ITT SMALL BUSINESS FINANCE CORPORATION, Plaintiff and Appellant, v. EDWARD I. NILES, Defendant and Respondent, 9 Cal. 4th 245

Opinion LUCAS, C. J. This is a professional negligence action brought against an attorney, defendant Edward I. Niles, based on Niles’s alleged failure to exercise reasonable care in preparation of loan documents for plaintiff ITT Small Business Finance Corporation (hereafter ITT). Although Niles prevailed on

summary judgment after the trial court concluded that the action was time barred, ITT persuaded the Court of Appeal to reinstate its cause of action. We now consider the narrow issue whether ITT suffered “actual injury” under the one-year statute of limitations for attorney malpractice actions (Code Civ. Proc., § 340.6; all statutory references are to the Code of Civil Procedure unless otherwise indicated) when ITT (

i) incurred legal fees defending a third party action that disputed the adequacy of the loan documents, or (ii) received substantially less in settlement from its debtor than ITT contemplated under its security agreement.

Section 340.6 provides that legal malpractice actions shall commence running when the client discovers or should have discovered the facts constituting the malpractice, but the statute is tolled under

section 340.6, subdivision (a)(1), during the time, inter alia, the client “has not sustained actual injury.” Applying

section 340.6 to the facts of this case, we conclude ITT’s action was timely filed. We therefore affirm the judgment of the Court of Appeal. Facts In December 1984, ITT retained Niles to prepare a promissory note and certain loan documents in connection with the closing of ITT’s $200,000 loan to California Solution, Inc. (hereafter debtor), not a party to this action. The documents granted ITT a first security interest in machinery, equipment, furniture, fixtures, inventory, accounts receivable, and leasehold improvements in exchange for a $200,000 loan to debtor.

In addition, the agreement granted ITT second liens on three pieces of real property and a pledge of certain stock as collateral securing the guaranty. On February 16, 1988, debtor filed for bankruptcy. On February 14, 1990, debtor filed an adversary proceeding (in effect to avoid ITT’s lien on its property) against ITT in United States Bankruptcy Court to contest inadequacies in the loan documents prepared by Niles on ITT’s behalf.

ITT retained independent counsel to represent it and defended the adequacy of the loan documentation during the adversary proceeding, claiming it was sufficient to protect debtor’s interests. At the same time ITT was defending the documentation in the adversary proceeding, it informed Niles that it expected him to indemnify ITT for any losses suffered due to negligent preparation of the loan documents. ITT also advised Niles to contact his malpractice insurer.

On January 28, 1992, almost two years after commencement of the adversary proceeding, ITT entered into a settlement with debtor under which it accepted an amount less than the full value of its security. On March 16, 1992, over two years after the commencement of the adversary proceeding, but only two months after signing the settlement agreement, ITT filed its claim of professional negligence against Niles, asserting that it was compelled to enter into the settlement agreement with debtor for an amount less than the value of its security because Niles had negligently prepared the loan documents.

On May 5, 1992, Niles filed a demurrer to ITT’s complaint on the ground that the malpractice claim was time barred under

section 340.6, because it was filed over two years after ITT discovered the alleged substandard nature of the loan documents and incurred legal fees defending those documents in the adversary proceeding. The demurrer was overruled, but two months later the trial court granted Niles’s motion for

summary judgment under

section 340.6. The Court of Appeal reversed

summary judgment in favor of Niles after concluding that the statute of limitations in “transactional malpractice” cases must commence on settlement or trial court judgment of the third party action involving the documents. We granted review to resolve a perceived conflict over the statute of limitations issue, and our review of cases interpreting

section 340.6 leads us to affirm the Court of Appeal judgment. Discussion

Section 340.6

Section 340.6 provides in pertinent part that “An action against an attorney for a wrongful act or omission, other than for actual fraud, arising in the performance of professional services shall be commenced 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.” (§ 340.6, subd. (a); hereafter

section 340.6 (a).) There are four exceptions that toll the limitations period, including a provision tolling the statute while “[t]he plaintiff has not sustained actual injury.” (§ 340.6, subd. (a)(1); hereafter

