In dismissing Stradley Ronon Stevens & Young’s lawsuit against former client Sovereign Bank, a federal judge has ruled the firm cannot use the Declaratory Judgment Act to pre-empt a state court malpractice filing by Sovereign. Stradley Ronon asked U.S. District Judge Joel H. Slomsky of the Eastern District of Pennsylvania to rule it did not commit legal malpractice when drafting an amendment to a loan agreement for the bank, in hopes of forestalling threats by Sovereign to sue over the $97 million it said it lost because of poor terms in the agreement.

Sovereign did eventually sue Stradley Ronon for legal malpractice in the Philadelphia Court of Common Pleas about a month after the law firm filed its declaratory judgment action in federal court. The state action had been stayed until Slomsky could address Sovereign’s motion to dismiss Stradley Ronon’s case against it.

In granting Sovereign’s motion, Slomsky said in his Tuesday opinion in Stradley Ronon Stevens & Young v. Sovereign Bank that prior case law has made clear declaratory judgment proceedings should not be used by a potential defendant to obtain a declaration that the defendant is not liable in an underlying, potential action.

“The essence of this case is a malpractice dispute between a law firm and an aggrieved client,” Slomsky said. “A claim of malpractice against a law firm involves a cause of action under state law. By filing the instant action, Stradley has attempted to pre-empt the ensuing state court proceeding against it for malpractice by suing first in federal court, rather than waiting to be sued in state court.”

Slomsky said he could not interfere with a state court action even if it was filed after the action before him.

The underlying facts involved in the alleged malpractice relate back to the bankruptcy filing of mortgage servicer Taylor, Bean & Whitaker Mortgage Corp.

Taylor Bean would work with mortgage lenders like Ginnie Mae and Wells Fargo on the lenders’ foreclosure actions. When a bank forecloses on a property, the homeowner still has to pay certain expenses such as property taxes and insurance premiums, Slomsky noted. To ensure those payments are made, lenders contract with mortgage servicers, like Taylor Bean, who advance the funds into escrow accounts. The funds are known as servicer advances. The lender then owes the mortgage servicer those advances, Slomsky said.

Taylor Bean contracted to be a servicer for Freddie Mac, Ginnie Mae, Wells Fargo Bank and Bayview Loan Servicing. To be able to make the servicer advances to those banks, Taylor Bean took out a $300 million revolving line of credit with Sovereign. Stradley Ronon began working with Sovereign on the financing when the loan agreement was in its fourth amended draft in 2007, Slomsky said.

As the real estate market crashed in 2008, it became harder for Taylor Bean to pay down the Sovereign debt and the loan agreement needed to be amended a few more times. It was the sixth amended agreement in which Stradley Ronon first had actual drafting responsibilities, Slomsky said. The goal of the amendment was to accelerate the collection of Taylor Bean’s line of credit, he said.

The section outlining the collateral Sovereign could collect from Taylor Bean was reincorporated into the sixth amended agreement from the prior agreements. It stated that, in the event Taylor Bean defaulted on the loan, Sovereign would get the rights to all of Taylor Bean’s servicing contracts. Under the section outlining approved investors whose service agreements would fall under that collateral, only Fannie Mae and Ginnie Mae were listed, not Wells Fargo or Bayview, according to Slomsky’s opinion.

When Taylor Bean went into bankruptcy, creditors challenged Sovereign’s security interest in the $97 million in servicer advances paid on behalf of Wells Fargo and Bayview as they were not expressly listed in the loan agreement as collateral Sovereign could go after, Slomsky said.

In letters between Sovereign in-house counsel and attorneys at Stradley Ronon, Sovereign argued Stradley Ronon should have included the other two banks in the loan agreement and asked the firm to enter a tolling agreement extending the time Sovereign could have to sue Stradley Ronon for malpractice. Stradley Ronon agreed, though the law firm said it didn’t think there were any valid claims against it. Stradley Ronon gave Sovereign a list of suggested defenses in the bankruptcy action, namely that the plain language of the definition of collateral in the loan agreement captured Wells Fargo and Bayview, according to the opinion.

In the bankruptcy proceeding, Sovereign took Stradley Ronon’s advice and argued the loan agreement protected its interests in the Wells Fargo and Bayview servicer advances. But in October 2011, Sovereign informed Stradley Ronon it would be settling with the unsecured creditors. Stradley Ronon objected to the settlement in a letter to Sovereign and said Stradley Ronon would not be responsible for losses Sovereign sustained from accepting a settlement that ignored all available defenses, Slomsky said.

After Sovereign settled with the creditors, Sovereign and Stradley Ronon spent nearly two years trying to resolve their dispute, but Stradley Ronon ended those talks and filed the declaratory judgment action in May 2012.

Aside from his analysis of why a declaratory judgment action was not an appropriate means to resolve the parties’ dispute, Slomsky further addressed Stradley Ronon’s main argument that Sovereign was judicially estopped from claiming Stradley Ronon committed malpractice in drafting the agreement when Sovereign argued in the bankruptcy court in Florida that the agreement protected Sovereign’s claim to the servicer advances.

“Stradley argues that the court should be concerned with protecting the federal judiciary from Sovereign’s allegedly inconsistent positions,” Slomsky said. “The court is not convinced that Sovereign has engaged in conduct so egregious that it is ‘tantamount to a knowing misrepresentation to, or even fraud on, the court.’”

Slomsky said Sovereign settled with the creditors before the court could rule on its arguments related to the protection provided by the loan agreement. The judge further noted that the position taken by Sovereign can be a defense used by Stradley Ronon in the state court malpractice action.
A federal court ruling on these issues would not resolve the action, Slomsky said, further supporting his decision to defer any rulings to the state court. Interpreting the loan agreement contract that Stradley Ronon was not a party to would simply give Stradley Ronon a defense in the malpractice action or establish the possibility that Stradley Ronon committed malpractice, Slomsky said.

Michael Kichline and Robert Heim of Dechert represented Stradley Ronon in the action. William Slaughter of Ballard Spahr represented Sovereign. Slaughter declined to comment on the decision.

Heim said Stradley Ronon is still reviewing the decision and hasn’t decided yet whether it will appeal. He said the “major issue” in the case is still the firm’s argument that Sovereign claimed in the bankruptcy action that the loan agreement was sufficient when it claimed in the malpractice action that the loan agreement didn’t protect Sovereign.

“All Judge Slomsky decided was, taking those inconsistent positions does not rise quite to the level of being a fraud on the federal bankruptcy court, but he said you can certainly raise that as a defense in the state court and that’s fully what we intend to do,” Heim said.

Gina Passarella can be contacted at 215-557-2494 or at gpassarella@alm.com. Follow her on Twitter @GPassarellaTLI.

(Copies of the 19-page opinion in Stradley Ronon Stevens & Young v. Sovereign Bank, PICS No. 13-0145, are available from The Legal Intelligencer. Please call the Pennsylvania Instant Case Service at 800-276-PICS to order or for information.) •