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California Court of Appeal reverses summary judgment for law firm finding that (1) statute of limitations was tolled due to lack of “actual injury” until alleged drafting error in partnership agreement became effective and (2) fees incurred for law firm’s allegedly negligent services did not, in themselves, constitute actual injury under CCP 340.6.  Callahan v. Gibson, Dunn & Crutcher LLP, B221338 (Cal.Ct.App.2nd Apr. 19, 2011) 


Significance of Decision


This decision contains a detailed discussion of how to assess the existence of actual injury for statute of limitations purposes in transactional malpractice cases.  It suggests that drafting errors regarding provisions not immediately effective may not be actionable until the provisions become effective or have a meaningful impact on the client’s rights.  The decision rejects the contention that incurring fees for services that include negligent work is sufficient, in itself, to establish actual injury.


Factual Background


Two brothers sought advice with regard to the restructuring of their business, including alleged implementation of a succession plan that would permit the business to remain a family-run enterprise after the brothers could no longer operate it.  Law firm advised the brothers to convert the business to a limited partnership with both brothers serving as general partners.  The firm prepared a limited partnership agreement which the brothers executed in 1988.

In February 2003, one of the brothers died and the other brother became the sole general partner.  In April 2004, a Bank initiated a probate action with regard to the deceased brother’s estate.  The Bank claimed that the surviving brother had become “disabled and/or incompetent” and sought, among other things, to dissolve the partnership pursuant to specified provisions in the partnership agreement.  The surviving brother’s spouse was allegedly prepared to run the company but the provisions of the agreement did not provide for succession while one of the brothers survived.  In October 2004 the surviving brother died.  The probate action continued, however, with the Bank unwilling to concede the propriety of the surviving spouse’s assumption of the role of general partner.  The parties eventually settled the probate action.  The settlement was approved in December 2006.

In December 2004, family members of the (now deceased) brothers entered into tolling agreements with the law firm, which were extended through June 2007.

In June 2007, the family members filed an action against the law firm asserting professional negligence.  They contended that the brothers’ primary goal with respect to the 1988 representation was to preserve and protect the company as a family run business and to ensure it remained in the family at all times.  However, under the terms of the agreement drafted by the law firm, there was no provision for the company to continue except upon the death of both general partners.  In particular, there was no mechanism in the agreement for the continuation of the partnership if the sole remaining partner was incompetent or disabled or retired.  The family members claimed that their damages included: (1) fees paid to the law firm for preparation of the partnership agreement which did not accomplish the express goal of the representation, (2) defense and settlement of the probate action, which included liquidation of certain assets, and (3) legal fees paid to another law firm to defend against the Bank’s claims, including its claims related to succession and termination of the partnership.

The law firm moved for summary judgment on statute of limitations grounds.  It argued that the family members suffered actual injury when the allegedly defective agreement was executed and the brothers thereby entered into a contract that set forth their legal rights and altered their legal relationship to each other.  The law firm further argued that actual injury was sustained in the form of attorneys fees to the firm for preparation of the partnership agreement, which fees were alleged as damages in the malpractice complaint.  The family members opposed the motion claiming there was no “actual injury” until the Bank asserted that the second brother was disabled and sought to dissolve the partnership under the terms of the agreement.

The trial court granted the firm’s motion for summary judgment on the grounds that the action was barred by the statute of limitations.  The court held that the statute ran no later than 1992 (four years after the 1988 execution of the partnership agreement).  The court further found that the firm’s legal fees constituted actual injury when they were incurred because, as a result of the firm’s alleged negligence, the fees exceeded the value of the legal services provided.  The family members appealed.


Analysis


The court of appeal began by acknowledging that the parties had not disputed that the absence of a comprehensive succession plan, and consequent threat of immediate dissolution in the event the surviving general partner became disabled and ceased being active in the business, could have been discovered through reasonable diligence at the time the agreement was executed.  Thus, under CCP 340.6, the plaintiffs’ action was untimely if plaintiffs suffered actual injury more than one year prior to December 2004 when they entered into the tolling agreements.  (Section 340.6 provides that a malpractice action must be filed “within one year after the plaintiff discovers, or through the use of reasonable diligence should have discovered, the facts constituting the wrongful act or omission, or four years from the date of the wrongful act or omission, whichever occurs first.”)


The Allegedly Deficient Partnership Provisions


The court explained that the actual injury analysis was governed by Jordache Enterprises, Inc. v. Brobeck, Phleger & Harrison (1998) 18 Cal.4th 749, in which the California Supreme Court held “Actual injury occurs when the client suffers any loss or injury legally cognizable as damages in a legal malpractice action based on the asserted errors or omissions ….”  The court further noted that Jordache had emphasized the need to distinguish between “an actual, existing injury that might be remedied or reduced in the future, and a speculative or contingent injury that might or might not arise in the future.”  The court framed the issue as follows: “Simply put, the question is whether in October 1988 the allegedly defective succession provisions in the partnership agreement caused an actual, existing injury that might be remedied or reduced in the future (for example, by amending the partnership agreement while both general partners were still alive) or a speculative or contingent injury that might or might not arise in the future.”

