Pitfalls for Corporate Counsel in Business Divorce Disputes

April 24, 2023

No corporate lawyer wants to get drawn into a nasty litigation between an entity’s owners. But the reality is that corporate and general counsel often find themselves unwittingly ensnared in business divorce cases. Sometimes a corporate transaction is the genesis of litigation, and corporate counsel’s role or advice may be exceedingly important.

Other times, corporate counsel may have served in a joint, dual, or uncertain capacity, providing advice to the entity and its owners simultaneously. This can create particular problems when formerly aligned interests diverge.

In this week’s business divorce, we’ll consider three doctrinal pitfalls for corporate and general counsel in business divorce litigation: the fiduciary exception to the attorney client privilege, the joint representation exception to the attorney-client privilege, and a virtual per se rule of disqualification for litigation counsel who previously served as corporate counsel for a closely-held entity whose owners become adverse.

The Fiduciary Exception to the Attorney-Client Privilege

Primary inspiration for this week’s article comes from Saratoga County Supreme Court Justice Richard A. Kupferman’s decision in Celia v Celia (2023 NY Slip Op 30995(U) [Sup Ct, Saratoga County Mar. 31, 2013]).

Celia is a direct and derivative lawsuit by Eric Celia, a minority shareholder, director, and limited partner of two family-owned construction entities, Celia Construction, Inc. and Trackside L.P., alleging that the plaintiff’s brothers, the majority owners, Samuel and Dominick, looted more than $5 million from the business, hiding their alleged defalcation by denying Eric access to books and records. The amended complaint alleges 14 causes of action, including breach of fiduciary duty, dissolution, and fraudulent conveyance.

In disclosure, Eric’s attorneys deposed the entities’ corporate / general counsel, asking several questions regarding counsel’s advice to Samuel and Dominick:

• Counsel’s advice regarding Eric’s requests to review corporate books and records, including whether to decline to provide the records;

• Counsel’s advice, understanding of, and reasons for removing Eric as a director and creating new bylaws for the purpose of doing so; and

• Counsel’s communications regarding Trackside’s dissolution, the formation of a new entity and whether he advised Samuel and Dominick to transfer assets from Trackside to the new entity to frustrate Eric’s claims.

Defense counsel instructed corporate counsel to decline to answer based upon attorney-client privilege, Eric’s counsel marked 13 questions for a ruling, and a motion to compel ensued. The parties’ briefs, which you can read here, here and here, focused on the fiduciary exception to the attorney-client privilege.

Justice Kupferman explained:

where a shareholder sues corporate management for breach of fiduciary duty or similar wrongdoing, courts have carved out a fiduciary exception to the privilege that otherwise attaches to communications between management and corporate counsel (quotations omitted).

“To invoke the exception,” wrote Justice Kupferman, “courts require a showing of good cause” based upon a balancing of nine factors:

(1) the number of shareholders and the percentage of stock they represent, (2) the bona fides of the shareholders, (3) the nature of the shareholder’s claim and whether it is obviously colorable, (4) the apparent necessity or desirability of the shareholders having the information and the availability of it from other sources, (5) whether, if the shareholders’ claim is of wrongful action by the corporation, it is of action criminal, or illegal but not criminal, or of doubtful legality, (6) whether the communication related to past or to prospective actions, (7) whether the communication is of advice concerning the litigation itself, (8) the extent to which the communication is identified versus the extent to which the shareholders are blindly fishing, and (9) the risk of revelation of trade secrets or other information in whose confidentiality the corporation has an interest for independent reasons (quotations omitted).

Applying these factors, the Court granted Eric’s motion to compel, concluded that the information Eric sought “may be the only evidence available on whether Samuel and Dominick’s actions respecting the relevant transactions were in furtherance of the interests of the entities and the minority owner or primarily for their own interests and benefit.”

The Joint Representation Exception to the Attorney-Client Privilege

Somewhat related to the fiduciary exception, the joint representation exception to the attorney-client privilege renders discoverable attorney-client communications from an attorney jointly representing multiple clients who later become adverse to one another. The theory is that because any one client can waive the privilege, none can assert the privilege against the other’s wishes.

This principle of law arises where lines of representation may be indistinct or blurry, and corporate or general counsel may have jointly represented multiple shareholders, board members, and/or the entity simultaneously. This fact pattern happens more often than one might think, implicating several rules of law.

Rule #1: “An attorney may not withhold work product from his own client” (Newmarkets Partners, LLC v Sal. Oppenheim Jr. & Cie. S.C.A., 258 FRD 95 [SD NY 2009] [quotations and brackets omitted]).