section 340.6 (a)(1).) That provision is the focus of this appeal. Under

section 340.6, a malpractice action accrues once a former client “discovers” the malpractice, and is tolled until the client suffers “actual injury” from the malpractice. There must be a nexus between the discovery and the harm, and without both elements the filing of the malpractice action is premature. Thus, discovery of the facts essential to the malpractice claim and the suffering of actual harm from the malpractice establish a cause of action and begin the running of the statute of limitations. (§ 340.6 (a)(1).) Recently, in Laird v. Blacker (1992) 2 Cal.4th 606, 611 [7 Cal.Rptr.2d 550, 828 P.2d 691] (hereafter Laird), we addressed the issue whether the statute of limitations of

section 340.6 is tolled during the time a legal malpractice plaintiff appeals from the underlying judgment on which the malpractice claim is based, or instead commences on entry of the adverse judgment or final order of dismissal. (Laird, supra, 2 Cal.4th at p. 615.) We concluded that because the focus of a legal malpractice action involving negligence that occurs in the handling of a client’s litigation is the attorney’s conduct in the underlying case, the statute of limitations should commence “on entry of adverse judgment or final order.” (Ibid.) In so holding, we recognized that “success on appeal or proof of the total amount of monetary damages suffered by the former client . . . does not negate an action for legal malpractice.” (Id., at p. 614.) We emphasized in Laird that the focus of the limitations period is on the fact of damage or actual harm giving rise to a cause of action in negligence, not the amount of damage, and disapproved language from earlier cases implying that actual harm may always occur at the point the client initially suffers monetary damage, including attorney fees, as a result of the negligence. (Id., at p. 612 [warning litigants against literal

interpretation of similar language in Budd v. Nixen (1971) 6 Cal.3d 195, 200-201 [98 Cal.Rptr. 849, 491 P.2d 433].) We also disapproved cases that held “actual injury” did not occur until the negligent attorney’s error became “irremediable,” noting that the irremediable damage rule had been rejected by the Legislature when it adopted

section 340.6. (Laird, supra, 2 Cal.4th at p. 617.) Since Laird, several Courts of Appeal have struggled with the question of when “actual injury” occurs under

section 340.6 (a)(1) in cases involving “transactional malpractice,” or malpractice that is based on the negligent preparation of documents that causes the client harm. This is an issue separate from that addressed in Laird, but one subject to analogous reasoning. Unlike the Laird plaintiff, who sought to toll the statute of limitations during the pendency of an appeal of an adverse judgment caused by her former attorney’s negligent representation, the plaintiff here seeks to toll the statute of limitations while the adequacy of the documents that formed the basis of the transaction is initially litigated.

In other words, plaintiff is claiming that actual injury does not occur until judgment or settlement of the transactional litigation. In reversing

summary judgment in favor of Niles, the Court of Appeal concluded ITT did not suffer “actual injury” until January 28, 1992, when it was forced to accept an adverse settlement with debtor at the trial court level in the adversary proceedings. Although ITT incurred attorney fees in defending the loan documentation, the nexus between the discovery of malpractice and “actual injury” that is required before a cause of action for legal malpractice will accrue did not occur until settlement of the adversary proceeding.

Had ITT prevailed in the adversary proceeding, it would have suffered no “actual injury” from the initial attorney’s preparation of the loan documents, just as the plaintiff in Laird suffered no “actual injury” until the moment the trial court dismissed her complaint. Guided by these principles, the Court of Appeal concluded that the statute of limitations under

section 340.6 commenced on final settlement of the adversary proceeding. 2. Actual Injury Niles contends that the better rule in transactional malpractice cases is stated in several Court of Appeal cases concluding that “actual injury” under

section 340.6 (a)(1) occurs when the former client as plaintiff incurs attorney fees either in defending the adequacy of the documentation in the third party action or in defending its reliance on the allegedly negligent attorney in that action. Once attorney fees have been incurred, asserts Niles, the former client has discovered the fact of damage that triggers the running of the limitations period of

