When Clients Become Liabilities: Protecting Law Firms From "Unworthy" Clients

Intro (00:00):
You are listening to the Alliant Specialty Podcast, dedicated to insurance and risk management solutions and trends shaping the market today.

Craig Howser (00:09):
Welcome back to another Alliant Specialty Podcast. My name is Craig Howser, and I'm the co-leader of the Alliant Law Firm Practice. I'm joined today by my colleague, Eric Hubbard.

Eric Hubbard (00:19):
Thank you, Craig. I'm Eric Hubbard, senior risk management consultant at Alliant. Prior to joining Alliant, I was a large law firm partner and then that firm's general counsel. I have a lot of experience with client intake issues. During my 20 years of involvement in law firm risk management, one of the drivers of significant claims continues to be unworthy clients. Unworthy clients are those that use their lawyers, usually unwittingly, to assist them in illegal or otherwise improper conduct or who fail to follow the lawyer's advice, improperly share the lawyer's advice with third parties and also seek legal services that they cannot or refuse to pay for. Unworthy clients account for some of the most costly legal malpractice claims in history. Think Enron, Stanford bank, and more recently, DC Solar. Today, we'll discuss the DC Solar situation to identify some of the problems it presented to the involved law firms, and we'll also discuss the best ways to identify unworthy clients, both at intake and after initial intake. We'll also discuss some of the practices and tools that are described in new ABA model rule 1.16(a).

Craig Howser (01:42):
We're going to actually use the DC Solar case to explore law firm risk management. We're really not looking to re-litigate the fraud, but it's more to examine how a seemingly reasonable client at intake can evolve into an unworthy client over time. The basic facts in the case, as described in an article in the Atlantic, kind of unfold like a Hollywood script. There's little greed, a little deception, lavish spending, but also the unveiling of a fraud leading to financial collapse of the business, and ultimately hundreds of millions of dollars in investor losses. Now, DC Solar was founded by Jeff Carpoff. He was a former small town auto mechanic, turned CEO, and they made large portable solar-powered generators. Think of a trailer that you hook onto a vehicle that's wrapped in solar panels, and that was their portable generators.

These generators were sold to large institutional buyers, and they would pay 30% of the $150,000 purchase price upfront, then they would finance the balance. In return, the investors would actually receive a pretty lucrative 30% investment tax credit from the IRS. In most cases, the investors never actually took possession of the generators. Instead, DC Solar would retain control of the equipment and then would supposedly lease the units out to third parties. They would use the lease revenue to actually service the investors' financing. However, in reality, the company was producing far fewer units than it was actually selling. The leasing revenues didn't really materialize as expected, and instead, new investor funds were being used to pay early investors. At the same time, the same generators were reportedly being sold and leased multiple times. So, in other words, we're kind of beginning to resemble a classic Ponzi scheme. To note, throughout the process, the parties involved were all represented by pretty sophisticated counsel, and we are no way suggesting that counsel had any knowledge of the fraud, but it does highlight how complex and difficult some of these situations can be. Eric, with that as the backdrop and looking at it from your experience, is there anything here that could have been identified at intake?

Eric Hubbard (04:02):
There are certainly no guarantees, but a strong intake process may well have been able to identify DC Solar's most egregious behavior. Now, the original intake was probably for a tax credit opinion, and that may very well have been pretty clean and pretty reasonable. Trouble seems to have arisen as the business progressed. Identifying that transition is going to require a firm to have infrastructure to continue to review client activity as the client's work progresses to assure that the client has not gone from being unworthy at intake to unworthy later on. This can be done in a couple of different ways. You can look at new matters that are coming in for the client. You can look at the progress of existing matters, and you really need to think about how detailed your firm's process is for reviewing new matters for existing clients and the progress of existing matters.

Craig Howser (05:02):
With that being said, what are some of the best ways to identify those unworthy clients?

Eric Hubbard (05:07):
Certainly a strong business intake procedure is going to be key. You want to make sure that you've got a very well thought out intake questionnaire. Different practices may require different intake questions. You want to make sure that you're getting accurate and complete answers to the questions that are sought in that questionnaire. Frequently, we understand that firms get frustrated with the quality of the responses to those intake questionnaires. Sometimes a partner will rely on an assistant to fill them out. One way to increase the quality of the answers and compliance is to require a partner sign off on the responses to those questionnaires. I'd ask the listeners if they have a process at their firm to assure quality responses to their intake questionnaires.

Now, most firms are getting information on their inbound clients, primarily to allow for an informed conflict analysis. They're going to get some information about the client identification, the scope of the representation and the prospective client's credit worthiness, but rooting out unworthy clients is going to require going deeper. You're going to want to assess client information at the level of owners and representatives of an entity client, perhaps beneficial owners, related entities. Are individual clients or entity representatives on any sort of politically exposed persons list, which is kept by the Department of Treasury. You're also going to want to do a dive into the client's public persona, news items, Google searches, litigation histories and social media presence all are going to be helpful in understanding who it is that you're proposing to bring in as a client.

Craig Howser (06:57):
It's interesting you say that because if you look back at it now, a Google search run on Jeff Carpoff himself probably would've uncovered some past business failures and even some criminal conviction, so that's an interesting approach.

