Framing Legal Malpractice as Negligence Saves Claims

Investor Loses Investment after Executive Embezzlement

An online marketing startup solicited an investment from an investor. To negotiate and memorialize the terms, the startup engaged a law firm. The final investment agreement provided for a $2.5 million investment, containing a restriction on executive compensation. Shortly after funding, the startup’s executive began withdrawing money for personal use.

The startup’s chief operating officer later discovered the withdrawals and asked the law firm to draft a line of credit that purportedly allowed the startup to loan up to $2 million to the executive. Both the law firm and the startup’s executives knew about the restriction on compensation. Even so, under the guise of a loan, the personal spending continued. Ultimately, the startup went out of business without bringing a product to market, and the investor lost its $2.5 million investment.

Contractual Duty—Not Fraud—Provides Basis for Malpractice Claims

The investor sued the startup for its losses. The parties settled after the startup agreed to assign its legal malpractice claims against the law firm to the investor. The investor argued that the law firm breached its contract with the startup. Specifically, counsel did not report the startup executive’s illegal spending or take action to prevent further abuse though contractually obligated to do so. According to the investor, counsel knowingly concealed the wrongdoing by drafting the line of credit and enabled the illegal spending to continue.

The investor, as assignee of the claims, sued the law firm. But the law firm argued the investor did not have standing to assert the claims derived from the executive’s fraud. In support, the law firm cited a state statute prohibiting assignment of fraud claims. The district court determined the investor’s claims arose from “personal torts or for injuries arising from fraud to the assignor.” As such, the court deemed the assignment invalid under the statute prohibiting the transfer and dismissed the claim.

The investor appealed to the U.S. Court of Appeal for the Eleventh Circuit. It argued the malpractice claim did not arise from fraud, but rather from a breach of the legal services contract. The Eleventh Circuit agreed and revived the investor’s legal malpractice claim. The Eleventh Circuit explained, “A legal malpractice action may, as here, be based upon the breach of a duty imposed by the contract of employment between the attorney and the client, and sounds in contract when it alleges negligence or lack of professional care.” The investor, therefore, could pursue its malpractice claims against the startup’s counsel even though counsel owed no duty to the investor.

Attorneys’ Ethical Obligations after Lucky

The Lucky decision forewarns that assignments of legal malpractice claims sounding in fraud may be prohibited. “This is somewhat of an unfortunate situation because it appears from the opinion that the CEO began using the funds at issue for personal reasons before seeking any advice from the attorney,” opines Robert E. Poundstone, IV, Montgomery, AL, cochair of the ABA Section of Litigation’s Ethics & Professionalism Committee. “This doesn’t appear to be a case where the CEO’s actions were undertaken because of advice given by the attorney,” observes Poundstone. On the other hand, “If funds are being misused by a client employee—meaning that the funds are being used for personal benefit or that the employer/client has been defrauded—and the lawyer knows this, the lawyer has to evaluate his or her responsibilities,” advises John M. Barkett, Miami, FL, cochair of the Section of Litigation’s Ethics & Professionalism Committee.

The risk is potentially higher when representing startup companies. “Startup companies like the startup in this case may be sloppily run and when they are collecting monies from investors, that should raise a red flag for any law firm representing the startup,” warns Barkett. “If investors lose money, they will look everywhere they can to recover their losses even if their targets have done nothing wrong,” Barkett adds. “Do not put yourself in a position to be accused of malpractice,” he warns. “A lawyer should be diligent to head off problematic issues already created by their client and should especially do so in an organizational setting where the lawyer’s professional obligation is to the organization as a whole and not individual members of upper management,” agrees Poundstone.

Ultimately, the ramifications of the opinion remain unclear. “What the client conveyed to the attorney and whether the attorney did, or was asked to, provide advice on the loan’s appropriateness” will affect the ethical obligations, concludes Poundstone. The Lucky Capital decision was “not necessarily intended to create a fiduciary-type duty to the investor, but it is not that much of a stretch for someone to draw that conclusion,” Poundstone opines. “Many attorneys will be uncomfortable on at least some level with the notion that a client, who specifically directed the action undertaken by the attorney, can assign a malpractice claim to a third party to presumably avoid some of the client’s own liability to the third party,” he warns. But one takeaway from Lucky is clear: “A law firm facing a third-party malpractice claim based on an assignment should always know the law on assignability!” advises Barkett.

Kristen L. Burge is an associate editor for Litigation News.

Hashtags: #legalmalpractice #professionalnegligence #corporatecounsel #legalethics

Related Resources

• O.C.G.A. Section 44-12-24.
• ABA Model Rule of Professional Conduct 1.13: Organization as Client.
•  Lucky Capital Management, LLC v. Miller & Martin, PLLC, 16-16161 (11th Cir. July 3, 2018).
• Kenneth R. Berman, "Litigation Ethics: Representing Corporations and Other Organizational Clients, Part 1 of 3," Corporate Counsel Committee (Dec. 11, 2013).
• Brian T. Sumner, "Ethical Considerations in Corporate Representations, 101 Practice Series," Young Lawyers Div. (Feb. 29, 2012).

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