Suit Alleging Bad Advice on Securities Laws Must Be Litigated in Federal District Court

By Samson Habte  


A malpractice action based on a law firm's alleged bad advice to an investment management company cannot be heard in state court because it raises significant questions of securities law in which there is a “strong federal interest,” the U.S. District Court for the Southern District of New York ruled Sept. 25 (Reserve Management Co. v. Willkie Farr & Gallagher LLP, S.D.N.Y., No. 11 Civ. 7045 (PGC), 9/25/12).

The decision, issued by Judge Paul G. Gardephe, rejected a motion to remand a professional negligence lawsuit that Reserve Management Co. (“RMCI”) filed against the Willkie Farr & Gallagher law firm.

RMCI faces a civil fraud action by the Securities and Exchange Commission as well as a slew of private lawsuits for allegedly misleading the public about the solvency of a money market fund that it oversaw.

The company sued Willkie in New York state court, claiming that RMCI's alleged securities violations are traceable to “incompetent advice” from Willkie attorneys.

The law firm removed the case to federal court, and Gardephe held that it must stay there.

Federal jurisdiction is proper, he determined, because RMCI can prevail in its malpractice action only if it can show that it did not violate federal securities law, and because there is “a strong federal interest in the federal securities law issues raised in [RMCI's] complaint.”

More Like Patent Cases.

The court's ruling was based on its application of Grable & Sons Metal Prods. Inc. v. Darue Eng'g & Mfg., 545 U.S. 308, 314 (2005), which established a multi-pronged test for determining whether state-law causes of action--such as legal malpractice--must be heard by federal tribunals.

Under Grable, federal courts have exclusive subject matter jurisdiction over state-law claims if:

• they “necessarily raise a federal issue”;

• the federal issue is “actually disputed and substantial”; and

• the exercise of federal jurisdiction will not disturb “any congressionally approved balance of federal and state judicial responsibilities.”

Courts applying Grable in the context of professional negligence actions have reached different conclusions. For example, some courts have found exclusive federal jurisdiction over patent-related malpractice claims. E.g., USPPS Ltd. v. Avery Dennison Corp., 647 F.3d 274, 27 Law. Man. Prof. Conduct 488 (5th Cir. 2011); Minton v. Gunn, 355 S.W.3d 634, 28 Law. Man. Prof. Conduct 5 (Tex. 2011), cert. granted, No. 11-1118 (U.S. Oct. 5, 2012).

By contrast, courts have held that the federal interest in trademark and antitrust cases is weaker--and, accordingly, that malpractice lawsuits involving those matters may be heard in state forums. See Singh v. Duane Morris LLP, 538 F.3d 334, 24 Law. Man. Prof. Conduct 406 (5th Cir. 2008); In re Haynes & Boone LLP, 2012 BL 190145, 28 Law. Man. Prof. Conduct 491 (Tex. App. July 26, 2012).

In this case, Gardephe found that the “strong federal interest in the adjudication of federal securities law claims” is comparable to the strong federal interest in patent malpractice-related cases. “As with the federal securities laws, federal courts have exclusive jurisdiction over patent laws,” he wrote.

Bad Day on the Street.

According to the opinion, RMCI served as the investment adviser for the Reserve Primary Fund (the “Fund”), a money market vehicle that held $785 million in Lehman Bros. debt when the brokerage firm collapsed in 2008.

The SEC complaint against RMCI is based on its actions following Lehman's announced bankruptcy--when, the agency claims, RMCI “engaged in a systematic campaign to deceive the investing public” into believing that the Fund was secure despite its Lehman holdings.

The SEC asserts that RMCI made materially false statements about the Fund's solvency, a forthcoming “credit support agreement” that would provide capital to the Fund, and a forthcoming “no-action” letter asking the SEC to implement the credit support agreement.

RMCI never executed or submitted the credit support agreement and “no-action” letter, according to the SEC complaint. The SEC further alleges that RMCI concealed information about a high volume of redemption requests that hit the Fund in the ensuing days.

The Lawyers Did It.

RMCI subsequently sought to pin blame on Willkie. Its malpractice complaint, Gardephe said, presents two theories of liability.

First, the complaint asserts that RMCI's purportedly false statements were made in accordance with “incompetent advice” that it received from Willkie and Rose DiMartino, a firm partner. The SEC case against RMCI, the complaint states, is based largely on purported misrepresentations in documents that were drafted by Willkie, which assured RMCI that the papers were compliant with securities laws.

The second theory of liability asserts that Willkie's “simultaneous representation of RMCI and the Fund presented a conflict of interest that the firm never disclosed to RMCI and that has caused significant prejudice to RMCI,” the court said.

According to the opinion, RMCI provides its investment services on behalf of the Fund under a management agreement that does not expressly require the Fund to indemnify RMCI.

“There is a strong federal interest in the adjudication of federal securities law claims in federal court because securities are regulated by a federal agency.”
Judge Paul G. Gardephe

The second malpractice claim alleges that Willkie--which drafted that agreement--was compromised by its dual representation, and that it was negligent for failing to negotiate an indemnification provision on behalf of RMCI.

Federal Issues Galore.

Gardephe concluded that federal jurisdiction is proper because the adjudication of RMCI's claims will require resolution of substantial questions of federal law.

“Moreover,” he added, “given the comprehensive federal securities regime, and the fact that Congress has granted federal courts exclusive jurisdiction over federal securities law actions, there is a strong federal interest in the federal securities law issues raised in [RMCI's] complaint.”

Gardephe first explained that the malpractice action involves “substantial question[s] of federal law” because a court will have to analyze and interpret two federal securities statutes before determining whether RMCI is entitled to relief.

As to the theory of liability regarding Willkie's failure to negotiate an indemnification clause, Gardephe found that RMCI can demonstrate causation only if it demonstrates that it did not violate the 1934 Securities Exchange Act and the 1940 Investment Advisers Act.

Those statutes preclude funds from indemnifying advisers for willful malfeasance and grossly negligent conduct, Gardephe observed. Accordingly, he explained, “to prove the proximate cause element of its malpractice claim, RMCI must show that it did not violate the federal securities laws and thus would be entitled to indemnification under the provision RMCI claims that Willkie should have negotiated.”

RMCI's “incompetent advice” theory also would turn on a legal determination regarding its compliance with federal law, the court found.

The plaintiff blames the SEC's investigation on Willkie's allegedly negligent advice, Gardephe noted. However, to prove proximate causation, he said, RMCI must demonstrate that “it committed no other federal securities law violation likely to provoke the SEC's enforcement action.”

The court also found its ruling to be harmonious with the balance of federal and state judicial responsibilities specified by Congress. “There is a strong federal interest in the adjudication of federal securities law claims in federal court because securities are regulated by a federal agency,” Gardephe wrote.

Willkie and DiMartino were represented by Michael J. Wernke and Thomas J. Kavaler of Cahill Gordon & Reindel, New York.

RMCI was represented by Kenneth E. Warner of Warner Partners, New York.

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The ABA/BNA Lawyers’ Manual on Professional Conduct is a joint publication of the American Bar Association Center for Professional Responsibility and Bloomberg BNA.

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