidence are also embodied in the Model Rules, the Rules’ specific guidelines allow more leeway than the standard of the Code.53 Unlike the Model Code’s “appearance of impropriety” standard, where “disqualification would become little more than a question of subjective judgment,” the Rules approach considers whether loyalty has been compromised realistically and objectively.54
[*PG1210] Model Rule 1.9 is also relevant to current conflicts because it requires a lawyer to maintain confidentiality.55 Although Rule 1.7’s approach to current client conflicts is based on concerns of loyalty, Rule 1.9’s approach to conflicts is more practical.56 Instead of concern with direct adversity, Rule 1.9 addresses the lawyer’s duty to maintain confidentiality both with current and former clients.57 Therefore, even if Rule 1.7 is not applicable because there is no conflict or the representation is not current, the more relaxed “substantial relationship” test of Rule 1.9 must still be met before the representation is ethical.58 The test under Rule 1.9 is whether the current representation is substantially related to the representation of the former client such that client confidences are likely to be compromised.59
In addition, Rule 1.13 is important in that it defines who an attorney’s client is in the case of an organization.60 Specifically, Rule 1.13(a) provides that: “A lawyer employed or retained by an organization represents the organization acting through its duly authorized constituents.”61 Therefore, its “[o]fficers, directors, employees, and shareholders” are not considered individual clients.62
Although both the Model Code and Model Rules prohibit adversity to current clients, and to a lesser extent former clients, neither the Model Code nor the Model Rules explicitly answer how representation against the corporate affiliate of a current client should be treated.63 Furthermore, they do not address the more specific question of how to deal with a conflict caused by the business actions of the client and not by any transgression of the law firm.64 The Restatement (Third) of the [*PG1211]Law Governing Lawyers (“Restatement”), however, provides another tool in determining a law firm’s duties in such a situation.65
The general concern of the Restatement is that the relationship and trust between the lawyer and the client, and the justified expectation of the client that the lawyer will be on her side, will be impacted by allowing lawyers to be adverse in any significant way to their client’s interests.66 Consequently, the Restatement prohibits suits brought by an attorney against a present client.67 Additionally, this prohibition may extend to “situations, not involving litigation, in which significant impairment of a client’s expectation of the lawyer’s loyalty would be [likely].”68 Such situations are likely to impair expectations of loyalty because, although they do not involve litigation, they involve “contentious” or emotional dealings.69 This may include charges of bad faith or transactions that involve a large part of the client’s financial worth.70
The Restatement, like the Model Rules, prohibits direct adversity but more specifically identifies what meets this standard.71 It emphasizes that adversity relates not to the end result of a given case but to the “quality of representation.”72 The Restatement also concludes that general adversity between clients is not enough; instead, the important test is whether the relationship between the lawyer and the client is likely to be compromised.73
In addition, the Restatement goes further than the Model Rules and provides a test to determine whether the financial and personal relationship between a client and its corporate affiliates are strong enough that the affiliate should be treated as the client for conflict purposes.74 These factors include: (1) whether financial loss or benefit to the non-client corporate affiliate will have a direct, adverse [*PG1212]impact on the client;75 (2) whether the lawyer’s relationship to one client is such that another client’s interests would be materially adversely affected;76 (3) whether the client enjoys significant control of the non-client affiliate;77 and (4) whether specific obligations such as confidentiality are compromised.78 The Restatement notes that various courts have used all, some or none of these considerations in determining whether representation without consent is permissible.79
Finally, unlike the Model Code and Model Rules, the Restatement directly addresses the underlying issue of fault in concurrent adverse representation.80 Under the Restatement, conflicts of interest arising from a client merger should trigger an exception to the so called “hot potato” rule.81 The hot potato rule prohibits a law firm from withdrawing from representation of one client when the purpose is to undertake representation of a new client adverse to it.82 The concern is that law firms prohibited from undertaking a new or lucrative representation by concurrent representation rules may try to drop a less lucrative client like a “hot potato.”83 By converting the current client to a former client they would try to avoid disqualification under the current client analysis and instead fall under the less strenuous former-client substantive relationship test.84 This doctrine is relevant to the conflict of interest question because some courts have addressed corporate family conflicts by crafting an exception to the hot potato [*PG1213]rule, allowing selective withdrawal and application of the substantive relationship test.85
