(Explanatory Update: Ben Edwards is a rising 2L at Columbia Law School who claimed that he was going to start posting last December. Serves him right that he decided to post for the first time on a day when everyone wants to talk about something else.)
Moral hazards emerge when individual behavior changes because of perverse alignment of incentives. For example, without fire insurance, homeowners have every incentive in the world to protect their home against fire; however, with insurance, normal citizens become arsonists and torch their own homes. These same concerns emerge in the context of legal malpractice litigation when attorneys later sue co-counsel for malpractice in relation to their lapse in exercising the fiduciary duties owed to a common client.
The recent notable case of EarthLink v. Powell Goldstein provides a scenario where moral hazards have emerged. In February of 2000, EarthLink merged with MindSpring, another Internet service provider. Prior to the merger, Powell advised MindSpring on its 401(k) plan. After the merger, the new company decided to allow all of its employees to purchase company stock.
Unfortunately, EarthLink never filed a registration statement with the SEC on time and incurred $1 million dollars in costs as a result. During the hectic merger and reorganization period, EarthLink retained counsel from not only Powell but also Hogan & Hartson, Hunton & Williams, and other consultants and advisors. In the fallout, EarthLink retained Hunton as counsel and sued Powell for malpractice, blaming them for the $1 million in costs.
The first moral hazard emerges from the dereliction of duty in filing the form on time with the SEC. Hunton also represented EarthLink during the reorganization period and likely knew that it was the preferred counsel of EarthLink. In the event of an omission or error by one of the other firms, Hunton was poised to gain from the litigation. Perversely, Hunton, if discovering an oversight by another firm, would stand to gain most by not rectifying the mistake. Even if Hunton never actively overlooked a mistake on the part of co-counsel, they still had incentive to reduce their vigilance in the area. The moral hazard here is that a party with a professional duty prevent or limit the effects of malpractice is positioned to benefit most from its being committed. Because Hunton stands to gain from malpractice litigation against a competitor, there is a perverse incentive to allow errors to occur.
Another moral hazard also emerges from the facts of EarthLink v. Powell Goldstein. Because Hunton served as counsel concurrently with Powell, Hunton may be liable for mistakes transpiring on its watch. Unsurprisingly, a court judgment against Powell forces Powell to prove collusion by Hunton to recover rather than just proving negligence. Another perverse incentive emerges because Hunton now has cause to forgo settlement or push for terms limiting its liability while negotiating on EarthLink’s behalf. Even small shifts in calculations evaluating a settlement offer based on the impact on firm liability is completely impermissible.
The moral hazards that pervade the malpractice litigation field only magnify when compounded with conflict of interest concerns. Judges ought require only the introduction of facts allowing the inference that counsel could be unduly influenced by personal interest in a malpractice claim before disqualifying counsel. While no evidence exists to indicate that either firm used as an example here will or has succumbed to the temptations of moral hazards, courts should not create precedent by allowing representation to continue here. Ethical and responsible attorneys, zealously representing their clients, may unwittingly open the door for charlatans all too willing to exploit moral hazards.