An investment bank brought a legal malpractice claim against Morrison & Foerster after the law firm failed to inform the bank that Puda Coal, Inc. was a shell company, despite receiving a report detailing that fact. A Judge of the New York Supreme Court, however, dismissed the case because the investment bank received the same report, and, as a sophisticated company, could not absolve itself of its own responsibilities.
Puda was a Delaware corporation that conducted mining operations in China through Shanxi Puda Coal Group Co., Ltd. Puda reported in public filings that it owned a 90 percent interest in Shanxi Coal. Puda’s chairman, Ming Zhao, however, had actually transferred Puda’s 90 percent ownership to himself and thereafter sold part of the interest to a Chinese state-owned investment firm.
Puda, continuing to represent that it owned 90 percent of Shanxi Coal, hired an investment bank underwriter for a December 2010 public offering. The investment bank in turn hired Morrison & Foerster and Kroll Inc., an international private investigation firm to conduct due diligence. Kroll uncovered Puda’s lack of ownership of Shanxi Coal and disclosed this fact in a report it emailed to an investment bank associate on December 2, 2010. The associate circulated the report to several other members of the internal deal team and then forwarded the report to Morrison & Foerster with a cover email stating that “no red flags were identified.” Neither the investment bank nor Morrison & Foerster noticed the finding in the Kroll Report that Puda did not own a 90 percent interest in Shanxi Coal. On December 13, Morrison & Foerster issued an opinion letter/negative assurance letter confirming its due diligence findings and indicating that “nothing has come to our attention” regarding false or misleading statements in the offering documents. Puda, with the investment bank serving as its underwriter, thereafter raised millions of dollars in two public offerings.
The financial press uncovered Puda’s fraud in April 2011. The investment bank thereafter faced an SEC investigation as well as a class action lawsuit, ultimately settling with the government and private plaintiffs for over $20 million. In 2015, the investment bank sued Morrison & Foerster based on the law firm’s failure to adequately investigate Puda’s ownership in Shanxi Coal and its failure to review the Kroll report. The investment bank argued that Morrison & Foerster promoted its experience with complex China-related transactions, that Morrison & Foerster was tasked with gaining a full understanding of the ownership and operating structure of Puda and its subsidiaries in China, and that the investment bank sent the Kroll Report to Morrison & Foerster with the expectation that the firm would review the report for any information relevant to its tasks. The investment bank contended that any negligence on its part should merely be a factor in the mitigation of damages and its email that “no red flags were identified” in the Report did not absolve Morrison & Foerster of its responsibilities.
Morrison & Foerster countered that any negligence was not the proximate cause of the investment bank’s damages because a client cannot sue its lawyer for failing to inform it of information that was in the client’s possession. A Judge of the New York Supreme Court agreed. Relying on Ableco Fin. LLC v. Hilson, 970 N.Y.S.2d 775 (N.Y. App. Div. 2013), the Judge concluded that because the investment bank possessed the Kroll Report and the crucial information contained therein, Morrison & Foerster’s own negligence did not proximately cause the damages. The Judge rejected the investment bank’s argument that it lacked “actual knowledge” of the key finding in the Kroll Report—as evidenced by the “no red flags” email, and concluded that the relevant issue is whether the information was in the investment bank’s possession, not the investment bank’s subjective understanding of the significance of the information.
The Judge refused to allow the investment bank to absolve itself of its responsibility to conduct diligence, and her reasoning can best be summarized through a comment she made during oral argument: the bank “is not my grandmother.” It “is a big, sophisticated company.”