There's an interesting new case out of the Seventh Circuit, reinstating a legal malpractice case against a transactional firm for an alleged failure to warn the client that it might be dealing with a Ponzi scheme. Worth reading in its entirety, but here are excerpts:
The Trustee's complaint contends that Katten violated its duty to its clients by not telling Bell that the actual arrangement (no checks with Costco, no money directly from Cost-co) posed a risk that Petters was not running a real business. Katten had been engaged to structure [*2] transactions, the Trustee asserts, and part of that duty entails telling the client what contractual devices are appropriate to the situation. The complaint focuses on two periods: first, a time during 2003 when principal contracts were being negotiated and signed; second, a time during 2007 when Petters fell behind in payments to the lockbox (he asserted that Costco was late paying him) and the Funds consulted Katten about what to do. According to the complaint, in 2003 Katten did not advise the Funds to ask for additional protections—the Trustee believes that Katten's lawyers did not recognize the risk from the combination of no contacts and no direct payments, plus the potential that the paperwork purporting transactions with Costco had been forged. The complaint also alleges that in 2007 Katten advised the Funds to defer the due dates on the payments, and that no other change was necessary, even though the delay coupled with the other indicators should have alerted any competent transactions lawyer to the possibility of fraud, and the lawyer should have counseled the client to obtain better security.
The district court dismissed the complaint under Fed. R. Civ. P. 12(b)(6) for failure to state a claim on which relief may be granted. Instead of taking the complaint on its own terms, the district court's opinion narrates the events from the law firm's perspective. Katten maintains, and the opinion states, that Bell knowingly bypassed verification with Costco in order to obtain a higher interest rate from Petters. Thus the Funds knowingly took a risk and cannot blame a law firm for failing to give business advice.
There are three problems with this decision. First, it rests on a factual view extrinsic to the complaint and therefore is not an appropriate use of Rule 12(b)(6) . The complaint alleges that Bell attributed the Funds' high return at least in part to the lack of direct verification with Costco and that he told some would-be investors about this tradeoff, but it does not allege that Bell was indifferent to legal advice concerning how to curtail risks given the no-contact constraint.
Second, the decision does not engage the complaint's main contention—not that Katten was supposed to do something about Petters's no-direct-contact edict, but that Katten 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. As the complaint depicts matters, Bell did not appreciate the difference between funds from Costco and funds from Petters. A competent transactions lawyer should have appreciated that the former arrangement offers much better security than the latter and alerted its client. 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 third problem is that the decision does not identify any principle of Illinois law that sharply distinguishes [*3] between business advice and legal advice. It is hard to see how any such bright line could exist, since one function of a transactions lawyer is to counsel the client how different legal structures carry different levels of risk, and then to draft and negotiate contracts that protect the client's interests. A client can make a business decision about how much risk to take; the lawyer must accept and implement that decision. But it is in the realm of legal advice to tell a client that the best security in a transaction such as this one is direct verification with Costco plus direct deposits to a lockbox; the second-best is direct deposits to a lockbox; and worst is relying wholly on papers over which Petters had complete control, for they may be shams with forged signatures by Costco managers who have never heard of Petters. 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 claimed to practice), to ensure that the client knows which legal devices are available and how they affect risks.