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The spring of 2000 was an exciting time for John Clarey. The Internet communications company he founded four years earlier had just moved into a brand new office at the coveted UC-Irvine Research Park in California alongside giants like Cisco Systems and America Online. Clarey had also just signed a letter of understanding to sell the business for $150 million. As the founder and owner of TeleCore Inc., Clarey would cash out with a cool $67 million from the deal. “My family’s taken care of forever,” he told the Los Angeles Times in a profile of him that appeared on the front page of the business section that May. Today, Clarey is still waiting for the payoff that was meant to relieve his kin of monetary concerns. Like many Internet entrepreneurs of the booming ’90s, his fortune has evaporated. But while Clarey’s experience has all the earmarks of the familiar Internet bust story, it also could portend a new chapter in that same story. According to Clarey, the vanished fortune is not simply an unavoidable consequence of the market downturn; it’s the direct result of bad lawyering. Los Angeles-based Sheppard, Mullin, Richter & Hampton, the firm that represented him in the transaction, drafted a contract full of “loopholes” and “traps,” that allowed the buyer to renege on paying him, contends Clarey. In January he filed a $70 million legal malpractice lawsuit against Sheppard Mullin and four of its attorneys. The big numbers attached to the suit and the marquee firm in the defendant’s spot immediately turned heads. And the nature of the suit raised speculation that an entire generation of lost millionaires might start pointing their fingers at the lawyers. It wouldn’t be the first time. Historically, when deals go sour people have sought to call outside professionals, like lawyers and accountants, to the carpet, says legal malpractice attorney Guy Calladine. “They’re usually involved in the transactions, and there’s the perception of deep pockets.” But according to Calladine and other malpractice experts, there’s yet to be a surge of Internet-related legal malpractice suits. MP3.com’s $175 million malpractice suit against Cooley Godward, also filed in January, is the only other notable case currently on the dockets. In the Cooley case, the issue is whether the firm gave adequate advice as MP3.com proceeded with its controversial business plan. The corporate transaction issues in the Sheppard Mullin case, however, are far more common, making it a more likely blueprint for what could lie ahead. Attorneys at Sheppard Mullin would not comment for this story other than to provide a prepared statement. “Mr. Clarey made his own informed business decisions and the evidence will show we did nothing wrong. We are confident we will prevail on the merits.” Indeed, some malpractice attorneys note that the fact that Clarey’s contract had loopholes in it is merely standard operating procedure in mergers and acquisitions. “All contracts are full of loopholes that are negotiated,” says Rogers, Joseph, O’Donnell & Phillips’ Pamela Phillips, who represents lawyers in legal malpractice cases. “If the buyer is buying a company that’s new and unproven, of course it’s going to put loopholes in. The sellers are charged with reading the agreement.” As a businessman, however, Clarey claims he was blind to the legal intricacies of the deal. That’s the reason he hired Sheppard Mullin. A former construction company owner, Clarey founded TeleCore with his wife Christy in 1996. Over the next several years the high-speed Internet access company grew from a small mom-and-pop shop to a market leader with more than 500 employees in 44 cities. In 2000, Clarey was approached by a Florida-based company called Viasource Communications Inc., and within a few months a letter of understanding for TeleCore’s acquisition was drafted and signed. Clarey, as the majority stockowner, would walk away with $67 million, 25 percent of it in cash and 75 percent in Viasource stock. Additionally, Clarey agreed to a non-compete agreement that basically kept him out of the broadband integration industry for the next three years. “I felt it was a fair deal,” says Clarey. “It left upside for all sides.” While lawyers from San Francisco-based Brobeck, Phleger & Harrison represented TeleCore, Clarey retained Sheppard Mullin to represent his personal interests as the original letter of understanding was transformed into a final, legal contract. And that, Clarey says, is when the trouble started. As is typical in these types of transactions, Clarey’s $50 million in Viasource stock was subject to a lock-up period during which it could not be sold. But while Clarey believed, and he claims Sheppard Mullin assured him, the lock-up period expired within seven months, it turned out that the stock could not be sold for an entire year. By that time, says the suit, “the stock declined dramatically in price.” Viasource’s stock dropped by 66 percent between February and June 2001. In another few months, Viasource filed for Chapter 11 bankruptcy protection and its stock was ultimately delisted from the Nasdaq. Meanwhile, Clarey had another $17 million in notes coming to him. But here, too, the devil was in the details. “About a few days after the IPO, I called [Viasource] to ask who I should send my wiring instructions to,” recalls Clarey. “They said ‘Oh, you didn’t know?’ “ A technicality in the final contract meant that instead of being paid the $17 million right after Viasource’s August 2000 IPO, Clarey would have to wait for the money until Nov. 30, 2001. More important was another provision in the contract stipulating that Clarey could only get paid after General Electric Capital Corp., Viasource’s senior lender and also a Sheppard Mullin client, was repaid its loans. These loans were not due until 2004. And since Viasource could continuously extend this credit facility to GE Capital, the company could perpetually delay paying Clarey. In all, Clarey received about $1 million of the $67 million he expected. Sheppard Mullin did not represent GE Capital in any Viasource matters, and disclosed its conflict to Clarey early on. In fact, Clarey even signed a waiver affirming that he was OK with the Sheppard Mullin-GE Capital relationship. Nonetheless, Clarey believes Sheppard structured a deal to benefit a longtime, big-ticket client like GE Capital over his own small-fry interests. “I knew that GE Capital was their [Viasource's] lender for the bank line,” says Clarey. “Did they tell me that they never had to pay my notes because GE Capital was their lender? No.” But the fact that a senior lender like GE Capital would have first dibs on payments doesn’t strike some attorneys as that out of the ordinary. The whole point of being a senior lender, says Gray Cary Ware & Freidenrich’s Diane Holt Frankle, is that you get paid first. While every deal is negotiated differently, some general principles are fairly standard. If the deal terms in Clarey’s case are as commonplace as they appear, then there could be a large number of entrepreneurs harboring similar grievances. “Looking at those allegations in the abstract, they certainly didn’t seem to be the types of thing that might not arise again in another suit,” says Carlson, Calladine & Peterson’s Guy Calladine. A large settlement or court victory could be the catalyst that sparks more such suits. But Clarey is more concerned about recouping his own lost treasure than on setting any precedent. The bottom line, he says, is that his lawyers let him down. “The agreement was a bunch of loopholes that allowed them to get my company and not pay me.”

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