In re Friedman's

Background: Trustee of creditor trust established under bankrupt jewelry chain's confirmed Chapter 11 plan brought adversary proceeding against debtor's insiders, against investment banking firm that had performed services for debtor pre-petition, and against law firm that had acted as debtor's outside counsel to recover on variety of theories, including breach of implied covenant, fraud, breach of fiduciary duty, aiding and abetting such fraud or fiduciary breaches, gross mismanagement, corporate waste and malpractice.

Friedman's Inc., a large jewelry store chain, financially collapsed and entered Chapter 11 Bankruptcy in 2005. In re Friedman's, Inc., Case No. 05–40129 (Bankr.S.D.Ga. filed 1/14/05). The “Friedman's Creditor Trust” arose from that. Its Trustee filed an Adversary Complaint, Case No. 07–04042 (Bankr.S.D.Ga. 1/12/07), since withdrawn to this Court, In re Friedman's Inc., 2007 WL 1541962 (S.D.Ga. 5/23/07) (unpublished), alleging 15 counts of wrongdoing on the part of Friedman's directors, officers, a controlling shareholder, and its attorneys. All defendants now move to dismiss the Complaint against them.

Defendant Phillip Cohen ... held all of Friedman's Class B voting stock, thus giving him the right to elect 75% of Friedman's directors. ... Cohen also controlled Crescent Jewelers, Inc., another jewelry retailer to whom Friedman's provided significant financial assistance from 1996 until Crescent's bankruptcy in 2004.

Defendant Sterling Brinkley was a Friedman's director from 1993 until 12/23/03. He also served as Executive Chairman of Friedman's Board of Directors at different times, but most importantly from 1998 until his resignation in 2003. ...

Defendant Bradley Stinn served as a Friedman's director and CEO from 1993 until his resignation on 12/2/03. ...

Defendant Victor Suglia, who has not made an appearance in this case, acted as Friedman's Senior Vice President and CFO, as well as its corporate treasurer and secretary, from 6/97 to 11/03. ...
... [Defendant] A & B is a law firm that acted as Friedman's outside general counsel from the 1990s until Friedman's, then run by a new board of directors, terminated A & B's representation in 2004. Prior to its termination, A & B had advised special committees Friedman's appointed to approve transactions with Crescent. One special committee was Friedman's Audit Committee. A & B acted as its lead investigator after the Government alleged wrongdoing at Friedman's. A & B attorney Mark McElreath, in turn, acted as A & B's main contact with Friedman's, and he became highly involved with the events of this case.

Crescent Jewelers, Inc., was a privately held retail jewelry corporation based in California. ... As stated previously, Cohen controlled both Crescent and Friedman's through ownership of each company's class B voting stock. Besides sharing the same controlling shareholder, Friedman's and Crescent had several overlapping directors. Brinkley and Stinn were directors at both simultaneously. The two companies also shared CEOs and CFOs, Stinn and Suglia. From at least 1995 until its 2004 bankruptcy, Crescent struggled financially, operating at a loss in each of those fiscal years. Beginning in 1996, Cohen used his influence over Brinkley and Stinn to have Friedman's financially support Crescent. ...

... A legal malpractice claim requires proof of (1) the employment of a lawyer; (2) failure of the lawyer to exercise ordinary care, skill and diligence; and (3) damages proximately caused by that failure. Tante v. Herring, 264 Ga. 694, 694, 453 S.E.2d 686 (1994). There is no question that A & B was hired by Friedman's to be its outside general counsel, so an attorney-client relationship existed. ...

“It is axiomatic that the element of breach of duty in a legal malpractice case—the failure to exercise ordinary care, skill, and diligence—must relate directly to the duty of the attorney, that is, the duty to perform the task for which he was employed.” Tante, 264 Ga. at 694, 453 S.E.2d 686.

...

A & B's Investigation and Disclosure of Conflicts

On 9/29/03 A & B attorney John Latham received a call from an assistant U.S. attorney for the Eastern District of New York informing him that it was conducting an investigation of Friedman's concerning the Capital Factors complaint. That complaint essentially alleged that Friedman's intentionally misrepresented the amount of money it owed to a company called Cosmopolitan. This caused Capital Factors, a receivables factoring company that purchased the accounts receivable of Cosmopolitan, to lend Cosmopolitan more money — much to its chagrin. ...

