Peterson v. Winston & Strawn LLP
729 F.3d 750 (2013)
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Rule of Law:
A legal malpractice claim against a corporate client's law firm for failing to report a manager's misconduct to the board of directors will be dismissed if the complaint fails to plausibly allege facts showing that such a report would have prevented the client's injury.
Facts:
- Gregory Bell managed the Lancelot/Colossus Funds ('the Funds'), which invested heavily in ventures run by Thomas Petters.
- Petters was secretly operating a Ponzi scheme, though the Funds' offering circulars represented that he was a legitimate commercial factor.
- These circulars promised investors that the Funds would verify the existence of inventory financed by Petters and ensure repayments were made to a secure 'lockbox'.
- In 2005, the Funds hired the law firm Winston & Strawn to revise their offering circular.
- Bell informed Winston & Strawn that Petters refused to allow inventory verification and did not use lockboxes.
- Winston & Strawn then prepared a revised offering circular, which the Funds began using in 2006, that continued to falsely represent that inventory verification and lockboxes were in use.
- The Funds collapsed in late 2008 when Petters's Ponzi scheme was exposed.
Procedural Posture:
- The Trustee for the bankrupt Lancelot/Colossus Funds (Peterson) sued the law firm Winston & Strawn, LLP, for legal malpractice in the U.S. District Court for the Northern District of Illinois.
- The district court granted Winston & Strawn's motion to dismiss, invoking the doctrine of in pari delicto (equal fault).
- The Trustee (appellant) appealed the dismissal to the U.S. Court of Appeals for the Seventh Circuit, with Winston & Strawn as the appellee.
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Issue:
Does a law firm commit malpractice by failing to report a corporate manager's misconduct to the company's board of directors, where the plaintiff has not pleaded facts to plausibly suggest that such a report would have prevented the company's harm?
Opinions:
Majority - Chief Judge Easterbrook
No. A law firm's failure to report a manager's misconduct to the board does not support a malpractice claim unless the complaint plausibly alleges that the report would have actually made a difference and prevented the company's losses. The court reasoned that the Trustee's claim on behalf of the Funds failed for two primary reasons. First, the argument that the law firm should have revealed the truth in the offering circular is invalid because such a disclosure would have harmed, not benefited, the client (the Funds) by causing its immediate collapse. Second, the claim that the firm should have reported Bell's conduct to the board of directors fails because a violation of professional conduct rules (such as the duty to 'report up') does not, under Illinois law, automatically create a private cause of action for malpractice. More critically, the complaint failed to meet the plausibility pleading standard established by Twombly and Iqbal because it did not allege any facts to suggest that the absentee, non-participatory board of directors would have actually intervened and prevented the harm had they been notified.
Analysis:
This decision reinforces the high pleading standard established by Twombly and Iqbal, particularly in the context of professional malpractice. It clarifies that a plaintiff cannot simply allege a breach of an ethical duty; they must also plead specific facts demonstrating that the breach was the direct cause of the injury. The ruling distinguishes between a lawyer's ethical obligations under rules of professional conduct and the elements of a tortious malpractice claim, signaling that an ethical breach is not a per se basis for a damages award. This makes it more difficult for a bankruptcy trustee to sue third-party professionals on behalf of a corporation that was complicit in its own downfall through the actions of its managers.
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