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Collective Scienter: an Unrecognized Danger in Legal Malpractice Cases

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Collective Scienter: an Unrecognized Danger in Legal Malpractice Cases number of facts that together supposedly Collective Scienter: An constituted red flags and from which the fact Unrecognized Danger in Legal finder can infer that the law firm consciously intended to further wrongdoing. This collec- Malpractice Cases tive knowledge or intent thus is used to estab- By: John K. Villa and John S. Williams lish the intent or knowledge element of many of the largest and most serious claims that are Major litigation against law firms is a rela- asserted against law firms. Collective scienter, tively recent phenomenon, with its roots in the to our knowledge, has never been expressly bank and savings and loan crisis of the mid- identified or discussed in any legal malpractice 1980s. To date, the theories of liability have opinion. Plaintiffs, however, implicitly use outpaced thoughtful development of defenses. the principle in their formulation of many of To a large extent, this is because very few large the most dangerous claims. While the doctrine legal malpractice cases proceed past the mo- of collective scienter has not received much tion to dismiss stage, where courts are often attention in most areas of the law, where it has inclined to reject novel arguments made by the been considered, it has, in general, been reject- defense. Defenses such as causation, case- ed. Legal malpractice defense lawyers should within-a-case, contributory negligence of cor- pay more attention to it, and focus the courts’ porate counsel, and loss causation, remain attention upon it, in defending the big case. formidable barriers to recovery but largely un- It is at the outset useful to identify where explored.2 collective scienter does and does not apply. The focus of this article is the little- Claims involving pure mistakes, conflicts of recognized concept of collective scienter, interest, and the like usually do not require the which, when invoked by a plaintiff in a lawsuit plaintiff to engage in this “aggregation” be- against a law firm, can be a cause those torts simply do formidable weapon. It is an not require scienter. Where issue most defense lawyers Collective scienter,… scienter becomes a major fac- have probably not examined. when invoked by a tor, however, is in cases of The term incorporates two plaintiff in a lawsuit aiding and abetting the mis- distinct but related concepts: conduct of others. See Re- whether the knowledge of in- against a law firm, can statement (Second) of Torts dividual lawyers in the firm be a formidable § 876(b) (1979). Illustratively, can be aggregated and at- weapon. claims for aiding and abetting tributed to the firm for the breach of fiduciary duty or knowledge requirement of aiding and abetting fraud re- various torts, and whether the quire that the lawyer or law firm know of the knowledge and conduct of individual lawyers primary wrong and have the specific intent to can be aggregated and attributed to the firm advance it. See, e.g., Lerner v. Fleet Bank, N.A., for the “scienter” element of various torts. The 459 F.3d 273, 292–93 (2d Cir. 2006) (applying concepts are closely related because plaintiffs New York law to aiding and abetting fraud); often try to prove law firm “scienter” by show- Kolbeck v. LIT Am., Inc., 939 F. Supp. 240, 247– ing that various lawyers in the law firm knew a 48 (S.D.N.Y. 1996) (applying New York law to aiding and abetting breach of fiduciary duty), -RKQ.9LOODDQG-RKQ6:LOOLDPVDUHERWKSDUWQHUVDW:LO aff’d, 152 F.3d 918 (2d Cir. 1998). OLDPV &RQQROO\ //3 ZKHUH WKH\ UHJXODUO\ UHSUHVHQW ODZ ILUPVDQGODZ\HUVLQSURIHVVLRQDOOLDELOLW\PDWWHUV As it happens, these are by far the most dangerous claims that a law firm can face, for $QXPEHURI FDVHVWKDW ZRXOGLOOXVWUDWHSRLQWVPDGHLQWKLV DUWLFOH ZHUH KDQGOHG E\ RXU ODZ ILUP :H GHFOLQH WR GLVFXVV a number of reasons. Aiding and abetting FODLPVDJDLQVWFOLHQWVXQOHVVVSHFLILFDOO\GLUHFWHGWRGRVR claims often arise out of failed companies; the Summer 2015 ALAS Loss Prevention Journal 11 46299_Summer_2015_Body.indd 13 5/26/15 6:15 PM gravamen of the claim is that the law firm aid- low, that is inconsistent with the theory of vi- ed and abetted management in causing the col- carious liability for scienter-based liability and lapse of the company or in defrauding classes with the relatively modest jurisprudence in of investors, creditors, or others. The alleged other areas of litigation. damages are the enterprise value—often in the I. Historical Background hundreds of millions of dollars or more—or the losses of classes of investors who have lost Prior to the 1980s, legal malpractice cases virtually all of their investment. Not only are were relatively infrequent, and were typically the losses enormous in such cases, but the aid- mistake-based claims. The savings and loan ing and abetting claim essentially deprives the crisis of the 1980s changed that. Federal agen- law firm of the contributory fault or contribu- cies that had insured deposits at failed