On July 7, 2015, the US Court of Appeals for the Seventh Circuit, in Peterson v. Katten Muchin Rosenman LLP, held that a transactional lawyer must affirmatively advise its client entering a securitized factoring relationship on which different security arrangements are available and the potential level of risk of each of those arrangements (792 F.3d 789 (7th Cir. 2015)).

The Trustee appointed to marshal the assets of Lancelot Investors Fund (Lancelot) filed suit against Katten Muchin Rosenman LLP (Katten), arguing that Katten committed legal malpractice by failing to advise Lancelot and other entities (Funds) on how to structure their transactions with entities controlled by Thomas Petters. Petters was convicted in 2009 for carrying out a $3.6 billion Ponzi scheme.

The Funds loaned money to the Petters vehicles, which in turn supposedly financed some of Costco's inventory. Petters insisted that the Funds not contact Costco on the grounds that it would upset his favorable business relations with it (a no-contact constraint). This turned out to be a total fabrication, as Petters was engaging in a classic Ponzi scheme.

According to the Trustee's complaint, Katten violated its duty to its client by not advising Gregory Bell, who established and managed the Funds, that the actual agreement posed a risk that Petters was not running a real business. The complaint asserts that Katten had been engaged to structure transactions, and part of that duty entailed telling the client what contractual devices were appropriate to the situation.

The district court dismissed the complaint for failure to state a claim on which relief may be granted under Rule 12(b)(6). According to the district court, Bell "knowingly bypassed verification with Costco in order to obtain a higher interest rate from Petters." Therefore, under the district court's ruling, the Funds knowingly took a risk and could not put the fault on Katten for failing to give "business advice."

The Seventh Circuit reversed the district court's decision and remanded the case for proceedings consistent with the opinion.

First, the Seventh Circuit noted that the district court's decision inappropriately rested on Rule 12(b)(6) because it relied on a factual view extrinsic to the complaint. The complaint alleged that Bell attributed the Funds' high return at least in part to the lack of direct verification with Costco and that he told some would-be investors about this tradeoff. However, it did not allege that Bell was indifferent to legal advice concerning how to curtail risks given the no-contact constraint.

Next, the Seventh Circuit reasoned that the district court did not engage the complaint's main contention (that Katten had to alert its client to the risk of allowing repayments to be routed through Petters, drafting and negotiating any additional contracts necessary to contain the risk). Rather, the district court focused on the contention that Katten was supposed to do something about Petter's no-contact constraint. The Seventh Circuit noted that a competent transactions lawyer should have appreciated which payment arrangement offered better security and alerted its client. The Seventh Circuit further noted that, while the client has the liberty to reject this advice, an attorney must nevertheless provide the advice.

Finally, the Seventh Circuit reasoned that the district court's decision did not identify any principle of Illinois law that sharply distinguishes between "business advice" and "legal advice." The Seventh Circuit noted that a client can make a business decision about how much risk to take. However, it then determined that it is in the realm of legal advice to advise a client about the different legal devices that are available and the potential risks of each of those devices. Here, Katten should have provided the following legal advice:

Knowing the degree of risk each of the different structures presents, the client can then make a business decision. The Seventh Circuit noted that it takes a competent lawyer who understands how the law of secured transactions works to ensure that the client knows about these legal devices and their risks. Whether Katten was negligent or has a defense will be subjects for the district court.

This case focuses on the level of advice provided by the secured transactions lawyer. The court noted that advising clients on how best to maintain security for their loans using legal devices is a vital part of a transactions lawyers' job. It said that "A lawyer is not a business consultant." However, this case illustrates that lawyers should provide value to their clients by offering them an overview of the benefits and risks associated with each legal device available to them. In addition, lawyers should be careful to clearly define what they are hired to do and the scope of their obligations to their clients.