Commercial Division Blog

Posted: October 21, 2014 / Categories Commercial, Law Firms and Professional Ethics

Standard of "Ordinary and Reasonable Skill and Knowledge" In Legal Malpractice Action Measured As Of the Time of the Representation

On September 18, 2014, the First Department issued a decision in Lichtenstein v. Willkie Farr & Gallagher LLP, 2014 NY Slip Op. 06242, affirming New York County Commercial Division Justice Melvin Schweitzer’s dismissal of a legal malpractice claim for failure to state a cause of action.

In Lichtenstein, the plaintiff, Lichtenstein, hired Willkie Farr to advise him in connection with the restructuring of an entity he owned, Extended Stay, Inc., which faced a liquidity crisis. The law firm advised Lichtenstein that, as an officer and director of ESI, he "had a fiduciary obligation to put ESI into bankruptcy for the benefit of the [company's] lenders." This had the effect of exposing Lichtenstein, and his company Lightstone Holdings, LLC, to $100 million in personal guarantees they had given in connection with mortgage loans to ESI. However, "Willkie Farr warned that Lichtenstein otherwise faced the prospect of unequivocal and uncapped personal liability in any subsequent action by the lenders absent a bankruptcy filing by ESI." Relying on this advice, Lichtenstein caused ESI to file a bankruptcy petition, and the lenders subsequently brought actions to enforce the guarantees, which resulted in the entry of a $100 million judgment against Lichtenstein and Lightstone Holdings.

Lichtenstein brought a malpractice action against Willkie Farr, arguing that the law firm's advice as to the viability of a breach of fiduciary duty claim by ESI's creditors was erroneous because ESI's "constituent entities" were LLCs, and recent Delaware Supreme Court authority holds that lenders of an LLC (as opposed to a corporation) lack standing to bring derivative claims for breach of fiduciary duty against the LLC's management. The First Department rejected this argument because the issue of lender standing in the LLC context had not been established at the time the advice was rendered:

On this appeal, plaintiffs argue that Willkie Farr's advice did not meet the requisite standard of professional skill because a derivative suit by the lenders against Lichtenstein for breach of fiduciary duty would not have been successful. In making the argument, plaintiffs recognize that under Delaware law, the exposure Lichtenstein faced by reason of ESI's insolvency differed from the exposure that would be faced by the officers and directors of a traditional stock-issuing corporation. For example, when a corporation is solvent its directors' fiduciary duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation's growth and increased value (North Am. Catholic Educ. Programming Found., Inc. v Gheewalla, 930 A2d 92, 101 [Del 2007]). On the other hand, when a corporation is insolvent, "its creditors take the place of the shareholders as the residual beneficiaries of any increase in value. Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties" (id.).

Citing CML V, LLC v Bax (28 A3d 1037 [Del 2011], plaintiffs argue that the landscape is different with respect to Lichtenstein's fiduciary duty because the constituent entities that made up ESI were Delaware limited liability companies (LLCs) as opposed to corporations. In CML, the Supreme Court of Delaware held that under the Delaware Limited Liability Company Act (6 Del Code Ann tit 6, ch 18) § 18-1002, derivative standing is limited to "member[s]" or "assignee[s]" and unavailable to creditors of LLCs (id. at 1046). Plaintiffs' argument is not persuasive because the Supreme Court of Delaware's opinion in CML as well as the Delaware Chancery Court's opinion, which it affirmed (6 A3d 238 [Del Ch 2010]), were decided after Willkie Farr gave the advice described in the complaint. In fact, the Chancery Court observed that "virtually no one has construed the derivative standing provisions [of § 18-1002] as barring creditors of an insolvent LLC from filing suit" (id. at 242). The Chancery Court further noted that "[m]any commentators . . . have assumed that creditors of an insolvent LLC can sue derivatively" (id. at 243 [citations omitted]).

In a legal malpractice action, what constitutes ordinary and reasonable skill and knowledge should be measured at the time of representation. In this case, the time of Willkie Farr's representation preceded the Chancery Court's decision in CML by approximately two years. Accordingly, the complaint fails to allege that Willkie Farr's advice was wanting by reason of its failure to advise Lichtenstein that the creditors of the ESI constituent entities lacked standing to bring derivative actions.

Whenever an attorney advises a client on an area of the law that is unsettled, as was the case in Lichtenstein, the advice may, with the benefit of 20/20 hindsight, prove to be incorrect. However, as this decision illustrates, the standard of "ordinary and reasonable skill and knowledge" does not require clairvoyance on the attorney's part. A malpractice claim will not lie because an attorney failed to predict future developments in the case law.