Lawyers' potential exposure to liability in fraudulent business transactions.

• Author: Sinclair, J. Walter

CAN attorneys in representing clients, requests become personally liable for their client's fraudulent actions? Yes, in limited, although expanding, situations.

Is this a concern? Absolutely.

Does it make sense? Yes, under a proper analysis, but not otherwise.

What are the primary causes of this expansion of attorneys, personal liability? As is common, bad fact cases with inadequate remedies.

Are there adequate defenses to potential personal liability when representing clients engaged in fraudulent actions? Yes, the best being strict compliance with the applicable rules of professional responsibility and conduct, with a sound understanding of the various issues at play.

What are those issues? Read on.

CONFLICTING DUTIES AND

CHANGING RULES

When it comes to fraudulent transactions, the traditional liability protection for attorneys inherent in the attorney-client relationship is eroding in the business litigation context and, in fact, in most legal representations. This results from business clients trying to avoid the actions of their fraudulent managers or directors, or both, and the attendant liability, as well as the search by damaged third parties for additional sources of recovery when business clients have inadequate financial resources.(1) While most of the cases cited in this article deal with corporate relationships, the principles are applicable to most forms of business entities, although with limited application to sole proprietorship relations.

Traditionally, if clients engaged in wrongdoing, their attorneys had only to be silent to avoid liability, but this is not necessarily the case now. Several commentators have observed there is a growing concern about attorneys, duties of confidentiality and loyalty to clients, as contrasted to an emerging view in some courts that attorneys owe a duty to the public to prevent vent their clients from committing fraudulent acts. In the face of these potentially conflicting duties, it is more and more important for attorneys to determine what action or inaction to take when clients commit or may commit an illegal or fraudulent acts.

The courts have recognized the duty to the public most significantly in the savings and loan association cases arising from the collapse of many financial institutions in the late 1980s and early 1990s. In those instances, federal agencies, in an effort to recoup some of the cost of bailing out the failed institutions, turned to the only deep pockets" available - the attorneys, and accountants, malpractice insurers.(2) In many of those cases, the courts found that the attorneys had an affirmative duty to seek out their clients, wrongdoing and prevent the fraudulent transactions.

A HIGHER STANDARD

Courts are holding attorneys to a higher standard than ever before in regard to the fraudulent actions of their clients. This is especially true in the corporate arena and specifically as a result of the savings and loan association crisis. The Federal Deposit Insurance Corp. and counsel for corporations in general are developing creative ways to shift or extend the liability for the fraudulent actions of directors and managers to their attorneys or accountants, or both.

1. Emerging Duty to Public

   The Ninth Circuit in FDIC v. O'Melveny & Meyers,(3) delivered one of the strongest messages as to lawyers, duties to prevent their clients' fraud. O'Melveny & Meyers was retained by American Diversified Savings Bank to prepare "Private Placement Memoranda," called PPMs, for two real estate limited partnership offerings. It was not the first law firm hired by ADSB to perform tasks related to real estate limited partnership offerings. In fact, prior to hiring O'Melveny, ADSB had retained and fired an accounting firm and a law firm.

   The second accounting firm was replaced with a third shortly after O'Melveny was hired. In April 1985, ADSB replaced Touche Ross & Co. with Arthur Anderson and Co., and, according to the Ninth Circuit's opinion, in May 1985, more than five months before the private placement offerings were sold, Touche Ross had notified ADSB, Rogers A Wells (then the ADSB law firm), and federal regulators that it believed ADSB's net worth was less than zero.

   In September 1985, Rogers & Wells requested up-to-date audited financial statements for its preparation of the "Hickory Trace" offering. But statements were not forthcoming, and the "Hickory Trace" offering never occurred. ADSB replaced Rogers & Wells with O'Melveny. Thereafter, Arthur Anderson expressed concern regarding ADSB's financial stability, and ADSB replaced Arthur Anderson with Coopers & Lybrand.

   The PPMS prepared by O'Melveny described the firm as "special counsel ... to the general partner and its affiliates in connection with federal securities laws, federal income tax law, and certain other matter." O'Melveny prepared considerable portions of the PPMs, edited them, and performed a due diligence review to confirm the accuracy and completeness of the PPMS, disclosures.

   The FDIC took over ADSB shortly after the real estate offerings, and it then received complaints from investors who asserted that they had been mislead by the PPMs. The FDIC returned the investors, money after agreeing that the PPMS were misleading. It then sued O'Melveny, alleging professional negligence. negligent misrepresentation, and breach of fiduciary duty.

   The law firm argued that it owed no duty to ADSB as a corporation to discover its fraud, especially when ADSB knew of the fraud based on the imputation of the director's knowledge to ADSB, and the fact that the directors were actively concealing their fraudulent actions. The Ninth Circuit did not agree, holding that every attorney has a duty to protect its client. "Part and parcel of effectively protecting a client, and thus discharging the attorney's duty of care," it stated, "is to protect the client from the liability which may flow from promulgating a false or misleading offering to investors."

   O'Melveny then argued that the fraudulent acts of the directors were attributable to the corporation and that the FDIC was not entitled to any more protection from the law firm than the directors. This has been coined as is the "insider fraud defense."(4) As a result, the firm argued, the directors should not be allowed to profit from their fraud. To this, the court responded: "We disagree with this flat statement of the law, particularly in view of the public expectation that the wrongdoing will be exposed, the wrongdoers pursued, and the innocent victims of fraud will have a chance at recovering."

   The court held O'Melveny to the duty of exposing the wrongdoing of its client, regardless of the attorney-client privilege and regardless of the active concealment of fraud by the ADSB's chief executive officer and executive vice president. In addition, the court in essence stated that O'Melveny was one of the wrongdoers to be punished, regardless of the culpability of the directors, who also were shareholders who would profit from any judgment assessed against O'Melveny.

   In the well-known Lincoln Savings & Loan Association case,(5) the court implied that attorneys for a corporation are responsible for injury to the corporation, regardless of the deceit and treachery of the directors, owners or management. In that case, Charles Keating Jr. acquired Lincoln Savings & Loan Association, which before the acquisition was conducting a traditional savings and loan business. After Keating gained control, Lincoln Savings became involved in all types of non-real estate investments and "high yield-high risk" bonds. In addition, several of the transactions had no substance but showed paper profits. Eventually, the Federal Home Loan Bank Board appointed a conservator, and in June 1989, it was concluded that Lincoln Savings was insolvent by approximately $631 million dollars.

   In regard to the...