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Standing to Assert Legal Malpractice: The Wagoner Rule, Adverse Interest Exception, and Sole Actor Rule

Cobalt Multifamily Investors I, LLC v. Shapiro, 2009 WL 2058530 (S.D.N.Y. July 15, 2009)

Facts:  Receiver for the defunct Cobalt Multifamily Investors I, LLC entities (“Cobalt”) filed suit against three sets of attorneys and their law firms for malpractice, looting, aiding and abetting conversion, conversion, unjust enrichment, breach of fiduciary duty, and breach of contract.  

The defendants moved to dismiss for lack of standing under the Wagoner Rule and the Court granted their motion.  The Wagoner Rule provides that a bankrupt corporation, and by extension, an entity that stands in the corporation’s shoes, lacks standing to assert claims against third parties for defrauding the corporation where the third parties assisted corporate managers in committing the alleged fraud. The Court rejected the Receiver’s argument that the adverse interest exception applied and granted the motion to dismiss, holding that the managers’ misconduct provided at least some financial benefit to the Cobalt entities, and therefore, they did not totally abandon the interests of the corporation, and were not acting entirely for their own or another’s purpose.  The Receiver filed a Motion for Reconsideration.  

Issue:  Did the Receiver have standing to bring a professional malpractice claim against the law firm defendants on behalf of Cobalt?

Ruling:  The Receiver had standing to bring a malpractice suit on behalf of the defunct entity. 

Applicability of the Adverse Interest Exception to the Wagoner Rule:

In granting the Motion for Reconsideration, the Court rejected the notion that a benefit to the corporation from the wrongdoer’s conduct precludes application of the adverse interest exception, and instead held that a corporation’s manager can totally abandon a corporation’s interests even if the manager’s actions somehow benefit the corporation because the relevant inquiry is whether the manager intended to benefit the corporation. 

Under this standard, the Court agreed that the Receiver’s allegations supported the conclusion that Cobalt’s managers had the intent to totally abandon Cobalt’s interests by utilizing investor funds for their personal benefit.  

The Court rejected the attorneys’ argument that the adverse interest exception is inapplicable because the managers set up a corporation expressly for the purpose of defrauding outsiders and by doing exactly that, they actually furthered the corporation’s interests:

Implicit in this argument is the view that the interests of the corporation should be defined solely by considering the interests of the managers, and not by considering the interests of the shareholders as well. Law Firm Defendants offer no compelling legal support for this position. Moreover, this position runs contrary to basic principles of corporate law that take into account the interests of the shareholders when defining the interest of the corporation.

Applicability of the Sole Actor Rule to the Adverse Interest Exception:

The Law Firm Defendants argued that even if the adverse interest exception applied to the Wagoner Rule, the sole actor rule would still preclude the Receiver’s standing to bring claims against them. The sole actor rule is an exception to the adverse interest principle and applies where the principal and agent are one and the same. In such instances, the agent’s knowledge is imputed to the principal, unless the corporation had owners or managers who were innocent of the fraud. 

The Court held that the sole actor rule would not prevent the Receiver from pursing his claims against the Law Firm Defendants, since the corporation (the principal) had 300 innocent shareholders versus three fraudulent managers. More importantly, the shareholders had the authority to stop the fraud, and would have done so had they known about it.

The Law Firm Defendants argued that the managers dominated and controlled the corporation, and therefore, the sole actor rule must apply notwithstanding the innocent shareholders. The Court found no merit to this argument, however, since the managers of Cobalt did not have “complete control”, i.e. the shareholders had the authority to remove them.

Lesson:  A Receiver will be allowed to bring professional malpractice claims where he can establish the insiders’ intent to benefit themselves at the expense of the corporation and its shareholders.

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Posted in: Corporate Law, Federal, New York