In 1991, in Stratagem Development Corp. v. Heron International N.V. & Heron Properties, Inc., the United States District Court for the Southern District of New York held that representation adverse to the corporate affiliate of a client is per se improper.86 Stratagem involved a motion to remove plaintiff’s counsel because of a conflict of interest in a breach of a real estate joint venture agreement case.87 The plaintiff, Stratagem Development Corporation (“Stratagem”), was represented in the action by Epstein, Becker & Green (“Epstein Becker”).88 The defendant, Heron Properties (“Heron”), moved to disqualify Epstein Becker because the firm also represented Fidelity Services Corporation (“FSC”), a wholly-owned subsidiary of Heron, in an unrelated labor lawsuit and arbitration.89 Epstein Becker responded to Heron’s complaints that it was violating the New York Code of Professional Responsibility by withdrawing from its representation of FSC but continuing to represent Stratagem in its dealings with Heron.90
To determine whether Epstein Becker’s representation of Stratagem against Heron was prohibited, the court looked to Cinema 5, Ltd. v. Cinerama, Inc. for the proposition that where there is adversity to a current client, “the conduct ‘. . . must be measured not so much against the similarities in litigation, as against the duty of undivided loyalty which an attorney owes to each of his clients.’”91 The court further stated that this duty is equally applicable where the client is a subsidiary of the entity being sued.92 The court found this especially true in the present case where, as a wholly owned subsidiary, damages against the subsidiary corporation “directly affect[ed] the bottom line [*PG1214]of the corporate parent.”93 As a result, Epstein Becker’s attempt to end the representation of FSC and avoid disqualification was ineffective.94
In 1994, in Cincinnati Bell, Inc. v. Anixter Bros., Inc. the United States District Court for the Southern District of Ohio also followed a per se rule that prohibited adversity against the corporate affiliate of a current client.95 In Cincinnati Bell, Anixter Brothers, Inc. (“Anixter”), the defendant, moved to disqualify Frost & Jacobs as counsel for the plaintiff, Cincinnati Bell, due to a conflict of interest.96 Frost & Jacobs first represented Cincinnati Bell in a partnership agreement with Anixter, which was subsequently purchased by Itel, the parent of Itel Rail Corp. (“Itel Rail”).97 Itel Rail then engaged Frost & Jacobs in unrelated litigation without either Frost & Jacobs or Itel Rail realizing the potential for a conflict of interest with Itel Rail’s sister corporation, Anixter.98 Frost & Jacobs subsequently instituted a suit on behalf of Cincinnati Bell against Anixter as a result of the prior representation on the partnership agreement, still not realizing that Anixter was the sister company of its client Itel Rail.99 In the meantime, Itel Rail was winding up its business and being integrated into the parent company Itel.100
Interestingly, even though the conflict arose because Frost & Jacobs failed to discover a potential conflict in its representation of Itel Rail, and the conflict arguably could have been prevented by an adequate conflicts check, the court characterized the conflict as one caused by the client’s business actions.101 The court further concluded that because neither party realized the conflict, the conflict arose in[*PG1215]nocently.102 But in actuality, Cincinnati Bell is factually distinct from true no-fault conflict cases.103
Despite finding the law firm to be without fault, the court went on to condemn the conflict with strong words.104 The court stated, “We cannot imagine how an attorney can maintain a duty of undivided loyalty to a client, while at the same time zealously attempting to exact millions of dollars of damages from a sister corporation.”105 Cincinnati Bell therefore exemplifies a per se prohibition of adversity to a current client because of the “direct effects upon the financial well-being” of the parent company and the resulting financial impact on the sister company.106 The court justified this result by interpreting Canon 5 of the Model Code to mean that the “very threat of divided loyalty is a basis for disqualification.”107
The per se disqualification rule of Stratagem and Cincinnati Bell has had followers, but the majority of courts have instead adopted a more flexible test to determine whether a law firm can undertake representation adverse to the corporate family member of a current client without consent.108 In fact, most cases citing Stratagem do not apply the per se rule of disqualification but instead adopt a more pragmatic balancing test.109 In addition, the cases on which Stratagem relies only weakly support a per se rule in corporate family conflicts.110
The American Bar Association Committee on Ethics and Professional Responsibility (“Committee”) directly addressed the question [*PG1216]of whether a lawyer who represents a corporate client may represent another client adverse to the affiliate of that corporate client in an unrelated manner.111 Their Opinion rejected the application of a per se rule in a corporate affiliate conflict situation, regardless of whether the affiliate is wholly-owned or has a more tenuous ownership connection with the original client.112 The test is not affiliation itself, but whether the circumstances of the client-lawyer relationship are such that the client has a reasonable expectation, known to the law firm, that its affiliate will be treated as a client for conflicts purposes.113
Moreover, the Opinion clarifies that Model Rule 1.7(a) applies only if two conditions are met.114 First, the corporate affiliate must be considered a client.115 Second, the representation must be directly adverse.116 If both conditions are met, the representation is prohibited unless the lawyer reasonably believes that the representation will not be adversely affected and both clients consent.117
If the corporate affiliate is not considered a client, then Rule 1.7(b) is applicable.118 Under Rule 1.7(b), if a lawyer’s representation of a client may be materially limited by the lawyer’s duties to another person or entity, such as an affiliate of another client, the lawyer is prohibited from accepting the representation.119 An exception is allowed if the attorney obtains consent from the client whose representation may be materially limited and the lawyer reasonably believes that the representation will not be adversely affected.120
