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July 11, 2016

ESG Capital Partners, LP v. Stratos, 828 F.3d 1023 (9th Cir. 2016)

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The Ninth Circuit holds an attorney can be liable under securities laws and common law torts if he goes beyond his proper role, and actively participates in the client’s fraud.

ESG Capital Partners, L.P. (“ESG”) was a group of investors formed to purchase pre-Initial Public Offering Facebook shares. Timothy Burns, ESG‘s managing agent, negotiated a purchase with “Ken Dennis,” an alias for Troy Stratos.  When the purchase turned out to be a fraud, ESG sued Stratos and his attorneys, David Meyer and Venable LLP.

ESG alleged Meyer helped Stratos form Soumaya Securities, LLC which allowed Stratos to conduct business without detection. Soumaya was never authorized to do business in California, had no bank accounts, and filed no tax returns.  Stratos masqueraded as “Dennis” for all Soumaya transactions.  Its operating documents, which Meyer prepared, listed Stratos as Soumaya’s manager and sole member and the fictional “Dennis” as its CEO.According to ESG, Burns spoke to Meyer who told Burns “Dennis” was in contact with Facebook executives; had access to millions of Facebook shares; verified “Dennis’s” identity; falsely said “Dennis” was affiliated with billionaire Carlos Slim; said the sale was legitimate; and promised to provide deal documentation.   Knowing “Dennis” was a fiction, Meyer participated in email exchanges between Stratos and Burns where Stratos masqueraded as “Dennis.”  Meyer’s assurances and conduct convinced ESG Capital to complete the deal.  ESG wired a substantial deposit into Venable’s trust account.  Venable promptly transferred the funds to Stratos’s personal client trust fund account, and then to Stratos.

Stratos could not open a bank account due to his reputation, so Meyer opened a bank account for Soumaya at Bank of America. Burns wired ESP’s second multi-million dollar tranche to this account.  Meyer provided purchase documentation, stating the funds were refundable if the transaction did not close.  Days later Bank of America froze and closed the Soumaya account.  Without notifying ESG, Meyer transferred the funds for Stratos’s benefit.  Meyer opened another account for Soumaya, listing Stratos as the beneficial owner, to accept a third tranche from ESG.

When ESG did not receive its Facebook shares, Burns threatened “Dennis” and Venable with legal action.   Venable’s counsel responded it had received no transfers, did not know of them, and that the email contact information Burns provided was for Stratos, not “Dennis.”  Venable denied representing any party in the transaction, and terminated Meyer.  Burns panicked and hid the news from ESG, who did not learn of the fraud until nearly a year later.

In the trial court, Venable filed a successful motion to dismiss ESG’s claims.   The Ninth Circuit reviewed the ruling under a de novo standard.  Non-fraud claims must survive minimal notice pleading requirements and provide a short and plain statement to survive a motion to dismiss. Common law fraud claims are subject to a heightened pleading standard alleging the circumstances constituting fraud or mistake and scienter with particularity.  Securities fraud claims under § 10b-5 of the Exchange Act of 1934, 15 U.S.C. § 78j(b) require a plaintiff to plead both falsity and scienter with particularity, higher than the standard for common law fraud allegations.

Venable asserted ESG failed to plead Meyer made material misrepresentations or omissions. According to Venable, Meyer merely communicated Soumaya’s understanding of the deal, and did not “make” statements on his own behalf.

The Court agreed Meyer must be the “maker” of statements to be liable under § 10b-5.  A “maker” of a statement is the entity with authority over the content of the statement and whether and how to communicate it.  Merely preparing or publishing another’s statement is insufficient; attribution to another party generally indicates that the attributed party is the “maker.”

The Ninth Circuit acknowledged that many of Meyer’s emails were prefaced with a disclamatory statement, “[i]t is Soumaya’s understanding …”  However, the Court was not convinced this short preface could shield a messenger from liability in all circumstances.

Meyer went far beyond reporting his client’s understanding of the deal and directly made false statements to ESG.  Meyer told Burns he represented the person Stratos was impersonating, “Dennis;” that “Dennis” was affiliated with Carlos Slim; and that “Dennis” was who he represented himself to be.  Meyer addressed his client in emails as “Dennis” although he knew the email was associated with Stratos, not “Dennis.”  Meyer told ESG that its initial deposit would be released to Soumaya, although it was transferred to Stratos’s personal client trust account.  Meyer personally made assurances to Burns about the deal, and detailed his relationship to “Dennis.”

Where an attorney has a duty to disclose, the attorney must provide truthful, non-misleading information.  When an attorney elects to make representations to prospective securities purchasers the attorney is required by §10b-5 to tell the truth and may be liable for misrepresentations.  Meyer made material omissions when he failed to reveal there was no Facebook deal; that Stratos, not Soumaya, was Venable’s client; and that ESG’s deposit would be immediately dispersed to Stratos.

The Court rejected Venable’s argument that only a “seller,” in this case Facebook, could be liable for failures to disclose under Federal securities laws.  As to ESG, Stratos was the “seller;” Facebook was not involved in the transaction.  There was no actual seller, and it is illogical to shield attorneys who represent the party acting as the seller.

ESG pled enough facts to lead to a strong inference of scienter required by § 10b-5.  Scienter is established by showing deliberate recklessness or some degree of intentional or conscious misconduct.   The individual acts Meyer performed, setting up bank accounts; facilitating wire transfers; and disbursing funds, are not inherently suspicious, and do not alone establish Meyer knew there was no deal in the works.  However, despite a heightened pleading bar, the plaintiff need not prove the case in the pleadings.  The plaintiff must provide a narrative of fraud — facts that substantiate a fraudulent explanation as easily as a non-fraudulent one.

