[Update: One month after this alert was posted, the Federal Circuit rejected an appeal seeking mandamus review of the district court’s decision. See our Post-Script below that recaps the Federal Circuit’s action.]

Key Points

• Defense Counsel Disqualified for Third-Party Funder Conflict: The court disqualified defense counsel after finding that Lincoln Diagnostics, Inc. paid defense counsel's fees and controlled litigation strategy, violating NJ RPCs 1.7, 1.8(f), and 5.4.
• Funder Directed Settlement Decisions Despite Divergent Interests: Lincoln rejected settlement offers on defendants' behalf while a clawback provision required defendants to refund $300,000 if the inventorship challenge failed, creating a material conflict.
• Client Consent Could Not Cure the Conflict: The court held that waivers under RPC 1.7(b) do not override RPCs 1.8(f) and 5.4, which independently bar third-party interference with counsel's professional judgment.
• Implications for Litigation Funding Arrangements: Patent litigators must ensure RPC compliance when a third party pays legal fees; overlapping interests between client and funder will not prevent disqualification where those interests diverge.

High Bar Was Met

A New Jersey federal judge has affirmed the disqualification of defense counsel more than three years into a patent case, finding that the lawyers had an impermissible conflict of interest arising from a third party’s payment of their fees and control over litigation strategy.

In her 19-page opinion in Harish v. Arbit, U.S. District Judge Evelyn Padin concluded that although disqualification is “a drastic measure which courts should hesitate to impose except when absolutely necessary" (Decision at 15) (cleaned up), that high bar was met because the third-party funder’s interests were not fully aligned with those of the defendants, and counsel had allowed the funder to improperly participate in the litigation — including rejecting settlement offers on behalf of the defendants.

The decision is a critical reminder of the essential role of the Rules of Professional Conduct in patent litigation, particularly where a party’s fees are paid by a third party.

Background

Four named inventors sought to license their patent for an allergy testing device to Lincoln Diagnostics, Inc. (Lincoln). After initial negotiations fell through, Lincoln sued them. Lincoln was represented by attorneys at the law firm of Banner Witcoff.

Two of the original inventors (referred to as "Appealing Defendants") eventually reached an agreement to sell and assign their rights in the patent to Lincoln, whereby they received $300,000 and promised to "do all things necessary to aid Lincoln to obtain and enforce for its own benefit, ownership of and patent protection for" the patent. In return, Lincoln agreed to indemnify Appealing Defendants up to $250,000 for challenges to Appealing Defendants’ inventorship.

However, if Appealing Defendants were to breach their warranties to Lincoln — for example by losing in an action where their inventorship is challenged — Appealing Defendants were required to immediately refund the full purchase price paid by Lincoln to Appealing Defendants.

The Litigation

The primary issue between the parties is a challenge to Appealing Defendants’ inventorship of the patent at issue. Attorneys from Banner Witcoff and Saiber LLC (Saiber) appeared on behalf of Appealing Defendants. Lincoln is not a party in the case, although its motion for leave to intervene was pending when the Court rendered its decision. Some of the appearing Banner Witcoff attorneys had previously represented Lincoln in its prior suit against the inventors, including Appealing Defendants.

Like many jurisdictions, the DNJ has adopted a local rule requiring all parties to file a third-party litigation funding disclosure statement. Local Rule 7.1.1. Defendants did not file any statement pursuant to Local Rule 7.1.1.

Plaintiff made repeated inquiries over the course of several hearings as to whether Appealing Defendants had complied with Rule 7.1.1 and whether Lincoln was paying defense counsel’s fees. At each turn, defense counsel represented that no disclosure was required, stating, for example, that they had "sat down quite a while ago, considered the rule, and have not filed any disclosure" and that they had "made a determination that it does not apply to [Appealing Defendants] in this matter." Decision at 3.

It was not until late 2023 — more than two years after litigation began — that Appealing Defendants confirmed Lincoln had been paying defense counsel’s fees throughout the litigation.

Magistrate Judge Disqualifies Counsel

U.S. Magistrate Judge André M. Espinosa disqualified defense counsel, in part after determining that defense counsel’s fees were being paid by Lincoln in violation of New Jersey Rule of Professional Conduct (RPC) 1.8(f) regarding third-party payer arrangements that involve conflicts of interest. Because "Lincoln had actively exerted control over Defense Counsel’s decisions and strategy despite there being material conflicts of interest between Appealing Defendants and Lincoln," Judge Espinosa found a potential violation of RPC 1.8(f). Judge Espinosa further consulted RPCs 1.7 and 5.4, as well as In re Grand Jury Investigation, a New Jersey Supreme Court case assessing when counsel may be compensated by "anyone other than the client" under certain RPCs.

