Seventh Circuit Delivers Split Decisions for Trustee

By Ron Peterson and Landon Raiford

Jenner & Block, LLP

Chicago, IL 

 

On July 7, the Seventh Circuit delivered two opinions involving trustee Ronald Peterson.   In one case, the Trustee's claim was dismissed under the doctrine of in pari delicto, while in the second, the trustee's malpractice claim against a law firm stated a plausible claim.   In both cases, the trustee for Lancelot Investors Fund, Ltd. had sued professionals for contributing to the debtor's demise.   (Click on the style of the case for a link to the decison).

Peterson v. McGladrey LLP, No. 14-1986 (7^th Cir. July 7, 2015)

In McGladrey, the Seventh Circuit recently expanded on an earlier decision (also in the same litigation) that the doctrine of in pari delicto may apply to a bankruptcy trustee if the doctrine otherwise would apply under the relevant state law.  In McGladrey, the trustee alleged that McGladrey negligently committed its audit of the debtor, and that if McGladrey had not done so, it would have discovered that the debtor was actually investing in a Ponzi scheme thereby saving the debtors millions of dollars lost through further investments in that scheme.  McGladrey argued that even if the trustee’s contentions were correct, McGladrey could not be liable because the debtors committed their own fraud by giving false information to its investors regarding certain safeguards the debtors stated they had put in place but which were not.  The question before the Seventh Circuit was whether the in pari delicto doctrine only applies if the plaintiff and defendant commit the same misconduct.  

 

The Seventh Circuit held that the in pari delicto is not limited only to situations where the parties have committed the same misconduct.  Instead, the doctrine applies so long as the plaintiff and defendant’s misconduct contributes to the same loss even if the actual misconduct is different.  In dismissing the trustee’s suit, the Seventh Circuit was quick to note that its rationale would not apply to suits brought by investors against McGladrey and stated that the time had come “to bring the investors’ claims to the fore.”  

Peterson v. Katten Muchin Rosenman LLP, No. 14-3632 (7^th Cir. July 7, 2015)

The Seventh Circuit’s decision in Katten Muchin is a warning shot for corporate lawyers.  Here, the trustee alleged that during the six years the law firm represented the debtors, it committed malpractice in the way it counseled (or did not counsel) the debtors regarding the debtors’ transaction with entities that turned out to be Ponzi schemes.  

The debtors sought to protect themselves from loss in two primary ways.  First, the debtors required its borrowers to provide the underlying paperwork between the debtors’ borrowers and the customers of those borrowers.  Second, the borrowers’ customer was supposed to deposit funds directly into a “lockbox” the debtors could access directly (and which the borrowers could not) as opposed to funds coming directly from the borrowers, thereby eliminating the risk that the borrowers could take the funds.  The lockbox arrangement, however, was an illusion; it was never establish and all the funds the debtors ever received came directly from the borrowers.  

The trustee sued the law firm alleged that the law firm committed malpractice because the law firm had been retained to structure the transactions on behalf of the debtors but never told the debtors that the actual arrangement used posed a risk that the borrowers were not operating a real business.  The Seventh Circuit held that the trustee’s theory stated a plausible claim that survives a motion to dismiss.  In doing so, the Seventh Circuit stated that “one function of a transactions lawyer is to counsel the client how different legal structures carry different levels of risk, and then to draft and negotiate contracts that protect the client’s interest.  A client can make a business decision about how much risk to take; the lawyer must accept and implement that decision.  But it is in the realm of legal advice to tell a client [what the optimal structure of a transaction would be].”  The court continued that while “[a] lawyer is not a business consultant … within the scope of the engagement a lawyer must tell the client which different legal forms are available to carry out the client’s business, and how (if at all) the risks of that business differ with the different legal forms.”  Given that the trustee’s argument was that at no point did the law firm counsel the debtors as to how best to protect themselves, the trustee had stated a plausible theory for relief.