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When Clients Become Liabilities: Protecting Law Firms From "Unworthy" Clients
00:17:04
Law firm risk management and client intake strate…
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- [00:01]
A
You're listening to the Alliance Specialty podcast dedicated to insurance and risk management solutions and trends shaping the market today.
- [00:09]
B
Well, welcome back to another Alliant specialty podcast. My name is Craig Hauser and I'm the co leader of the Alliant law firm practice. And I'm joined today by my colleague Eric Hubbard.
- [00:19]
C
Thank you, Craig. I'm Eric Hubbard, Senior risk management Consultant at Alliant. Prior to joining Alliant, I was a large law firm partner and then that firm's general counsel. And I have a lot of experience with client intake issues during my 20 years of involvement in law firm risk management. One of the drivers of significant claims continues to be unworthy clients. Unworthy clients are those that use their lawyers, usually unwittingly, to assist them in illegal or otherwise improper conduct, or who fail to follow the lawyer's advice improperly, share the lawyer's advice with third parties and also seek legal services that they cannot or refuse to pay for. Unworthy clients account for some of the most costly legal malpractice claims in history. Think Enron, Stanford bank, and more recently, DC Solar. Today we'll discuss the DC Solar situation to identify some of the problems it presented to the involved law firms. And we'll also discuss the best ways to identify unworthy clients, both at intake and after initial intake. We'll also discuss some of the practices and tools that are described in new ABA Model Rule 1, 16A.
- [01:43]
B
Yeah, and we're going to actually use the DC Solar case to explore, you know, law firm risk management. We're really not looking to re litigate the fraud, but it's more to examine how a seemingly reasonable client at intake can evolve into an unworthy client over time. And the basic facts in the case, as described in an article in the Atlantic, kind of unfold like a Hollywood script. There's a little greed, a little deception, lavish spending, but also the unveiling of a fraud leading to financial collapse of the business and ultimately hundreds of millions of dollars in investor losses. Now, DC Solar was founded by Jeff Karpoff. He was a former small town auto mechanic turned CEO. And they made large portable solar powered generators. And think of a trailer that you hook onto a vehicle that's wrapped in solar panels and that was their portable generators. And these generators were sold to large institutional buyers and they would pay 30% of the $150,000 purchase price up front and then they would finance the balance. And in return, the investors would actually receive a pretty lucrative 30% investment tax credit from the IRS. You know, and in Most cases, the investors never actually took possession of the generators. Instead, DC Solar would retain control of the equipment and then would supposedly lease the units out to third parties, and they would use the lease revenue to actually service the investor's financing. And however, in reality, the company was producing far fewer units than it was actually selling. The leasing revenues didn't really materialize as expected, and instead, new investor funds were being used to pay early investors. And at the same time, the same generators were reportedly being sold and leased multiple times. So, in other words, were kind of beginning to resemble a classic Ponzi scheme. And to note, throughout the process, the parties involved were in the process, were all represented by pretty sophisticated counsel. And we are in no way suggesting that counsel had any knowledge of the fraud, but it does highlight how complex and difficult some of these situations can be. So I guess, you know, Eric, with that as the backdrop and looking at it from your experience, is there anything here that could have been identified at intake?
- [04:02]
C
Well, there are certainly no guarantees, but a strong intake process may well have been able to identify DC Solar's most egregious behavior. Now, the original intake was probably for a tax credit opinion, and that may very well have been pretty clean and pretty reasonable. Trouble seems to have arisen as the business progressed. Identifying that transition is going to require a firm to have infrastructure to continue to review client activity as, as the client's work progresses to assure that the client has not gone from being unworthy at intake to unworthy later on. And this can be done in a couple of different ways. You can look at new matters that are coming in for the client. You can look at the progress of existing matters. And you really need to think about how detailed your firm's process is for reviewing new matters for existing clients and the progress of existing matters.
- [05:02]
B
Well, so with that being said, you know, what are some of the, what are some of the best ways to identify those unworthy clients?
- [05:08]
C
Well, certainly a strong business intake procedure is going to be key. You want to make sure that you've got a very well thought out intake questionnaire. And different practices may require different intake questions. And you want to make sure that you're getting accurate and complete answers to the questions that are sought in that questionnaire. Frequently we understand that firms get frustrated with the quality of the responses to those intake questionnaires. Sometimes a partner will rely on an assistant to fill them out. One way to increase the quality of the answers and compliance is to require a partner sign off on the responses to those questionnaires. And I'D ask the listeners if they have a process at their firm to assure quality responses to their intake questionnaires. Now, most firms are getting information on their inbound clients primarily to allow for an informed conflict analysis. We're going to get some information about the client identification, the scope of the representation, and the prospective client's creditworthiness. But rooting out unworthy clients is going to require going deeper. You're going to want to assess client information at the level of owners and representatives of an entity client, perhaps beneficial owners. Related entities are individual clients or entity representatives on any sort of politically exposed persons list which is kept by the Department of Treasury. You're also going to want to do a dive into the client's public Persona. News items, Google searches, litigation histories, and social media presence all are going to be helpful in understanding who it is that you're proposing to bring in as a client.
- [06:58]
B
It's interesting you say that because if you look back at it now, a Google search run on Jeff Karp himself probably would have uncovered some past business failures and even some criminal convictions. So that's, that's an interesting approach and
- [07:11]
C
that might have made a significant difference to some of the firms that ultimately took DC Solar in as a client. Now, in addition, the client's history with prior counsel is a important place to look. You can find out about poor history of payment to other counsel. You can find out about poor history of following the advice of other counsel. And for a client that has prior counsel or identifies somebody as referring them to you, I recommend that you interview or have significant communication with those other client, other counsel, or those other references. You want to assess the circumstances of the client's relationship with that person to understand how they behaved. Of course, more information is going to be available if prior to that conversation, you get consent from the prospective client, which would allow for permission for you to perhaps get into, for example, privilege material. Now, where a contact with a prior counselor referrer is not satisfactory, you want to consider having a further discussion with the client about your impressions before you determine how to proceed. You should certainly consider requiring a statement from your firm's sponsoring lawyer concerning any experience that he or she has with the client and how the client came to the lawyer's attention. Getting history about the prior actions of the client is particularly important with respect to lateral lawyers. Clients that come into the firm with a lateral lawyer are significantly greater source of unworthy client claims.
