First Department Says, "Do As We Say, Not As We Do"

Local Law Firm Could Be Back on the Hook for Claims It Aided $22 Million Ponzi Scheme
The New York Law Journal by Nate Raymond - July 7, 2010

A state appellate court yesterday reinstated aiding and abetting charges against a New Jersey law firm in a suit by investors over its alleged role in a $22 million Ponzi scheme. Justice Sallie Manzanet-Daniels, writing for a unanimous panel of the Appellate Division, First Department, said that the court "cannot and will not endorse what is essentially a 'see no evil, hear no evil' approach." "If the facts and circumstances herein do not support an inference of actual knowledge, then it is doubtful that any action for aiding-and-abetting fraud could be sustained by an attorney, who, like the defendant attorneys, consciously chose to look the other way when their clients asked them to prepare the [offering memoranda] for their next 'investment' vehicle," Justice Manzanet-Daniels wrote in Oster v. Kirschner, 602081/2007. Supreme Court Justice Charles Ramos in 2008 granted Lum, Drasco & Positan's motion to dismiss the charges brought by investors who claimed the lawyers knew about the undisclosed criminal histories of the perpetrators of the scheme prior to its unravelling. The firm was sued under a previous name, Lum, Danzis, Drasco & Positan. But Justice Manzanet-Daniels reversed, saying the investors had adequately alleged the lawyers had actual knowledge of the underlying fraud. Donald Chase, a partner at Morrison Cohen who represents the two investors who brought the case, praised the decision as "fantastic" in holding that lawyers could be pursued for aiding and abetting in fraud. "The notion that lawyers are somehow protected when their clients do fraud was, I think, an important notion for this court to dismiss," Mr. Chase said. "And I'm happy that they did so." Neither William E. Goydan, a lawyer for Lum Drasco at Wolff & Samson, nor Anne P. Richter, a lawyer for Lum Drasco of counsel and defendant Philip L. Chapman at McManus, Collura & Richter, responded to requests for comment. Investors Avi and Ann Oster sued Lum Drasco and others in 2007 after losing the $1.9 million they had invested in Cobalt Multifamily Investors I, LLC, a purported real estate investment company. The company, which was actually a Ponzi scheme, went into receivership after its principal backers were indicted on federal securities fraud charges in March 2006. In their complaint, the Osters alleged that they invested their money in Cobalt in reliance on private offering memoranda drafted by Roseland, N.J.-based Lum Drasco and Mr. Chapman that contained misrepresentations and omissions. The memoranda misrepresented who was investing in Cobalt, with units of Cobalt being sold to people who did not meet the investor criteria, the complaint said. The memoranda also misrepresented Cobalt's management team, according to the complaint. The documents said William B. Foster ran Cobalt on a day-to-day basis and Mark Shapiro was a "consultant." But Mr. Shapiro, a convicted felon, ran Cobalt with the help of Irving J. Stitsky, who had been convicted for numerous securities violations and was banned from the industry, the complaint said. The placement memoranda did not disclose the extensive criminal histories of Mr. Shapiro and Mr. Stitsky dating to 1998. After the FBI raided Cobalt's offices in December 2005, the complaint alleges that a backdated amendment that claimed to reveal Mr. Shapiro's and Mr. Stitsky's criminal past was drafted for the December 2004 memoranda. The Osters claimed that Lum Drasco, which drafted three versions of the private placement memoranda, had actual knowledge of and assisted in the Cobalt fraud. As escrow agent, Lum Drasco received documents about the suitability of potential investors. And it knew about the criminal histories of the management, the complaint claimed. Lum Drasco countered that any misrepresentations in the memoranda were irrelevant to whether the lawyers knew Cobalt was a Ponzi scheme. The firm did not seriously dispute its lawyers knew about the backgrounds of Mr. Stitsky and Mr. Shapiro, who was revealed in a related Securities and Exchange Commission case to have hired Lum Drasco. But the law firm argued its knowledge of their backgrounds and misrepresentations in the memoranda was not enough to allege "actual knowledge" of the Ponzi scheme. In April 2008, Justice Ramos dismissed the charges against Lum Drasco and another law firm, Certilman Balin Adler & Hyman, finding arguments that the firm as escrow agent had a duty to investigate and disclose the frauds to the Osters were "unavailing" and "illogical."

'Narrow Formulation'

In reversing, the First Department rejected what Justice Manzanet-Daniels called a "narrow formulation of the pleading requirements for fraud." Actual knowledge of the fraud only needs to be pleaded generally, she wrote, particularly before discovery has commenced when plaintiffs lack the materials needed to reveal a defendant's state of mind. "Participants in a fraud do not affirmatively declare to the world that they are engaged in the perpetration of a fraud," she wrote. In this case, the Osters had adequately alleged actual knowledge and that the Lum firm had provided substantial assistance, the court said. Lum Drasco pointed to two prior cases where attorneys represented parties in deals that were only later revealed as frauds. But investments in Cobalt, Justice Manzanet-Daniels wrote, "were from their inception objectionable" since they were offered to investors who did not meet the criteria and because of the criminal histories of those running the company. The Appellate Division decision contrasts with a September 2009 federal decision by Eastern District Judge Raymond Dearie in which he dismissed claims against Lum Drasco and other Cobalt lawyers. Justice Manzanet-Daniels in a footnote noted that in the federal case the investors had not alleged the lawyers had actual knowledge of the fraud. "To the extent the federal court took a narrow view of the 'actual knowledge' requirement under New York law, we respectfully disagree with the decision," Justice Manzanet-Daniels wrote. Joining the decision were Justices Luis A. Gonzalez, Richard T. Andrias, David B. Saxe and Dianne T. Renwick. Messrs. Shaprio, Stitsky and William B. Foster were found guilty in 2009 after a three-week jury trial on securities fraud, wire fraud, mail fraud and conspiracy charges.