Protect Your Insurance

Whether in bankruptcy or in liquidation, trustees or liquidators of insolvent corporations look for available sources of cash to pay creditors. Unfortunately for in-house or outside attorneys representing such corporations, director and officer liability policies or professional malpractice policies are identified early on as possible sources of funds for insolvent companies. This article discusses the theories that are typically brought in these cases, and suggests ways to avoid or defend such claims in the future.

General theories of liability. Complaints against attorneys will almost always involve negligence claims in order to trigger insurance coverage. Since negligence principles are generally well known, they will not be discussed in this article. In addition to negligence claims, attorneys often are charged with claims for breach of contract or fiduciary duty when a corporation becomes insolvent. In a breach of contract claim, the negligence allegations are often used as a basis for the breach. Some state courts also incorporate negligence principles in a breach of contract claim by creating in every attorney-client relationship an implied contractual term that the attorney will conform to the applicable standard of care.

Attorneys also commonly face breach of fiduciary claims when companies become insolvent. A breach of fiduciary duty claim may be based on allegations that the attorney failed one of the following duties: 1) safeguarding the client's property; 2) avoiding conflicts of interest; 3) dividing loyalty; and 4) providing adequate information so that the client can make an informed decision. The most common claims are based on alleged conflicts of interests.

In addition to a breach of fiduciary claim, some courts hold defendants liable for aiding and abetting a breach of fiduciary duty under the Restatement (Second) of Torts '876 (1979). The elements of a cause of action for aiding and abetting a breach of fiduciary duty are: 1) a breach of a fiduciary duty owed to another; 2) knowledge of the breach by the aider and abettor; and 3) substantial assistance or encouragement by the aider or abettor in affecting that breach. Id.

Higher duties alleged against regulatory counsel. In addition to the theories discussed above, attorneys who represent regulated entities are often accused of undertaking duties in addition to those assumed by counsel for non-regulated entities. While the Sarbanes-Oxley Act of 2002 has created a debate regarding whether an attorney should be a corporate watchdog, such a debate existed before that Act and attorneys have been sued under similar theories. As stated in a leading treatise on legal ethics, “[i]t is clear that a lawyer for a corporation is not and should not be a 'corporate watchdog' as a general proposition. A lawyer is ordinarily entitled to assume that corporate officers and employees are performing their duties in good faith, including their duty to convey information fully and truthfully to the corporation's lawyers. However, a lawyer may not blindly proceed when circumstances indicate that that assumption is untenable, and that the entity faces legal risk. Under those circumstances, the duty of zealous and competent representation dictates that the lawyer must take appropriate steps to protect the entity, even where the threat comes from within.” G. Hazard and W. Hodes, The Law of Lawyering '17.11, (3d ed. 2001) (emphasis in original).

Attorneys for insolvent corporations thus face potential suits from corporate trustees or liquidators alleging that the attorney was aware of red flags that should have triggered a further investigation of certain corporate transactions. According to Professors Hazard and Hodes, “[m]uch of the factual testimony will come from former corporate officers who usually will have substantial incentives to render self-serving testimony. If that testimony is accepted, even a completely innocent lawyer may be at risk of civil liability for having failed to interdict the faithless corporate officers.” Id. Cf. Loyd v. Paine Webber, Inc., 208 F.3d 755 (9th Cir. 2000). The Loyd case rejects the theory that the insurer's former lawyers had a duty to investigate transactions by the insurance company because it was a regulated entity. However, in FDIC v. O'Melveny & Myers, 969 F.2d 744 (9th Cir. 1992), the court imposed a duty on a law firm to investigate, and held the firm liable for certain faulty disclosures made to the Securities and Exchange Commission (SEC) by the firm's client.

Conflicts of interest. Both in-house and outside counsel are often accused of breach of fiduciary because of alleged conflicts of interest. This is particularly true when an attorney represents a corporation with corporate parents or affiliates. In an insolvency, the directors, officers and counsel for a corporation may be accused of allowing the corporate parents, or the shareholders in close corporations, to drain the company through excess dividends or other business arrangements.

