California Court of Appeal Issues Ruling on Derivative Legal Malpractice Actions in Favila v. Katten Muchin Rosenman LLP

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In McDermott, Will & Emery v. Superior Court, 83 Cal. App. 4th 378 (2000), the California Court of Appeal held that a shareholder derivative action against a corporation’s outside counsel, in the absence of the corporation’s waiver of the attorney-client privilege, cannot proceed. This is because when facing such a claim, outside counsel will be unable to mount an effective defense without disclosing the privileged communications with the corporation which are alleged to constitute the breach of duty. But what if the attorney-client privilege has allegedly been waived by the privilege holder or otherwise no longer exists? That issue was recently addressed in Favila v. Katten Muchin Rosenman LLP, 188 Cal.App.4th 189 (2010).

In Favila, the assets of a dissolved corporation were sold to a another corporation after the death of the dissolved corporation’s founder and shareholder. The estate of the deceased shareholder then brought derivative claims for breach of fiduciary duty and professional negligence against outside counsel for the dissolved corporation. Outside counsel asserted that the attorney-client privilege prevented them from mounting a meaningful defense.

The Court of Appeal explained that “[t]he practical problem confronting a corporation’s outside counsel named as a defendant in a derivative action that led to our decision in McDermott, Will, of course, is eliminated if the lawyer-client privilege has been waived by the privilege holder or otherwise no longer exists.” The court went on to explain that, under the facts before it, there had been no transfer of the privilege to the successor corporation and persons winding up the dissolved corporation could continue to assert the privilege during the windup process. However, the court concluded that there was a “realistic possibility” that insiders of the dissolving corporation could waive the privilege in the future. The court also cited the unresolved issue as to whether the crime-fraud exception to the attorney-client privilege applied in the case.

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