To determine whether the corporate affiliate is also a client, the Committee stated that although the Model Rules could be interpreted otherwise, Rule 1.13 includes a presumption that an organization is considered separate from its constituents for conflict of interest purposes.121 Whether the affiliate is considered a client thus depends on the particular circumstances of the relationship, and is a matter of implied or express contract.122 If, however, the client has an expecta[*PG1217]tion that corporate affiliates will be protected as clients from adverse representation, the Committee believes that lawyers who perform only a limited role for the client should not be expected to be current on all corporate affiliations and that the burden is on the client to keep the lawyer informed.123 Therefore, the Committee stated that a lawyer who has no reason to know of the conflict will not necessarily violate the ethics rules by accepting new representation without client consent.124
To determine whether the particular circumstances indicate a client relationship with the affiliate, the Committee examined whether the nature of the lawyer’s dealings was intended to benefit all subsidiaries and involved obtaining confidential information from these subsidiaries.125 Adverse representation against a corporate affiliate may be particularly problematic when the lawyer has had access to confidential information through her previous work for the corporate client that could be used against the affiliate.126 In addition, if the relationship is more attenuated, the affiliate could still be considered a client if the lawyer-client relationship is such that the affiliate reasonably believes that it is a client.127 This is exemplified where the legal teams of the affiliate and the corporate client are closely linked.128 Finally, a lawyer may be required to consider a client’s affiliate as a client when the two corporations are alter-egos.129 An alter-ego is characterized by a disregard of corporate formalities or a complete overlap of management and board of directors.130
Significantly, a mere economic impact on the affiliate that results in an economic impact on the corporate client, does not warrant disqualification.131 While it directly impacts a non-client, the affiliate, the [*PG1218]representation is only indirectly adverse to the client.132 Finally, the Committee noted Rule 1.7(b) limits the lawyer’s representation where a lawyer cannot recommend or carry out an appropriate course of action because of other responsibilities or loyalties.133 Here the Committee worries that the attorney’s concern for pleasing one client might compromise his professional judgment in advising another client.134
The Opinion also advises a law firm to clarify which of its clients’ corporate affiliates are to be considered its clients for conflicts of interest purposes from the onset of the representation.135 This understanding is not, however, mandatory.136
The dissents to the Opinion are concerned that the majority departed from the traditional interpretation of the Model Rules and shifted the burden of protection from the lawyer to the client in requiring it to bargain for protection of its affiliates.137 Furthermore, the dissenters believe that considering economic impact as merely indirect conflict is an inaccurate portrayal of the business world.138 Indeed, the dissent states that outside the Fortune 500, most companies would find a suit that imposed economic harm as a clear conflict of interest.139
In 2001, in Colorpix Systems v. Broan Manufacturing Co., the United States District Court for the District of Connecticut, consistent with the ABA Ethics Opinion, as well as the dominant approach in the United States Court of Appeals for the Second Circuit, rejected the per se rule.140 Defendant Broan Manufacturing Co. (“Broan”) moved to disqualify the law firm of Robinson & Cole (“R&C”) from representing the plaintiff, Travelers Casualty and Surety Company of Illi[*PG1219]nois (“Travelers”), because R&C represented Broan’s parent company, Nortek, Inc., in a prior suit.141 The Colorpix case, unlike Stratagem, involved a former client relationship, but the issue of whether Broan was a client of R&C for conflicts of interest purposes still arose.142 The court noted that Broan was a wholly-owned subsidiary of Nortek and that a significant share of Nortek’s business was comprised of Broan and Nordyne, Inc., another wholly-owned subsidiary.143 In addition, Broan and Nordyne shared a legal department, management personnel and business strategy.144 The court stated that whether there is a former or current client relationship, and whether the client is traditional or attenuated, is immaterial for purposes of the conflicts of interest standard.145 To determine whether Broan was a client of R&C, the court asked whether there were “sufficient aspects” of a traditional client relationship to trigger protection, not whether there was actually such a relationship.146
The Colorpix court did not interpret Stratagem to require a per se test.147 Instead, it cited Stratagem for the proposition that financial impact “weighs in favor of finding a conflict of interest.”148 According to Colorpix, elements of the “facts and circumstances” test include the level of control over the subsidiaries’ litigation, coordinated business strategy, and whether the entities are alter-egos of one another because they share management and legal departments.149 The court concluded that because Broan was a wholly-owned subsidiary of Nor[*PG1220]tek and comprised a substantial share of Nortek’s business, any claim against Broan would directly and adversely affect Nortek’s “bottom line.”150 Furthermore, the connection between the legal departments and sharing of corporate management personnel and business philosophy meant Broan had a sufficient attorney-client relationship with R&C to create a potential conflict.151