section 340.6. Niles relies on several appellate cases to support his contention, including Sirott v. Latts (1992) 6 Cal.App.4th 923 [8 Cal.Rptr.2d 206] (hereafter Sirott), Johnson v. Sionelli (1991) 231 Cal.App.3d 105 [282 Cal.Rptr.2d 205] (hereafter Johnson), Kovacevich v. McKinney & Wainwright (1993) 16 Cal.App.4th 337 [19 Cal.Rptr.2d 692] (hereafter Kovacevich), and Hensley v. Caietti (1993) 13 Cal.App.4th 1165 [16 Cal.Rptr.2d 837] (hereafter Hensley). As the Court of Appeal below observed, however, these cases were either wrongly decided, can be distinguished from the present case or are consistent with it.

In Sirott, supra, 6 Cal.App.4th 923, defendant attorneys negligently advised the plaintiff, a physician, that he did not have to purchase a specific type of specialized medical malpractice insurance. The plaintiff was later sued for medical negligence and, as of January 1988, had incurred legal fees in an amount less than the $50,000 premiums he would have paid had he purchased the specific malpractice insurance. The physician’s attempt to reinstate his insurance was unsuccessful: an arbitrator held that the insurer was not obligated to defend or indemnify plaintiff in the medical malpractice action.

A judgment confirming the arbitration award was entered in January 1988. Because he had no insurance coverage, the physician was forced to defend and settle the malpractice claim against him at his own expense. Over two years later, in January 1990, the physician sued the attorneys who advised him not to purchase the malpractice insurance. The Court of Appeal affirmed the trial court’s judgment sustaining defendants’ demurrer based on

section 340.6, on the ground that plaintiff sustained actual damage as a result of the attorneys’ malpractice on entry of the judgment confirming the arbitration award in January 1988.

It was at this point, the court reasoned, that it was “judicially determined that plaintiff was not entitled to [the specialized] malpractice insurance coverage, and he was compelled to pay the expenses of defending the medical malpractice action regardless of the outcome of that action.” (Sirott, supra, 6 Cal.App.4th at pp. 929-930, italics added.) Relying on Sirott, Niles asserts that ITT suffered “actual injury” when it was forced to incur legal fees in order to defend the negligently prepared documents in the adversary proceeding. As plaintiff observes, however, Niles ignores a key factor in that case.

In Sirott, if the plaintiff had been successful at the arbitration regarding his insurance coverage, the advice rendered by the attorney would have been correct, and no actionable malpractice would have been committed. The resolution of the arbitration necessarily included a determination regarding the attorney’s advice. Therefore, the Sirott court correctly concluded that the physician’s cause of action for legal malpractice accrued on entry of the adverse judgment of arbitration.

The Sirott court did not hold that the legal fees incurred in litigating the arbitration proceeding itself represented sufficient “actual injury.” The legal malpractice action was held to accrue once the arbitration judgment was entered. In the present case, the adversary proceeding is analogous to the arbitration in Sirott. Here, there was no indication the attorney’s alleged negligent preparation of documents would cause ITT loss until it was forced to settle on adverse terms with its debtor.

ITT incurred legal fees in defending its former attorney’s actions in negligently drafting the loan documents, just as the doctor in Sirott incurred legal fees in defending his attorney’s advice during the coverage dispute eventually resolved against him in the arbitration proceeding. As in Sirott, these initial legal fees incurred by ITT were not sufficient “actual injury” within the meaning of

section 340.6(a)(1) because at the time the proceeding was filed and ITT hired counsel to defend the loan documentation, there was no actual harm attributable to malpractice. The statute of limitations remained tolled until ITT suffered an actual loss attributable to its attorney’s alleged malpractice, that is, when it was forced to accept an unfavorable settlement of the adversary proceeding. Niles also relies on Johnson, supra, 231 Cal.App.3d 105, in which the court held the former client suffered “actual injury” under

section 340.6 (a)(1) when buyers defaulted on a promissory note that was secured by inadequate and defective collateral. The promissory note had been prepared by the former attorney. The Johnson court reasoned that the inadequate security created a potential for injury that was realized once the buyers defaulted on the promissory note.