Under Grand Jury, the conditions to accept payment from a third-party are: (1) An attorney must obtain the client’s informed consent; (2) A third-party payer may not direct, regulate, or interfere with counsel’s professional judgment; (3) There may not be a current attorney-client relationship between counsel and the third-party payer; (4) Counsel may not communicate with the third-party payer about the substance of the representation; (5) The third-party payer must treat all invoices within the same manner, speed, and frequency with which it pays its own counsel; and (6) "Once a third-party payer commits to pay for the representation of another, the third-party payer shall not be relieved of its continuing obligations to pay without leave of court . . . ."

Judge Espinosa found a partial violation of condition (1) as well as likely violations of at least (2), (3), (4), and (6), after making the following findings:

• Saiber had not obtained informed consent from Appealing Defendants regarding potential conflicts of interest, although Banner Witcoff had.
• Lincoln had actively participated in litigation strategy and denial of settlement offers.
• Banner Witcoff and Saiber each had ongoing client relationships with Lincoln.
• Lincoln had been informed of the substance of Appealing Defendants’ representation, including the details of settlement negotiations.
• Lincoln’s indemnification obligations to Appealing Defendants were capped under the assignment agreement.

Disqualification Affirmed

Judge Padin did not find any of Judge Espinosa’s holdings to be "clearly erroneous or contrary to law," as required for modification or vacatur.

First, Judge Padin determined that "the potentially conflicting interests here do outweigh any current overlap in interests" between Appealing Defendants and Lincoln. The Court reasoned that, should Appealing Defendants fail to perform "all things necessary to aid Lincoln" under the assignment agreement, "Appealing Defendants’ interests will be directly averse to Lincoln’s interests and Defense Counsel’s continued representation of both groups would be definitively untenable."

Central to this analysis was the clawback provision in the assignment agreement. Appealing Defendants provided warranties that they were the inventors of the patent, and if they lose the inventorship challenge, they must immediately refund the full $300,000 purchase price to Lincoln. This means that a settlement offer mitigating or helping Appealing Defendants avoid liability to Lincoln could be in Appealing Defendants’ best interests but may not be in Lincoln’s — creating precisely the kind of divergent interests that give rise to a conflict. The Court further noted that "Defense Counsel previously represented Lincoln in a suit against Appealing Defendants nine years ago relating to the patent at issue," emphasizing defense counsel’s long-time loyalty to Lincoln and the risk that counsel’s professional judgment would be materially limited by that loyalty. The Court also assessed that "counsel may have to defend Appealing Defendants against Lincoln if litigation does not pan out in the manner Lincoln hopes it will," ultimately finding no error in Judge Espinosa’s determination of a conflict of interest between Appealing Defendants and Lincoln.

Waiver Was Insufficient

The Court rejected Appealing Defendants’ argument that any conflicts were waived under RPC 1.7(b) for three reasons. First, waiver under RPC 1.7(b) could not override the separate requirements of RPCs 1.8(f) and 5.4, which prohibit third-party interference with counsel’s professional judgment regardless of client consent. The Court found that "Defense Counsel has permitted Lincoln to improperly participate in this litigation and has subordinated Appealing Defendants’ interests to Lincoln’s," invoking those additional rules.

Second, the RPCs also require maintaining the lawyer-client relationship as "sacrosanct," prohibiting disclosure of representation details and third-party influence over counsel’s judgment — requirements that were not met here "in light of the shared communications and Lincoln’s control." Third, the Court dismissed Appealing Defendants’ argument that attorney conflicts should be regulated without court intervention. "Because Plaintiff raised an issue of professional conduct, this Court was not free to overlook it." The Court accordingly found no waiver of any conflict of interest.

Third-Party Payment Rules Apply

The Court next rejected Appealing Defendants’ argument that Grand Jury did not apply because it would imperil common joint defense agreements. The Court held that "[t]he distinction drawn by Grand Jury is between third-party payer arrangements that satisfy all six conditions and third-party payer arrangements that do not," and identified that "[t]he common joint defense arrangements identified by Appealing Defendants are themselves still subject to the conditions described by Grand Jury."