fi- tory negligence defenses that are effective nancial institutions embarked on a campaign against claims by corporate plaintiffs.3 The of lawsuits against directors of these failed plaintiff has, in effect, placed the corporate of- financial institutions. When the insurers of ficer on the lawyers’ side of the “v.” directors and officers inserted “regulatory ex- clusions” in the insurance policies to foil FDIC When these claims are examined carefully, suits, the FDIC’s attention turned to claims it becomes clear that in order to make their against former counsel for failed thrifts and case that the law firm “knew” of the breach of banks, which the FDIC had acquired when the fiduciary duty or “knew” of the fraud, the insured depository institution failed. To col- plaintiffs describe a series of so-called “red lect on these claims, the receiver must file a flags” typically involving several lawyers over lawsuit against the professional. Accordingly, a period of time, and implicitly aggregate all of the FDIC and other agencies brought suits this conduct to one consciousness—that of the against law firms, alleging offenses including defendant law firm. Thus, associate A saw one negligence, ethical violations, conflicts of inter- suspicious fact, partner B saw a second suspi- est, violations of banking regulations, gross cious fact, counsel C saw a third suspicious negligence, and, as most pertinent here, aid- fact, etc., and therefore the law firm must have ing and abetting fraud by management and known that the client was engaged in breach of aiding and abetting breach of fiduciary duty fiduciary duty or fraud. In such circumstanc- by management. es, judges are likely to deny motions to dismiss (thus setting the stage for a large settlement), The aiding and abetting claims were par- as they, like the plaintiffs, have implicitly ag- ticularly vicious as the law firms were saddled gregated all of this knowledge and intent to with the entire loss caused by management, the law firm, as an entity. As we discuss be- typically the loss incurred in the failed bank. The FDIC hired a new and better class of law firm to develop and assert these claims, hired 'HSHQGLQJRQWKHMXULVGLFWLRQDQGWKHFODLPDVVHUWHGWKHODZ ILUPPD\VWLOOSRVVHVVDQLQSDULGHOLFWRGHIHQVHZKLFKFDQEH first-rate experts, and thereby ushered in a new YHU\SRZHUIXOLQGHIHDWLQJVXFKFODLPV6HHHJ.LUVFKQHUY era of legal malpractice cases. Some of these .30*//31(G 1< 7KHUHDUHDQXPEHU actions against law firms rested on theories of RIRWKHUGHIHQVHVWRDLGLQJDQGDEHWWLQJFDVHVHVSHFLDOO\DULV LQJRXWRIWKHUHTXLUHPHQWWKDWWKHDLGHUDQGDEHWWRUVXEVWDQWLDO vicarious liability and failure to monitor the O\ DVVLVWHG LQ WKH SULPDU\ ZURQJ ,Q VRPH MXULVGLFWLRQV WKH lawyer’s compliance with professional stand- VXEVWDQWLDODVVLVWDQFHPXVWLWVHOIDPRXQWWRDSUR[LPDWHFDXVH ards. See FDIC v. Nathan, 804 F. Supp. 888 (S.D. LQWKHZURQJ6HHHJ/XVVLHUY%HVVHWWH$G 9W 6WDQILHOG2IIVKRUH/HYHUDJHG$VVHWV/WGY0HWUR Tex. 1992) (holding law firm could be liable for /LIH ,QV &R 1<6G $SS 'LY²VW 'HS¶W failure to supervise attorneys in the firm); RTC 0RUHRYHUODZ\HUVGRLQJQRWKLQJPRUHWKDQSHUIRUPLQJ Mortg. Trust 1994 N-1 v. Fid. Nat’l Title Ins. Co., URXWLQHOHJDOVHUYLFHVRIWHQFDQQRWDVDPDWWHURIODZDPRXQW WRVXEVWDQWLDODVVLVWDQFH6HHHJ:LW]PDQY/HKUPDQ/HKU 58 F. Supp. 2d 503 (D.N.J. 1999) (applying re- PDQ )ORP 1:G ± 0LQQ 8OLFR spondeat superior principles). Defendants &DV&RY:LOVRQ(OVHU0RVNRZLW](GHOPDQ 'LFNHU raised a number of defenses, including con- 1<6G $SS'LY²VW'HS¶W tributory and comparative negligence, unclean Summer 2015 ALAS Loss Prevention Journal 12 46299_Summer_2015_Body.indd 14 5/26/15 6:15 PM hands, estoppel, failure to mitigate damages, only bring claims that contain a knowledge, loss causation, statute of limitations, and spec- intent, or scienter element because the lawyer’s ulative damages. fiduciary obligations extend only to the client. See generally Restatement (Third) of the Law Gov- Ultimately, the banking agencies recov- erning Lawyers § 56 (2000) (describing a law- ered millions of dollars through settlements in yer’s civil liability to nonclients as the same as these cases and a rare verdict. See FDIC, Man- that owed by a nonlawyer in similar circum- aging the Crisis: The FDIC & RTC Experience, stances). 281, available at www.fdic.gov/bank/histor ical/managing/history1-11.pdf. (“The FDIC Many times, the client will have already and the RTC filed a total of 205 attorney mal- failed, therefore leaving plaintiffs primarily practice suits arising from less than 10 percent focused on the client’s outside advisors as a of all failed institutions. From those cases and source of compensation. Accordingly, the some prelitigation settlements, the agencies claims are often for aiding and abetting torts recovered more than $500 million, averaging committed by the client, as to which plaintiffs about $2.5 million for each suit filed. Most of will need to show actual knowledge of the cli- the cases were settled at an early stage in the ent’s wrongdoing and intent to further it. See litigation.”); see also Steve France, Unhappy Pio- Restatement (Second) of Torts § 876(b).
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