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In a pair of opinions, a federal judge has refused to disqualify either himself or the lead defense lawyers in a class action suit against Rite Aid Corp., rejecting the claims of a former top executive at the company who said the judge and his former lawyers held ex parte meetings in which they engineered a settlement that leaves him out in the cold with no insurance coverage. U.S. District Judge Stewart Dalzell found that neither he nor attorney Alan J. Davis of Ballard Spahr Andrews & Ingersoll did anything unethical by meeting with plaintiffs’ lawyers and negotiating the $200 million settlement — even though none of the other defendants were invited. Dalzell’s rulings reject the claims of former Rite Aid CEO Martin Grass who said the judge’s conduct showed a bias against him and that Davis, his former lawyer, breached his duty of loyalty. Another executive, Frank Bergonzi, the former chief financial officer at Rite Aid, had also called for Dalzell and Davis to be taken off the case, but dropped the motion against Davis during a hearing when Dalzell insisted that he take the witness stand — even if he intended to assert his 5th Amendment right not to testify. Bergonzi’s move provided further confirmation of the ongoing federal grand jury probe into Rite Aid’s fiscal scandals currently underway in the Middle District of Pennsylvania. Grass had also objected to the settlement, claiming it was the fruit of a tree poisoned by the unethical participation of Ballard Spahr in its negotiation and consummation. But Dalzell concluded that since neither he nor any of the lawyers had acted unethically, there was no reason to derail the settlement. Dalzell’s opinions offer a rare glimpse into the inner workings of a corporation when it is forced to hire lawyers not only for itself, but for its top executives. More importantly, the rulings show just how carefully a corporate lawyer must tread when the company and some of its executives suddenly become adversaries. Davis and his firm, Ballard Spahr, were hired almost immediately after Rite Aid was hit with a slew of lawsuits in the wake of its March 1999 announcement of disappointing earnings. The market had reacted swiftly, with Rite Aid stock plummeting from $37 to $23, losing more than $3.7 billion in market capitalization in one day. Rite Aid’s general counsel, Elliot S. Gerson, hired Davis, whom he had known since 1984 when they both practiced at Wolf Block Schorr & Solis-Cohen. At first, Davis represented only Rite Aid and Grass, who at the time was the only senior officer of Rite Aid named as a defendant in the litigation. Gerson testified that, after conferring with Grass and Bergonzi, he concluded that all defendants in the class action had an identity of interest because the suit had no merit. But Dalzell found that from the very beginning, Davis made it clear in his engagement letter that a conflict could arise that would make it impossible for him to represent both Rite Aid and Grass. Davis’ letter said that if a conflict did arise, “it is understood that Mr. Grass would retain separate counsel and that the firm [Ballard Spahr] would continue to represent the corporation.” Grass already had his own lawyers — the Washington, D.C., firm of Wilmer Cutler & Pickering — hired for him by Gerson after The Wall Street Journal published a January 1999 expos� regarding related-party transactions involving Rite Aid that allegedly benefited Grass and his family. Within weeks of the first shareholder suit, new suits added additional Rite Aid executives as defendants, including Bergonzi and Timothy Noonan, then Rite Aid’s president and chief operating officer. Davis took on the defense of everyone and filed a motion to dismiss the case. DRAMATIC DEVELOPMENTS But in October 1999, dramatic developments at Rite Aid led to Grass’ resignation when the company announced that its 1997, 1998 and 1999 financial statements would have to be restated, resulting later that month in a $500 million reduction of Rite Aid’s previously represented pre-tax earnings. An internal audit was begun and its report faulted Grass and Bergonzi for “serious breaches of their fiduciary duties,” both before and after the lawsuits were filed. When Davis learned of the audit report, he testified that he decided that his firm could no longer represent Grass and Bergonzi. Davis’ partner, William A. Slaughter, called Grass’ personal lawyer, William McLucas of Wilmer Cutler, to advise him that a conflict had arisen, and thus, Ballard Spahr could no longer represent Grass. Davis himself telephoned Bergonzi and explained that the conflict meant Bergonzi, too, would need his own lawyers. Bergonzi later hired O’Melveny & Myers. Ultimately, Wilmer Cutler retained James J. Rodgers of Dilworth Paxson as local counsel for Grass, and O’Melveny retained Duane Morris & Heckscher for Bergonzi. Judge Dalzell found that neither of the executives objected to Davis’ continued representation of Rite Aid between October 1999, when they were told of the conflict, and December 2000 when they moved for Davis’ disqualification. But when the proposed settlement was announced, lawyers for both executives cried foul, claiming that Rite Aid’s lawyers — who still owed them a duty of loyalty — had put them in a terrible position by settling the case in a way that left them still facing claims and without any insurance coverage. Under the proposed settlement, the Zurich American Insurance Co. will pay $43.5 million, and Rite Aid will contribute