Commercial Litigation and Arbitration

Federal Jurisdiction Extends to Legal Malpractice Claim That Requires Plaintiff to Prove That No Violation of the Federal Securities Laws Occurred in Order to Establish Causation

Reserve Mgmt. Co. v. Willkie Farr & Gallagher LLP, 2012 U.S. Dist. LEXIS 137682 (S.D.N.Y. Sept. 25, 2012):

Plaintiff RMCI served as the investment advisor for the Reserve Primary Fund ("the Fund"), a money market fund that, prior to September 2008, held approximately $62.5 billion in assets. (Cmplt. ¶ 2) From July 2002 through September 2008, Willkie provided legal advice to RMCI and the Fund concerning the Investment Company Act of 1940 and other matters.***

The current dispute between RMCI and Willkie has its root in the September 2008 bankruptcy of Lehman Bros., which led to the rapid collapse of the Fund. At the time Lehman announced its intention to file a bankruptcy petition, the Fund held $785 million in Lehman commercial paper. (Id. ¶¶ 2, 39) Lehman's announcement led to a run on the Fund, with "investors . . . submitting redemption requests in massive numbers." ***

RMCI's malpractice complaint presents two broad theories of liability. The first is that -- at the time of Lehman's bankruptcy -- Willkie provided incompetent advice to RMCI that has led the firm, two of its principals -- Bruce Bent, Sr. and Bruce Bent II -- and a related entity to become the subject of an SEC enforcement action***

The Complaint further alleges that -- but for the negligent legal advice Willkie gave RMCI in September 2008 -- RMCI would not have been sued by the SEC or by private parties, and would not have incurred millions of dollars in attorneys' fees and other defense expenses. ***

In the SEC enforcement action, which is also pending before this Court, the Commission alleges that RMCI, the Bents, and the distributor for the funds managed by RMCI -- Reserv Partners, Inc. -- violated various provisions of the federal securities laws when they "engaged in a systematic campaign to deceive the investing public into believing that the Primary Fund . . . was safe and secure despite its substantial Lehman holdings."***

The malpractice complaint's second theory of liability against Willkie is that the firm's simultaneous representation of RMCI and the Fund presented a conflict of interest that the firm never disclosed to RMCI and that has caused significant prejudice to RMCI. ... The relationship between the Fund and RMCI is governed by a Comprehensive Fee Investment Management Agreement dated June 26, 2007 and amended on July 16, 2007, September 13, 2007, and February 13, 2008, and renewed in September 2008 ("the Management Agreement"). ***

The Management Agreement provides that "RMCI shall not have any liability to the Fund arising from the provision of its investment management services except in the case of willful malfeasance, bad faith, or gross negligence." (Id. ¶ 31) However, "the Management Agreement contains no provision expressly requiring the Fund to indemnify RMCI for losses arising from claims by third parties, or to advance and indemnify RMCI for its attorneys' fees in defending such actions. . . ." (Id. ¶ 32) RMCI claims that Willkie never advised it to request that indemnification and advancement of fees provisions be included in the Management Agreement, and that had such provisions been requested by RMCI, the Fund would have agreed to include them....



"As a general proposition, '[a] suit arises under the law that creates the cause of action.'" Nazzaro v. Balber, No. 05 Civ. 2172(CSH), 2005 WL 1251785, at *3 (S.D.N.Y. May 25, 2005) (quoting Am. Well Works Co. v. Layne & Bowler Co., 241 U.S. 257, 260 (1916)). However, original federal jurisdiction is present when "it appears that some substantial, disputed question of federal law is a necessary element of one of the well-pleaded state claims, or that one or the other claim is 'really' one of federal law." Franchise Tax Bd. v. Constr. Laborers Vacation Trust, 463 U.S. 1, 13 (1983). "Federal jurisdiction in these circumstances is predicated on 'the presence of a federal issue in a state-created cause of action.'" D'Alessio v. New York Stock Exchange, Inc., 258 F.3d 93, 99 (2d Cir. 2001) (quoting Merrell Dow Pharms. Inc. v. Thompson, 478 U.S. 804, 810 (1986)).

While "the mere presence of a federal issue in a state cause of action does not automatically confer federal-question jurisdiction," Merrell Dow, 478 U.S. at 813, "a case is deemed to 'arise under' federal law 'where the vindication of a right under state law necessarily turn[s] on some construction of federal law.'" D'Alessio, 258 F.3d at 99 (quoting Franchise Tax Bd., 463 U.S. at 9). "Consequently, in cases where 'state law creates the cause of action, [courts] ask[ ] whether that cause of action poses a substantial federal question.'" Id. (quoting W. 14th St. Commercial Corp. v. 5 W. 14th Owners Corp., 815 F.2d 188, 192 (2d Cir.1987)).

