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When a bankruptcy lawyer embezzles funds from an estate, the 3rd U.S. Circuit Court of Appeals has ruled that statutes of limitations should not be strictly enforced since the trust placed in the lawyer may have prevented the debtor and trustee from discovering the theft. In its 25-page opinion in In Re: Mushroom Transportation Co., a unanimous three-judge panel revived legal malpractice and breach of fiduciary duty claims against now-disbarred attorney Jonathan Ganz and his former, now-dissolved firm, Pincus Verlin Hahn & Reich. Ganz pleaded guilty to charges that he used his position as a bankruptcy attorney for trustees of bankrupt businesses to skim more than $2.6 million funds from the companies’ estates. He was sentenced in 1995 to two years in prison. But when one of Ganz’s victims, Mushroom Transportation Co., filed an adversary proceeding against his firm and its individual partners, U.S. Bankruptcy Judge Bruce Fox found that the statute of limitations had run on all the claims. MTC’s claims failed, Fox found, because it could not show that it had acted with reasonable diligence in ferreting out the embezzlement. Fox’s ruling was later upheld by U.S. District Judge Eduardo C. Robreno. Now the 3rd Circuit has ruled that the lower courts were too quick to reject the debtor’s claim that the statutes of limitations should have been tolled since there was evidence that Ganz took steps to hide his thefts. “We believe that the decisions below establish a policy that fosters lawyers’ abuse of their fiduciary relationships with their clients, and fail adequately to protect the justifiable reliance of clients on their lawyers’ probity and trustworthiness,” 3rd Circuit Judge Michael Fisher wrote. Because a bankruptcy debtor’s lawyer is in a fiduciary relationship and enjoys a position of trust, Fisher said, the delay in uncovering an embezzling lawyer’s misconduct may be excusable. And since there remain factual disputes on that point, Fisher said, MTC is entitled to a jury trial on that question. “The existence of a fiduciary relationship is relevant to a discovery rule analysis precisely because it entails such a presumptive level of trust in the fiduciary by the principal that it may take a ‘smoking gun’ to excite searching inquiry on the principal’s part into its fiduciary’s behavior,” Fisher wrote in an opinion joined by 3rd Circuit Chief Judge Anthony J. Scirica and visiting Senior Judge Arthur L. Alarcon of the 9th Circuit. According to court papers, MTC and its related subsidiaries filed a Chapter 11 bankruptcy petition in June 1985. MTC became the debtor-in-possession and remained so until December 1990, when the bankruptcy was converted to a Chapter 7 liquidation proceeding. Ganz was hired as the debtor’s lawyer and, within six months of the filing of the Chapter 11 petitions, MTC ceased operations and began to liquidate assets. In February 1986, the bankruptcy court appointed Michael C. Arnold, MTC’s executive vice president, as “special liquidation consultant” to assist in the liquidation. MTC allocated a large percentage of the liquidation proceeds to satisfying a substantial debt owed to Continental Bank, a secured creditor. The bankruptcy court later authorized Ganz to open an escrow account to hold the balance of proceeds generated from the sale of MTC’s assets not yet paid to Continental. Between August 1987 and April 1988, Ganz embezzled more than $500,000 from the escrow account, the 3rd Circuit said. Although Arnold contacted Ganz and inquired about the funds, he says he was satisfied by Ganz’s assurances that the funds had been invested in CDs. But in February 1992, the U.S. Trustee informed Arnold that Ganz had embezzled funds from several bankruptcy estates. Shortly thereafter, Arnold, who by that time had been appointed trustee following the conversion to Chapter 7, filed an adversary suit against Ganz, his firm and its individual partners alleging claims of conversion, breach of fiduciary duty, breach of contract and legal malpractice. But defense lawyers argued that all of the claims were time-barred because MTC had failed to exercise reasonable diligence in ferreting out Ganz’s embezzlement. In bankruptcy court, Fox agreed, finding that MTC was not entitled to any “equitable tolling” of the statutes of limitations. On appeal to the district court, Robreno agreed, finding that while MTC had the right to delegate some duties to Ganz, it had no right under the Bankruptcy Code to “abdicate” its own duties. “In this case,” Robreno wrote, “the debtors not only ‘delegated’ to Ganz the duty to collect the funds generated from the sale of assets, deposit them into the escrow account … and transfer the funds to the law firm account … but rather they surrendered totally their obligation to oversee the liquidation of the estate or to supervise, even in the most relaxed fashion, the activities of a retained professional.” Because MTC had abdicated its statutory duty to preserve the estate’s assets, Robreno said, it could not possibly demonstrate reasonable diligence for purposes of the discovery rule. Now the 3rd Circuit has ruled that a jury must decide the factual issue of whether MTC’s executives exercised “reasonable diligence.” Fisher found that in another case that also involved Ganz’s embezzlement, Senior U.S. District Judge Lowell A. Reed Jr. had refused to dismiss claims as time-barred. Reed found that since “reliance on counsel is inherent in the bankruptcy code,” the bankruptcy court invaded the province of the jury by depreciating the evidence that Ganz’s client had trusted him and therefore “failed to discover the thefts by Ganz until a later date.” Fisher found the same was true in MTC’s case. A jury, Fisher said, could conclude that “Arnold’s efforts went beyond abdication of the debtor’s duty to preserve the estate’s assets and in fact constituted reasonable diligence for purposes of the discovery rule.” Under the bankruptcy court’s orders, Fisher noted, Ganz was given “nearly exclusive control” over MTC’s assets, and there was no mechanism by which the court could monitor use of those funds. As a result, Fisher said, a jury could conclude that MTC’s decision “to entrust its lawyer, Ganz, with the task of safeguarding its assets was within the bounds of reasonableness.” Fisher found it was “highly relevant” that the suit stemmed from Ganz’s abuse of his fiduciary, lawyer-client relationship. “Where the wrongdoing underlying causes of action has been perpetrated by a fiduciary to the detriment of its principal, this fact militates strongly against summary judgment on the issue of whether the principal … exercised reasonable diligence in failing to discover the fiduciary’s malfeasance within the applicable statutes of limitations,” Fisher wrote.

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