stock worth at least $149.5 million. The settlement could grow in value if the stock price climbs by January 2002 since Rite Aid has promised to give the class at least 20 million shares or as many shares as needed to equal at least $149.5. But even if the settlement is approved, the litigation will continue against Grass, Bergonzi, Noonan and KPMG, Rite Aid’s former outside auditors. RECUSAL AND DISQUALIFICATION Grass and Bergonzi argued that both Dalzell and Davis should be taken off the case since their conduct had severely prejudiced the former executives. In asking the judge to recuse himself, Grass’ lawyers argued that he had participated in “secret ex parte settlement negotiations, which did not include defendants Grass and Bergonzi and occurred without their consent or knowledge.” Grass also argued that Dalzell “not only countenanced, but played a central role in furthering, the secret settlement negotiations, and the secret effort to deprive the non-settling defendants of their insurance rights.” Such ex parte meetings, Grass argued, were “outside the scope of the normal and permissible judicial process and violated the ethical rules designed to ensure the court’s impartiality.” But Rite Aid and the plaintiffs’ lawyers — Sherrie Savett of Berger & Montague and David Bershad of Milberg Weiss Bershad Hynes & Lerach — argued that the judge’s participation in settlement conferences with some, but not all, of the defendants, was permissible. Dalzell found that he had done nothing that required his recusal, saying, “Upon a careful review of our conduct in this case, we find that there are no grounds for our disqualification.” Although the judge conceded that he had prompted the insurer to participate in the settlement, he denied that he ever pressed the insurer to deplete all available coverage so that the former executives would be left uncovered. “The court’s discussion was limited to urging Zurich to participate constructively in negotiations. At no point did the court express any views on whether Zurich should contribute the ‘entire cash portion,’ or any other amount,” Dalzell wrote. RULING ON DAVIS Soon after Dalzell refused to recuse himself, he held hearings on the issue of whether Davis and Ballard Spahr should be disqualified. After looking at all the facts, Dalzell has now concluded that Davis behaved ethically in dropping Grass as a client and that Grass waited too long before objecting since he knew for at least nine months that Rite Aid had interests that were adverse to him. Dalzell also found it significant that Grass now admits he never conveyed any confidential information to Davis. Under cross-examination by Davis during the hearing, Grass agreed that he never thought he could share confidences with Davis that Davis would keep from Rite Aid. In further questioning, Grass conceded that he never shared any confidential information with Davis of any kind. But Grass’ lawyers argued that under Pennsylvania Rule of Professional Conduct 1.9(a), Davis and his firm should nonetheless be taken off the case. Since Ballard Spahr previously represented Grass, they said, the firm has now, by virtue of its representation of Rite Aid in the negotiation of the partial settlement, taken a position adverse to him and never obtained his consent. But Dalzell found that “upon a close examination of the circumstances surrounding Ballard Spahr’s representation of Rite Aid and Grass, we conclude that Ballard Spahr did not engage in unethical or inappropriate conduct with respect to Grass and that disqualification is therefore not warranted.” Other courts have found similar situations “unobjectionable,” Dalzell said, where a corporation hires lawyers who later learn that the company has interests to assert against executives. Rite Aid was always the “primary client,” Dalzell found, and Ballard Spahr agreed to represent the executives only because they, themselves, insisted the suit was meritless. Dalzell also concluded that Grass waived any objection to Ballard Spahr’s continued representation of Rite Aid by waiting for more than nine months despite knowing all along that his former employer had become his adversary. Grass insisted he was ignorant of any conflict until November 2000 when he first learned of the proposed partial settlements. Dalzell flatly rejected that argument, saying, “We cannot accept this as reasonable (much less credible), as the circumstances unambiguously demonstrated Rite Aid’s adversity to him well before that date.” The simple fact that Ballard Spahr had ceased to represent Grass because of possible conflicts, he said, “should naturally have alerted Grass and his counsel to the possibility of future adversity.” Although Davis testified that he did not specifically tell Wilmer Cutler that Rite Aid might have claims against Grass, the judge found it was obvious. “We cannot see how such highly sophisticated counsel could have failed to understand the import of Grass’s resignation based on the widespread media coverage of events at Rite Aid,” he wrote. And the circumstances of Grass’ departure from Rite Aid — which Dalzell said “amounted to, at best, a pressured resignation without any provision of a severance package” — also showed adversity between Grass and the corporation, he said. Confirmation of that fact came soon after, Dalzell said, when Wilmer Cutler explored with Ballard Spahr the issue of a joint defense agreement between Rite Aid and Grass, but Ballard Spahr rejected the proposal.

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