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WSHB Case Update – California Court of Appeals Allows for “Delayed Discovery” of Fraud Claims Against Law Firms for Improper Handling of Settlement Funds 17 Years After the Settlement Occurred; Decision Could Trigger Additional Suits Against Law Firms

March 5, 2014

Why This Case Is Important

On February 11, 2014, the California Court of Appeal issued its decision in Prakashpalan v. Engstrom, Lipscomb and Lack, holding that two homeowners could sue their former attorneys for alleged mishandling of funds received from settlement of claims involving the 1994 earthquake. Significantly, the court held that despite the fact the alleged fraudulent conduct by the law firm occurred 16 years earlier, the statute of limitations does not bar late-discovered fraud claims. This decision has the potential to trigger more professional liability claims because it establishes that law firms owe clients a fiduciary duty to provide an accounting of client trust accounts under the Probate Code, significantly expanding the delayed discovery rule concerning fraud as it relates to client trust accounts. As a result of this decision, potential claimants have three years from the date a firm provides an accounting or the date the client discovers the wrongful act to bring a fraud claim against a fiduciary and clients have no duty of inquiry until the fiduciary provides the accounting.

Facts

Plaintiffs Muruganandan and Navamalar Prakashpalan (“Plaintiffs”) filed suit against their former attorneys, Engstrom, Lipscomb, and Lack (“Engstrom”) alleging fraud, fraudulent concealment of conflict of interest, conspiracy to commit intentional fraud, and other tort claims arising from Engstrom’s representation of Plaintiffs in two separate legal matters, including the Allegro Matter, and a third matter involving a conflict with Plaintiffs. For purposes of this case update, the issues surrounding the Allegro Matter are most important; thus, we discuss only the Allegro issues.

In the Allegro Matter, Engstrom represented 93 families, including Plaintiffs, in a bad faith and property damage claim against Plaintiffs’ insurer arising from the 1994 Northridge earthquake. Engstrom settled the claim for approximately $100 million in or around November 1997. Plaintiffs’ share of the settlement was $745,000, of which approximately one third went to Engstrom. Engstrom had instructed all 93 families not to discuss how much they received. The only information Engstrom told Plaintiffs was the amount of Plaintiffs’ share of the settlement, Engstrom’s attorney fees, and that the 93 families received a total of $100 million.

In February 2012, after speaking with 17 of the 93 families, Plaintiffs realized $22 million of the settlement was unaccounted for and believed Engstrom withheld funds from Plaintiffs.

Procedural Background

Plaintiffs filed an initial complaint in June 2011 and filed a First Amended Complaint shortly thereafter, including additional claims for conversion and civil conspiracy after Plaintiffs discovered the missing funds from the Allegro settlement. Engstrom demurred and Plaintiffs filed a Second Amended Complaint.

Engstrom demurred to the Second Amended Complaint and the trial court sustained the demurrer without leave to amend, holding that although the statute of limitations did not bar Plaintiffs’ claims in the Allegro matter, the attorney-client privilege barred Plaintiffs’ claims because Engstrom would have to reveal confidential information about its other clients to resolve whether Engstrom improperly distributed client funds. Plaintiffs appealed.

Holding

The California Court of Appeal held that the statute of limitations in Probate Code section 16460, including the delayed discovery rule, applies to client trust accounts and the disbursement of settlement funds from such accounts.

Discussion

Code of Civil Procedure Section 338 provides a three-year statute of limitations for actions for fraud against attorneys that begins to run upon discovery of the claim. Probate Code section 16460 imposes a duty upon fiduciaries of a trust to provide an accounting to a beneficiary. Under 16460, a trust beneficiary who receives an accounting sufficient to put him or her on notice of a claim against the trustee must bring his or her claim within three years from the date he or she either receives the accounting or otherwise discovers facts to notify him or her of the claim.

In determining whether to apply the delayed discovery rule from Code of Civil Procedure section 338 or Probate Code section 16460 to Plaintiffs’ claim, the court looked to the statutory rule of construction, which provides that when two statues govern the same subject, a particular intent controls a general, inconsistent intent. After reviewing both statutes, the court found that client trust accounts qualify as express trusts and thus the Probate Code applies to client trusts. Further, the California Rules of Professional Conduct provide that attorneys owe clients a duty to provide an accounting of client trusts and attorneys who represent multiple clients may not enter into an aggregate settlement of claims without the “informed consent” of each client. The court also relied upon the American Bar Association’s Rules of Professional Conduct to determine that “informed consent” requires a lawyer to disclose the total amount of the aggregate settlement and details of that lawyer’s other clients’ participation in the settlement.

Based on finding that client trusts are express trusts, the appellate court held that section 16460 governs Plaintiffs’ fraud claims. Under section 16460, the statute of limitations had not begun to run on the claim that Engstrom did not properly distribute the aggregate settlement proceeds in the Allegro matter because Engstrom had failed to provide Plaintiffs with sufficient information to evaluate whether all monies were properly distributed.

One prominent plaintiffs’ attorney noted that this ruling–and the potential for further “delayed discovery claims”– will send “shockwaves” through the plaintiffs’ bar and could “open the floodgates of litigation”. Certainly this case is groundbreaking in that it applies the delay discovery rule under section 16460 in the context of law firms’ management of trust funds. However, we find these concerns of “opening the floodgates” to be overstated. While the potential for claims being brought for matters handled years prior is significant under this ruling, best practices of providing complete accountings and information combined with thorough client communication upon settlement of claims should help alleviate these concerns.

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