Law firm must return fees earned by faithless fiduciary

There is a new development in the saga of Monarch Entertainment, Robert Strother and Davis & Company. Strother’s former law firm, Davis & Company, has been ordered by the British Columbia Court of Appeal to disgorge fees paid to it by Monarch plus the profits it earned from another client because it acted in a conflict of interest. This case turns on exceptional facts, but may represent hardening of the already harsh law relating to law firm conflicts of interest.

Background

Our earlier case commentary, A Tale of a Faithless Fiduciary,[1] by Meredith Hayward, addressed the recent case of 3464920 Canada Inc. v. Strother,[2] where the same court found lawyer Robert Strother liable for breach of fiduciary duty to a client to the tune of approximately $30 million. Strother is a former partner of the prominent Vancouver-based law firm, Davis & Company. Until legislative amendments closed certain tax shelters, Strother set up tax sheltered film production financing for 3464920 Canada Inc. (which carried on business as Monarch Entertainment Corporation).

Around the same he stopped tax shelter work for Monarch, Strother discovered that notwithstanding the changes to the tax law there may still be tax shelters available to companies similarly situated to Monarch. Strother began pursuing this idea with a new client, Sentinel Hill. Strother then left Davis & Co. to work for Sentinel Hill. In finding Strother liable for his breach of fiduciary duty to Monarch, the court held that a lawyer’s duty to the client continues beyond the expiry of his retainer agreement. Strother was ordered to disgorge his profits from his involvement with Sentinel Hill – estimated to be approximately $30 million. In its decision the court invited further arguments on whether Strother’s firm, Davis & Co., should be held jointly and severally liable with its former partner.

Davis & Co. not liable for Strother’s profits

The court then turned to consideration of Davis & Co.’s liability, which it addressed in its most recent decision, issued on July 25, 2005 . [3] The court held that Davis & Co. was neither directly nor vicariously liable to account for Strother’s $30 million in profits. However, Davis & Co. was liable to disgorge the profits it earned from acting for Sentinel plus the fees paid by Monarch.

Davis & Co. was not directly liable because it did not provide “knowing assistance” to Strother in breaching his fiduciary duty to Monarch, nor was the firm recklessly or wilfully blind to Strother’s conduct. The court was influenced by the fact that the firm was unaware of Strother’s secret dealings with Sentinel Hill and that, when Strother informed Davis & Co. about his potential involvement with Sentinel Hill, Davis & Co. expressly forbad him to go into business with Sentinel, and was unaware that he did.

Similarly, Davis & Co. was not vicariously liable to Monarch for Strother’s profits. The court found that Strother:

was on a frolic of his own; that no part of Davis & Co.’s ordinary course of business involves taking secret interests in clients; that the secret agreement between Strother and Sentinel Hill added nothing and was not necessary to the services Davis & Co. was providing to Sentinel Hill; and that Davis & Co. did nothing to materially enhance the risk of wrongdoing.

Newbury J.A. concluded that “Equity will not…order an accounting or disgorgement by an innocent person who has not received any of the profits resulting from the wrong.”

Davis & Co. liable for Strother’s conflict of interest

Nonetheless, the court did find Davis & Co. vicariously liable for Strother’s breach of fiduciary duty to Monarch, and ordered the firm to disgorge to Monarch the profits it earned from acting for Sentinel Hill. In its earlier decision, the court had found that Strother was in a conflict of interest in two senses: first, he had a conflict between two clients, Monarch and Sentinel, and could not act for both; second, he had a conflict between his duty to his client Monarch, and his own interest in receiving a share of Sentinel’s profits. Strother should have turned Sentinel away, and could not join Sentinel and take a share of the profits.

His firm, Davis & Co., was therefore liable, the court found. And the “underlying prophylactic purpose of fiduciary liability” logically required that the firm not be permitted to retain the profits the firm made by acting in a conflict of interest for Sentinel, even if Strother’s partners were personally innocent.

Davis & Co. was also ordered to return to Monarch the fees Monarch paid to the firm, not including disbursements, during the time that Davis & Co. acted for both Monarch and Sentinel Hill (the period in which they were in a conflict of interest). The total value of these two awards has not yet been determined but is expected to be substantial.

It should be noted that Monarch did not suffer any loss as a result of Strother’s action. Thus, the order that Davis & Co. disgorge its profits appears to fly in the face of the principle that punitive damages cannot be imposed for vicarious liability. The court addressed this issue stating, “the more important purpose [of the law] is to maintain the integrity of fiduciary relationships by ensuring that persons who are subject to fiduciary duties cannot profit from them, except to the extent permitted by the beneficiary of the duty”.

Newbury J.A. did not see any reason why either liability for accounting profits or liability under partnership principles should be restricted to compensatory damages. The court held that Davis & Co.’s profits from its breach of fiduciary duty were its fees (minus disbursements) – both those charged to Monarch and those it received from the retainer that put it into conflict with Monarch: its retainer to act for Sentinel Hill.

Part of a trend, or exceptional facts?

It remains to be seen whether Strother is part of the present trend toward increasingly strict conflicts rules, or is simply an exceptional case with exceptional facts.

The facts were certainly exceptional. First, Strother’s advice to Monarch that there was “nothing to be done” resulted in Monarch’s decision to wind up its business entirely. It was, in short, of signal importance to Monarch. Second, while it was in the process of winding up, Monarch remained Strother’s client. During this period, Strother began investigating the possibility of obtaining a tax ruling that would revive the tax shelters. Given the importance of Strother’s advice to Monarch on this issue, it is not unreasonable for Monarch to have expected Strother to have advised it that his opinion had changed. Third, there was evidence to suggest that at the same time as he was considering how to revive the tax shelters, Strother repeated his view to Monarch that there was nothing to be done. He was not, the court held, honest with his client.

However, part of the court’s basis for finding a conflict is troubling. Strother had a written retainer agreement with Monarch in respect of the tax shelter work. That agreement contained an exclusivity arrangement prohibiting Strother from arranging tax shelters for other clients. However, after the change in the law, Strother advised Monarch that he saw no way of continuing to arrange the tax shelters, and the retainer agreement was terminated. The general rule is that there is no conflict in solicitors acting for clients who are competitors. Since the retainer agreement was over, there is no reason why Strother should not have been able to act for both Monarch and Sentinel in arranging tax shelters. Incorporating an exclusivity arrangement into a contractual retainer should not vest the exclusivity with a fiduciary character that survives the retainer. Yet the Court of Appeal’s decision appears to do precisely this.

In the result, Strother raises the possibility that when clients bargain with their lawyers for special contractual terms in a retainer agreement that go beyond the lawyers’ normal fiduciary duties, those contractual terms may become invested with a fiduciary character that survives the end of the retainer.

Whether Strother is a further increase in the harshness of conflict rules, or simply an exceptional case, the message from the courts is clear: firms that fail properly to navigate the increasing perilous conflict minefield will pay the price.

Published October 18, 2005