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The proverbial “other shoe” dropped last week for Pepper Hamilton when the firm was hit with the second in a pair of potentially massive legal malpractice suits over its representation of Student Finance Corp., which crashed amid allegations of widespread fraud. In the new lawsuit, filed in U.S. District Court for Delaware, Royal Indemnity Co., SFC’s business liability insurer, claims that Pepper Hamilton became an “insider” with the loan company and helped to “ensure the success” of an alleged corporate practice to disguise nonperforming loans. Pepper Hamilton’s executive partner, Robert E. Heideck, said Monday the action was without merit. Heideck has said that the law firm bore no responsibility for its client’s financial demise and insisted on prompt disclosure of wrongdoing at SFC. Heideck also said Monday that the second lawsuit is largely a repetition of claims earlier made in the U.S. Bankruptcy Court for Delaware by SFC’s bankruptcy trustee, and that he expects Pepper Hamilton to be cleared of liability in both matters. The lawsuits stem from the alleged business practices of SFC, which the trustee and Royal Indemnity say acted as a “loan mill” and systematically covered up the fact that many of its student loans for trucking schools were in default. SFC accomplished this, the lawsuits allege, by routinely making the initial payments itself when a student defaulted, thereby creating the false appearance of a sizeable portfolio of “performing” loans. SFC allegedly called the practice “forbearance payments,” but, in its complaint, Royal Indemnity characterized them as “ghost payments.” The false appearance allegedly created by the payments, the suits say, helped SFC to secure hundreds of millions in additional financing from banks, as well as insurance on those loans. When the alleged scheme unraveled and SFC collapsed, its demise sparked several rounds of litigation. In the first round, the banks battled with the insurer, Royal Indemnity, and the banks emerged victorious. U.S. District Judge Joseph J. Farnan Jr. of the District of Delaware awarded nearly $400 million to a trio of banks in their disputes with Royal Indemnity, the American subsidiary of the London-based insurance giant Royal & SunAlliance, over its refusal to cover SFC’s defaulted student loans. Farnan rejected Royal Indemnity’s claim that it was entitled to deny coverage on the grounds that SFC’s policies were procured through fraud. In a series of orders, Farnan awarded nearly $270 million to Wells Fargo; more than $110.4 million to PNC Bank; and more than $12.9 million to Wilmington Trust. In recent months, the focus has shifted to the lawyers and accountants. In the first suit, SFC’s bankruptcy trustee alleged that Pepper Hamilton and one of its prominent tax partners, W. Robert Gagne, ignored blatant conflicts of interest when it allowed Gagne family members and trusts to invest heavily in SFC in order to hide its deteriorating financial condition from its creditors. In the suit, filed in U.S. Bankruptcy Court in Delaware, the trustee alleged that Pepper Hamilton’s simultaneous representation of SFC and its affiliates, as well as its insurer, Royal Indemnity, and the Gagne family members as investors, created a situation in which the law firm had “unavoidable and inevitable divided loyalties.” Pepper Hamilton’s conduct, the suit alleges, “foreseeably contributed to the financial demise of SFC” and caused “hundreds of millions of dollars of harm.” Now, in a second and very similar suit, Royal Indemnity is also lodging professional malpractice claims against Pepper Hamilton and Gagne, as well as two accounting firms, Freed Maxick & Battaglia and McGladrey & Pullen. The suit alleges that the lawyers and accountants garnered millions in fees from SFC and were effective “SFC insiders” who “had every incentive to ensure the success of SFC’s fraud.” The suit alleges that the term “forbearance payment” is a misleading term that SFC used to hide the fact that it was making “ghost payments.” Royal Indemnity claims that it was kept in the dark about SFC’s practice of making ghost payments on defaulted loans because SFC had to report to Royal Indemnity whenever a loan was more than 90 days overdue. By making the ghost payments, the suit says, SFC created the false appearance of a portfolio of loans that had a default rate of just 20 percent. The suit also alleges that the lawyers and accountants