The determination of whether a claim "arises under" federal law is "determined by reference to the 'well-pleaded complaint.'" Merrell Dow, 478 U.S. at 808 (quoting Franchise Tax Bd., 463 U.S. at 9-10). The well-pleaded complaint rule dictates that a federal question must appear on the face of the plaintiff's properly pled complaint. "This rule enables the plaintiff to be the 'master of the claim' and permits plaintiff to avoid federal jurisdiction by exclusively relying on state law." Panizza v. Mattel, Inc., No. 02 Civ. 7722(GBD), 2003 WL 22251317, at *2 (S.D.N.Y. Sept. 30, 2003) (citing Caterpillar, Inc., 482 U.S. at 392). Plaintiffs are limited only by the artful pleading doctrine -- "an independent corollary of the well-pleaded complaint rule" -- which prevents a plaintiff from defeating federal jurisdiction by "omitting to plead necessary federal questions in a complaint." Franchise Tax Bd., 463 U.S. at 22. Federal jurisdiction may not be premised on the assertion of a federal defense, "even if the defense is anticipated in the plaintiff's complaint, and even if both parties admit that the defense is [essential to adjudication of the claims]." Id. at 14.

Courts assessing grounds for removal "'must make principled, pragmatic decisions, engaging in a selective process which picks the substantial causes out of the web and lays the other ones aside.'" Fin. and Trading, Ltd. v. Rhodia S.A., No. 04 Civ. 6083(MBM), 2004 WL 2754862, at *6 (S.D.N.Y. Nov. 30, 2004) (quoting Barbara v. New York Stock Exch., Inc., 99 F.3d 49, 54 (2d Cir. 1996)). With respect to whether a plaintiff's right to relief for a state law claim necessarily depends on resolution of a substantial question of federal law, the following legal standard applies:

[T]he question is, does a state-law claim necessarily raise a stated federal issue, actually disputed and substantial, which a federal forum may entertain without disturbing any congressionally approved balance of federal and state judicial responsibilities.

Grable & Sons Metal Prods., Inc. v. Darue Eng'g & Mfg., 545 U.S. 308, 314 (2005).

Grable creates only a "special and small," "slim category" of cases that may be appropriately removed to federal court. Empire Healthchoice Assur., Inc. v. McVeigh, 547 U.S. 677, 699, 701 (2006). Indeed, the "mere presence" of a federal issue does not create federal jurisdiction over a state claim. Ins. Corp. of New York v.. Monroe Bus Corp., 491 F.Supp.2d 430, 434 (S.D.N.Y. 2007) (citing Merrell Dow Pharms. Inc., 478 U.S. at 808, 813-14). Nor is the assertion of a federal interest enough to warrant the exercise of federal jurisdiction. Empire Healthchoice Assur., Inc., 547 U.S. at 701. Under Second Circuit precedent, a federal issue is substantial if it "involve[s] aspects of [a] complex federal regulatory scheme . . . as to which there is 'a serious federal interest in claiming the advantages thought to be inherent in a federal forum.'" Broder v. Cablevision Systems Corp., 418 F.3d 187, 195 (2d Cir. 2005) (quoting Grable, 545 U.S. at 313).

A single claim over which federal-question jurisdiction exists is sufficient to allow removal. Id. at 194 (citing Exxon Mobil Corp. v. Allapattah Servs., Inc., 545 U.S. 546 (2005)). "Where a federal issue is present as only one of multiple theories that could support a particular claim, however, this is insufficient to create federal jurisdiction." Id. (citing Christianson v. Colt Indus. Operating Corp., 486 U.S. 800, 807-09, 811-13 (1988)). "The question is whether at least one federal aspect of [the plaintiff's] complaint is a logically separate claim, rather than merely a separate theory that is part of the same claim as a state-law theory." Id.


III. Analysis

Defendants contend that both of the principal theories of liability in the malpractice complaint -- incompetent advice in connection with the fallout from Lehman's bankruptcy and the failure to seek indemnification provisions in the Management Agreement -- present "substantial federal question[s] under the Exchange Act and Advisers Act . . . over which the federal courts have exclusive jurisdiction. ***

As to Plaintiff's claim regarding indemnification provisions, RMCI will be required to prove -- in order to demonstrate causation -- that it did not violate the Federal securities laws. If RMCI violated the Exchange Act or the Advisers Act -- as is alleged in the SEC action -- then it would not be entitled to indemnification from the Fund, even if it had a contractual right to indemnification. See 15 U.S.C. § 80a-17(i) (prohibiting funds from indemnifying investment advisers against liabilities arising from "willful malfeasance, bad faith, or gross negligence").

RMCI's malpractice claim concerning indemnification provisions thus triggers the "case within a case requirement" discussed in Kirk. See 2009 WL 2870167, at *9. In order to show that Willkie's failure to negotiate an indemnification clause has caused damage to RMCI, RMCI must demonstrate that it would be entitled to indemnification -- that "'but for' the attorney's conduct the client . . . would not have sustained any ascertainable damages." Fashion Boutique of Short Hills, Inc., 10 A.D.3d at 272. Accordingly, in order to satisfy the causation element of its indemnification-related malpractice claim against Willkie, RMCI must show that it did not violate the Federal securities laws.