The Court held that "[w]hile Lincoln may have overlapping interests with Appealing Defendants, those interests are not coextensive," and there was no error in applying Grand Jury to the present case.

Disqualification Was Proper

Courts in the Third Circuit consider five factors regarding whether the facts of a case warrant disqualification: (1) prejudice to the non-moving party; (2) prejudice to the moving party; (3) the cost — in terms of time and money — to retain new counsel; (4) the complexity of the issues in the case and the time it would take for new counsel to acquaint themselves with the facts and issues; and (5) which party, if either, was responsible for creating the conflict.

The Court found no abuse of discretion after reviewing Judge Espinosa’s Disqualification Order. First, the Court found no error in Judge Espinosa’s factual findings regarding prejudice to Appealing Defendants here, where "(1) new counsel could familiarize themselves with the case because it was limited in scope to inventorship (as opposed to a patent case involving questions of validity and infringement); (2) much of the time spent on the case and on motion practice had been necessitated only because of the parties’ apparent inability to compromise on any issue, ‘regardless of its significance’; and (3) disqualification was occurring at this stage, rather than earlier, because Appealing Defendants themselves obfuscated Lincoln’s role in the litigation from both Plaintiff and the Court." On this last point, the Court emphasized that Appealing Defendants’ obfuscation was not the result of a one-time omission, but that: Appealing Defendants had delayed disclosure of Lincoln’s payment arrangement for years.

Second, the Court dismissed Appealing Defendants’ argument that the disqualification motion was too late in the proceedings. "Because Appealing Defendants only made Lincoln’s third-party payer status apparent more than two years after litigation began, it is of no fault to Plaintiff that the timing of his motion comes years after litigation began. To allow otherwise would permit parties to avoid accountability for a violation of the RPCs by persistently misleading their opponents."

Finally, the Court dismissed Appealing Defendants’ argument regarding alternative remedies to disqualification. The Court found no error in Judge Espinosa’s determination that "disqualification was necessary because an alternative remedy, such as conflict counsel, would not cure the extent to which Lincoln has impermissibly controlled Appealing Defendants’ representation."

Appealing Defendants have filed a notice of appeal of the disqualification.

Takeaways

• Patent litigators must be mindful of the RPCs, particularly where a party’s fees are paid by a third party, such as in the context of an assignment agreement or litigation funding arrangement. Even overlapping interests between the client and a third-party payer will not insulate counsel from disqualification where those interests are not fully coextensive.
• Carefully consider potential conflict issues early or before a case begins, including those from prior representation and any contractual obligations.
• Critically assess whether a Rule 7.1.1 third-party funding statement needs to be filed.
• Disqualification may be imposed where there is an RPC violation, even though it is a drastic measure and potential alternative remedies may be available.

Post-script:

Defendants filed in the Federal Circuit a petition for writ of mandamus directing the district court to vacate its order disqualifying Defendants’ counsel. The Federal Circuit applied Third Circuit law and evaluated whether the district court abused its discretion in disqualifying counsel. In a short decision, the Federal Circuit found Defendants were not entitled to mandamus relief, declining to “disturb what amounts to a case-specific discretionary judgment that Counsel violated the applicable rules.” Further, the Federal Circuit stated the magistrate plausibly found that the terms of the agreement indicated the dominance of Lincoln’s interests to Defendants’ interests and noted Lincoln’s involvement in denial of settlement offers. Finally, the Federal Circuit did not find the decision to be clearly arbitrary or erroneous, where the district court “reviewed all the relevant factors on the record before it and reasonably balanced those weighing for and against disqualification.”

Paul W. Kalish and Jonathan J. Madara are members of the IP Litigation team in Fox Rothschild’s Princeton, NJ office and write about patent litigation decisions in the District of New Jersey. Contact Paul at pkalish@foxrothschild.com or 609.895.6751 and Jonathan at jmadara@foxrothschild.com or 609.844.7428.

This information is intended to inform firm clients and friends about legal developments, including the decisions of courts and administrative bodies. Nothing in this alert should be construed as legal advice or a legal opinion. Readers should not act upon the information contained in this alert without seeking the advice of legal counsel. Views expressed are those of the authors and not necessarily this law firm or its clients.