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Even before an arbitration panel decides if venture capital firm Interfase Capital Partners of Austin, Texas, mismanaged funds entrusted to it by investors, Interfase Capital is hedging its bets by suing its lawyers. The malpractice suit filed against Houston-based Baker Botts in October, which seeks reimbursement for potential damages in the underlying litigation, could signal a new wave of litigation stemming from the rampant failure of dot-coms since the technology market went bust in the spring of 2000. “There is a belief there will be more litigation in the venture world between VCs and portfolio companies and VCs and angel investors,” says S. Michael Dunn, a partner in Palo Alto, Calif.-based Gray Cary Ware & Friedenrich in Austin. “These things happen when the economy contracts, but I personally am not aware of a flurry of suits,” says Dunn, whose practice is helping VCs and their clients do deals. Two lawyers in Texas who do malpractice litigation also say they haven’t heard of similar litigation against other firms. But Larry Doherty of Houston and James McCormack of Austin say they won’t be surprised if more Texas firms get drawn into finger-pointing disputes involving unsatisfactory dot-com investments. “Lawyers sometimes do create problems for themselves in that they stray out of their role of providing legal advice into providing business advice,” says McCormack, a partner in Austin’s Tomblin, Carnes, McCormack. “If the client misinterprets that as legal advice, it could give undue weight to a lawyer’s mutterings or unsolicited advice about business matters. In that case, the lawyers may have created some liability.” Interfase Capital, which started in 1999, was known as a “vulture fund” for its investments in struggling dot-coms. But its investments in troubled companies such as drkoop.com, Chipshot.com and Mall.com didn’t do well. In 2001, a number of disgruntled investors filed two suits against Interfase Capital and related entities and individuals, seeking millions in damages from the funds and individuals who ran them or sought investors for them. The allegations include securities fraud, breach of fiduciary duty, mismanagement and unauthorized use of money. An arbitration in Steve Wilson, et al. v. R. Steven Hicks, et al. is set for May 2003. But with the arbitration looming, Interfase Capital and four related investment funds and a number of individuals involved with the funds aren’t waiting around to find out if an arbitration panel will order them to pay damages to unhappy investors. The suit filed against Baker Botts in state court in Austin by Austin firms Knisely & Prehoditch and Spivey & Ainsworth alleges the firm engaged in professional negligence and malpractice, negligent misrepresentation and breach of fiduciary duty in connection with work for the venture capital entities and individuals. It doesn’t name individual lawyers. Plaintiffs’ lawyer Paul Knisely, a partner in Knisely & Prehoditch, says the suit was filed more than a year after investors sued Interfase Capital to avoid statute of limitations problems. Knisely says his clients are suing their lawyers because his clients believe they did nothing wrong and maintain that the investors who are suing them have no legitimate claims against them. “To the extent that our clients, the managers of those investment funds, have been accused of making unauthorized investments and/or statutory fraud- [and] securities-law violations, much of those allegations turns on the drafting of the original partnership documents and related documents, private placement documents,” he says. He alleges any liability belongs to the lawyers, who documented not only the original partnership transactions, but also some of the investment transactions. “It’s the legal advice and the documentation of the transactions … there’s no claim that they gave business advice or gave investment advice,” Knisely says in describing the allegations against Baker Botts. Baker Botts did nothing wrong, says Joseph Knight, a litigation partner in the firm’s Austin office. He says the allegations in Interfase Capital, et al. v. Baker Botts make no specific claims against the firm. “There really aren’t any allegations in it. Our response is we are quite confident we did not do anything wrong, and the lawsuit really doesn’t accuse us of doing anything wrong,” Knight says. He alleges the suit appears to be an attempt by the plaintiffs to blame their lawyers if they come out on the wrong side of the arbitration. He says the firm did not give business advice to the venture capital fund. “We played a pretty limited role in performing certain discrete legal functions that they asked us to do. We weren’t their GC,” Knight says. The firm’s defense lawyer in the suit is Stephen McConnico, a partner in Austin’s Scott, Douglass & McConnico; he did not return a telephone call seeking comment before press time on Nov. 27. Doherty, a Houston lawyer who files malpractice suits against attorneys, says the suit the Interfase Capital entities filed against Baker Botts may be a hard sell simply because lawyers aren’t in the business of giving investment advice to institutions. “It sounds to me that one [underlying] suit is for investment advice and the investors are saying, ‘No. We were just a conduit for lawyers to give investment advice,’ ” says Doherty, a partner in Doherty Long Wagner. But he points out that the role of the Baker Botts lawyers could make it easier for the plaintiffs’ lawyers to collect damages from the firm. For instance, he says, if the Baker Botts lawyers assisted the VC in rounding up investors from the firm’s client pool, then it would be easier to prove the Baker Botts lawyers should be liable for damages against Interfase Capital. “I guess one of the questions would be how long has Baker Botts been representing this venture capital company,” says Doherty. But Doherty says he’s not surprised that firms are being drawn into the morass of litigation that’s developing out of the