Although RMCI argues that any issue of federal securities law violations is not an element of its claim but rather an affirmative defense to be raised by Defendants..., RMCI must prove -- as an element of its prima facie case -- that it suffered a compensable loss that was proximately caused by Willkie's breach of its duty. See Kirk, 2009 WL 2870167, at *9 ("With respect to proximate causation, a plaintiff 'must show that but for the attorney's negligence, he or she would have prevailed in the underlying action or would not have sustained any damages.'") (quoting Nobile, 265 F.Supp.2d at 289). RMCI implicitly recognizes this in the Complaint, in which it repeatedly pleads that it did not commit any securities law violations. *** In sum, to prove the proximate cause element of its malpractice claim, RMCI must show that it did not violate the federal securities laws and thus would be entitled to indemnification under the provision RMCI claims that Willkie should have negotiated.

RMCI's incompetent advice theory of liability will also require it to demonstrate that it did not violate the federal securities laws. As discussed above, RMCI claims that "the SEC is seeking to hold RMCI and the Bents liable for actions taken by the Willkie firm" -- specifically, a no-action letter and credit support agreement drafted by the firm. (Cmplt. ¶¶ 42-43). In order to demonstrate that it would not have "incur[red] expense in connection with the defense of the SEC's investigation and subsequent suit" "but for" Willkie's "negligent legal services," ... RMCI will be required to demonstrate that it committed no other federal securities law violations that would have been likely to provoke the SEC's enforcement action.


Moreover, given the comprehensive federal securities regime, and the fact that Congress has granted federal courts exclusive jurisdiction over federal securities law actions, there is a strong federal interest in the federal securities law issues raised in RMCI's malpractice complaint. See D'Alessio, 258 F.3d at 104 ("'The comprehensive scheme of statutes and regulations designed to police the securities industry is indicative of a strong federal interest.'") (quoting Friedlander v. Troutman, Sanders, Lockerman & Ashmore, 788 F.2d 1500, 1504 (11th Cir. 1986)); see also New York City Health and Hosps. Corp., v. Wellcare of New York, 769 F.Supp. 2d 250 at 257 (S.D.N.Y. 2011) (federal question was "substantial" because it "implicate[d] the complex reimbursement schemes created by Medicare) (citing Broder, 418 F.3d at 195). In sum, RMCI's legal malpractice claims "necessarily raise a stated federal issue, actually disputed and substantial." Grable, 545 U.S. at 314.

As to the third prong of Grable, this Court may entertain this case "without disturbing any congressionally approved balance of federal and state judicial responsibilities." Id. As noted above, Congress has given the federal courts exclusive jurisdiction over the Federal securities laws. See, e.g., 15 U.S.C. § 78aa. There is a strong federal interest in the adjudication of federal securities law claims in federal court because securities are regulated by a federal agency. Cf. Air Measurement Techs., Inc. v. Akin Gump Strauss Hauer & Feld, L.L.P., 504 F.3d 1262, 1272 (Fed. Cir. 2007) (noting "strong federal interest in the adjudication of patent infringement claims in federal court because patents are issued by a federal agency"). Moreover, there is no reason to believe that the exercise of federal jurisdiction here would "open the floodgates" to federal courts or otherwise "interfere with the 'normal currents of litigation.'" WellCare, 769 F.Supp. 2d at 258 (quoting Grable, 545 U.S. at 318).

Courts' treatment of legal malpractice cases in the patent context supports this Court's conclusion that the exercise of federal jurisdiction here is proper. As with the federal securities laws, federal courts have exclusive jurisdiction over patent laws. See 28 U.S.C. § 1338(a). The exercise of federal jurisdiction has been found proper where a legal malpractice claim requires a showing that a plaintiff would have succeeded in obtaining damages for patent infringement but for counsel's negligent advice. See USPPS, Ltd. v. Avery Dennison Corp., 647 F.3d 274, 281-82 (5th Cir. 2011) (finding exercise of federal jurisdiction proper where legal malpractice claim would require deciding issues of patent law); Warrior Sports, Inc. v. Dickinson Wright, P.L.L.C., 631 F.3d 1367, 1372 (Fed. Cir. 2011) (finding exercise of federal jurisdiction proper where "to prove the proximate cause and injury elements of its [legal malpractice] claim, Michigan law requires Warrior to show that it would have prevailed on its [patent] infringement claim against STX and would have been entitled to an award of damages as a result"); Air Measurement Techs. Inc., 504 F.3d at 1269 (When "proof of patent infringement is necessary to show [plaintiff] would have prevailed in the prior litigation, patent infringement is a 'necessary element' of [plaintiff's] malpractice claim and therefore . . . presents a substantial question of patent law conferring § 1338 jurisdiction."); see also Katz v. Holland & Knight LLP, No. l:08cvl 137, 2009 WL 367204, at *4 (E.D. Va. Feb. 12, 2009) (extending Air Measurement to legal malpractice claim based on copyright infringement suit).

Finally, the exercise of federal jurisdiction here is consistent with Second Circuit authority endorsing a district court's exercise of supplemental jurisdiction over a legal malpractice claim related to securities litigation overseen by that court.

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