Advance Sheet: Risk Assessment

All such numbers are mostly nonsense. They have much the same character as weather predictions. Statisticians will tell you there are ways to ensure a meteorologist stays honest when predicting a 30 percent chance of rain. Apart from such statistical means, however, we all know as laypeople these numbers are designed to ensure that almost no weather prediction can ever turn out wrong, unless the meteorologist is foolhardy enough to say the chance of rain is zero and thunderstorms later prove otherwise. So, too, a litigator can never be faulted for having said the client had a 60 percent chance of winning. A loss conveniently resides in the remaining 40 percent, even if the client may need to be reminded of that once the negative verdict is in.

Risk numbers do have some value, however, in calculating settlement figures. As a defendant you can always take the maximum (or, if you prefer, the reasonably achievable maximum) damages the plaintiff may get and discount them by whatever generous or cheap percentage you believe is a plaintiff’s chance of success. So a prospective $10 million judgment, if all goes right for the plaintiff in a toss-up case, may be worth no more than $5 million, less the time value of money (assuming no prejudgment interest). Your own unrecoverable attorney fees may be added to the figure and, presto, you have a not-to-exceed number for settlement purposes.

One reason the numbers are left so vague is that so many unpredictable elements go into litigating. There is just so much that can go wrong (or right), so much that is unforeseeable. There are surprise emails, careless witnesses, and especially mistaken assumptions. Mark Twain was famous for saying that “Truth is stranger than fiction, but it is because Fiction is obliged to stick to possibilities; Truth isn’t.” Ordinary assumptions are dangerous in litigation. Possibly the very reason there is litigation in the first place is that someone wrongly assumed events would transpire as they usually do. To put it more simply, paraphrasing Yogi Berra, in litigation you don’t know nothin’. There is no end to what can happen.

Fortunately, clients’ expectations tend to be reasonable, particularly the expectations of clients used to the litigation drill. What they want when asking for a risk assessment is a review of the presumed facts and the law, not which way the vagaries of litigation may cut. In most cases, they seem just as likely to cut for you as against you. Perhaps a closer look at the parties or the facts or a first encounter with the judge may counsel otherwise. The other side’s lead witness could be a real sweetheart, bound to be beloved of the jury. Or that jumpy witness on your side may seem unlikely to perform well and may, if you listen closely, cause you to wonder if he’s hiding something or is liable to collapse on the witness stand or some such thing. Your 60-40 may then become 50-50 or worse. But most of the time, these matters are not separately considered.

Transactional Lawyers

Most transactional lawyers have been blissfully spared the burden of this kind of risk assessment. Usually, the client has a specific objective in mind: the acquisition or sale of an asset, real property, or a company; the negotiation and documenting of a relationship-to-be; the formation of an entity for tax relief while in compliance with law. In the last example, there may be a prediction regarding the likelihood of avoiding tax. In the negotiation of contracts, there needs to be an assessment of the value of a particular point or provision. The best lawyers have a clear understanding of what’s necessary to protect the client and what isn’t, giving up the latter but grasping the former tightly.

There is also due diligence. This includes the spotting of risks in an acquisition that need to be highlighted and considered. Those of genuine concern need to be scheduled. Ordinarily, there will also be a negotiation with the other side regarding the allocation of unforeseeable risks. The outcome of that negotiation will appear in the agreement’s representations and warranties, with one side or the other maintaining (and thereby taking the risk) that certain things aren’t going to happen or that particular problems will not arise.

But what about the transaction itself? Do transactional lawyers have an obligation to advise clients what the risks are of entering into a particular transaction in the first place? It is difficult to think of a case in which that would be obligatory, short of the client proposing something criminal, which calls less for a risk assessment than a firm “no.” Lawyers have never understood themselves as being obligated to save their clients from their own foolhardiness. Most clients don’t want to hear it either. Tell a client that his decision to do business with a particular party is too parlous an endeavor and you are likely to get an icy stare. They intend to do what they want, and the lawyer who even discreetly suggests that the deal may not be an advantageous one, or very risky, must either have a very close relationship with her client or be willing to be tossed out on her ear.