Preference claims. Some state statutes also authorize preference claims against the officers and directors of insurance companies. These claims may be asserted in two forms. First, an attorney, if an officer, may face a preference claim for payments to creditors transfers within one year of the date of the insurer's insolvency if the attorney knowingly participated in the payment. Second, an attorney, if an officer, may face a preference claim for any amounts paid by the company to the attorney, including bonus or severance payments within the year before the insolvency.

Limitations of certain defenses. In addition to potential claims available to a liquidator, attorneys also face a disadvantage in some jurisdictions in that several defenses are restricted.

(1) The Statute of Limitations is often tolled. Trustees and liquidators also often are entitled to an expanded statute of limitations in which to file suit through tolling statutes. In addition, the statute of limitations can be expanded by several other doctrines. Many states employ discovery and fraudulent concealment rules to permit tort claims after the statute would otherwise have run. Courts also sometimes recognize an adverse domination doctrine to defeat statute of limitations defenses. Under the adverse domination doctrine, the statute of limitations is tolled for as long as the alleged wrongdoers control the corporate plaintiff. Courts apply this doctrine under the theory that the corporation which can only act through the controlling wrongdoers cannot reasonably be expected to pursue a claim which it has against them until they are no longer in control. The adverse domination theory has been applied to toll claims against not only the wrongdoing corporate officers and directors but also, in some jurisdictions, to toll claims against the corporation's attorneys and auditors. See, eg, R.T.C. v. Farmer, 865 F. Supp. 1143 (E.D. Pa. 1994); but see F.D.I.C. v. Shrader & York, 991 F.2d 216 (5th Cir. 1993).

(2) It is difficult to blame the client. In many cases, the professionals who provide services to a corporation face claims based upon the alleged wrongdoing of corporate directors and officers. In such cases, it is logical to take the position as a defendant that the client was itself negligent by imputing the knowledge and intent of the wrongdoing officers or directors to the corporation itself. This defense typically is not available, however, where the officers or directors were not acting in the best interests of the corporation. See, eg, In re Personal and Business Ins. Agency, 334 F.3d 239, 243 (3d Cir. 2003).

(3) It is difficult to rely on regulatory approvals as a defense. Common sense suggests that approval by a regulator of a transaction would provide some measure of defense against later claims alleging that the transaction was improper or was not in the best interests of the corporation. Unfortunately, counsel should also take little comfort from regulatory approval to corporate transactions because regulatory approval is not a defense to suits against directors, officers and outside professionals. See, eg, Gross v. Weingarten, 217 F.3d 208 (4th Cir. 2000).

While not a complete defense, regulatory approval may still be relevant and admissible as a defense to defeat the intent element of fraud and breach of fiduciary duty claims. See Gross v. Weingarten, 217 F.3d at 216. Defense counsel should also attempt to introduce such evidence as a causation defense. In liability suits filed by insurance departments as liquidators of insurance companies, liquidators often allege lack of disclosure to the insurance department as a basis for claims. They also claim that the lack of disclosure caused damages to the corporation because it delayed intervention by the regulator and therefore deepened an impending insolvency. Since this theory alleges that earlier disclosures would have caused the regulator to take action earlier, the information previously revealed to the regulator and the regulator's actions, or lack thereof, may provide a causation defense to such a theory.

Tips for reducing liability exposures. Since the above defenses are limited, counsel representing corporations would be wise to:

(1) Specify the scope of the representation in writing. Lawyers are often accused of expressly or impliedly assuming duties that they did not perform. To avoid such a claim, an attorney should send the client a letter for each matter specifically describing the scope of the representation and limiting the duties that are undertaken. The Restatement of the Law Governing Lawyers explicitly recognizes that a lawyer may place limits on the scope of the representation and “may agree to limit a duty that a lawyer would otherwise owe to the client,” as long as “(a) the client is adequately informed and consents; and (b) the terms of the limitation are reasonable in the circumstances.” Restatement of the Law Governing Lawyers (Third) '19(1) (2000).