The court stated: “Hence, at the time of default on the note if the security was adequate, plaintiff had no cause of action; if the security was inadequate actual injury occurred and the statute of limitations commenced running.” (Johnson, supra, 231 Cal.App.3d at p. 110.) Because the buyers defaulted on the note in July 1983, more than one year prior to the filing of the malpractice action in December 1985, the Johnson court concluded the action was barred by

section 340.6. {Johnson, supra, 231 Cal.App.3d at p. 110.) In our view, the Johnson court erred in determining that actual injury occurred when the buyers defaulted on the promissory note in July 1983. In Johnson, the plaintiff was injured not by the promissory note itself; rather he was injured by the inadequacy of the collateral securing the note.

Thus, the plaintiff suffered actual injury in Johnson at the time of the sale of the collateral for less than the balance due on the note in June 1984. {Johnson, supra, 231 Cal.App.3d at p. 108.) Because the sale of collateral occurred more than one year prior to the filing of his complaint for legal malpractice in December 1985, the action was time barred by the limitations period of

section 340.6. To the extent the Johnson court analysis is inconsistent with our analysis herein, it is disapproved. Niles’s reliance on Kovacevich, supra, 16 Cal.App.4th 337, is also misplaced. There, Kovacevich was an investor in a joint venture and member of an organizing committee formed to establish a bank. On the advice of his counsel, Kovacevich signed a personal guaranty for notes securing the lines of credit to establish the new bank.

After the new bank defaulted on the notes, the lending institution filed a complaint against the bank and its investors, seeking damages for breach of the line of credit notes and for breach of the continuing guaranties. In December 1984, when Kovacevich was served with the lending institution’s action, he hired independent counsel, not to challenge the claim that he was personally liable on the notes, but to mitigate his losses by arranging matters so that he could sue some of his fellow investors and the original lawyers as well.

This new counsel advised Kovacevich that his original attorneys had given him negligent advice pertaining to the legal import of a continuing personal guaranty and to the liability of the other organizers on the notes, and had failed to obtain contribution agreements from the organizers who were not liable under the notes. Cal-Farm Insurance Company insured Kovacevich under a general liability policy covering the investors. The insurer agreed to pay Kovacevich’s new attorney.

The lending institution selected Kovacevich as its “target defendant,” obtained a writ of attachment against his land holdings and later, in June 1985, obtained

summary judgment against him in the sum of $927,000. Kovacevich paid the judgment and in March 1986, filed a legal malpractice action against his original counsel based on counsel’s failure to give Kovacevich adequate legal advice and failure to obtain contribution agreements. The Kovacevich court affirmed

summary judgment against Kovacevich on the ground that the statute of limitations for the legal malpractice action barred the suit. The court determined that Kovacevich suffered “actual injury” under

section 340.6 (a)(1) when he incurred legal fees after hiring the second law firm to mitigate the harm caused by the original malpractice, because that was the point when Kovacevich accepted the adverse position in which his former counsel had placed him. We conclude the Kovacevich court erred and its holding should be disapproved. In our view, Kovacevich did not suffer “actual injury” within the meaning of

section 340.6 until June 1985, when

summary judgment was entered against him. As the Court of Appeal below observed, the Kovacevich analysis produces a result against public policy and ignores Laird’s critical distinction between the “fact and knowledge of damage, and the amount of damage.” (Laird, supra, 2 Cal.4th at p. 615, italics in original; see also Budd v.

Nixen, supra, 6 Cal.3d 195 [cause of action for legal malpractice accrues when client discovers or should discover facts essential to malpractice action, and suffers appreciable and actual harm from malpractice].) Therefore, to the extent that Kovacevich can be interpreted to hold that the mere accrual of the obligation for attorney fees is sufficient to trigger the statute of limitations, it is disapproved. Niles also relies on Hensley, supra, 13 Cal.App.4th 1165. There, the plaintiff was represented in a marital dissolution by the defendant attorney.

