Dancing With the Devil: Aiding and Abetting Liability for Lawyers

Lawyers are not generally responsible for the misconduct of their clients. But according to speakers at the Spring 2014 ABA National Legal Malpractice Conference, there is a disturbing trend of claims against lawyers based upon the theory of aiding and abetting the client’s misconduct.

Richard A. Simpson of Wiley Rein LLP in Washington, D.C., moderated the discussion by panelists April Otterberg of Jenner & Block, Chicago; Kathy Bazoian Phelps of Diamond McCarthy LLP in Los Angeles; and Mark S. Rapponotti, claim manager—professional liability for AmTrust North America in Chicago.

The conference, presented by the ABA Standing Committee on Lawyers’ Professional Liability, was held April 30-May 2 in Boston.

Otterberg and Phelps reported some key differences between a legal malpractice action and an aiding and abetting claim.

First is the issue of intentional conduct versus negligence. The key issue in an aiding and abetting claim is generally not whether the lawyer complied with the standard of care. Rather, liability primarily turns on what the lawyers knew and when they knew it.

Second, because privity is generally not required for an aiding and abetting claim, the universe of claimants may be broader. This brings the possibility of many plaintiffs and many lawsuits all arising out of the same conduct, thereby increasing the potential exposure.

Third, because of the intentional nature of the aiding and abetting claim, liability may be joint and several, with comparative fault schemes being inapplicable.

Fourth, settlement of these claims can be complicated with the need for releases from a number of parties.

Phelps, co-author of The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes, noted that although most of the audience members were familiar with a Madoff-type Ponzi scheme, the “type of business can be anything.” She related the example of a Ponzi scheme from India last year where investors invested in the purchase of a goat that would yield high returns if the goat bore three to four kids annually.

Elements of A&A Claim

Otterberg outlined the three elements required to prove an aiding and abetting claim against a lawyer:

• wrongful conduct by a third party or former client;
• actual knowledge of the wrongful conduct; and
• substantial assistance to the wrongful conduct.

Rapponotti noted the coverage implications of these claims. Insurers are often able to use the complaint to show that if the plaintiff proves the allegations, then the lawyer had prior knowledge of a possible claim at the time the lawyer answered “no” on the insurance application. Accordingly, the insurer will often bring a declaratory action and name the plaintiffs as parties. Frequently, the declaratory action will be stayed until the underlying case is finished.

Rapponotti cautioned that the terms and conditions of the individual policies need to be examined to ascertain the potential outcome. For example, in some policies, if one lawyer should have said “yes” on an application question, then the entire firm would be excluded from coverage. However, in the directors and officers context, the policies are usually severable such that “innocent” parties might still be afforded coverage. That can also be true on occasion for larger law firms, depending on the terms of their policies.

Type of Wrongful Conduct

Otterberg noted that the aiding and abetting theory is not limited to attorneys but rather has been asserted against accountants, auditors, banks and other professionals. “The plaintiffs’ bar is pursuing professionals who were at the scene in some way,” she said.

The panelists agreed that unlike the legal malpractice context, privity is not necessarily required. Liability can attach even without direct contact between the defendant law firm and the plaintiff. In fact, as Rapponotti noted, the aiding and abetting claims are designed to get around the privity requirement.

He continued that every insurance contract has an implied covenant of good faith in dealing. He believes that the implied covenant should run in both directions. In his view, the plaintiffs’ bar has not always excelled at understanding the insurance policy implications of their allegations.

As an example, he noted that “no physician would do a heart surgery without an MRI or other diagnostic test.” However, counsel for plaintiffs often file their complaints without knowing the language of the applicable insurance policy.

As to the type of conduct involved, the panelists distinguished between intentional conduct and negligence. Generally, three types of wrongful conduct are commonly pled as the predicate act to support an aiding and abetting claim:

• fraud;
• breach of fiduciary duty; and
• breach of a statutory duty.

A notable exception to the third type is federal securities law. The U.S. Supreme Court held in Cent. Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), that no private claim exists for aiding and abetting a federal securities violation. The result may be different if the alleged statutory breach was one of state law. Some states have statutes that allow a claim for aiding and abetting a state securities law violation.

Actual Knowledge of Attorney

The knowledge required must be knowledge of the specific wrongful conduct, and not just knowledge of general conduct. Generally, the argument that the lawyer “should have known” of the wrongful conduct is not enough.

As an example, Phelps discussed Casey v. U.S. Bank N.A., 26 Cal. Rptr.3d 401 (Cal. Ct. App. 2005), which was a claim against a financial institution. The bank allowed accounts to be opened for nonexisting entities on behalf of their customers, using invalid tax identification numbers. They withdrew large amounts of cash in unmarked duffel bags. The bank knew that certain signatures were forgeries. Nevertheless, although the court held that this was sufficient for the bank to know that “something fishy was going on,” it was insufficient for the bank to know the source of the deposits, and thus the specific wrongful conduct.

Phelps then discussed Facciola v. Greenberg Traurig, 2011 BL 152590 (D. Ariz. June 9, 2011), a case that was filed against two law firms, one of which had prepared two private offering memoranda after the firm knew of financial turmoil within the company.

According to the court opinion, the plaintiff alleged the law firms engaged in a fraudulent securities scheme by conduct that included knowingly creating offering memoranda containing false and misleading statements, participating in the termination of a potential whistleblower and orchestrating a plan to have a manager register as a securities dealer under another’s securities license, all for the purpose of hiding failing financials and keeping the company in business.