(2) Avoid conflicts of interest and/or advise board members of duties when conflicts exist. While most lawyers understand the need to avoid conflicts of interest, the existence of an alleged conflict is often less apparent when the conflict exists within a corporate structure. For instance, directors and officer are often accused of a conflict when transactions occur between a corporate parent and subsidiary, particularly with respect to dividends. Such a conflict is more likely to be asserted when there are interlocking boards of directors. Attorneys, either as in-house or outside counsel, may be able to limit the liability of themselves and the directors by advising the directors of the standards by which transactions between corporate affiliates will be judged, ie, whether the transaction was fair and reasonable to both parties to the transaction.

(3) Investigate any red flags. As discussed above, attorneys may be able to defend against a claim by arguing as a matter of law that there is no duty to investigate facts stated to the attorney by a client. However, as the person who may be responsible for making a filing with a court or regulatory body, the attorney will less likely be successful with such a defense if the facts did, or should have, raised a red flag to the attorney. Accordingly, the attorney should not turn a blind eye to any such red flags and should perform a reasonable investigation of such facts.

(4) Make your opinions known to the officers and directors of the company. Many lawyers feel restricted in revealing their opinions about corporate transactions due to their duties of confidentiality and loyalty to the company and/or its officers. The circumstances in which an attorney may reveal information to outsiders are beyond the scope of this article. However, if any concerns exist about a transaction or event known to the attorney, such concerns should be made known to the individuals at the highest levels within the corporation, including, if necessary, the board of directors to avoid negligence and breach of fiduciary claims against the attorney.

While lawyers will continue to be enticing targets to liquidators and trustees because of the existence of insurance, an attorney who understands the theories upon which such suits are filed is certainly in a better position to avoid such claims, or successfully defend such claims when they are filed.

Whether in bankruptcy or in liquidation, trustees or liquidators of insolvent corporations look for available sources of cash to pay creditors. Unfortunately for in-house or outside attorneys representing such corporations, director and officer liability policies or professional malpractice policies are identified early on as possible sources of funds for insolvent companies. This article discusses the theories that are typically brought in these cases, and suggests ways to avoid or defend such claims in the future.

General theories of liability. Complaints against attorneys will almost always involve negligence claims in order to trigger insurance coverage. Since negligence principles are generally well known, they will not be discussed in this article. In addition to negligence claims, attorneys often are charged with claims for breach of contract or fiduciary duty when a corporation becomes insolvent. In a breach of contract claim, the negligence allegations are often used as a basis for the breach. Some state courts also incorporate negligence principles in a breach of contract claim by creating in every attorney-client relationship an implied contractual term that the attorney will conform to the applicable standard of care.

Attorneys also commonly face breach of fiduciary claims when companies become insolvent. A breach of fiduciary duty claim may be based on allegations that the attorney failed one of the following duties: 1) safeguarding the client's property; 2) avoiding conflicts of interest; 3) dividing loyalty; and 4) providing adequate information so that the client can make an informed decision. The most common claims are based on alleged conflicts of interests.

In addition to a breach of fiduciary claim, some courts hold defendants liable for aiding and abetting a breach of fiduciary duty under the Restatement (Second) of Torts '876 (1979). The elements of a cause of action for aiding and abetting a breach of fiduciary duty are: 1) a breach of a fiduciary duty owed to another; 2) knowledge of the breach by the aider and abettor; and 3) substantial assistance or encouragement by the aider or abettor in affecting that breach. Id.