In 1989, in Hartford Accident & Indemnity Co. v. RJR Nabisco, Inc., the United States District Court for the Southern District of New York again applied the facts and circumstances test developed in the Second Circuit.152 To determine whether there was a traditional client relationship requiring disqualification, the Hartford court considered whether the parent and subsidiary were distinct and separate entities for the purposes of legal representation.153 In Hartford, the court concluded there was a traditional relationship because the general counsel of the parent retained a supervisory role over the subsidiary.154 The court, however, also found that the relationship was not a continuing one, such that the less stringent substantial relationship test could be applied to determine disqualification.155 The court also found an exception to the “hot-potato” doctrine, which prohibits applying the less stringent former-client conflict test when a law firm drops a client, was warranted in Hartford because the law firm did not drop its client.156 Instead, the client’s long-time lawyer merely left the firm with the client in tow.157 Therefore, the less stringent test was applied by the court and disqualification was ultimately unnecessary.158
As shown, the preferred approach of most courts to a corporate family conflict is a balancing of the facts and circumstances.159 In these cases, presumption of loyalty to a client’s affiliate is rejected and adversity to the corporate affiliate of a client is treated as merely indi[*PG1221]rect.160 Instead, the courts look to the relationship between the client and the law firm, and the client and its affiliate, to determine if there are enough similarities to a traditional client relationship that the same loyalty concerns are raised and the same strict duties should be imposed.161
Within the complex framework of current conflicts of interest, some cases address a conflict that arises through the actions of the client and not through those of the law firm.162 There is, however, considerable disagreement as to how this element should work into the basic framework of either the per se or the balancing tests.163 There are three basic approaches to the problem.164 The first two approaches developed in the case law, one following from the per se framework of Stratagem Development Corp. v. Heron International N.V. & Heron Properties, Inc.,165 the second from the cases that reject a per se conflict rule in the corporate family situation.166 The third approach has no case support and originates from a strict reading of the Restatement.167 All three approaches, even the per se test, address the fault issue by incorporating a balancing test, but differ in how this test is applied.
The first approach seen in the case law deals with the problem of a no-fault conflict that arises when the court uses the per se conflict rule seen in Stratagem.168 This approach was used by the United States District Court for the Northern District of Ohio in 1990 in Gould, Inc. v. Mitsui Mining & Smelting Co.169 Gould has been widely cited to support an exception to the hot potato rule when a current conflict is [*PG1222]caused by client action.170 The per se rule is applied and disqualification is presumed, but a second step mitigates this strict rule by allowing withdrawal if the facts and circumstances warrant.171 In other words, a conflict is presumed but the law firm has the option to drop either client at its own discretion if it was not at fault.172 Once the law firm is allowed to convert the problem client into a former client the conflict is then analyzed under the more permissive standard for former client conflicts.173
In Gould, the plaintiff, Gould, Inc., was represented by the law firm Jones, Day, Reavis & Pogue (“Jones, Day”) against multiple defendants including Pechiney and Trefimetaux (“Pechiney”).174 Pechiney moved to disqualify Jones, Day as Gould’s counsel because of two conflicts of interest created by a complex sequence of events including a law firm merger and a client acquisition.175 In 1985, Gould filed suit against Pechiney with Jones, Day as local counsel.176 In 1987, Pechiney, which had been represented by McDougall, Hersh & Scott in patent matters wholly unrelated to the suit at hand, became a client of Jones, Day as a result of the merger of the law firms of McDougall, Hersh & Scott and Jones, Day.177 In addition, in 1989 Pechiney acquired IG Technologies Inc. (“IGT”), which Jones, Day represented in numerous matters unrelated to the suit against Pechiney.178 Thus, after the acquisition, Jones, Day was put in the position of suing Pechiney, the parent company of its client IGT.179 Pechiney claimed that Jones, Day should be disqualified because of the conflicts.180
In approaching the issue, the Gould court considered two questions.181 First, whether Jones, Day violated Canon 5 of the Model Code, and, second, if such a violation occurred, whether disqualification was necessary.182 The court, applying a per se approach, stated that suing [*PG1223]a client’s corporate affiliate was the same as suing the client itself.183 The court then concluded that consent to the conflict was required not only by Gould but also by Pechiney, the non-client and parent of the client IGT.184
