Imagine yourself as the owner of a small company, or the CEO of a large corporation. The company is not doing well, but you are convinced the distress can be overcome. While sales are down, competition is fierce and your latest expansion – made with borrowed money – did not go well, the business is fundamentally sound. Indeed, you are convinced the business would be profitable if only the debt service wasn’t so high. For many, a conversation with counsel to discuss restructuring options – specifically, how to get the creditors to accept less than they are owed or to receive their money over a longer time – is the first order of business. The law encourages these conversations and, critically, keeps them confidential from third parties, especially those creditors.
Attorney-client communications are not a one-way street, both sides have obligations to the other. “A client who consults a lawyer needs to disclose all of the facts to the lawyer and must be able to receive in return communications from the lawyer reflecting those facts.”ii The lawyer’s advice, based on the facts disclosed by the client, is required to be kept confidential. This protection allows for “open communication between attorneys and their clients so that fully informed legal advice may be given.”iii
In the hypothetical that opened this article, the client needs fully informed legal advice about available options to restructure the business’ obligations, how to deal with creditors, employees and other matters. For example, can the business restructure the debt? Can employees be fired? Can unencumbered assets be moved to a new company and borrowed against to inject new capital into the business? These conversations, and more, are generally protected by the attorney-client privilege from disclosure to the impacted creditors and other third parties.
Despite the importance of the attorney-client privilege and the wide protections given to attorney-client communications, the privilege is not absolute. For example, the law will not protect communications that are made in furtherance of a fraud. Fraud in this context does not require a criminal act; instead, civil fraud, and even a fraudulent transfer, will suffice and will permit the court to breach the attorney client privilege and require the disclosure of otherwise protected materials.
This is what happened in Fragin v. First Funds Holdings LLC f/k/a First Funds LLC. In Fragin, the New York court compelled the defendants’ lawyers to reveal to the plaintiff their communications with the defendant relating to the defendant’s transfer of assets to a newly formed company owned by defendant’s principals.
Defendant First Funds operated a merchant advance business, financing small businesses through a purchase of their future credit card receivables. First Funds owed large sums to its lenders and its owners sought to satisfy some of those debts, and to protect the company’s valuable assets, by sellingiv them to a newly-formed business they controlled. The sale was discussed and executed pursuant to documents prepared by First Funds’ attorneys.
A few months after the sale and in an unrelated transaction, First Funds gave the plaintiff Fragin a promissory note for $1.4 million but never made any payments on the note. In his lawsuit against First Funds and the other defendants to collect on the note and for other damages, Fragin alleged that First Funds’ asset sale was a fraudulent conveyance pursuant to New York Debtor Creditor Law 276. This section provides, as relevant here, that “every conveyance made and every obligation incurred with actual intent . . . to hinder, delay or defraud either present or future creditors is fraudulent as to both present and future creditors.” Thus, even though Fragin was not a creditor of First Funds at the time of the transfer (such that First Funds’ asset transfer was not designed to secret the company’s assets away from him), he was still, as a future creditor of First Funds at the relevant time, able to assert that he had been damaged by the transfer.
Fragin asked the defendants to produce to him documents relating to the transfer; specifically, he asked for drafts of the transfer documents and correspondence between the lawyers and their clients concerning the transfer. Defendants refused to produce the documents, or to provide deposition testimony concerning the transfer, because the information was protected from disclosure by the attorney-client privilege. Fragin agreed that the privilege applied to the requested information but argued the documents should be produced anyway under the crime-fraud exception to the privilege.
On Fragin’s motion to compel production, the court ruled that the evidence Fragin introduced relating to the sale of First Funds’ assets was sufficient to establish probable cause that a fraud (the fraudulent conveyance of the assets) may have been committed, and that the subject communications with counsel were in furtherance of the fraud as they indisputably related to the asset transfer.v The court did not find, nor was it required to, that the law firm knowingly participated in the client’s fraudulent conduct. Instead, the law is clear that communications are properly “excluded from the scope of the privilege even if the attorney is unaware that his advice is sought in furtherance of such an improper purpose.”vi As a result, the disputed documents were ordered to be produced and that ruling was affirmed on appeal.
The Fragin case has valuable lessons to share for both lawyers and clients the most important of which is the same for both – make sure that legal advice given and received is based on knowledge of all the relevant facts. With a full and frank conversation, and thoughtful legal advice, the issues addressed by the Fragin court could have been avoided entirely. And, the conversations between lawyer and client would have remained protected by the attorney-client privilege.
ii: Restatement (Third) of the Law Governing Lawyers §68 cmt. c (2000).
iii: In re John Doe, Inc., 13 F.3d 633, 635-36 (2d Cir. 1994).
iv: No cash was exchanged as part of this sale. Instead, the newco assumed a portion of First Funds’ debt.
v: The court’s ruling was based on the ‘crime-fraud’ exception to the attorney-client privilege which permits the disclosure of otherwise privileged communications where there is a factual basis for a showing of probable cause to believe: (1) that a fraud or crime had been committed; and (2) that the communications in question were in furtherance of the fraud or crime. In re N.Y. City Asbestos Litig., 109 A.D.3d 7, 10 (1st Dep’t 2013).
vi: In re Grand Jury Subpoena Duces Tecum Dated Sept. 15, 1983, 731 F.2d 1032, 1038 (2d Cir. 1984).
Patrick Fitzmaurice is a partner at Troutman Sanders. Patrick’s practice focuses on representing lenders and other creditors in workouts, restructurings, litigation and bankruptcy matters. In addition, a significant portion of Patrick’s practice includes representing clients in connection with fraudulent transfer and other types of avoidance litigation.
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