Rule #2: “An attorney who represents two parties with respect to a single matter may not assert the privilege in a later dispute between the clients” (Quintel Corp., N.V. v Citibank, N.A., 567 F Supp 1357 [SD NY 1983]).

Rule #3: A corporation may not assert attorney-client privilege against a former controlling shareholder or board member at the time of the rendering of legal advice (see e.g. Fochetta v Schlackman, 257 AD2d 546 [1st Dept 1999] [“Plaintiff was a principal and a 50% shareholder of each of the closely held defendant corporations until 1996 when he executed the stock surrender, the validity of which forms the focal point of the present litigation. Given the extent of plaintiff’s ownership interest and managerial involvement in defendant corporations prior to the disputed stock surrender, the motion court properly determined that the attorney-client privilege was not properly invoked by defendants to deny plaintiff access to otherwise privileged pre-surrender materials essential to the proof of his claims”]).

Rule #4: A client is entitled to “presumptive access to the attorney’s entire file on the represented matter,” and “should be entitled to inspect and copy work product materials, for the creation of which [he] paid during the course of the firm’s representation” (Matter of Sage Realty Corp. v Proskauer Rose Goetz & Mendelsohn L.L.P., 91 NY2d 30 [1997]).

The latter rule of law treats material prepared for a client, such as an entity’s owner, as a “property right,” and a law firm has a “general duty to provide that material . . . upon . . . request absent a substantial showing of good cause to refuse client access” (Sage Realty Corp. v Proskauer Rose Goetz & Mendelsohn LLP, 294 AD2d 190 [1st Dept 2002]).

Under Second Department case law, a law firm’s refusal to return to a client his or her files is potentially actionable legal malpractice (see e.g. Lewis, Brisbois, Bisgaard & Smith, LLP v Law Firm of Howard Mann, 141 AD3d 574 [2d Dept 2016]).

Deerin’s Virtual “Bright Line” Disqualification Rule

A final rule of law that crops up repeatedly in business divorce cases: “One who has served as attorney for a corporation may not represent an individual shareholder in a case in which his interests are adverse to other shareholders” (Matter of Greenberg, 206 AD2d 963 [4th Dept 1994]).

Under this principle of law, an attorney may not serve as corporate or general counsel for an entity, or its owners jointly, then morph roles to become litigation counsel for one owner adverse to the other.

Under this principle of law, in a trio of decisions, the Second Department has three times reversed lower courts for denying disqualification of litigation counsel in both LLC member and corporate shareholder disputes (see Deerin v Ocean Rich Foods, LLC, 158 AD3d 603 [2d Dept 2018]; Gordon v Obiakor, 117 AD3d 681 [2d Dept 2014]; Morris v Morris, 306 AD2d 449 [2d Dept 2003]). The First Department recently relied upon the Deerin rule to affirm disqualification in Poretsky v Bartleby and Sage, Inc. (203 AD3d 523 [1st Dept 2022]).

According to one Court, “Deerin . . . provides something close to a bright line rule” requiring disqualification in shareholder disputes where litigation counsel formerly represented the entity or its owners jointly then switches roles to serve as litigation counsel in a dispute between the owners (Wiener v Braunstein, 2019 NY Slip Op 31155[U] [Sup Ct, NY County 2019]).

The bottom line of all of these concepts is that corporate and general counsel should be exceedingly careful when taking on taking on new representation to spell out in their engagement letters exactly who are the clients, who are not the clients, and the precise scope of the representation.

Recently, my firm and I successfully relied upon the Deerin line of case law for disqualification of opposing counsel in a pair of cases involving a 50% / 50% father-son shareholder dispute in the Suffolk County Commercial Division.

According to our client (the father), opposing counsel previously served as both trust and estate counsel for the father and as corporate counsel for the entity and its shareholders, including drafting the shareholders’ agreement on behalf of both shareholders. Opposing counsel then switched roles, becoming litigation counsel for the son suing the father for attempted rescission and damages relating to a stock purchase agreement both sides allege the other breached. You can read the resulting disqualification decisions here and here.

Conclusion

A well-crafted conflict waiver, for example, may solve the Deerin disqualification problem. But where lines of representation become blurred, and counsel are not careful to document the outer bounds of their representation and precisely who are their clients, unforeseen attorney-client privilege issues and potential conflicts of interest may arise. Careful corporate counsel should expect, and plan for, the unexpected.