Big Bad Bankruptcy Trustees Aim
to Blow Some BigLaw Houses Down

By Anthony Lin
New York Law Journal
New York Lawyer
November 26, 2007

In April 2003, Steven Garfinkel, the chief financial officer of DVI Inc., wrote a memo to chief executive officer Michael O'Hanlon about the crushing liquidity crisis facing the health-care finance company and its implications for a pending stock float. The CFO urged his boss to talk as soon as possible to the company's main outside lawyer, John Healy, a partner in the New York office of Clifford Chance.

"John will tell you that the plans to go ahead with the exchange offer and raise capital without solving the cash problem will represent serious securities fraud," Mr. Garfinkel wrote in the memo. "Our issues now are defrauding an FDIC insured bank, which has federal law implications as well as serious civil liability issues. The board will become enormously exposed to the securities fraud implications. In John's own words - 'We all go to jail' - in my words, 'This is serious shit.'"

Mr. Healy's words to Mr. Garfinkel proved prophetic. A few months later, DVI filed for bankruptcy, where it emerged that the Jamison, Pa.-based company, which reported $2.8 billion in assets at the time of its filing, had for years concealed its true financial condition. In March 2007, Mr. Garfinkel was sentenced to 30 months in prison for his role in the scandal, making him one of the first executives successfully prosecuted under the Sarbanes-Oxley Act.

As for Clifford Chance, it is now facing two lawsuits in federal court in Philadelphia charging that it participated in the fraud at the company. One is the familiar shareholder class action, which is also targeting Merrill Lynch and Deloitte & Touche. The other suit, however, is by DVI itself, or, rather, the bankruptcy trustee overseeing the fallen company's estate. Trustee Dennis J. Buckley requested $2 billion in damages from the London-based law firm in a complaint filed in March 2006.

Though they garner fewer headlines, such bankruptcy trustee suits have largely replaced shareholder class actions in the nightmares of law firm managing partners. These suits are often better-funded, better-lawyered and, with the U.S. Supreme Court likely to further limit third-party liability in securities fraud cases, they may soon have a distinct legal edge as well.

"These are the lawsuits firms are most worried about now," said Michael Carlinsky, a partner at Quinn Emanuel Urquhart Oliver & Hedges who is representing Marc S. Kirschner, the bankruptcy trustee of failed commodities brokerage Refco Inc. in a $2 billion suit against the company's former lawyers at Mayer, Brown, Rowe & Maw, among others.

Indeed, the journey of Enron Corp. law firm Vinson & Elkins illustrates the shifting landscape of law firm liability. The Houston-based firm vigorously fought the high-profile securities fraud suit brought against it by former class action king William S. Lerach, getting off scot-free with a voluntary dismissal in January 2007. But last year Vinson & Elkins quietly paid $30 million to Enron's bankruptcy trustee, who never formally filed suit against the firm.

Law Firms as Targets

While securities class actions are brought on behalf of shareholders, bankruptcy trustee suits are brought for the benefit of creditors, the biggest of which are usually banks and investment funds. These creditors have grown more aggressive about recouping losses, lawyers say, with trustees acting accordingly.

"In the past, there was not a strong inclination on the part of trustees to sue lawyers and accountants," said Stephen F. Caley, a bankruptcy partner at Kelley Drye & Warren. "Over time that broke down and now they go after everyone."

Denis F. Cronin, a bankruptcy litigator who represented Vinson & Elkins before the Enron bankruptcy trustee and recently joined the firm himself as a New York partner, declined to discuss that case, but agreed that bankruptcy litigation has become a bigger concern for law firms. He said distressed-debt hedge funds, which buy bankruptcy claims as an investment, bore a large part of the blame.

"They'll fight for every two or three cents," said Mr. Cronin.

Mr. Caley also said that hedge funds had raised the stakes for lawyers.

"More than a lot of other plaintiffs, they've shown little hesitation about suing law firms," he said.

But Mr. Kirschner said there were no distressed-debt hedge funds behind the Refco case, in which Chicago-based Mayer Brown is accused of handling sham transactions that company executives used to paper over massive losses ahead of an initial public offering. Refco eventually had a highly successful IPO but was forced into bankruptcy a few weeks later, when its suspect transactions came to light. Refco's collapse has also given rise to a shareholder class action, now pending in federal court in New York.

Michael Venditto, a partner at Anderson Kill & Olick who is representing DVI's bankruptcy trustee, also said there were no distressed-debt hedge funds driving that case, just the misconduct that led to the companies' demise.

The scandal that brought down DVI bears some resemblance to the current subprime mortgage crisis. The company, which provided financing for hospitals and clinics to buy medical equipment, had expanded its business among less-qualified borrowers. DVI moved these loans off its balance sheet through biannual securitizations, and the sale of these securities became the main source of the company's operating cash.
But when large numbers of its borrowers began to default, DVI executives allegedly tried to hide its losses in order to maintain its credit rating and its lifeblood in the securitization lifeblood. According to a bankruptcy examiner's report, they engaged in sham "round-trip" transactions designed to stave off defaults by advancing company money to delinquent borrowers. Desperate to raise capital to cover their loan losses, DVI executives turned to lenders themselves, in some cases pledging the same collateral more than once, the report says.