Yet, while it applied a per se rule, the court also recognized the conflict was caused by the client not the law firm.185 The court therefore created a second step in the analysis, asking whether there should actually be disqualification, or whether the remedy of selective withdrawal (an exception to the hot potato rule) would be appropriate.186 The court advocated a balancing approach to take into account the changing corporate environment and increasing merger activity.187 In applying this balancing test, the Gould court found that judicial integrity was not threatened because, among other factors, no information or confidences were compromised and Pechiney created the conflict by acquiring IGT after the suit had commenced.188 Therefore, while the first prong of the test in Gould is a per se disqualification rule, it is softened by allowing an exception under the second prong: a balancing of the facts and circumstances, including the law firm’s fault.189
Although Gould has spurred a line of cases applying some version of an exception to the hot potato rule, most cases do not actually seem to use a two step test.190 Instead, they skip the per se analysis and use a facts and circumstances test that considers the fault of the law firm as one element.191 This is consistent with the widespread rejection of a per se approach discussed earlier.192
The United States Courts of Appeals for the Second, Third, and Ninth Circuits all favor some type of a balancing test over a per se standard to determine whether corporate family members should be [*PG1224]considered the same client for current conflict purposes.193 In practice, per se jurisdictions treat corporate affiliates as the same client, and therefore automatically remedy a conflict through disqualification or withdrawal.194 To determine whether disqualification or withdrawal is appropriate, courts implement a balancing test.195 In contrast, in jurisdictions that favor the second “facts and circumstances” approach, the test has only one step.196 This step is a balancing test where the law firm’s lack of fault is merely one factor to consider in determining whether the law firm should be disqualified, forced to withdraw, or whether representation can continue.197
In 1980, the United States District Court for the District of Delaware decided Pennwalt Corp. v. Plough.198 Plaintiff Pennwalt Corporation’s (“Pennwalt”) counsel, Dechert, Price & Rhoads (“Dechert”) also currently represented the defendant’s sister corporation, Scholl, Inc., in an unrelated suit.199 Dechert continuously represented Pennwalt in litigation matters starting in 1956.200 In 1977, Pennwalt began considering a law suit against Plough.201 In 1978, Dechert became the defense counsel for Scholl in an unrelated anti-trust case.202 In 1979, Schering-Plough, the parent company of Plough, acquired Scholl as a wholly-owned subsidiary.203 Approximately one month later, Dechert instituted the lawsuit against Plough on behalf of Pennwalt, and only later became aware of the corporate relationship.204
Dechert was allowed to withdraw from representing Scholl, leaving the court to consider Plough’s attempt to disqualify it from representing Pennwalt.205 Plough urged a per se rule of disqualification because any action against it would necessarily harm its affiliate [*PG1225]Scholl.206 In contrast, Dechert argued that because it never represented either Plough or Schering-Plough there was no ethical duty implicated in being adverse to them.207 Furthermore, Dechert argued that the conflict was the fault of Schering-Plough because it was created by its purchase of Scholl.208
The court analyzed the issues under a Model Code framework and rejected the positions of both parties.209 The court rejected the per se rule because neither Schering-Plough nor Plough were clients of Dechert and all the companies were distinct legal entities.210 Instead, the court used the facts and circumstances test to determine if the ultimate objectives of the Code, undivided loyalty and confidentiality, were violated.211 To determine whether there is a threat to loyalty, a court following Pennwalt should consider the relationship between the sister corporations to determine to what degree the representation of one client may be influenced by a regard for the other client.212 The Pennwalt court concluded that there was no threat of disloyalty because the conflict arose significantly after the actions began.213 Although Scholl and Plough were in the process of merging their personnel and operations, including their legal departments, these changes had not yet taken place at the time of Dechert’s withdrawal from representing Scholl.214 Therefore, under the formula in Pennwalt, the integration of the legal departments and a close structural relationship between the sister companies could implicate loyalty.215 More interestingly, it was important to the court’s analysis that the conflict arose through the actions of one of the clients and not the law firm.216 The court ultimately concluded that there was no threat to loyalty and no conflict, such that Dechert’s withdrawal never implicated the hot potato rule.217 Importantly, Dechert had to withdraw because of the impending conflict created as the legal departments of Scholl and Schering-Plough merged.218 Implicitly, if there had been [*PG1226]no such operational integration then withdrawal might not have been necessary.219
The Second Circuit has a well-defined approach that uses a similar balancing test for the current conflict of interest question.220 If the law firm is adverse to a “traditional client,” or if the legal relationship is a continuing one, a strict prima facie rule against representation is applied.221 If the client is neither traditional nor continuing then it can be treated as a former client and the more permissive substantial relationship test is applied.222 Most courts then look at factors such as links between the affiliates in terms of management and legal decision-making to determine if they are separate entities or should be considered one traditional client.223 Courts consider whether the law firm was at fault as relevant to whether the relationship is continuing.224 Therefore, like in Pennwalt and the second step of Gould, although it is normally unacceptable to terminate a client relationship after a conflict arises and then use a more lenient conflicts test, courts will allow this exception to the hot potato rule where the facts and circumstances warrant it.225 Namely, an exception to the hot potato doctrine is allowed when the client and its affiliate are not so closely connected that they should be treated as one client, and where the conflict is not the fault of the law firm.226