After a settlement conference on September 1989, the parties and their counsel asked the court to record a stipulated settlement agreement allocating property and debts, providing for equalization payments, waiving spousal support, and obligating each party to execute implementing documents. After examining the parties under oath, the court approved the stipulation, informed them that the settlement was effective immediately, and directed husband’s attorney to prepare the judgment. The Hensley plaintiff later refused to agree to the proposed judgment and discharged defendant as her attorney.

The plaintiff’s new counsel moved unsuccessfully to set aside the stipulated settlement agreement. The judgment of dissolution incorporating the settlement agreement was entered in October 1990. The plaintiff filed her legal malpractice action in November 1990. The trial court granted

summary judgment for the defendant on the ground that the one-year statute of limitations of

section 340.6 had run because the plaintiff suffered “actual injury" at the time she stipulated to the settlement. The Court of Appeal affirmed, concluding that the statute of limitations was not tolled by defendant’s “continuing representation” of the plaintiff. The court reasoned that such representation ceased when the plaintiff asked new counsel to represent her, not when the defendant signed the substitution of attorney.

The court concluded that the statute was not tolled until the judgment of dissolution, and agreed with the trial court that the plaintiff suffered “actual injury” when she stipulated to the settlement agreement. Contrary to Niles’s contention, Hensley is distinguishable on its facts. In Hensley, the stipulation to the marital settlement agreement acted immediately to deprive the plaintiff of certain property. Thus, once the stipulation was entered by the court, the plaintiff suffered “actual injury” under

section 340.6 (a)(1). (See also Bennett v. McCall (1993) 19 Cal.App.4th 122, 127 [23 Cal.Rptr.2d 268] [plaintiff suffered actual harm when he entered into binding marital settlement agreement and hired new counsel in attempt to correct alleged inequities in agreement].) By contrast, as noted above, ITT did not suffer “actual injury” until it entered into the adverse settlement agreement with the debtor.

In essence, the Hensley final settlement agreement, like the ITT settlement agreement with the debtor, acted as the benchmark from which the plaintiff could sue for legal malpractice, for that is the point the malpractice was both discovered and confirmed and the plaintiff was damaged. Such a holding is consistent with our observation in Laird that “the focus of

section 340.6 is on discovery of the malpractice and actual injury, not success on appeal or proof of the total amount of monetary damages suffered by the former client.” (Laird, supra, 2 Cal.4th at p. 614.) In a related context, Niles asserts that the pre-Laird case of Horne v. Peckham (1979) 97 Cal.App.3d 404 [158 Cal.Rptr. 714] supports his contention that the statute of limitations for legal malpractice should commence at the point the former client incurs attorney fees defending the documentation drafted by the former attorney.

In Horne, an attorney was sued for malpractice after negligently drafting an irrevocable trust and a license agreement for Home’s three sons. The negligence cost the plaintiffs substantial additional taxes assessed by the Internal Revenue Service in August 1970, because the trust failed to transfer tax liability for the licensor’s income to the tmst beneficiaries. The plaintiffs hired independent counsel to contest the assessment, but after losing at the administrative level conceded the tax liability.

In 1972, the plaintiffs brought a malpractice action against the lawyer who drafted the tmst and license agreement. The defendant asserted the cause of action for malpractice was barred by the limitations period for malpractice actions, which at that time was two years, (former § 339, subd. (1)), and claimed the statute of limitations commenced when the plaintiffs paid the defendant’s bill for the legal work in creating the tmst in 1967.

The Court of Appeal disagreed, concluding that the cause of action for malpractice accmed when the tmst was challenged and “plaintiffs were forced to pay legal fees to defend the negligently drafted tmst documents.” (Horne v. Peckham, supra, 97 Cal.App.3d at p. 417.) This statement in Horne, asserts Niles, supports his contention that in transactional malpractice cases, the cause of action for legal malpractice should accme once the former client incurs attorney fees to defend the negligently drafted documents. We do not read Horne v. Peckham, supra, 97 Cal.App.3d 404, to stand for such a broad rule.