Both the securities class action and bankruptcy trustee suits charge that Mr. Healy, through his close working relationship with Messrs. O'Hanlon and Garfinkel, knew what was going on and participated by preparing false filings to the Securities and Exchange Commission.

These filings included the registration statement for the stock float Mr. Garfinkel discussed in his April 2003 memo to Mr. O'Hanlon. Addressing further SEC inquiries, Clifford Chance allegedly drafted responses that suggested that DVI maintained adequate reserves against anticipated loan losses. The trustee's suit called one of these responses "a shameful moment of outright prevarication."

In Pari Delicto

The firm's lawyer, William J. Schwartz of Cooley Godward Kronish, declined to comment on either the shareholder or trustee claims. But there are well-recognized defenses to both kinds of suits, and Clifford Chance has already raised them in court filings.

Shareholder claims against lawyers, bankers and other professionals have long run up against the U.S. Supreme Court's 1994 decision in

, 511 U.S. 164, which barred third-party "aider and abettor liability" in securities fraud cases. The high court is widely expected to deal another blow to shareholder suits by prohibiting third-party "scheme liability" claims when it issues its decision in the recently argued Stoneridge Investment Partners v. Scientific-Atlanta, Inc.

Shareholders do not have the sort of relationship with a company's outside counsel that would give them the right to bring common-law claims based on duty or contract. On the other hand, the bankruptcy trustee, who stands in the shoes of the company, has access to any claims the company could bring against its lawyers, including legal malpractice. But this closer relationship gives rise to a major legal obstacle of its own.

In pari delicto means "in equal fault." It is a defense based on the legal doctrine that a party cannot seek relief for a crime or tort for which he or she is also to blame. In pari delicto would bar a corporation whose top executives committed fraud on the company's behalf from suing others who may have aided that fraud. That bar extends to a trustee standing in the shoes of the corporation.

It has been grounds for dismissal of many trustee actions.
"In pari delicto is real," said Mr. Cronin. "It's a big hurdle to overcome."

In the wake of the Enron scandal, many commentators called for the abolition of the in pari delicto defense in bankruptcy trustee suits, arguing that it unfairly prevented recoveries for bankruptcy trustees and, by extension, creditors by attributing to them the crimes of executives who, in most cases, were long gone from the company. But while federal circuit courts have noted law review articles calling for an end to in pari delicto, none have yet taken up the suggestion.

But several lawyers said the attitudes of courts, at least at the trial level, has become less favorable towards in pari delicto, particularly when defendants cite the defense as grounds for dismissal.

"Courts are realizing it's unfair to knock out these claims on in pari delicto," said Mr. Carlinsky. "It calls for a fact-intensive inquiry."

Most bankruptcy trustee suits against lawyers cite the so-called adverse interest exception, under which in pari delicto does not apply because the company's executives committed fraud not on the company's behalf but wholly for their own personal benefit.

The judge overseeing the DVI case declined last October to dismiss claims against Clifford Chance on in pari delicto grounds, citing the adverse interest exception. Addressing the law firm's argument that the executives' actions, however misguided, were intended to save the company, Judge Legrome Davis of the U.S. District Court for the Eastern District of Pennsylvania said DVI might have been better off dead.

"Sustaining a failing corporation does not benefit the corporation if the most prudent strategy would be to immediately confront the company's fiscal realities," the judge wrote.

Incentives to Settle

Getting past a motion to dismiss is often enough for the bankruptcy trustee to extract a settlement. Law firms already have enormous incentive to settle lawsuits against them. Such cases are highly disruptive to ongoing practices, and most firms think they will be unsympathetic defendants should a case ever get to trial.

Bankruptcy trustees may have even more leverage in that regard than shareholders. Most securities class action lawyers working on contingent fees are also eager to settle with law firms, because their time is better spent focusing on defendants with deeper pockets, like investment banks. Bankruptcy trustees in large corporate failures can generally tap multi-million-dollar litigation trusts, allowing them to more vigorously pursue their claims against firms.

To do so, they often turn to firms who could just as easily show up on the defense side. Mr. Cronin noted that the increase in bankruptcy trustee litigation has led to more law firms being sued by erstwhile peer firms, rather than their usual foes among plaintiff's lawyers.
"If there ever was a gentlemen's agreement among firms not to sue each other, it's over now," he said.

Mr. Carlinsky said he disliked suing other lawyers, an act he described as "cannibalism," but he said the facts concerning Mayer Brown's role in Refco's collapse were extremely compelling. Mayer Brown's lawyer, John Villa of Williams & Connolly, who also previously represented Vinson & Elkins in the Enron class action, declined to comment.

The near-certainty of settlement in trustee cases means questions about the applicability of the in pari delicto defense remain unanswered, as does the larger question of how much responsibility lawyers should bear for actions taken by their clients.

Mr. Cronin said lawsuits against lawyers generally assumed that sophisticated lawyers would be able to clearly recognize certain transactions as fraudulent, but he said even the smartest lawyers often lacked the expertise to make such judgments.

Faced with a rising threat from trustee suits, Mr. Cronin said some firms may start to turn away work from fast-growing companies whose business model or finances are extremely complex.

"Everybody's kind of scared," he said. "The threat of this alone can bust up weaker firms."

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