downfall of e-commerce companies and other dot-coms. Firms should be concerned about it, he says. “The sad aspect of it is they weren’t concerned about it when times were good,” he says. Austin’s McCormack, a former general counsel of the State Bar of Texas who gives advice to firms on ethics, agrees with Doherty that the role of Baker Botts is the key to the claims alleged by Interfase Capital. “Merely doing the paperwork that the VC wanted to do isn’t negligent in itself. If those were poor investments, the law firm would have to have had some direct role in influencing the VC,” McCormack says. “You have to see how tight the linkage is between the so-called legal advice and the actual judgments that the company made. It may be that the lawyers influenced the client in an improper way. It may be the company made poor investment decisions and is simply looking for another deep pocket to cover its own financial losses,” McCormack says. Doherty also points out that Interfase Capital, or any other VC that sues its lawyers, could be waiving privilege. “The privilege belongs to the client, and once you sue the lawyers, it’s waived,” he says. “Is Baker Botts going to want to maintain the confidence? They don’t have to, they could still if they wanted to.” ‘MONEY IS MONEY’ In the suit against Baker Botts, the plaintiffs allege the firm began in the fall of 1999 to represent various Interfase Capital limited partnerships and entities, along with partners and managers at the entities, and failed to disclose that the plaintiffs were doing anything unauthorized, improper or questionable in connection with the investment partnerships and funds, or risking it. The suit alleges Baker Botts was responsible for creating the structures of the Interfase entities and their venture capital funds, for preparing the limited partnership agreements and related documents, and for ensuring compliance. The plaintiffs allege that if the underlying litigation is successful, Baker Botts is wholly or partly to blame for its acts and omissions in representing the plaintiffs in the matters that are the basis of the arbitration claims. They seek unspecified damages. Knisely is working on the litigation along with his partner, Tom Prehoditch, and former partner Broadus Spivey, of Spivey & Ainsworth. The team has had success in suing lawyers, most prominently in 1994 when they won a $21.7 million verdict in state court in Houston in Moran, et al. v. Vinson & Elkins. In that suit, heirs of Houston oilman William T. Moran alleged that V&E did not disclose serious conflicts of interest when representing Moran’s estate. Houston-based V&E and the plaintiffs agreed to a confidential settlement in 1998 after years of appeals. In the underlying litigation against Interfase Capital that’s heading to arbitration, a group of investors in one or more Interfase Capital investment funds alleges the Interfase entities and managers and promoters of them violated the Texas Securities Act, engaged in common law fraud, statutory fraud in stock transactions and conspiracy to commit fraud. They allege the defendants misrepresented where the money would be invested and also exaggerated the size of some of the funds, which made each individual investment riskier. The investors allege, for example, that defendant R. Steven Hicks of Capstar Partners, and others caused the funds to loan money to Mall.com at a time when they knew or should have known the loans were unsecured. “By February 2001, the Funds had loaned over $5,000,000 to Mall.com — loans which Defendants (who approved and encouraged the loans) knew or should have known would never be paid back,” the investor-plaintiffs allege in Steve Wilson, et al. v. Jon Rex Jones Jr. A defense attorney for Hicks, David Bickham, a partner in V&E in Austin, was out of the office on Nov. 27 and did not return a telephone call seeking comment before presstime. Neither did a defense lawyer for Interfase, Kevin Lee, a partner in Thompson, Coe, Cousins & Irons in Austin. Interfase Capital’s telephone number in Austin has been disconnected, and its Web site is down. The two underlying suits, both filed by R. James George Jr., a partner in Austin’s George & Donaldson, have been consolidated for the arbitration. George says the binding arbitration is confidential, and he cannot say exactly how much his clients are seeking from the arbitration panel. But in the pleadings filed in state court in Austin, the investors seek a minimum of $7.5 million in actual damages plus unspecified punitive damages. The suits also detail other loans to other companies, including Wild Brain Inc., a video company in San Francisco, and dot-coms drkoop.com and chipshot.com and Urban Box Office Network, an Internet media company that received a $3 million loan from an Interfase entity, but later sued it for $20 million. According to George, Chipshot.com and Mall.com are now defunct. A health Web site operated by drkoop.com is still operating. The investors allege they lost millions in the Interfase Capital investment funds and seek to have it returned, along with punitive damages and attorney fees. They allege they weren’t kept informed. “Despite Defendants’ promise to account and report on each Fund, once their money was invested, Plaintiffs learned nothing about the value of their investment or the activities of the Funds. Defendants sent out no audits, no tax returns, no individual tax statements,” George alleges in Steve Wilson, et al. v. Jon Rex Jones Jr. “Basically, this is taking money they said they were going to use for one thing, but used it for someone else,” George alleges. George says the suits are going to arbitration because of the terms of the contracts between his clients and the limited investment partnerships. George alleges it seems clear, with the litigation against Baker Botts, that the Interfase Capital entities and individuals are attempting to blame their lawyers for their business problems. He says, “Money is money. I don’t care who pays.”

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