were aware of the practice and participated in hiding it from Royal Indemnity. “No one, including SFC or the [lawyer and accountant] defendants disclosed to Royal that SFC was making ghost payments or that ghost payments were preventing massive amounts of otherwise-defaulting loans from being reported as defaults,” the suit says. The suit says Pepper Hamilton knew that the ghost payments were helping SFC to manipulate its financial figures, and that the accountants knew that the practice distorted the true picture of SFC’s default rate. Heideck, Pepper Hamilton’s executive partner, said Monday that both suits have “no merit.” In an interview soon after the first suit was filed, Heideck said the alleged conflicts of interest were all properly addressed with letters that waived any conflict, and that the lawsuit’s allegation that the conflicts were “unwaivable” is simply wrong. Heideck also said at the time that Pepper Hamilton bears no responsibility for SFC’s demise, and that it withdrew from its representation of SFC soon after the alleged financial improprieties came to light. “When we learned that everything was not as it had been represented by SFC, Pepper Hamilton insisted that SFC make immediate disclosure and take immediate internal corrective actions. When SFC did not take all of the actions that it had agreed to undertake, we immediately resigned from any further representation of SFC,” Heideck said. “Far from concealing any wrongdoing at SFC, Pepper Hamilton insisted on prompt disclosure and correction,” Heideck said. In an interview Monday, Heideck said Royal’s suit makes the same allegations as the trustee’s suit and that Pepper Hamilton expects to be cleared of any liability in both cases. SFC’s trustee claims Gagne and his family played key roles in hiding SFC’s financial woes from its bankers and insurer. The suit alleges that Pepper Hamilton’s representation of SFC, Royal and the Gagne family members and trusts “implicated multi-layered conflicts of interest.” Gagne, the suit alleges, “elevated personal and familial interests above that of SFC and its creditors.” Over a six-year period, the suit says, SFC paid Pepper Hamilton approximately $3.2 million in legal fees. “No lawyer or law firm acting reasonably, with the requisite care and in the best interests of its multiple clients, would have represented SFC at the same time that the lawyer’s family was loaning millions of dollars of personal wealth to SFC,” the suit alleges. Pepper Hamilton’s withdrawal from its representation of SFC came just six weeks before SFC’s bankruptcy, the suit says, and “only after its actions caused and contributed to SFC’s insolvency and it became clear that Gagne and his family would no longer benefit from their investment with SFC and that SFC would no longer be able to pay Pepper’s fees.” 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 Pepper Hamilton “acted in the capacity of SFC’s general counsel.” More than 100 Pepper Hamilton partners, associates, legal assistants and other employees “worked on a host of SFC-related matters,” the suit says, and “the comprehensive nature of these services and Pepper’s involvement … establish and confirm Pepper’s position as an insider of SFC.” Royal’s suit alleges that the scheme to hide SFC’s default rate led the insurer to write a series of huge policies — ranging from $5.5 million to $100 million — to cover SFC’s student loans. The suit says Pepper Hamilton participated in drafting the applications for those policies and failed to disclose SFC’s practice of making ghost payments despite being aware of it. Royal claims it was “shocked” when SFC disclosed for the first time in 2002 that it had made $50 million in forbearance payments over the past year. The suit says documents from Pepper Hamilton show that Gagne was aware of the practice two years before that disclosure. The documents, the suit says, show that “Pepper and Gagne knew about the deceptive nature of SFC’s ghost payments, and the domino effect such payments have on the participants in the program, including, especially, Royal.” Royal is represented in the suit by attorneys Lawrence C. Ashby, Philip Trainer Jr. and Tiffany Geyer Lydon of Ashby & Geddes in Wilmington, Del., along with Michael H. Barr, Kenneth J. Pfaehler, Alan S. Gilbert and John Grossbart of Sonnenschein Nath & Rosenthal in New York. Gilbert and Grossbart are with the firm’s Chicago office.

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