The court distinguished several pre-Jordache decisions holding that actual injury occurred when an agreement dividing marital property or other form of settlement agreement was signed because the parties’ legal relations were altered.  The court acknowledged that a party’s alteration of its legal position in reliance on its counsel can constitute actual injury even though the party is able to avoid or reduce the injury through subsequent legal action, but distinguished the cases on the ground that in each case the alleged negligent agreement, and the specific provisions therein that adversely impacted the client, were “effective immediately.”

The court analogized the present situation to the decision in Foxborough v. Van Atta (1994) 26 Cal.App.4th 217.  In Foxborough a client alleged that a lawyer had failed to secure an automatic annexation right, without time constraints, in connection with a real estate transaction.  Notwithstanding language in the parties’ agreement, an applicable regulation limited automatic annexation to a three year period following approval of the preceding phase of development.  The Foxborough court held that actual injury was sustained when the three year period for annexation expired, not when the documentation for the real estate transaction was completed, because during the three year period the client could have effected an automatic annexation under the regulation and therefore the alleged negligence created only a “potential” for harm.  When the three year period expired, however, the client lost the right it retained the lawyer to secure and therefore suffered actual injury.

The appellate court reasoned that, as in Foxborough, prior to the death of the one brother, and the other brother’s alleged disability/incompetence, the purportedly negligent succession provisions created only a potential for harm.  Had the second brother passed away while fully engaged in management of the company (rather than first becoming disabled or incompetent) the agreement would have provided for the surviving spouse to be elected the successor general partner.  The partnership would then have continued on the same terms and conditions as before, and the alleged negligence in failing to provide a succession plan in the event of retirement or incapacity of the surviving partner would never have ripened into actual injury.  Accordingly, the fact the family members’ future rights were allegedly compromised by the agreement “constituted only contingent or speculative harm until the absence of those rights had some meaningful effect.”

The court of appeal further explained that even if the second brother was not in fact disabled or incapacitated, the family members suffered actual injury when the Bank claimed that such condition permitted it to force a dissolution of the partnership under the terms of the agreement and the family members were thereby required to incur attorney fees to respond to the claim.  The mere fact of litigation regarding the issue was the unwanted consequence – hence, the “actual injury”.


The Attorney’s Fees Incurred for the Firm’s Legal Services


Turning to the issue of attorneys fees, the court rejected the law firm’s argument that actual injury occurred simply by incurring fees for the firm’s services.  The court acknowledged that the California Supreme Court’s decision in Budd v. Nixen (1971) 6 Cal.3d 195 recognized that fees previously paid to a defendant-attorney in a legal malpractice action may, in some circumstances, constitutes damages recoverable in a malpractice action, but only “to the extent that, in consequence of defendant’s negligence, those fees exceed the value of the defendant’s legal services.”  The court reasoned that unlike fees paid for services that were never performed, the family members in this case had received “substantial value” from the law firm’s legal work as the company was successfully operated under the allegedly defective partnership agreement for several years.

The court acknowledged that had the company or brothers personally incurred attorney fees to “remedy” the alleged defects in the partnership agreement caused by the drafting errors, such fees would be recoverable and would constitute actual injury under CCP 340.6.  However, no remedial action was taken in this case and the cost of amending the agreement was therefore hypothetical, not actual.  Additionally, had the second brother passed away (rather than becoming disabled/incompetent) the succession provisions of the agreement, whatever their purported defects, would have accomplished the intended result (i.e., permitted the surviving spouse to operate the business) and the company would have received full value for the legal fees it incurred.  Thus, any potential injury based on the “overpayment” of legal fees remained contingent or speculative until some further, future event transpired (e.g., the second brother’s alleged disability/incompetence which purportedly triggered the dissolution provisions).

The court went on to explain that “legal fees for defective services will inevitably be ‘excessive’: The client received less than it had agreed to pay for (that is, services performed with ordinary skill and knowledge).  To equate these potential damages with actual injury would return California to a strict, occurrence-based limitations period for malpractice claims, contrary to the Legislature’s express purpose in adopting section 340.6 ….”  The court noted that the firm had not cited, nor could the court locate, a single California appellate decision holding that “actual injury was first sustained as a result of payment for legal services that exceeded the value of the services provided due to negligence.”  The court further noted that not only was there a lack of case law supporting the contention that actual injury is automatically sustained when fees are incurred for negligently performed legal services, such a contention would be impossible to reconcile with the myriad cases that had struggled with the question of when actual injury first occurred – since payment of fees to the allegedly negligent lawyers in those cases would have precluded the need for any further analysis of the actual injury issue and rendered much of the discussion in those cases superfluous.

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