Higher duties alleged against regulatory counsel. In addition to the theories discussed above, attorneys who represent regulated entities are often accused of undertaking duties in addition to those assumed by counsel for non-regulated entities. While the Sarbanes-Oxley Act of 2002 has created a debate regarding whether an attorney should be a corporate watchdog, such a debate existed before that Act and attorneys have been sued under similar theories. As stated in a leading treatise on legal ethics, “[i]t is clear that a lawyer for a corporation is not and should not be a 'corporate watchdog' as a general proposition. A lawyer is ordinarily entitled to assume that corporate officers and employees are performing their duties in good faith, including their duty to convey information fully and truthfully to the corporation's lawyers. However, a lawyer may not blindly proceed when circumstances indicate that that assumption is untenable, and that the entity faces legal risk. Under those circumstances, the duty of zealous and competent representation dictates that the lawyer must take appropriate steps to protect the entity, even where the threat comes from within.” G. Hazard and W. Hodes, The Law of Lawyering '17.11, (3d ed. 2001) (emphasis in original).

Attorneys for insolvent corporations thus face potential suits from corporate trustees or liquidators alleging that the attorney was aware of red flags that should have triggered a further investigation of certain corporate transactions. According to Professors Hazard and Hodes, “[m]uch of the factual testimony will come from former corporate officers who usually will have substantial incentives to render self-serving testimony. If that testimony is accepted, even a completely innocent lawyer may be at risk of civil liability for having failed to interdict the faithless corporate officers.” Id. Cf. Loyd v. Paine Webber, Inc. , 208 F.3d 755 (9th Cir. 2000). The Loyd case rejects the theory that the insurer's former lawyers had a duty to investigate transactions by the insurance company because it was a regulated entity. However, in FDIC v. O'Melveny & Myers , 969 F.2d 744 (9th Cir. 1992), the court imposed a duty on a law firm to investigate, and held the firm liable for certain faulty disclosures made to the Securities and Exchange Commission (SEC) by the firm's client.

Conflicts of interest. Both in-house and outside counsel are often accused of breach of fiduciary because of alleged conflicts of interest. This is particularly true when an attorney represents a corporation with corporate parents or affiliates. In an insolvency, the directors, officers and counsel for a corporation may be accused of allowing the corporate parents, or the shareholders in close corporations, to drain the company through excess dividends or other business arrangements.

Preference claims. Some state statutes also authorize preference claims against the officers and directors of insurance companies. These claims may be asserted in two forms. First, an attorney, if an officer, may face a preference claim for payments to creditors transfers within one year of the date of the insurer's insolvency if the attorney knowingly participated in the payment. Second, an attorney, if an officer, may face a preference claim for any amounts paid by the company to the attorney, including bonus or severance payments within the year before the insolvency.

Limitations of certain defenses. In addition to potential claims available to a liquidator, attorneys also face a disadvantage in some jurisdictions in that several defenses are restricted.

(1) The Statute of Limitations is often tolled. Trustees and liquidators also often are entitled to an expanded statute of limitations in which to file suit through tolling statutes. In addition, the statute of limitations can be expanded by several other doctrines. Many states employ discovery and fraudulent concealment rules to permit tort claims after the statute would otherwise have run. Courts also sometimes recognize an adverse domination doctrine to defeat statute of limitations defenses. Under the adverse domination doctrine, the statute of limitations is tolled for as long as the alleged wrongdoers control the corporate plaintiff. Courts apply this doctrine under the theory that the corporation which can only act through the controlling wrongdoers cannot reasonably be expected to pursue a claim which it has against them until they are no longer in control. The adverse domination theory has been applied to toll claims against not only the wrongdoing corporate officers and directors but also, in some jurisdictions, to toll claims against the corporation's attorneys and auditors. See , eg , R.T.C. v. Farmer , 865 F. Supp. 1143 (E.D. Pa. 1994); but see F.D.I.C. v. Shrader & York , 991 F.2d 216 (5th Cir. 1993).

