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Pepper Hamilton and one of its prominent tax partners, W. Robert Gagne,have been hit with a potentially massive legal malpractice suit broughtby a bankruptcy trustee who claims the firm ignored blatant conflicts ofinterest when it allowed Gagne family members and trusts to investheavily in an ailing company in order to hide its deterioratingfinancial condition from its creditors. The suit, filed in U.S. Bankruptcy Court in Delaware, stems from thedemise of Student Finance Corp., and alleges that Pepper Hamilton’ssimultaneous representation of SFC and its affiliates, as well as itsinsurer and the Gagne family members as investors created a situation inwhich Pepper Hamilton had “unavoidable and inevitable dividedloyalties.” Pepper Hamilton’s conduct “foreseeably contributed to the financialdemise of SFC” and caused “hundreds of millions of dollars of harm,” thesuit alleges. The complaint in Stanziale v. Pepper Hamilton was filed by attorneysPeter C. Hughes and Dawn Zubrick of Dilworth Paxson’s Wilmington, Del.,office along with attorneys James J. Rodgers and Derrick A. Dyer ofDilworth Paxson’s Philadelphia office. In addition to Pepper Hamilton and Gagne, the suit names as defendantsGagne’s wife, Pamela Bashore Gagne; his uncle, Robert L. Bast; and sevenGagne family trusts. Pepper Hamilton’s executive partner, Robert E. Heideck, said Mondaythat the suit has “no merit.” In an interview, Heideck said the alleged conflicts of interest were allproperly addressed with letters that waived any conflict, and that thelawsuit’s allegation that the conflicts were “unwaivable” is simplywrong. Heideck also said Pepper Hamilton bears no responsibility for SFC’sdemise and that it withdrew from its representation of SFC soon afterthe alleged financial improprieties came to light. “When we learned that everything was not as it had been represented bySFC, Pepper insisted that SFC make immediate disclosure and takeimmediate internal corrective actions. When SFC did not take all of theactions that it had agreed to undertake, we immediately resigned fromany further representation of SFC,” Heideck said. “Far from concealing any wrongdoing at SFC, Pepper insisted on promptdisclosure and correction,” Heideck said. Heideck also noted that the suit was just one of nearly 70 lawsuitsfiled last week by SFC’s Chapter 7 trustee in an effort to maximize thedefunct company’s estate. Although Heideck said Pepper Hamilton “takes the case seriously,” healso said the firm is “confident” that it will ultimately be cleared ofany wrongdoing. Heideck said Pepper Hamilton will be represented in the case byElizabeth K. Ainslie of Schnader Harrison Segal & Lewis. The potential magnitude of the suit may be gleaned from another federalsuit in Delaware in which U.S. District Judge Joseph J. Farnan Jr. hasawarded nearly $400 million to a trio of banks in their disputes withRoyal Indemnity Co., the American subsidiary of the London-basedinsurance giant Royal & SunAlliance, over its refusal to cover SFC’sdefaulted student loans. Farnan rejected Royal Indemnity’s claim that it was entitled to denycoverage on the grounds that SFC’s policies were procured through fraud.In a series of orders, Farnan awarded nearly $270 million to WellsFargo; more than $110.4 million to PNC Bank; and more than $12.9 millionto Wilmington Trust. In a separate suit pending in U.S. District Court in Tennessee, Royalhas accused SFC, of Newark, Del., and the Commercial Driver InstituteInc., a Nashville-based chain of truck-driving schools, of operating a”loan mill” that churned unqualified students through trucking schools.The Tennessee suit says the loans defaulted “at an astonishing rate ofover 80 percent,” a statistic that Royal claims was masked by SFC whenit obtained credit-risk insurance from Royal. Now, in the suit against Pepper Hamilton, SFC’s trustee claims Gagne andhis family played key roles in hiding SFC’s financial woes from itsbankers and insurer. The suit alleges that Pepper Hamilton’s representation of SFC, Royal andthe Gagne family members and trusts “implicated multi-layered conflictsof interest.” Gagne, the suit alleges, “elevated personal and familial interests abovethat of SFC and its creditors.” Over a six-year period, the suit says, SFC paid Pepper Hamiltonapproximately $3.2 million in legal fees. In the opening paragraphs of the 63-page suit, the Dilworth Paxsonlawyers outlined Pepper Hamilton’s alleged mishandling of SFC. “No lawyer or law firm acting reasonably, with the requisite care and inthe best interests of its multiple clients, would have represented SFCat the same time that the lawyer’s family was loaning millions ofdollars of personal wealth to SFC,” the suit alleges. “No lawyer or law firm acting with the requisite