Reexamining Conflicts of Interest in the Current Economic Environment

October 17, 2011

By Alexandre Montagu, Esq. and Thomas Walsh, Esq.

With the EU banking system facing serious issues and the threat of another recession looming in the United States, many people are asking what lessons can be drawn from the economic collapse in 2008. For corporate counsel, one takeaway from the Great Recession, and specifically from the proliferation of litigation that has followed, is the importance of thoroughly vetting potential conflicts of interest when choosing outside counsel.

Prior to the Great Recession there may have been a tendency to overlook issues such as potential conflicts because the business was profitable and the conflicts may not have been obvious or likely to present themselves. However, perhaps more than anything else, the Great Recession has taught us that profits are never guaranteed and that if the day comes when the profits stop coming in, everyone will want to know who is at fault.

If faced with that scenario, the last thing you, as in-house counsel, want to realize is that you approved the use of a firm which turns out to have been conflicted, and that you are now being blamed for the deal going bad (regardless of whether the conflict was the real cause of the problem).

Law firms too, should be proactive when it comes to potential conflicts because, as the following case demonstrates, clients in the current economic environment will not hesitate to bring a malpractice claim when they believe the firm’s representation was deficient due to a conflict of interest.

The case, Reserve Management Company, Inc. (“RMCI”) v. Willkie Farr & Gallagher LLP and Rose F. DiMartino, involves allegations of legal malpractice by a mutual fund management company against its former law firm, Willkie Farr & Gallagher and one of its partners, Rose F. DiMartino.  RMCI was the investment manager of a money market mutual fund, The Reserve Primary Fund (the “Fund”).

According to the complaint, Willkie Farr had represented both RMCI and the Fund since 2002.  In September 2008, the Fund had over $60 billion invested with it. Then, following the collapse of Lehman Brothers, the Fund “broke the buck” (i.e., its per-share net asset value had fallen below $0.995) and was forced into liquidation. In the aftermath, investors in the Fund filed numerous lawsuits against RMCI and the Fund, and in February 2009, the Fund adopted a plan of distribution that withheld $3.5 billion until the resolution of all pending and future lawsuits.

In May 2009, the SEC filed a complaint against RMCI, its chairman and vice president, alleging that in the days following Lehman’s bankruptcy filing, RMCI made false statements to investors and the Fund’s board in an effort to convince them that the Fund was safe and to dissuade the investors from making redemption requests. The SEC also sought to compel distribution of the remaining Fund assets to the shareholders. In January 2010, pursuant to an order by Judge Gardephe of the Southern District of New York, the Fund distributed $3.4 billion of the withheld assets to shareholders, which brought the investors’ total recovery to more than 98 cents on the dollar.

In October 2011, RMCI brought suit against Willkie Farr alleging that Willkie committed malpractice for various reasons, including for failing to properly advise RMCI regarding its public statements about the Fund during the time period surrounding Lehman’s collapse.  RMCI also alleges that Willkie failed to properly advise it when it negotiated and entered the management agreement with the Fund. One specific failure in this area, according to RMCI, was that Willkie did not advise RMCI to seek an indemnification from the Fund or the inclusion of a clause requiring the Fund to advance the cost of defending against lawsuits. RMCI claims that it had significant leverage in the negotiations with the Fund because one of RMCI’s principals, Bruce Bent, Sr. was the founder of the Fund, and therefore, the Fund would have agreed to provide indemnification and advancement if RMCI had so requested.

Other allegations in the complaint include:

  • Willkie advised the Fund’s board in December 2008 that RMCI and the Fund were not clearly adverse and that joint representation would benefit the Fund and was reasonable and appropriate.
  • Willkie continued to represent both RMCI and the Fund until the SEC informed Willkie that representing both parties presented a conflict. Willkie then withdrew as RMCI’s counsel, but continued to represent the Fund.
  • Before withdrawing as RMCI’s counsel, Willkie failed to provide adequate advice when the Fund stopped paying its management fees, and failed to advise RMCI about making claims for insurance proceeds.
  • Since withdrawing as RMCI’s counsel, Willkie has taken a number of positions directly adverse to RMCI, including interfering with the receipt of insurance proceeds that would cover the costs of defending the SEC litigation.
  • Willkie has requested the Court to approve payment to it from the Fund’s remaining assets for an amount in excess of $7 million, while also arguing that it was not acceptable for RMCI to be reimbursed for the cost of operating the Fund over the prior two years.

RMCI is seeking compensatory damages, which could be substantial.

This case exposes deep fissures in the structure of the mutual fund industry. It appears that it has been common practice for law firms to represent both funds and advisors. What this case may mean for the future of the mutual fund industry and 40 Act lawyers remains to be seen.  However, regardless of the outcome of the case, one clear lesson is that in this economic environment all attorneys should be especially vigilant about assessing potential conflicts of interest.