The distinction would seem to be between legal advice and business advice. The former concerns how to make the transaction the client wants to do as legally sound and risk-free as the lawyer can make it. The latter concerns the decision to do the transaction at all. Seems simple enough. And not just in theory. Most lawyers know where the line is drawn. This is not to say that a trusted counselor might not venture into the businessperson’s realm from time to time. But most clients, too, appreciate that this is not obligatory and beyond the realm of the legal engagement.

There are all kinds of reasons to support this distinction. Like litigators, transactional lawyers cannot be expected to see all that can go wrong, or even right. It is for the businessman to make the financial bet, using his judgment to know whether a transaction is a good one or not. Lawyers document the wager in the best possible way. They cannot be expected to reassess the sense of the deal in the first place, can they?

The Seventh Circuit Speaks

Yes, the Seventh Circuit has now said. Speaking through the sometimes controversial Judge Easterbrook, the court has opined that it is imperative, on pain of a later malpractice claim, for deal lawyers to warn clients about the foreseeable risks of the transaction itself.

The case at issue was Peterson v. Katten Muchin Rosenman LLP, 792 F.3d 789 (7th Cir. 2015). There, a couple of investment funds sued the Katten law firm for negligence in connection with documenting transactions the funds had decided to do with entities controlled by one Thomas Petters. The Petters entities supposedly financed some of the inventory of Costco pursuant to paperwork Petters provided, including a Costco undertaking to pay its obligations into a “lockbox” bank account. One of the managers of the funds knew the money was not coming from Costco directly. There was a Petters entity in between, but he lied to his investors about it. In the end, however, he was himself the victim of a bigger fraud: Petters had no relationship with Costco. It was all a Ponzi scheme.

The funds claimed that Katten committed malpractice by not advising the funds of the risk of fraud. According to the complaint, Katten should have advised there was a chance Petters was not running a real business. Two facts added some force to this claim. Apparently, Katten was told at the outset, in 2002, that no one was to contact Costco, given a supposedly sensitive relationship between Petters and Costco. Also, when Petters fell behind in payments in 2007, Katten was asked what to do and neglected, so the argument went, to seek new security for the funds’ investment.

When the now-defunct funds sued all the professionals, the district court dismissed the complaint against Katten, apparently convinced that a risk assessment of the kind Katten was alleged not to have done was not within the province of the lawyers. In the Seventh Circuit, however, Judge Easterbrook took a different view. Asserting that the complaint’s allegations had to be taken as true, he contended that there was no basis yet to believe that Katten acquitted itself of its obligation to warn the funds they were in parlous territory.

But did Katten really have that obligation? Emphatically so, said Judge Easterbrook. Perhaps, he offered, the matter sounds more in the nature of business advice about whether the deal was a good one or bad one, not something within the purview of the lawyers. But, he emphasized, there is no easy distinction between business advice and legal advice. Moreover, it is always in the nature of legal advice, he claimed, to warn of dangers in a transaction, as any competent transactional lawyer (he says) would do. The client may not wish to hear the advice, let alone accept it, but the risk assessment of “the transaction” itself should be made and given. On the basis of the complaint, no judgment could be made whether Katten had done what a competent lawyer would have done, so the complaint was reinstated and returned to the district court. See id. at 791–93.

This outcome is deceptively simple, not to say simple-minded. It is doubtless true that there is no easy distinction between business and legal advice. The former seems more comprehensive than the latter, which itself seems more in the nature of technical assistance. But lawyers are not like plumbers. They need to exercise judgment. The case was also helped along by its procedural posture. At the pleadings stage, it was difficult to say exactly how much Katten really knew, what real warning signs there were, and even what specifically Katten was asked to do. Complaints with high-flown rhetoric can obscure a host of deficiencies. There had been some hope in the legal community that Bell Atlantic Corp v. Twombly, 550 U.S. 544 (2007), and Ashcroft v. Iqbal, 556 U.S. 662 (2001), might curtail the problems created by clever pleading, but once you assumed, as Judge Easterbrook did, that the role of transactional lawyers reached into the merits of the transaction, it was not too difficult for the funds to meet the heightened pleading requirements imposed by those cases.