This approach was followed in 2000, in University of Rochester v. G.D. Searle & Co., where the United States District Court for the Western District of New York balanced the facts and circumstances and determined that disqualification was not warranted.227 In this case, a law firm represented the University of Rochester against the subsidiary of its client Pharmacia because of Pharmacia’s subsequent merger with Upjohn and Monsanto, to whom Searle previously was related.228 The court used a balancing test, considering several factors including the unexpected nature of the merger that caused the conflict, and that substantial work had been done by the firm prior to the [*PG1227]merger.229 Attempting to avoid the hot potato rule, the law firm withdrew from the prior representation for the merged company and claimed that this cured its conflict.230 The court agreed that an exception was warranted, citing several factors in support of withdrawal.231 These factors included the conflict created by a client business decision, and the law firm’s prompt reaction to the conflict once it was discovered.232
This approach can also be seen in In re Wingspread Corp., where the trustee of Wingspread Corporation and its subsidiaries sought to retain Hahn & Hessen as its counsel against NCNB National Bank of North Carolina (“NCNB”).233 The parent of NCNB, NationsBank Corporation (“NationsBank”), sought to disqualify Hahn & Hessen because Hahn & Hessen was counsel for Citizens, a NationsBank subsidiary, in unrelated matters.234 The conflict was created by a merger that made NationsBank the parent company of both NCNB and Citizens.235 Due to the merger, Hahn & Hessen was representing one sister company of the NationsBank family while suing another.236 The court first asked whether the relationship between Hahn & Hessen and NationsBank was attenuated and vicarious or a traditional client relationship.237 The court considered that Hahn & Hessen never represented NationsBank or any other subsidiaries before the merger, and after the merger continued to represent only Citizens as a separate entity from NationsBank.238 Furthermore, NationsBank’s extended corporate structure sufficiently distanced NationsBank from Hahn & Hessen.239 The court also looked to whether the representation was current, and found that there was minimal work, only approximately eight hours, done for Citizens since the dismissal of the last case.240 The court noted that withdrawal is usually not allowed to cure a current conflict.241 In this case, however, the more lenient sub[*PG1228]stantial relationship test was appropriate because the conflict was created by a client action after representation commenced.242
In Teradyne, Inc. v. Hewlett-Packard Co., a 1991 case decided by the United States District Court for the Northern District of California, the court used an “alter-ego” test to determine whether corporate affiliates were to be treated as the same client for conflicts purposes.243 The alter-ego approach in Teradyne has significant similarities to the balancing approach.244 The court found that the intimate connection between the two affiliates made them alter-egos.245 The connections between the two affiliates included supervision of legal work for the subsidiary by the parent’s legal department, regular instructions to the subsidiary’s law firm by the parent corporation’s management, the direction of correspondence and billing by the subsidiary’s law firm to the parent, and the full integration of most of the subsidiary’s employees and business to the parent company.246 The court found this significant identity of legal interest key in finding the companies to be alter-egos of one another for conflicts purposes.247
In 1991, in Ex parte AmSouth Bank, N.A., the Supreme Court of Alabama addressed the issue of concurrent adverse representation not created by the law firm.248 The plaintiff, AmSouth, attempted to disqualify counsel for defendant, Drummond Company, Inc.249 In 1990, AmSouth approached Arnold & Porter to represent it in some transactional undertakings.250 Three months later, Arnold & Porter was retained by Drummond in regards to a suit by a minority stockholder of ABC who complained of a merger process.251 AmSouth was trustee for a number of trusts that held ABC stock, and sued Drummond two months later.252 Arnold & Porter decided to withdraw from its representation of AmSouth but continued to represent Drummond.253 The parties stipulated that Arnold & Porter’s work for [*PG1229]Drummond in the case was unrelated to its prior transactional work for AmSouth.254 The court then found that there was no threat to confidentiality.255
Although this case did not involve corporate family conflicts, but rather the more stringent rules of a traditional conflict, the court gives an enlightening consideration of a conflict caused by the subsequent actions of the clients and not the law firm.256 The court found that although lawyers ordinarily cannot shift from a Rule 1.7 (current client) to a Rule 1.9 (former client) test by dropping a client as Arnold & Porter did, the conflict was caused by AmSouth’s suit, not by the law firm.257 The court acknowledged the hot potato rule but distinguished it from the facts of the case, holding that Arnold & Porter could permissibly drop one of its clients because the conflict was not its fault and disqualification would be unfair.258 The court also noted that Arnold & Porter sought a waiver as soon as the conflict became apparent, and that the decision to withdraw from one client and not the other was made after careful consideration of its duty of loyalty to both clients.259
