Attorney. Counselor. Advisor. As “the last bastion of the generalist,” the role of the restructuring attorney takes various forms and requires a restructuring attorney to wear many different hats – at times acting both as lawyer and business advisor. This combination of business and law is very often what draws professionals to the practice area in the first place. The line, however, between business and legal advisor is often blurry and imprecise, and a recent decision from the Seventh Circuit addressing legal advice in the context of what appeared to be ordinary corporate transactions may have just made the line a little blurrier.
The case stems from the chapter 7 bankruptcies of Lancelot Investors Funds and certain affiliated entities. Lancelot was established by Gregory Bell in 2002 as a single-investment hedge fund which invested in promissory notes from Petters Company, Inc., a company owned by Thomas J. Petters. Petters asserted that he was financing consumer-electronics inventories for stores such as Costco and Sam’s Club. In reality, however, there were no purchases or invoices, or business relationship of any kind with Costco, as Petters was actually running a Ponzi scheme, which collapsed in September 2008. Both Bell and Petters were subsequently sent to prison for the fraud. The debtors were forced to file for chapter 7 protection to conserve what assets remained and recover additional assets from solvent entities.
The chapter 7 trustee commenced an action against the law firm that represented the Lancelot Funds, alleging that the firm committed legal malpractice during the six years it advised the Funds on how to structure their transactions with the entities controlled by Petters.
Under their prior arrangements, the Funds loaned money to the Petters vehicles, which in turn, were to finance some of Costco’s inventory. To legitimize these arrangements and to provide his investors with some (false) sense of security, Petters provided the Funds with paperwork that showed the inventory that was allegedly being purchased, and paid for, by Costco and also set up a lockbox account where Costco would supposedly deposit its payments for the Funds to draw on. Costco, however, never deposited any money into the account. All of the money came from a Petters entity. According to Bell, Petters told him that Costco insisted on paying one of Petter’s vehicles rather than paying the Funds directly. Petters further insisted that the Funds not contact Costco as, according to Petters, that would upset his favorable business relationships. Not surprisingly, when Petter’s Ponzi scheme collapsed, so did the Funds.
The trustee contended that the law firm violated its duty to its clients by not telling Bell that the actual arrangement with Petters – no checks with Costco, no direct funds from Costco, and no contact with Costco – posed a risk that Petters was not running a real business. The trustee maintained that the law firm had been engaged to structure transactions, and part of that duty “entails telling the client what contractual devices are appropriate to the situation.”
The complaint focused both on the time period when the principal contracts were negotiated as well as a subsequent period when Petters fell behind in payments to the lockbox. (Petters alleged that Costco was late in paying him.) The trustee alleged that attorneys at the firm did not recognize the risk from the combination of no contacts and no direct payments, plus the potential that the paperwork may have been forged. According to the trustee, these were all “serious red flags” that should have led to the firm advising the Funds to ask for additional protections. The complaint also alleged that the firm advised the Funds to defer the due dates on the late payments and that no other change was necessary, even though “the delay coupled with the other indicators should have alerted any competent transaction lawyer to the possibility of fraud, and the lawyer should have counseled the client to obtain better security.”
The district court dismissed the complaint against the law firm under Federal Rule of Civil Procedure 12(b)(6) for failure to state claim on which relief may be granted, stating that Bell knowingly bypassed verification with Costco in order to obtain a higher interest rate from Petters, and, thus, the Funds “knowingly took a risk and cannot blame a law firm for failing to give business advice.” The trustee appealed.
The Seventh Circuit took issue with the district court’s opinion and reversed and remanded the decision. First, the Seventh Circuit found that the district court’s decision narrated the events from the law firm’s perspective and, therefore, rested on a factual view extrinsic to the complaint that was not appropriate in the context of a motion to dismiss. Second, the Court of Appeals held that the district court’s decision failed to engage the complaint’s main contention – that the firm 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. According to the complaint, Bell did not appreciate the difference between funds from Costco and funds from Petters. The Seventh Circuit found that “a competent transactions lawyer should have appreciated that the former arrangement offers much better security than the latter and alerted its client.” The Seventh Circuit went on to state that “if a client rejects that advice, the lawyer does not need to badger the client; but the complaint alleges that the advice was not offered, leaving the client in the dark about the degree of the risk it was taking.”
The Court of Appeals also criticized the district court’s decision for failing to identify any principle of law that distinguished between business advice and legal advice. The court recognized the inherent difficulty in establishing such a bright line test because one function of a transactions lawyer is to counsel the client about how different legal structures carry different levels of risk and then to draft and negotiate contracts that protect the client’s interests. The court held, though, that it was “in the realm of legal advice” to explain the degree of business risk attached to a transaction. According to the complaint, the trustee faulted the firm for not advising the Funds about the value of a direct-deposit lockbox and for not recognizing, even after Petters fell behind in payments, that the existing arrangements were at risk when compared with other arrangements that could have been adopted. The Court of Appeals stated, “knowing degrees of risk presented by different legal structures, a client then can make a business decision; but it takes a competent lawyer, who understands how the law of secured transactions works (and who also knows what’s normal in the world of commercial factoring that Petters claims to practice), to ensure that the client knows which legal devices are available and how they affect risk.”
The Court concluded its opinion by stating that a “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” and specifically recognized that “a lawyer is not a business consultant.” However, the Court went on to say that “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.”
The Court reversed the judgment and remanded the case to the district court for further proceedings consistent with the opinion.
While appealing, the combination of business and law that draws so many to the restructuring profession also presents risks of which attorneys should be mindful. The Peterson decision is a reminder that the line between attorney and business consultant can often be blurred but remains a distinction that must be respected nevertheless. Attorneys should be careful to advise clients of all known transaction risks even after a client has made a decision on a course of action to pursue.