care would have enableda client to continue to incur debt with the obvious — and ultimate –consequence of not being able to satisfy its financial obligations tothe material detriment of the client’s creditors and investors,” thesuit says. “No lawyer or law firm acting reasonably and with the requisite carewould have facilitated a bail-out of a partner’s family’s investment bySFC’s principal immediately prior to bankruptcy, when it knew or shouldhave known that less assets would be available for recovery by othercreditors of SFC in bankruptcy,” the suit says. Pepper Hamilton’s withdrawal from its representation of SFC came justsix weeks before SFC’s bankruptcy, the suit says, and “only after itsactions caused and contributed to SFC’s insolvency and it became clearthat Gagne and his family would no longer benefit from their investmentwith SFC and that SFC would no longer be able to pay Pepper’s fees.” The suit says Gagne’s uncle, Bast, and SFC’s founder, Andrew N. Yao,”have had a relationship spanning approximately 20 years.” Gagne, a former partner of the now-defunct Clark Ladner Fortenbaugh &Young, joined Pepper Hamilton in 1996. From that time until April 2002, the suit says, Gagne and PepperHamilton “acted in the capacity of SFC’s general counsel.” More than 100 Pepper Hamilton partners, associates, legal assistants andother employees “worked on a host of SFC-related matters,” the suitsays, and “the comprehensive nature of these services and Pepper’sinvolvement … establish and confirm Pepper’s position as an insider ofSFC.” The suit says SFC experienced “rapid expansion,” but “failed toimplement adequate controls” to ensure the quality of its student loanaccounts. As a result, the suit says, SFC originated or acquired numerous studentloans that eventually went into default. The suit says SFC then set out to hide its high default rate.”To avoid classifying student loans as in ‘default,’ SFC made paymentsfrom reserve accounts and from its own funds on behalf of the studentloan accounts and treated such payments as though they had been made bythe student borrowers themselves,” the suit says. “SFC characterized these payments, made on behalf of the borrowers, as’forbearance payments.’ Through employment of forbearance payments,default rates on the student loans appeared to be very low, but, infact, were very high,” the suit alleges. In 1999, the suit says, SFC made about $2 million in forbearancepayments. By 2000, the suit says, that amount had multiplied almostfive-fold, to nearly $9.5 million. And in the year leading up to the filing of the bankruptcy, SFC madeforbearance payments of more than $45 million, the suit says. The suit says Pepper Hamilton “was aware of SFC’s practice of utilizing’reserves’ and forbearance payments to manipulate reported student loanaccount default rates, or, at the very least, should have been aware ofthis practice.” The suit outlines a series of loans from Gagne family members and truststo SFC, including a loan of more than $21.9 million from Bast, a loan ofmore than $5.7 million from Pamela Gagne and at least $7 million inloans from the family trusts. Gagne was clearly aware that the loans created a conflict of interest,the suit alleges. In August 1998 and against March 2002, the suit says, Gagne “issuedpurported conflict waiver letters for Yao to sign on behalf of SFC,stating that the [Gagne] family had loaned substantial additional fundsto SFC and referencing Gagne’s alleged prior admonitions to Yao aboutthe need for separate counsel due to the ‘inherent conflicts ofinterest.’” The suit alleges that, “despite having ‘admonished’ Yao in purportedconflict waiver letters that SFC should retain independent counsel basedon Pepper’s ‘inherent’ conflict between SFC and Gagne’s family’sinterests, Pepper continued to represent SFC at the same time the familyhad substantial loans outstanding to SFC.” The suit accuses Gagne and Pepper Hamilton of breach of their fiduciaryduty to SFC, alleging that “due to its concern for the family’sinterests, including its desire to enable the family to continue to reaphigh interest payments, to recoup its principal on investments and toprotect the family from being implicated in the financial downfall ofSFC, Pepper Hamilton continued to promote the business of SFC and tocreate the impression of its viability by … concealing material loanperformance information and SFC’s making of forbearance payments.” And in another clear conflict, the suit alleges, Pepper Hamilton “notonly represented SFC in its financing, refinancing, insurance andsecuritization transactions, but also represented Royal during the sametime frame Pepper was involved in SFC/Royal matters, including whenRoyal’s interest had become adverse to SFC.”

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