In conclusion, the elements of the facts and circumstances test have varied when applied by different courts.260 However, the most common elements include: prejudice to one of the parties from losing its chosen representation;261 financial impact on the traditional client;262 the importance the traditional client affiliate places on the litigation including supervision of the litigation;263 “identity of interest” between the corporate affiliates including sharing personnel, management, and legal departments;264 whether the law firm was at [*PG1230]fault in creating the conflict;265 and whether the law firm reacted promptly and appropriately upon discovering the conflict.266 These elements all directly address loyalty concerns, and ensure that the balancing test appropriately considers all factors that weigh towards disqualification, withdrawal, or continued representation in a corporate affiliate conflict situation.267
In comparison to the two case law approaches towards no-fault conflicts, the Restatement approach, read literally, is less flexible in its treatment of fault.268 The Restatement is valuable in that it explicitly spells out a balancing test to determine whether two affiliates should be treated as the same client such that there is a conflict.269 The balancing test involves considering four factors: (1) whether financial loss or benefit to the non-client corporate affiliate will have a direct, adverse impact on the client;270 (2) whether the lawyer’s relationship to one client is such that another client’s interests would be adversely affected;271 (3) whether the client enjoys significant control of the non-client affiliate;272 and (4) whether specific obligations such as confidentiality are compromised.273 This approach is similar to the facts and circumstances test developed in the case law and to the balancing test that is the second step of Gould.274 The fault element of the test does not, however, seem to be part of this balancing test.275 The comment to Section 132 instead seems to indicate that if the conflict was not the fault of the law firm then there is an automatic exception to the finding of a conflict under the balancing test.276 Indeed, this is the interpretation of the court in University of Rochester [*PG1231]where the court looked to the Restatement but explicitly rejected its implication that there is an automatic exception.277 Instead, the court chose to use the no-fault element as merely one element of the balancing test.278
The preferred approach in addressing corporate family conflicts is one that looks at the facts and circumstances involved and determines whether ethical concerns are actually implicated.279 This method is superior to a per se approach because it is practical instead of theoretical.280 A flexible approach that looks at the facts and circumstances instead of automatically treating corporate affiliates as one client is more consistent with corporate formalities.281 It also appropriately considers loyalty concerns by imposing disqualification, a harsh burden on the client’s resources and right to counsel, only when there is an actual, not an imagined, threat to the integrity of the profession.282 Finally, using a balancing of the facts and circumstances that includes the fault of the law firm, instead of the per se approach or the Restatement approach, renders an appropriate result that reflects actual loyalty concerns.283
A per se rule ignores corporate legal norms by treating corporate affiliates of a client as the same entity as the client itself.284 The per se rule allows a corporation to acquire a subsidiary, retain the protection of limited liability created by the corporate form, but at the same time [*PG1232]ignore any disadvantages in the realm of legal ethics.285 Notably, if the affiliate had chosen not to take advantage of a corporate family structure and had simply treated the acquisition as a new department, for instance, it would receive the full protection of client loyalty.286 Furthermore, in a conflict between the client and the affiliate the law firm’s duty of loyalty would clearly be with the client.287 The per se rule is therefore inconsistent with standard treatment of corporate affiliates as separate entities.288 Additionally, corporate affiliate conflicts arise in regards to sophisticated clients with complex legal structures.289 A strict per se rule ignores the ability of large corporations with extensive affiliate structures to protect themselves by negotiating representation for their affiliates.290
Over-zealous disqualification, which can come from a per se rule, also ignores a number of important values.291 This can lead to an unduly formalistic result, out of touch with reality, and ultimately undermining public confidence in the legal profession.292 A per se rule undervalues the client’s right to representation of its choice.293 In contrast, a more flexible approach correctly recognizes that disqualification is a serious remedy and a hardship on the party whose attorney is being disqualified.294 This is true in terms of both time [*PG1233]considerations as well as the financial expense of retaining and orienting new representation on a case that may be complicated or technical.295 Furthermore, a client could consider its long time counsel’s rejection of representation as much a betrayal as undertaking conflicting representation.296 Finally, the attorney’s right to practice is also a value ignored by the per se rule; one that has increasing implications as the opportunities for conflict situations grow.297
