The Student Finance Corp. Debacle: Pepper Hamilton's Court Retort

Back from my blogging vacation, during which I instead devoted significant chunks of spare time to bringing current a project I started in 2004 -- that of electronically sorting cases, articles, and news stories from the past 3-5 years (now numbering about 10,000) into various topical e-folders in MS-Outlook, thus putting my entire precedent file literally at my fingertips.  The quantum leaps in productivity from technology never cease to amaze me!  What in the early 90's absorbed the full-time efforts of two paralegals to assemble and maintain and entire banks of cabinets on high-rent office floors to store, today can be compiled, archived, and retrieved by me alone from the comfort of wherever I'm sitting in 1/50th the time it once took.  Remember the sea-change effected not that long ago by the fax, prompting many a young lawyer to ask "what did people ever do without a fax?"  How incredibly fast the world has changed!  Hopefully, however, Stephen Hawking and his scientist friends are wrong and all this rapid change doesn't spell our swift destruction!

Anyway, being nearly done with that project -- for now -- it's back to blogging.  Lots of interesting case developments have passed through my porous sieve, but it's hard to pass up commenting on today's salacious front page story in the Wall Street Journal (referenced here) about the collapse of Student Finance Corp. (SFC) and the actions of its counsel, Pepper Hamilton (and partner W. Roderick Gagne in particular).

Most of the article's central allegations regarding Pepper Hamilton's culpability rest upon the allegations made in the trustee's 67 page, first amended complaint.  In its 12/22/05 ruling on Pepper Hamilton's motion to dismiss, however, the Court tossed most of the trustee's more attenuated claims against Pepper Hamilton (such as deepening insolvency, negligent misrepresentation, and aiding and abetting breach of fiduciary duty), while leaving intact the trustee's primary causes of action for breach of fiduciary duty and professional malpractice.  Stanziale v. Pepper Hamilton, et. al. (In re Student Finance Corp.), 335 B.R. 539 (D. Del. 2005) (pdf).

The WSJ article concludes that "Pepper Hamilton's own day in court against the bankruptcy [trustee] ... is scheduled for October."  In fact, however, if Pepper Hamilton's latest arguments to the Court succeed, there will be no day in Court for Pepper Hamilton (or if there is, it'll be a short day), since the guts of the trustee's complaint will have been eviscerated and there will be little of real substance left to litigate!

What is it that led to Pepper Hamilton's surge of optimism?  None other than the Third Circuit's recent decision (reviewed at length here) in Seitz v. Detweiler, Hershey & Assocs., P.C. (In re CitX Corp.), 448 F.3d 672 (3d Cir. 5/26/06) (pdf), which (as noted here) arguably went farther than it needed to by "hold[ing], unnecessarily, that deepening insolvency is not a valid theory of damages for other independent torts." 

Pepper Hamilton picked up on this theme that CitX (or Seitz) should be broadly construed to apply to other independent torts and within weeks of the decision filed this "omnibus brief" in support of its motion for judgment on the pleadings.  In it, Pepper Hamilton advanced the following argument:

Seitz clarified that deepening insolvency is a new cause of action but is not a new and expansive measure of damages for traditional causes of action, such as malpractice or breach of fiduciary duty (as in the Trustee Litigation)....  The Trustee's claim for professional malpractice against the Pepper Defendants seeks only deepening insolvency damages.  Therefore, the Trustee fails to allege any recoverable damages supposedly incurred by Student Finance Corporation ("SFC") as a result of the allegedly bad legal advice that the Pepper Defendants provided to SFC and [thus] the Court should enter judgment on the pleadings in favor of the Pepper Defendants on the malpractice claim.  As for the Trustee's claim that the Pepper Defendants breached their fiduciary duty to SFC by simultaneously representing persons or entities whose interests may have conflicted with those of SFC, the Trustee claims that he is entitled to both deepening insolvency damages as well as the traditional measure of damages on this type of claim, disgorgement of legal fees paid during the period of the supposed conflict.  Seitz makes plain that this Court should remove the alleged deepening insolvency damages from the claim and only permit the Trustee to proceed on his request for disgorgement of fees.

What was the Trustee's response?  In this response brief, he argued that:

  • The Amended Complaint seeks damages other than those arising from deepening insolvency (such as for increases in liabilities and decrease in asset values "without reference to the incidental impact upon the solvency calculation") (quoting Seitz);
  • The Pepper Defendants too narrowly construe the allegations of damages in the Amended Complaint; and
  • It's premature to limit damages sought since discovery and expert disclosures haven't been completed.

The Pepper Defendants' retort?  They concluded in this reply brief:

The Trustee attempts to elude this motion by re-labeling his deepening insolvency damages as “traditional” tort damages. However, the Trustee’s current damage theory does not align with his allegations because, as the Trustee repeatedly has acknowledged until now, his supposed damages really are deepening insolvency damages....  The Trustee should be limited to pursuing damages arising from any alleged above-market loan terms and disgorgement of legal fees paid during any allegedly impermissible conflict of interest.

What will the Court do?  Likely punt, for now, since -- as the Trustee argued -- discovery and expert disclosures haven't yet concluded.  Clearly, however, the Seitz decision radically altered the landscape for bankruptcy trustees suing professionals for the losses associated with failing enterprises.

Thanks for reading.

© Steve Jakubowski 2007

Written By:Francis Pileggi On January 22, 2007 10:14 PM

Welcome back from what appears to be your very busy hiatus!

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