- [08:55]
B
And if you look at it, you kind of talk about just these, even the scopes of the engagements of how they have it. And it's kind of an interesting topic, even by underwriters, because they've actually been known to ask about what goes into crafting a proper engagement letter. And how do you avoid a scope of representation of being too broad or too narrow? I mean, neither is good. And then ultimately, how do you address the potential scope creep as clients evolve? You know, how does the change in their needs lead to a client that becoming potentially unworthy?
- [09:28]
C
Yeah, well, certainly the scope of the representation. There are some. Some hallmarks, I think, of risky activity. One is the work is going to involve raising funds or otherwise soliciting business from third parties. If the lawyer is involved in those activities, that raises risk and should be considered. Will funds be flowing in and out of the firm's trust account? If that is going to happen, there is further risk of unfortunately savory activities that are going to look back at the law firm. You also want to identify all the jurisdictions that may be relevant to the representation. There are certain jurisdictions that have experience with money laundering that you may want to be aware of. Often like DC Solar. Unworthy clients are, as you say, going to start worthy and change over time. There are a couple of different ways that you can identify those things I
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B
was about to say. I mean, how can you actually detect that sort of change as the client representation evolves?
- [10:32]
C
Well, the first thing you want to be able to do is have good communication with your lawyers who are working with the client regularly. For example, with, as we discussed with lateral lawyers, you want to have a detailed review to understand the client that they are seeking to bring in. You want to monitor new matters for existing clients and do a significant intake process on those new matters. You want to encourage your lawyers to discuss their concerns about client behavior with the firm's gc. The individual lawyers are going to be the first ones who get the sense that there is some change in the client and can discuss those concerns with the firm and with the general counsel. The kind of things that I'm thinking about are changes in control at the client or significant changes in personnel. Different sources of funding for matters. Is the funding now coming from third parties? Those are the kinds of things that are going to dictate some heightened scrutiny. You can also watch the client's business metrics. Are payments continuing to be current? Are unexpected lawyers or practices appearing on bills? Are budget assumptions being met? And you certainly want to require regular communication between your business team and your general counsel as you consider how to address any of these business anomalies. Where the firm has offices in jurisdictions that have anti money laundering or know your client requirements for lawyers, you might think about implementing those requirements across all the offices of your firm.
- [12:10]
B
It's kind of interesting because if you do, you know, if a firm was seeking to take on DC Solar and ran the the recommended inquiries, now you kind of look at some of the things that you would have discovered that the founder was an inexperienced mechanic with a criminal history and at least one prior bankruptcy. As we previously mentioned. It was also interesting as the as the representation of the firm grew, you'll start to notice that the top officers had questionable qualifications. I believe the individual who created the first solar prototype or for Jeff was his brother in law who actually had a Google solar power to actually learn how to put the trailer together. So probably not the greatest qualifications of a background. And then also just the review of the business fundamentals looked a little unusual for the process. And then really the biggest one was just the tax shelter structure that gave the credits to DC Solar, the customers based on downstream actions, I.e. future revenues to pay the leases. So the program itself was a little bit of the overall scope of the representation. Just it morphed. But however, is it really realistic to believe that other firms, you know, would have been able to actually identify Jeff and his company as unworthy?
- [13:25]
C
One of the things that stood out to me from the public information about the DC Solar claim is that it looks like the lawyers were involved in helping DC Solar acquire clients for its business. And that I think is something of a highlight for these unworthy client situations. It's certainly unrealistic to expect to be able to avoid all unworthy clients, but if you have an intake process that does a detailed inquiry appropriate in the circumstances into prospective clients and into their new matters, I think you have a reasonable chance of catching these kinds of circumstances. As you say, there was much to be learned about Karpov if you were looking at what was publicly available and much about the transactions that he was engaged in could have been recognized to be the kind of troubling things that would cause you to want to look deeper. This client inquiry is the subject of a recently amended model rule 1 16A. Rule 1 16A was amended in 2023. It is a good starting point for describing some of the successful prospective client inquiries that we've been discussing today. Although that rule has not been widely adopted yet by states, There is an ABA formal opinion 513 which is opined that the requirements of this amended rule do not create new duties for lawyers. And indeed the current rules implicitly include the duties that are described in 1 16A. It expresses that the rule requires a risk based inquiry for all prospective clients, so the depth of the inquiry should reflect the circumstances of concern for a particular client. Factors are described that should be considered in assessing that level of risk. Many of the things that we've been talking about Is the client a natural person or is it an entity? Are there beneficial owners? Who are they? What is the lawyer's experience and familiarity with the client? What is the nature of the legal services? Are you being asked to do work in jurisdictions that are troublesome who are potentially depositing funds into the firm's trust account? You can see from the new rule that it also identifies in comments some of the resources that can give further guidance in assessing risk. It identifies some of the treasury recommendations on politically exposed persons and other lists of jurisdictions that are known to often be sites for money laundering enterprises.
- [16:24]
B
Well, there's a lot to be unpacked either way and I think good lessons learned. But I think maybe with that we thank everybody for listening. And if you are interested in learning a little bit more about our services, feel free to reach out. For more information about our team and alliance, visit our website@alliant.com law firms and again, we thank you for listening.