ESG’s narrative strongly pointed to the existence of scienter.  The email exchanges show Meyer knew Stratos was employing an alias to communicate with ESG.  Meyer had frequent contact with Stratos, and authorized payments from Stratos’s client trust account.  Meyer opened bank accounts for Stratos knowing he could not open them on his own behalf.  Venable provided extensive non legal services for Stratos, including purchases of office supplies and car insurance. These allegations established a cogent and compelling inference of scienter.

ESG sufficiently alleged reliance.  It did not transmit funds to purchase the securities until after Meyer vouched for Soumaya and “Dennis.”

The common law fraud claim, which is evaluated by a lesser standard than the federal securities law fraud claim, was therefore also properly plead.

The Court gave short shrift to Venable’s contention that, as Stratos’s agent, it could not be liable for aiding and abetting his fraud.  The Agent’s Immunity Rule shields an attorney who merely acts as an agent or employee of a third party who owes a duty to plaintiff.  It does not apply when an attorney has an independent legal duty to the plaintiff, or the attorney goes beyond a professional duty as part of a conspiracy for the attorney’s personal financial gain beyond receiving fees.

Meyer’s communications with Burns violated an independent duty to not defraud non-clients.  When Venable accepted ESG funds, it accepted a further independent duty regarding disbursing the funds.  These acts trumped agent immunity.

ESG sufficiently alleged aiding and abetting and conspiracy.  Aiding and abetting requires a defendant substantially assist or encourage another to breach a duty, or substantially assist another’s tort through an independently tortious act.  Plaintiff must show the defendant actually knew of the fraud.  Conspiracy requires the formation and operation of the conspiracy; wrongful conduct to further the conspiracy: and damages.  Like aiding and abetting, conspiracy requires actual knowledge.  For the same reasons scienter was sufficiently alleged under the § 10b-5 allegations, actual knowledge was sufficiently alleged under the aiding and abetting and conspiracy causes of action.

Conversion requires proof a defendant possessed property; disposed of the property in a manner inconsistent with the plaintiff’s property rights; and damages. ESG alleged it transferred funds to Venable LLP.  An unauthorized transfer of funds can constitute disposal of funds in a manner inconsistent with the plaintiff’s rights. ESG alleged Venable disposed of its funds by placing them in an unauthorized client trust account and then to Stratos without ESG’s knowledge or permission.

Although California case law is unsettled on whether there exists a cause of action for unjust enrichment, the Ninth Circuit has construed California common law to allow it premised on a quasi-contract theory. A plaintiff must show the defendant received and unjustly retained a benefit at the plaintiff’s expense. ESG Capital alleged Venable received funds it promised to hold in a client trust account; that the funds would be refundable; actually placed the funds in Stratos’s control; and paid itself a substantial amount from the trust funds.  This was sufficient to allege unjust enrichment for the amount received by Venable under a quasi-contract.

Under Bus. & Professions Code § 17200 et seq. a plaintiff must prove a defendant’s business practices are unfair, unlawful, or fraudulent.  A fraudulent business practice is one likely to deceive the public.  ESG’s allegations that Venable assisted Stratos in using ESG’s funds for his personal use by putting them in an unauthorized client trust account and issuing checks to itself were enough.

The Ninth Circuit disagreed with the trial court that California’s one year statute of limitations, C.C.P. § 340.6, should apply to bar all of ESP’s state law causes of action.  Section 340.6 does not automatically apply merely because an attorney’s alleged misconduct occurs during the period of legal representation, or because representation provided the attorney the opportunity to engage in misconduct.  For § 340.6 to apply, the claim must depend on proof the attorney violated a professional obligation.  ESP’s claims for conversion, unjust enrichment, and unfair competition did not necessarily involve the violation of a professional obligation, mandating application of § 340.6.

Unresolved was whether the independent duties that circumvented the agent immunity rule would trigger the statute of limitations applicable to attorney omissions and errors.  This conundrum was not considered below, and would be analyzed on remand.

Only the claim for breach of fiduciary duty, which involves attorney professional obligations, was governed by the attorney statute of limitation.  Section 340.6 was not tolled for ESP by Burn’s failure to disclose the fraudulent transaction.  Burns was ESP’s agent, and his knowledge was imputed to ESP.

Nor was Venable entitled to raise an “unclean hands” defense.  A plaintiff who participates in wrongdoing cannot recover for injury incurred because of the wrongdoing.  Although ESG’s agent, Burns, pled guilty for stealing money from a different investment fund, it was unrelated to the Stratos transaction.

Comment: The cavalier analysis threatens to undermine decades of careful jurisprudence refusing to impose responsibility for the acts of clients on their attorneys.  When attorneys maintain their proper role advising and advocating for clients, they should not be held responsible for client wrongdoing.

The unproven allegations against Meyer bear the hallmark of cases where attorneys are drawn into the web of their client’s transgressions: moving beyond the role of advisor and advocate and becoming an active participant in the transaction.  This case demonstrates two separate threads – marketing and fund handling.  Meyer allegedly spoke to the buyer’s agent, and “sold” him on the concept.  When Meyer and Venable became a conduit for the investment funds, they again moved beyond traditional attorney functions.  In a face-paced transaction it is tempting to go above and beyond to facilitate deals as a team player for a client, but as this case demonstrates there could be a very steep price to pay if things turn south.




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