... Later on 9/29/03, Latham had a conference call with Friedman's Audit Committee in which all agreed that Friedman's should cooperate with the Government's investigation. The Committee also resolved to conduct its own “independent investigation.” The Committee, out of Latham's presence, discussed the need to preserve its independence during this investigation. It then decided to retain Latham to assist and represent the Committee and Friedman's in the investigation. ... [T]he Audit Committee found it necessary to expand the investigation to include Crescent, since Crescent was a subject of the Government's investigation as well. ...

Very quickly Latham's investigation grew beyond the Capital Factors complaint. “Other matters [were] being raised by the SEC and Justice Department,” and the investigation identified “potential financial and control issues.” ...

... On 11/3/03, Latham received a subpoena directed to Friedman's from the SEC seeking, inter alia, minutes from every meeting of both Friedman's Board and Audit Committee, fiscal-year end financial statements, documents concerning payments by Crescent to any officer or director of Friedman's, documents identifying all business transactions between Friedman's and Crescent, and documents concerning loans made by Crescent to officers or directors. ...

... Plaintiff claims that A & B committed malpractice by agreeing to represent Friedman's and its Audit Committee when A & B's conflicts were then too substantial to conduct a loyal and adequate investigation. Also, the Trustee contends, even if A & B could have accepted the engagement with the informed consent of Friedman's, A & B committed legal malpractice by failing to adequately disclose to Friedman's Audit Committee its conflicts from prior representations and the risks associated with such a conflicted representation. Due to A & B's inadequate disclosure, plaintiff alleges, the Audit Committee was unable to provide an informed consent waiver to the hiring of a conflicted-A & B as counsel. A & B also allegedly committed malpractice by failing to inform Friedman's Audit Committee of further conflicts that arose as the investigation expanded after its initial hiring. Plaintiff states that A & B failed to conduct an “adequate, impartial and vigorous investigation” because of its conflicts. Consequently, Friedman's had to retain counsel to basically redo the investigation and complete it.

In Georgia, “[a] mere potential of inadequate representation that is caused by a split of loyalties is a harm that the conflict of interest rules were designed to protect.” Paul v. Smith, Gambrell & Russell, 267 Ga.App. 107, 111, 599 S.E.2d 206 (2004). A conflict of interest may be waived, but “such waiver must be knowingly made after full disclosure of all facts.” Id. While the Georgia Rules of Professional Conduct do not establish civil liability for professional misconduct, “pertinent Bar Rules are relevant to the standard of care in a legal malpractice action.” Allen v. Lefkoff, Duncan, Grimes & Dermer, P.C., 265 Ga. 374, 376, 453 S.E.2d 719 (1995).

“In order to relate to the standard of care in a particular case ... a Bar Rule must be intended to protect a person in the plaintiff's position or be addressed to the particular harm suffered by the plaintiff.” Id. at 377, 453 S.E.2d 719. Because the Court finds that GA.R.PROF.CONDUCT 1.7—dealing with conflicts of interest—was designed to protect individuals from conflicted representations without informed consent, it will be considered for determining the standard of care that A & B should have exercised here.

The fact that A & B had conflicts of interest is not contested here. A & B was Friedman's outside general counsel from at least 1996 until May of 2004 when its representation was terminated by the company. During that time, A & B, primarily represented by Mark McElreath, performed extensive services for Friedman's ...

... A & B claims that its letter of 10/24/03 disclosed all actual and potential conflicts and Friedman's made an informed decision to continue with the representation, thereby constituting a waiver. This letter was sent to Mark Pickup, the Audit Committee chairman, and Shanagher, Friedman's in-house general counsel. A & B's letter included the following disclosures:

(1) A & B was not independent from Friedman's due to previously provided legal services;

(2) due to the expansion of SEC and Department of Justice inquiries, A & B would have to investigate securities filings that it prepared in the past;

(3) the investigation would include matters pertaining to Crescent;

(4) issues regarding A & B's lack of independence could arise if the integrity of Brad Stinn is questioned because A & B previously provided limited legal services to him in the past and Stinn was the primary contact at Friedman's for A & B attorney McElreath. (paraphrased).