The Horne court recognized that the plaintiffs learned of the malpractice when they were advised by the new attorney that they would have to pay additional taxes as a result of the deficiencies in the documents drafted by the defendant. Under former

section 339, subdivision (1), the plaintiffs then had two years to file the malpractice action. The Court of Appeal simply concluded that the date on which the plaintiffs should have discovered the malpractice was a factual issue for the jury, and that there was substantial evidence to support the jury’s finding of timeliness. The Horne court was not faced with the question, nor did the court specifically determine, whether “actual injury” occurred when the client incurred attorney fees, or after the tmst was challenged. That determination was not necessary to the court’s judgment.

Accordingly, Horne is not helpful to Niles in creating a bright line mle that establishes the incurring of attorney fees as the event triggering the malpractice action in transactional malpractice cases. Nonetheless, to the extent the case can be so interpreted, it is disapproved. Niles next asserts ITT admitted in its pleadings that it suffered actual injury when it hired an attorney to defend the adequacy of the negligently prepared documentation in an effort to mitigate its damages.

Niles claims ITT’s defense of the loan documentation in the adversary proceeding amounted to a judicial admission that is conclusive evidence that ITT had discovered the malpractice and suffered “actual injury” at the time it defended the adversary proceeding. (See, e.g., Troche v. Daley (1990) 217 Cal.App.3d 403 [266 Cal.Rptr. 34] [judicial admission in pleading is conclusive concession of truth of matter and has effect of removing it from issues in litigation].) Niles’s contention is without merit.

Section 340.6 provides that knowledge or discovery of malpractice is different from “actual injury” and both knowledge and “actual injury” must be present before a cause of action for legal malpractice will accrue. (§ 340.6 (a)(1).) Accordingly, ITT’s statement in its pleadings that it defended the documentation in the adversary proceeding in an attempt to “mitigate” its damages may indicate that ITT “discovered” the potential malpractice at the time the adversary proceeding was filed, but did not conclusively establish or “admit” that ITT was actually damaged by the malpractice. 3.

Public Policy Niles contends that the Court of Appeal’s conclusion that ITT suffered “actual injury” on settlement of the adversary proceedings is inconsistent with Laird's observation that tolling periods in statutes of limitations be limited to avoid allowing clients “unilaterally to control the commencement of the statute of limitations and hence undermine the legislative goal of resolving cases while the evidence is fresh, witnesses are available, and memories have not faded.” (Laird, supra, 2 Cal.4th at p. 618.) Our discussion in Laird, however, presumes that the client has discovered the malpractice and suffered “actual injury” as a result of the malpractice.

In the present case, ITT did not suffer “actual injury” resulting from Niles’s alleged malpractice until it settled the adverse proceeding on unfavorable terms. Moreover, there was no danger in the present case that tolling the malpractice statute of limitations until conclusion of the adversary proceeding would undermine the statute’s goals of preserving evidence and notifying defendants. ITT notified Niles that he should contact his malpractice insurer as soon as ITT realized it would have to defend the documentation prepared by Niles in the adversary proceeding.

Finally, it would be a waste of judicial resources to require both the adversary proceeding and the attorney malpractice action to be litigated simultaneously. Had ITT prevailed in the adversary proceeding, the malpractice action would have been unnecessary. Conclusion Consistent with our reasoning in Laird, in which we held that a cause of action for legal malpractice accrues under

section 340.6 (

a) when the former client “discovers” the malpractice and is “actually harmed” by it, we conclude that in transactional legal malpractice cases, when the adequacy of the documentation is the subject of dispute, an action for attorney malpractice accrues on entry of adverse judgment, settlement, or dismissal of the underlying action. It is at this point that the former client has discovered the fact of damage and suffered “actual injury" due to the malpractice under

section 340.6. Therefore, in the present case, the statute of limitations of

section 340.6 was tolled until the action contesting the documentation was concluded. Our holding is narrow, and limited to the circumstances typified by this case. Of course, under Laird, supra, 2 Cal.4th 606, the statute will not be tolled during the time the client appeals from the underlying judgment, settlement, or dismissal on which the claim of malpractice is based. Accordingly, the Court of Appeal judgment is affirmed. Arabian, J., Baxter, J., George, J., and Werdegar, J., concurred.