Law firms must prepare for credit crunch litigation wave

The recent crises in the capital markets are likely to trigger claims against participants and their advisers. History shows that, where large losses are suffered, litigation usually follows; and it’s fair to predict that loss-making deals will be scrutinised, particularly where companies have been pushed to the brink of insolvency or, indeed, into liquidation or administration.

Those potentially exposed include investment banks, asset managers, hedge funds, investment advisers, directors and officers and other professional advisers. Leaving aside the risk of direct contractual claims, those groups may find themselves the subject of claims for contribution as defendants seek to spread the pain.

Against this backdrop, what potential areas of exposure do law firms face?The starting point is the solicitor’s core duty – to negotiate an agreement that reflects and gives legal effect to the client’s instructions and its understanding of the commercial deal. In addition, the client must be given such advice as it requires to reach an informed decision on whether to proceed with the agreement, and if so, on what terms.

The range of work undertaken by law firms in the sub-prime sector is broad and claimants may seek to develop a range of allegations. Even so, for most cases a limited set of principles will be relevant.

First and foremost, a solicitor is not obliged to give advice to experienced clients on the commercial wisdom of a transaction. The client operating in the relevant market is in the best position to assess the commercial viability of the proposed transaction, particularly in capital markets, where the deals are often large and complex, involving securitisation, warehousing and other financing arrangements in the packaging and repackaging of sub-prime loans.

This makes it difficult for clients to contend credibly that their lawyers should have obtained more extensive and effective protection for them when they were driven by competitive pressures to accept a dilution of their traditional rights of recourse – for example the prevalence, until recently, of covenant-lite loans.

Although much of the investor-driven litigation is likely to revolve around allegations of a failure to warn and to identify risks, these arguments will be difficult to substantiate against lawyers in this highly specialist and sophisticated market. Thus the existence (or otherwise) of a solicitor’s ‘duty to warn’ in any given case will depend upon: what they were instructed to do; the nature of the assignment in question; whether any allegedly negligent omission related to a hidden legal pitfall that would not have been apparent to the client; and, critically, the experience and standing of the client.

But a client will have a legitimate cause for complaint where there has been a failure to implement properly and give effect to terms and structure of an agreement. In this case the client will be entitled to be put back into the position it would have been in but for the solicitor’s breach of duty. In a hugely competitive and fast-moving market, transactions have been completed within very tight time constraints, with the risk of errors and oversights being exacerbated by the inherent complexity of these arrangements. Where mistakes have been made, a lack of time is a factor to be taken into account, but it is not a licence to be negligent.

Much of the anticipated fallout of the current problems is likely to be centered around issues of valuation and misselling. Although it is possible that a lawyer’s oversight could undermine their client’s position in relation to the latter, problems in valuation will be laid at the doors of others.

Even if a claimant can establish a breach of duty, it will recover nothing unless it can demonstrate that this breach was the cause of the loss. But the claim will still fail if the causal link between the breach and the loss is too tenuous as the breach of duty must be a dominant or effective cause of the loss (not merely the occasion for it).

Causation is often a pivotal issue in solicitors’ cases, and given the number of factors that have contributed to the present liquidity problems, it may prove to be one of the most complicated.