Also included in this letter was A & B's professional opinion that these conflicts would not impair its judgment or affect the legal advice provided. ... Most importantly, A & B said, “[i]f at anytime we believe the interest of [A & B] and the Audit Committee differ, we will promptly advise you of our concern.”

Plaintiff's allegations that A & B committed malpractice because it could not perform an independent investigation based on its conflicts fails based on A & B's disclosure that it was not independent and Friedman's Audit Committee then continued to employ it.

Plaintiff next points out that A & B's disclosures were inadequate because it did not include the material risks of the representation; nor did it advise the Audit Committee or offer it the opportunity to consult independent counsel as required by GA.R.PROF.CONDUCT 1.7(b)(2) and (3). But A & B responds that the Audit Committee had in-house legal counsel to advise it, thereby obviating the need to provide details about the risks of representation. See REST.3D OF LAW GOVERNING LAWYERS § 122 cmt. (c)(i) (2007) (“A client independently represented ... by inside legal counsel ... will need less information about the consequences of a conflict....”).

The presence of inside counsel also obviously afforded the Audit Committee the opportunity to consult with independent counsel, and A & B points out that Georgia Rules only require that the client have the “opportunity to consult with independent counsel,” and not that a conflicted lawyer must advise the client of that in writing. Doc. # 35 at 36–37 (citing Roy M. Sobelson, Legal Ethics, 56 MERCER L.REV. 315, 325 (2004) (Georgia “does not go as far as most states, which require that ‘the client be advised in writing of the desirability of seeking ... advice of independent legal counsel’ ”) (quoting MODEL R.PROF.CONDUCT 1.8(a)(2))).

It is apparent from A & B's letter that, while it disclosed its conflicts of interest and lack of independence, it identified none of the risks involved with it representing the Audit Committee. However, it is reasonable for A & B to rely in this situation on the fact that it was dealing with sophisticated clients accustomed to employing lawyers, and the client had in-house legal counsel to opine on the advisability of hiring conflicted attorneys. Accordingly, A & B's initial disclosure through the 10/24/03 letter was sufficient to constitute a knowing waiver by Friedman's when it continued with the representation.

Nevertheless, the Court finds that the plaintiff has sufficiently pled a claim for legal malpractice against A & B for failure to obtain Friedman's informed consent to continue its representation as the investigation broadened and A & B's conflicts became more severe. “If a material change occurs in the reasonable expectations that formed the basis of a client's informed consent, the new conditions must be brought to the attention of the client and new informed consent obtained.” REST.3D OF LAW GOVERNING LAWYERS § 122 cmt.(d) (2007). A & B's own letter conveyed that if conditions changed concerning its own interests or the integrity of Stinn, it would address the Audit Committee on such matters. For that matter, even without such a commitment in the letter, it was part of A & B's duty of loyalty to Friedman's to inform it of material changes in the representation that might create new conflicts. ...

... On 11/3/03, A & B, on behalf of Friedman's, received a subpoena from the SEC seeking documents concerning all business transactions between Friedman's and Crescent ... all large transactions that A & B was intimately involved with and structured. ...

A & B's investigation broadened such that it was expected to perform an unimpaired and loyal investigation for Friedman's of the work that it performed on these transactions. Plaintiff's expert affidavit states, “[t]here was a significant risk that [A & B's] own financial and reputational interests could materially and adversely affect its representation of Friedman's from [10/03] through [4/04] in conducting the investigation ... because of [A & B's] direct involvement in transactions that were the subject of that investigation.” This is a clear conflict of interest that emerged after the 10/24/03 engagement letter, yet it was never addressed with the Audit Committee.

... Plaintiff has adequately pled that A & B deviated from the ordinary care, skill and diligence of an attorney by failing to disclose the new conflicts created by the expansion of the scope of the investigation ...