The allegations survived a dispositive motion resulting in a total $87.5 million settlement against the two law firms involved. According to Phelps, in some cases, if a plaintiff can allege enough red flags it may be sufficient to show that the law firm must have known of the wrongful conduct.

Otterberg disagreed, stating that red flags are not sufficient to support an aiding and abetting claim. The lawyer’s job is to help clients achieve their objective. For example, if the objective is lawful, how could the lawyer have known of wrongful conduct?

She warned that defense attorneys must acknowledge that there can be a hindsight bias as a plaintiff attempts to plead the knowledge element in a complaint. Although it can feel like the defense must attempt to prove a negative (i.e., the lack of knowledge), it remains the plaintiff’s burden to prove actual knowledge. Defense lawyers should look at the timing and focus their attention on what the lawyer is alleged to have known and when.

Substantial Assistance to Wrongdoer

For liability to attach, the lawyer’s work must have provided “substantial assistance” to the misconduct. This means more than just providing normal legal services. Silence or inaction generally is not enough. However, according to Phelps, some courts have deviated from the more generally accepted “substantial assistance” standard, and she cited Reynolds v. Schrock, 142 P.3d 1062, 22 Law. Man. Prof. Conduct 447 (Or. 2006), as an example.

Phelps discussed a case out of Florida against BDO Seidman, In re E.S. Bankest, L.C., 2010 BL 218435 (Bankr. S.D. Fla. April 6, 2010).

In that case, the auditor was hired to detect fraud but did not do so and, as a result, $170 million of investments were made during the seven audit years. The case involved the allegation that the auditor had ignored its own audit manual. When the auditors did not receive confirmations of third-party checks, they terminated the representation. Later, however, after a closed door meeting, the auditors restarted their engagement. At that point, they did not follow the procedures of their own manual. In ruling against the auditors, the court noted that one of the auditors testified that the principal of the wrongdoer entity was “an important person in the community and could lead to future business.”

Otterberg reiterated that for liability to attach against a lawyer, the assistance must be something other than the normal work of the law firm. She noted that although there is sometimes an allegation that the lawyer should have gone to the SEC or other regulatory authority, the lawyer also has a professional obligation to maintain client confidences, which makes a “duty to report” claim a challenge for a plaintiff.

Further, she noted that causation is an element of an aiding and abetting claim as described in the Restatement (Second) of Torts, but the term “substantial assistance” also suggests a causation requirement, because assistance cannot be “substantial” without being causally tied to the underlying fraud. New York is one of the states that has picked up on the causation aspect of aiding and abetting claims.

Rapponotti indicated that the substantial assistance element is generally not that relevant to coverage issues. For coverage purposes, the allegations need only “arise out of” legal services. He noted that there may be an investment advice exclusion that applies to the conduct alleged.

Standing

According to Phelps, many of the entities involved in Ponzi schemes end up in receivership or bankruptcy. Generally, the receiver or trustee will stand in the shoes of the entity itself and can bring claims that belong to the entity. The question for an aiding and abetting claim is whether the claim against the wrongdoer and the wrongdoer’s lawyers is owned by the company or the investors. She stated that in Ponzi schemes, the line can be blurred as to who owns the claim, leading to confused case law on the subject.

Otterberg noted that the Madoff trustee and the Stanford receiver have sought certiorari from the U.S. Supreme Court on the issue of the standing of a receiver or bankruptcy trustee.

Phelps pointed to a Seventh Circuit case which provided a useful distinction in her view. Knauer v. Jonathon Roberts Fin. Grp., Inc., 348 F.3d 230, 233-34 (7th Cir. 2003), analyzed Ponzi schemes as having two phases: sales and embezzlement. In the sales phase, the wrongdoer is soliciting investments to contribute to the entity. Once the investments have been made, the second phase involves misappropriation of those investments for the wrongdoer’s own purposes.

In this case, the court held that any claims in the sales phase belongs to the investors. However, once the money has come in, the claim belongs to the company.

Statute of Limitations

Otterberg noted that Ponzi schemes may take years to come to light. If the relevant statute of limitations contains a discovery rule, accrual of the claim may be tolled. However, there also may be statutes of repose which may not be subject to the discovery rule. She gave the example of the six-year Illinois statute of repose for claims against lawyers arising from their legal services. Similarly, statutes of repose under state securities laws can sometimes run from the date of the sale of the security, with no discovery rule tolling.

SLUSA

Phelps noted a recent Supreme Court case relevant to aiding and abetting liability. In Chadbourne & Park LLP v. Troice, 2014 BL 51065 (U.S. Feb. 26, 2014), the only person who actually bought securities was the wrongdoer himself. The Stanford Financial Ponzi scheme involved CDs, which are not “covered securities” under the Securities Litigation Uniform Standards Act of 1998. Thus the scheme was not in connection with securities. That meant that a class action could proceed and was not barred by the SLUSA’s prohibition against state law securities class actions.

In Pari Delicto

Finally, the panel discussed the defense of in pari delicto, which bars a plaintiff from seeking redress against another wrongdoer when the plaintiff or one standing in the shoes of the plaintiff was equally or more at fault.

Phelps noted that one court has referred to this defense as a “refined form of finger pointing.” There is an adverse interest exception to this rule, and a sole actor exception to the adverse interest exception. In Phelps’s view, practitioners should examine whether the agent was acting solely in his or her own interest, as opposed to the interest of the company, as well as whether the wrongdoer was the sole actor of the corporation.