(2) It is difficult to blame the client. In many cases, the professionals who provide services to a corporation face claims based upon the alleged wrongdoing of corporate directors and officers. In such cases, it is logical to take the position as a defendant that the client was itself negligent by imputing the knowledge and intent of the wrongdoing officers or directors to the corporation itself. This defense typically is not available, however, where the officers or directors were not acting in the best interests of the corporation. See, eg, In re Personal and Business Ins. Agency, 334 F.3d 239, 243 (3d Cir. 2003).

(3) It is difficult to rely on regulatory approvals as a defense. Common sense suggests that approval by a regulator of a transaction would provide some measure of defense against later claims alleging that the transaction was improper or was not in the best interests of the corporation. Unfortunately, counsel should also take little comfort from regulatory approval to corporate transactions because regulatory approval is not a defense to suits against directors, officers and outside professionals. See , eg , Gross v. Weingarten , 217 F.3d 208 (4th Cir. 2000).

While not a complete defense, regulatory approval may still be relevant and admissible as a defense to defeat the intent element of fraud and breach of fiduciary duty claims. See Gross v. Weingarten , 217 F.3d at 216. Defense counsel should also attempt to introduce such evidence as a causation defense. In liability suits filed by insurance departments as liquidators of insurance companies, liquidators often allege lack of disclosure to the insurance department as a basis for claims. They also claim that the lack of disclosure caused damages to the corporation because it delayed intervention by the regulator and therefore deepened an impending insolvency. Since this theory alleges that earlier disclosures would have caused the regulator to take action earlier, the information previously revealed to the regulator and the regulator's actions, or lack thereof, may provide a causation defense to such a theory.

Tips for reducing liability exposures. Since the above defenses are limited, counsel representing corporations would be wise to:

(1) Specify the scope of the representation in writing. Lawyers are often accused of expressly or impliedly assuming duties that they did not perform. To avoid such a claim, an attorney should send the client a letter for each matter specifically describing the scope of the representation and limiting the duties that are undertaken. The Restatement of the Law Governing Lawyers explicitly recognizes that a lawyer may place limits on the scope of the representation and “may agree to limit a duty that a lawyer would otherwise owe to the client,” as long as “(a) the client is adequately informed and consents; and (b) the terms of the limitation are reasonable in the circumstances.” Restatement of the Law Governing Lawyers (Third) '19(1) (2000).

(2) Avoid conflicts of interest and/or advise board members of duties when conflicts exist. While most lawyers understand the need to avoid conflicts of interest, the existence of an alleged conflict is often less apparent when the conflict exists within a corporate structure. For instance, directors and officer are often accused of a conflict when transactions occur between a corporate parent and subsidiary, particularly with respect to dividends. Such a conflict is more likely to be asserted when there are interlocking boards of directors. Attorneys, either as in-house or outside counsel, may be able to limit the liability of themselves and the directors by advising the directors of the standards by which transactions between corporate affiliates will be judged, ie, whether the transaction was fair and reasonable to both parties to the transaction.

(3) Investigate any red flags. As discussed above, attorneys may be able to defend against a claim by arguing as a matter of law that there is no duty to investigate facts stated to the attorney by a client. However, as the person who may be responsible for making a filing with a court or regulatory body, the attorney will less likely be successful with such a defense if the facts did, or should have, raised a red flag to the attorney. Accordingly, the attorney should not turn a blind eye to any such red flags and should perform a reasonable investigation of such facts.

(4) Make your opinions known to the officers and directors of the company. Many lawyers feel restricted in revealing their opinions about corporate transactions due to their duties of confidentiality and loyalty to the company and/or its officers. The circumstances in which an attorney may reveal information to outsiders are beyond the scope of this article. However, if any concerns exist about a transaction or event known to the attorney, such concerns should be made known to the individuals at the highest levels within the corporation, including, if necessary, the board of directors to avoid negligence and breach of fiduciary claims against the attorney.

While lawyers will continue to be enticing targets to liquidators and trustees because of the existence of insurance, an attorney who understands the theories upon which such suits are filed is certainly in a better position to avoid such claims, or successfully defend such claims when they are filed.