Duty to Warn

The problem, if there was one, lay in something more fundamental. Judge Easterbrook ruled that lawyers had to warn clients about the risks of the transaction. Note how different this is from the kinds of risk assessment litigators are asked to do. Litigators have a known risk—the lawsuit—and merely opine on chances, one way or the other. Even if they venture into the more likely developments along the way, they are dealing with something concrete. Due diligence for transactional lawyers is also subject to clear limits, ferreting out and scheduling known risks and providing in contractual language for undiscovered ones. A failure to warn is a different kettle of fish altogether. There one has to look beyond the transaction to ponder what else might go wrong.

And what transaction? In the Katten case, was it the mere documentation of the narrow elements of payment and repayment, at one extreme, or the whole relationship of the funds and Petters, or even Costco, at the other? The risks Judge Easterbrook insisted the lawyers needed to opine on would differ depending how you characterize the engagement. At the narrow extreme, the only risk to be assessed was whether the documentation served the purposes it was designed for, i.e., did it provide for the money to be invested and repaid? At the other end, Katten would be called upon to do extensive due diligence and a detailed risk assessment of all things that could conceivably go wrong. This concerns not merely the possibility that Petters might not be legitimate but also the possibility that Costco itself might go broke or even be corrupt or itself defrauding Petters.

Indeed, at this broad end of the spectrum, there is and can be no end to the possibilities, as Mark Twain foretold. Assume, for example, that Costco is heavily invested in China. Must the lawyers assess the risk of a devaluation of the Chinese currency? Or how about a political upheaval there? Might not this affect Costco’s ability to pay? To say these possibilities are absurd is to say nothing. They remind us that there is no such thing as a perfect hedge or a sure thing. A lot of people who were engaged in European commerce in 1914 thought a total continental war was impossible too. Or, to take a simpler example, stock market analyses in 1998 did not take into consideration the possibility of Russian sovereign debt default. It was just assumed it would never happen. But it did, causing losses for many. And who foresaw the collapse of Lehman Brothers in 2008?

Judge Easterbrook, to be fair, would likely never expect the lawyers to have foreseen and advised of the risk of those events. It is only what a reasonably diligent lawyer would be expected to foresee. But the parade of horribles should alert us to several problems. First, a failure-to-warn approach raises the danger of looking through the wrong end of the telescope, from the end result backward. When events no one conceived of or thought possible occur, it is easy to make them seem foreseeable. Take the simple example of a lawn mower. It likely never occurred to lawn mower manufactures that a user would be so great a knucklehead as to put his hands or feet underneath a switched-on mower. The warning signs that now grace lawn mowers suggest that there was someone just so obtuse, with the manufacturer having been held liable or at least sued for not warning about it. Bad outcomes in business transactions may well take on the same characteristics and risks for lawyers who work on them.

Second, even if the engagement is a narrow one, it can, through crafty pleading, be made to look like a broader one. Expand the engagement, or the description of the engagement, and increase the risk, or the liability. Many meritless cases will, on this analysis, get past the pleading stage, as this one did. The pressure for settlement will then ratchet up and result in many spurious claims being paid.

Third, the impact on engagement letters may be significant. Fearful of their duty to warn, lawyers may now try to document carefully exactly what they are being asked to do and what risks they do not wish to take. This hampers the free flow of advice, not necessarily for the benefit of the clients. Or perhaps the more likely outcome is that lawyers will now simply bear the risk, providing commercial clients with a kind of insurance policy against their failed transactions.

This seems unlikely to be a good development. Whereas a businessperson could always fire a lawyer she viewed as an ineffective counselor, she may now be able to sue him too. One also wonders how far the contagion might spread. Will the scope of a litigator’s obligation to warn of risk also expand to include the impact of negative publicity from a case or the risk that litigation may prove too costly for the client to sustain? We seem perhaps on the edge of new territory, where lawyers are no longer held to account for the risks they are asked about, with all the careful hedging that permits, but now must also account for an uncertain and perhaps unlimited realm of the failure to foresee what may happen. Be forewarned.