Law Firms Can Be Liable For Failing to Advise Clients of Risks Resulting From Filing for Bankruptcy

By: Nicole Strout

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

            In Peterson v. Katten Muchin Rosenman LLP., the Seventh Circuit held that the allegations in a legal malpractice complaint by the trustee for Lancelot Investors Fund and other entities in bankruptcy (collectively “the Funds”), was plausible on its face.[1]  In Peterson, the trustee filed suit against the Funds’ law firm for failing to detect the peril and curtail the risks pertaining to the Funds.[2]  The Funds loaned money to and invested in vehicles owned by Thomas Petters, which, in turn, was supposed to finance Costco’s consumer-electronics inventory.[3]  The Funds’ advances were to be secured by deposits made by Costco, not Peters, into a lockbox bank account.[4]  However, Costco never deposited money into the account.[5]  All the money came from a Petters entity.[6]  In reality, Petters never had any dealings with Costco, and the whole set up was a Ponzi scheme.[7]  Once the scheme collapsed, the Funds also collapsed.[8]  Consequently, the Funds filed for relief under chapter 7 of the Bankruptcy Code.[9]  The chapter 7 trustee for the Funds brought a cause of action against Katten, the law firm which acted as transactions counsel for the Funds, claiming that the law firm had a duty to inform its clients that the actual arrangement posed a risk because Petters was not actually running a real business.[10]  In granting the law firm’s motion to dismiss, the district court held the Funds “knowingly took the risk and cannot blame the firm for failing to give business advice.”[11]  After the trustee appealed the motion to dismiss, the court of appeals reversed the district court decision, holding the firm was liable not for failing to provide business advice but for failing to inform its clients of “the different legal forms that are available to carry out the business and how risks differ with different legal forms.”[12]  Clients do not have to take the advice of their attorneys, but attorneys need to advise clients.[13]

            Courts have universally found that lawyers are not business consultants and do not owe a duty to protect their clients from making poor business choices.[14]  For example, in Abrams v. DLA Piper (US) LLP., the United States District Court of the Northern District of Indiana stated, “attorney client relationships do not include business advice given to the Debtors.  Rather lawyers had obligation to exercise reasonable care only with respect to their legal advice.”[15]  Lawyers do not have the knowledge required to give business advice; that knowledge should be with the business itself or business-consulting firms.[16]  Lawyers should “provide advice regarding alternatives where the failure to consider them could result in adverse consequences.”[17]  Clients need to understand the risks, and once provided the possible alternatives, they would have reasonably acted different in their ultimate decision than if they were not provided the alternatives and risks.[18]  Courts have held however that if the debtor assumes the risk then they are just as much at fault for the results, and there is no valid legal malpractice claim.[19]

            The Peterson decision was important because the Seventh Circuit decided not to extend the holdings from several of the other courts involving this issue.[20]  Peterson acknowledged other decisions holding lawyers are not business consultants, but the court did state that it is within the lawyer’s duty to advise the client on the risks and different legal options concerning business decisions.[21]  In a way, the Seventh Circuit recognized that there is no bright line between business advice and legal advice with both types of advice overlapping.[22]  The Peterson Court did not impose on lawyers a duty to give business advice.[23]  It simply ruled that they must provide advice regarding the different legal forms and risks associated with the alternatives.[24]  Even though the person who established and managed the funds was involved in the Ponzi scheme and at fault for the bankruptcy, the attorneys can still be held liable to the debtors for not properly advising at all when the lawyers should have known that end result would be one not favorable to their clients.[25]



[1] 792 F.3d 789, 793 (7th Cir. 2015) The court reasoned that the law firm failed to advise the Funds on all the different legal devices for securing and collecting loans and the risks to which they are exposed to under the different legal devices.

[2] See id. at 790.

[3] See id.

[4] Id.

[5] See id.

[6] See Peterson, 792 F.3d at 790.

[7] See id.

[8] See id.

[9] See id.

[10] See id.

[11] Id. at 791.

[12] Id. at 793.

[13] See id.

[14] See Abrams v. DLA Piper (US) LLP., 2013 WL 2634767, *6 (N.D. Ind. June 12, 2013)(holding that law firm is not liable based on failure to provide business advice); Peterson, 792 F.3d at 793.

[15] 2013 WL 2634767 at *8 (quoting In re Greater Southeast Community Hospital Corp., 333 B.R. 506, 529 (Bankr. D.D.C. 2005)).

[16] Id.

[17] Abrams, 2013 WL 2634767 at *9 (quoting In re JTS Corp., 305 B.R. 529, 552 (Bankr. N.D. Cal. 2003))

[18] See id.

[19] See Behrens, 698 N.W.2d 555,572–73 (S.D. 2005) (stating that “to assume the risk of one’s own loss, person must know that danger exists, appreciate the character of the danger and voluntarily accept such risk by having sufficient amount of time, knowledge, and experience to make an intelligent choice”); See generally Peterson v. Winston & Strawn LLP, 729 F.3d 750 (7th Cir. 2013) (holding that under in pari delicto, the debtor was just as much at fault for knowing poor business situation and therefore there was no legal malpractice).

[20] Compare Peterson, 792 F.3d 789 with Abrams, 2013 WL 2634767, and also with Behrens, 698 N.W.2d 555.

[21] See Peterson, 792 F.3d at 793; Contra Abrams, 2013 WL 2634767 at *8.

[22] See Peterson, 792 F.3d at 791–93.

[23] See id.

[24] See id. at 791.

[25] See id. at 791–93.