Legal Advice Must Allude to Client's Business Risks

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By Samson Habte

July 13 — Lawyers aren’t business consultants, but they are subject to malpractice liability if they fail to give a client sufficient legal advice about business-related risks to allow the client to make informed business decisions, the U.S. Court of Appeals for the Seventh Circuit held July 7.

In this case the district court overemphasized a blurry distinction “between business advice and legal advice” when it held that Katten Muchin Rosenman LLP couldn't be sued for malpractice for failing to advise hedge funds about the risks posed by loan arrangements with someone who turned out to be Ponzi scheme artist, Judge Frank H. Easterbrook said.

The decision revives a lawsuit alleging that the law firm committed malpractice while advising hedge funds on how to structure loans to Thomas Petters, a businessman who ultimately was convicted of “perpetrating [a] massive Ponzi scheme through the sale of notes” to investors.

Petters said the loans financed Costco Wholesale Corp. inventory and were secured by Costco's accounts receivable. But Petters—who insisted the funds not contact Costco to confirm the collateral—“never had any dealings with Costco,” according to the opinion.

A district court dismissed the malpractice suit after finding that the funds knowingly bypassed verification with Costco so as to obtain a higher interest rate.

But the appellate panel said the district court erred in concluding that the funds failed to state a malpractice claim because they “knowingly took a risk and cannot blame a law firm for failing to give business advice.”

The district court did not “identify any principle of Illinois law that sharply distinguishes between business advice and legal advice,” Easterbrook wrote. “It is hard to see how any such bright line could exist,” he added, “since 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 interests.”

Misreading Complaint

The malpractice complaint was filed by the trustee for Lancelot Investors Fund Ltd. and other entities that allegedly invested $2 billion with Petters and went bankrupt when his Ponzi scheme collapsed.

The district judge dismissed the suit after finding that the “the cause of the loss to Lancelot was the failure to demand verification of inventory,” and not “the form of the agreement” that Katten prepared.

“The failure was a business decision made [by Lancelot founder Gregory Bell], not the legal services performed,” the district court said.

But Easterbrook said the decision was problematic because it relied on facts extrinsic to the complaint and thus was not an appropriate use of Fed. R. Civ. P. 12(b)(6).

“The complaint alleges that Bell attributed the Funds' high return at least in part to the lack of direct verification with Costco and that he told some would-be investors about this tradeoff, but it does not allege that Bell was indifferent to legal advice concerning how to curtail risks given the no-contact constraint,” he wrote.

Easterbrook said the district court also failed to “engage the complaint's main contention—not that Katten was supposed to do something about Petters's no-direct-contact edict, but that Katten had to alert its client to the risk of allowing repayments to be routed through Petters, drafting and negotiating any additional contracts necessary to contain that risk.”

“As the complaint depicts matters, Bell did not appreciate the difference between funds from Costco and funds from Petters,” Easterbrook said. “A competent transactions lawyer should have appreciated that the former arrangement offers much better security than the latter and alerted its client.”

No ‘Bright Line' on Business Advice

Easterbrook said the district court also erred in drawing a “bright line” between business advice and legal advice. “The district court did not cite any Illinois statute or decision holding that a transactions lawyer never needs to supply a client with legal information that affects the degree of business risk attached to a transaction,” he said.

“We take the point that a transactions lawyer's task is to propose, draft, and negotiate contractual arrangements that carry out a client's business objective, not to tell the client to have a different objective or to do business with a different counterparty,” the panel acknowledged, adding: “A lawyer is not a business consultant.”

“But 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,” Easterbrook stated.

“The Trustee alleges that Katten did not offer any advice about how relative risks correspond to different legal devices, and its complaint states a legally recognized claim for relief,” the court said.

Client Sophistication

The panel said the lower court also erred in relying on opinions holding that lawyers were not liable for failing to adequately advise sophisticated clients about risky transactions.

“The ‘needs and sophistication of the client' is a factual issue unsuited to a motion under Rule 12(b)(6),” Easterbrook said.

“The complaint does not tell us how sophisticated Bell and the Funds were about commercial factoring and the legal devices available for lenders' protection,” he added. “Nor does it reveal what Katten was hired to do—what kind of advice the Funds wanted, what kind of advice Katten promised to provide.”

“Whether the law firm has a defense—and whether any neglect on its part caused injury—are subjects for the district court in the first instance,” the panel said.

Judges William J. Bauer and Diane S. Sykes joined the opinion.

Williams Montgomery & John Ltd. represented Katten. Edward T. Joyce & Associates P.C. represented Peterson.

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