Law Firm Sued as Sale Fails to Meet Client's Expectations

Staff Reporter

John and Christy Clarey thought they jumped off the dot-com bubble at the perfect time.

The Irvine couple was counting on a $68 million payday from the $150 million deal for the sale of their telecommunications company, TeleCore Inc., in April 2000.

When the dust settled on the deal, however, they say their share was more along the lines of $1 million, and they are blaming their lawyers Sheppard Mullin Richter & Hampton LLP for drafting a bad agreement of sale.

"I trusted these guys," John Clarey said. "They really put on a good show and represented they had done these types of transactions before. This was a sophisticated deal with a lot of money, and the loopholes they left in it allowed the company that we sold to to take my company and not pay me for it. It's been devastating."

Now the pair has filed a $68 million malpractice lawsuit against Sheppard Mullin, one of the largest legal malpractice suits filed against a Los Angeles-based firm.

In the lengthy complaint filed Jan. 16 in State Superior Court, the Clareys claim that the agreement with Viasource Communications Inc. for the sale of the digital subscriber line (DSL) services company they formed in 1996 was negligently drafted.

The Clareys should have received $16.8 million in cash and $50 million in stock in the Ft. Lauderdale, Fla. company, according to the lawsuit.

But, they allege, they received only $1 million in cash a year after the deal closed and watched the value of their stock decline as Viasource, then trading at 14 cents a share, was de-listed from Nasdaq.

According to SEC filings, the Clareys jointly held 2.7 million shares of Viasource as of August 2001, representing more than 6 percent in the company.

Reviewing the documents

In response, Fred Puglisi, Sheppard Mullin general counsel, said in a prepared statement that, "Mr. Clarey made his own informed business decisions. The evidence will show we did nothing wrong and that we will prevail on the merits."

Clarey, a former construction company owner who now runs his own investment firm, acknowledged that he approved the merger documents, but said he trusted Sheppard Mullin to draft them.

"The documents were very complex; there were hundreds of pages," Clarey said. "I'm not a lawyer. That's why I hired the professionals. If you were to read the documents, a normal businessman would've come to the same conclusions."

The amount sought in the lawsuit turned legal heads.

"That's huge," said Steven Yee, a partner at L.A.-based Anderson McPharlin & Conners LLP, who handles malpractice work. "At that point you're talking about two or three (insurance) carriers on the hook, plus the firm. Even bigger firms don't get more than $10 million to $20 million in insurance."

Very few malpractice suits rise above $10 million. One that did recently involved O'Melveny & Myers LLP, which was hit with a $100 million malpractice lawsuit last year from the L.A. Unified School District over the Belmont Learning Center controversy. That case is pending.

Tom Thompson, vice president of L.A.-based Chanin Capital Partners, a financial advisory group, doubted the Clareys would prevail. Even if the law firm acted negligently, it's the responsibility of the client to be aware of the terms of the deal. "They agreed to take stock into consideration," he said. "There are risks to taking stock."

Ties to GE Capital

Besides poor drafting, the Clareys' suit alleges Sheppard Mullin structured the deal so that Viasource could avoid paying the couple, in part because of an ongoing relationship with GE Capital Corp., a lending arm of General Electric Co. Viasource had a credit facility with GE Capital.

The deal between the Clareys and Viasource included two payment thresholds, the suit said.

If Viasource, which was privately held at the time of the acquisition, raised $50 million or more in its initial public offering, the Clareys would receive the $16.8 million in cash.

If the IPO raised less than $35 million, the Clareys could receive special rights to protect their stock until the exercise date, one year after the IPO.

According to Securities and Exchange Commission filings, the company issued 5.7 million shares at $8.16 each in August 2000, raising $46.5 million. Viasource shares traded above $10 shortly after the IPO, but slid quickly, falling below $2 per share from January 2001 until its delisting.

Viasource filed for Chapter 11 bankruptcy protection last November.

"What Sheppard did was leave a gap of between $35 million and $50 million," said Don Howarth, of Howarth & Smith in L.A., who is representing the Clareys. "Viasource chose to have an IPO at a figure between those two numbers, so Clarey got neither his rights under the rights agreement nor did they have to pay his notes. And there was no legitimate reason for leaving that gap there."

The $1 million the Clareys did receive was part of the agreement to pay the cash portion of the sale concurrent with the IPO or 18 months from the April 2000 merger agreement, whichever came first.

The suit alleges Viasource did not pay the full amount by claiming payments to the Clareys were not due until its primary credit facility from GE Capital came due in 2004.

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