Eric Hubbard (07:10):
That might've made a significant difference to some of the firms that ultimately took DC Solar in as a client. Now, in addition, the client's history with prior counsel is an important place to look. You can find out about poor history of payment to other counsel. You can find out about poor history of following the advice of other counsel. For a client that has prior counsel or identifies somebody as referring them to you, I recommend that you interview or have significant communication with those other clients, other counsel or those other references. You want to assess the circumstances of the client's relationship with that person to understand how they behaved. Of course more information is going to be available if prior to that conversation you get consent from the perspective client, which would allow for permission for you to perhaps get into, for example, privileged material. Now, where a contact with a prior counselor referral is not satisfactory, you'll want to consider having a further discussion with the client about your impressions before you determine how to proceed. You should certainly consider requiring a statement from your firm's sponsoring lawyer concerning any experience that he or she has with the client and how the client came to the lawyer's attention. Getting history about the prior actions of the client is particularly important with respect to lateral lawyers. Clients that come into the firm with a lateral lawyer are significantly a greater source of unworthy client claims.

Craig Howser (08:54):
If you look at it, you're kind of talking about just these, even the scopes of the engagements of how they have it. It's kind of an interesting topic, even by underwriters, because they've actually been known to ask about what goes into crafting a proper engagement letter and how do you avoid a scope of representation of being too broad or too narrow. I mean, neither is good. Then ultimately, how do you address the potential scope creep as clients evolve? How does the change in their needs lead to a client becoming potentially unworthy?

Eric Hubbard (09:27):
Well, certainly the scope of the representation, there are some hallmarks of risky activity. One is the work is going to involve raising funds or otherwise soliciting business from third parties. If the lawyer is involved in those activities, that raises risk and should be considered. Will funds be flowing in and out of the firm's trust account? If that is going to happen, there is further risk of unsavory activities that are going to look back at the law firm. You also want to identify all the jurisdictions that may be relevant to the representation. There are certain jurisdictions that have experience with money laundering that you may want to be aware of. Often, like DC Solar, unworthy clients are, as you say, going to start worthy and change over time. There are a couple of different ways that you can identify those things.

Craig Howser (10:24):
I was about to say. How can you actually detect that sort of change as the client representation evolves?

Eric Hubbard (10:31):
The first thing you want to be able to do is have good communication with your lawyers who are working with the client regularly. For example, as we discussed with lateral lawyers, you want to have a detailed review to understand the client that they are seeking to bring in. You want to monitor new matters for existing clients and do a significant intake process on those new matters. You want to encourage your lawyers to discuss their concerns about client behavior with the firm's GC. The individual lawyers are going to be the first ones who get the sense that there is some change in the client and can discuss those concerns with the firm and with the general counsel. The kind of things that I'm thinking about are changes in control at the client, or significant changes in personnel, different sources of funding for matters. Is the funding now coming from third parties? Those are the kinds of things that are going to dictate some heightened scrutiny. You can also watch the client's business metrics. Are payments continuing to be current? Are unexpected lawyers or practices appearing on bills? Are budget assumptions being met? You certainly want to require regular communication between your business team and your general counsel as you consider how to address any of these business anomalies. Where the firm has offices in jurisdictions that have anti-money laundering or know your client requirements for lawyers, you might think about implementing those requirements across all the offices of your firm.

Craig Howser (12:09):
It's kind of interesting because if a firm was seeking to take on DC Solar and ran the recommended inquiries now, you kind of look at some of the things that you would've discovered that the founder was an inexperienced mechanic with a criminal history and at least one prior bankruptcy, as we previously mentioned. It was also interesting as the representation of the firm grew, you'll start to notice that the top officers had questionable qualifications. I believe the individual who created the first solar prototype, or for Jeff, was his brother-in-law who actually had to google solar power to actually learn how to put the trailer together, so probably not the greatest qualifications of a background. Then also, just the review of the business fundamentals looked a little unusual for the process. Then really the biggest one was just the tax shelter structure that gave the credits to DC Solar. The customers based on downstream actions, i.e. future revenues to pay the leases, so the overall scope of the representation, it morphed. However, is it really realistic to believe that other firms would've been able to actually identify Jeff and his company as unworthy?

Eric Hubbard (13:24):
One of the things that stood out to me from the public information about the DC Solar claim is that it looks like the lawyers were involved in helping DC Solar acquire clients for its business. That I think is something of a highlight for these unworthy client situations. It's certainly unrealistic to expect to be able to avoid all unworthy clients, but if you have an intake process that does a detailed inquiry appropriate in the circumstances into prospective clients and into their new matters, I think you have a reasonable chance of catching these kinds of circumstances. As you say, there was much to be learned about Carpoff if you were looking at what was publicly available. Much about the transactions that he was engaged in, could have been recognized to be the kind of troubling things that would cause you to want to look deeper.

This client inquiry is the subject of a recently amended model rule 1.16(a). Rule 1.16(a) was amended in 2023. It is a good starting point for describing some of the successful prospective client inquiries that we've been discussing today. Although that rule has not been widely adopted yet by states, there is an ABA Formal Opinion 513, which is opined that the requirements of this amended rule do not create new duties for lawyers. Indeed the current rules implicitly include the duties that are described in 1.16(a). It expresses that the rule requires a risk-based inquiry for all prospective clients.

The depth of the inquiry should reflect the circumstances of concern for a particular client. Factors are described that should be considered in assessing that level of risk. Many of the things that we've been talking about, is the client a natural person or is it an entity? Are there beneficial owners? Who are they? What is the lawyer's experience and familiarity with the client? What is the nature of the legal services? Are you being asked to do work in jurisdictions that are troublesome? Who are potentially depositing funds into the firm's trust account? You can see from the new rule that it also identifies in comments, some of the resources that can give further guidance in assessing risk. It identifies some of the treasury recommendations on politically exposed persons and other lists of jurisdictions that are known to often be sites for money laundering enterprises.

Craig Howser (16:23):
There's a lot to be unpacked either way. Good lessons learned. Maybe with that, we thank everybody for listening. If you are interested in learning a little bit more about our services, feel free to reach out. For more information about our team and Alliant, visit our website at Alliant.com/LawFirms. Again, we thank you for listening.