In contrast, a test that balances the facts and circumstances allows for a more practical and less formalistic approach to identifying conflicts of interest, and disregards the corporate form only when public policy reasons demand it.298 Such a practical approach, focusing on real and concrete threats to loyalty, protects loyalty and judicial integrity while refusing to undermine other values equally important to the integrity of the profession under the guise of protecting it.299 It is true that allowing conflicts of interest to continue unchecked will harm the integrity of the legal profession and foster negative perceptions by the public.300 However, a formalistic rule that imposes the burdens of disqualification on parties when the motion stems from litigation tactics not ethical concerns will likewise harm the integrity of the profession.301
Whether a law firm is at fault in creating a current conflict, or whether it was created by business actions of a client, should always be an element in determining disqualification.302 The fault of the law firm should be considered because it is directly related to concerns of loyalty.303 After all, if there is no fault on the part of the law firm then there is no ethical misconduct, no action to sanction, and no poten[*PG1234]tial for deterrence.304 Some courts, such as Gould, Inc. v. Mitsui Mining & Smelting Co., recognize the importance of the fault element in any loyalty analysis, but cling to a per se rule.305 They try to incorporate fault by implementing a balancing test as a second step after a per se conflict rule.306 This approach is correct in incorporating the valuable factual element of fault, but is theoretically flawed in using a per se approach when the conflict is against a client’s family member because, as already seen, a per se rule is unduly formalistic and inconsistent with corporate norms.307 Furthermore, a Gould approach attempts to take into account fault, but fails to fully recognize its implications in terms of remedies.308 For example, because the Gould analysis is based on a per se rule, there is a presumptive conflict that must be addressed by the court.309 There are therefore only two results to the balancing test step in Gould: disqualification or withdrawal.310 Such an approach ignores that when a law firm is not at fault, and the conflict is with a current client’s affiliate, that there may be no conflict at all.311 A better approach recognizes that, like the other elements of the balancing test, the no-fault element goes directly to whether there is actually any conflict of interest present.312 These elements, therefore, may not just weigh in favor of allowing withdrawal over disqualification, but could also show that in a corporate family context withdrawal may not be necessary either.313
Equally important to including the no-fault element in any consideration of current client conflicts in the corporate family situation, or even the traditional client conflict situation, is not overvaluing its importance.314 It is vitally important in any balancing test not to look blindly at each factor in the test, but to consider each in light of the underlying concern: preserving the value of loyalty.315 An example of overvaluing fault and ignoring the underlying ethical concerns can be [*PG1235]seen in a literal reading of the Restatement approach.316 In the Restatement a balancing test is applied to determine if there is a conflict.317 Fault is not, however, a factor in this test.318 Instead, the fault element is treated as an exception to the determination of a conflict under the balancing test.319 Presumably, then, the law firm’s lack of fault overrides the determination of whether there is a conflict under the balancing test.320 The court in University of Rochester v. G.D. Searle & Co. explicitly cites the Restatement approach and rejects an automatic exception based on the law firm’s lack of fault.321 Instead, the court praises the case law approach that uses the fault element as only one factor in the balancing test.322 The Restatement approach is inferior to the case-law approach because it ignores why fault is important: because it has loyalty implications.323 In allowing an automatic exception based on fault, the Restatement ignores other actions by the law firm that may shift the balance in favor of withdrawal or disqualification.324 For instance, a law firm could be innocent of creating the conflict, but act inappropriately in addressing that conflict.325 It could fail to adequately inform the clients of the conflict when it is discovered, delay in addressing the problem, or otherwise act in a way that compromises loyalty and warrants disqualification.326
Disqualification motions in current client conflicts raise many competing values, the most basic of which are maintenance of judicial integrity versus the right of parties to choose their own representation. When there is a traditional client conflict the courts favor disqualification, finding the risk to loyalty values too extreme. Yet, when there is a corporate affiliate situation, or when the conflict is created [*PG1236]by client business decisions and not the law firm, the balance may and should be shifted. The courts should follow the flexible, practical, balancing of facts and circumstances approach instead of a strict per se rule. Such an approach rejects labels and formalistic rules and looks to determine if loyalty is really at risk. It protects the integrity of the profession by disqualifying law firms that have compromised loyalty, but refuses to undermine the profession by allowing disqualification to be used as a litigation tactic.
A balancing of the facts and circumstances must consider all facts that implicate loyalty, including the law firm’s fault in creating the conflict. Whether the actions of the law firm were inappropriate is directly relevant to loyalty and to the justified expectations of that client. Additionally, when a law firm is not at fault disqualification serves no sanctioning or preventative value. The balance of the facts and circumstances may therefore lean towards withdrawal or continued representation when the law firm’s lack of fault is taken into account.