Behold the “Litigation Hold”

Litigation Hold

You are an officer, director/manager or agent for a corporation, limited liability company or residential cooperative/condominium. You occasionally receive garden-variety  claims for  personal injuries (e.g. slip-and-falls).  And from time-to-time more threatening claims (e.g. discrimination, breach of fiduciary duty).

First thing first: immediately notify your liability insurance carrier in writing.  And second: preserve all hard copy and electronic documents and communications (including all audio and visual records) directly or indirectly relating to the claim.

The first admonition of your obligation to preserve and protect relevant records may be a so-called “litigation hold”—a direction from either your attorney or the lawyer for the claimant to save all  related documents or communications and to suspend any document deletion practices or protocols.

The deliberate or inadvertent loss or destruction of relevant records is called “spoliation”.  And the after-effects  of spoliation can be severe and  consequential to your defense. A recent case, involving both a delay in sending a “litigation hold” and the deliberate destruction of documents, illustrates an almost “worst case” scenario.

China Development Industrial Bank sued Morgan Stanley for fraud arising out of a financial instrument called the STACK 2006-1. Stack was a derivative that issued notes backed by an asset portfolio containing mostly credit default swaps linked to non-prime residential mortgage backed securities. CDIB’s investment in Stack ultimately resulted in a total loss.

According to CDIB, Morgan Stanley (the underwriter for Stack) designed and marketed  the investment as an “almost risk free” product that was nearly impossible to fail. And Morgan Stanley secretly constructed Stack to be a “hitman” that was designed to blow up in CDIB’s hands.

Morgan Stanley was alleged to have altered Stack’s investment rules to force Stack to buy a particularly problematic slice of sub-prime securities from an already risky and toxic class of securities that Morgan Stanley was hoping to get off its own books. At the same time, permitting the firm to profit by shorting the transactions, fueling an $8 billion short. Shortly after Morgan Stanley closed the trade, the credit default obligation at the heart of Stack began to collapse.

CDIB filed suit against Morgan Stanley in 2010 alleging common law fraud, premised on the contention that the firm had a duty to disclose the unstable collateral which was sold into its Stack CDO– and Stack’s true risks, given Morgan Stanley’s misstatements regarding the investment risks involved. Morgan Stanley argued that it did not misrepresent or omit material information. And also asserted that the record showed that CDIB could not  prove that it justifiably relied on any alleged misrepresentations or omissions. Finally, Morgan Stanley maintained that dismissal of the complaint was warranted as a spoliation sanction because CDIB has destroyed evidence.

Morgan Stanley moved for summary judgment, dismissal and/or sanctions for spoliation of evidence, and an award of fees and costs.

Under the common law doctrine of spoliation, dismissal for spoliation is appropriate where key evidence is destroyed prior to examination by the opposing party. Willfulness or bad faith are not necessary predicates.

It was undisputed that CDIB failed to impose a litigation hold until 2010, despite reasonably anticipating litigation in August 2007. It was also undisputed that CDIB began collecting some, but not all, evidence relating to Stack as early as 2007. CDIB failed to preserve and actually destroyed two hard drives, including one used by its employee who monitored Stack. In addition CDIB failed to preserve the metadata for 59 audio recordings, and internal and external email communications predating 2010. The Court was troubled by CDIB’s selective destruction  of  evidence.

CDIB did not offer a reasonable excuse for its grossly negligent and/or willful conduct. Moreover, CDIB refused to produce key witnesses for deposition, preventing Morgan Stanley from deposing the custodians whose files were destroyed.

The destroyed evidence was clearly relevant and might even be critical to the issues in the suit. Nonetheless, the destroyed evidence did not constitute the sole source of relevant information by which Morgan Stanley could establish a defense. Thus, the extreme sanction of striking the complaint was not appropriate.

The Court determined that the appropriate sanction for CDIB’s conduct was to preclude CDIB from presenting and relying upon any audio recordings and email communications to establish its claims.

The irony of the situation:  CDIB (the self-proclaimed victim of an alleged fraud)  was precluded for using at trial certain evidence  that may have established its claim against Morgan Stanley.  But for the fact that the missing documents were available from another source, CDIB’s claim might have been dismissed entirely, letting Morgan Stanley “off the hook”.

So- early notice of,  and compliance with, the admonitions of  a “litigation hold”  is not merely optional.  Prompt notice and  immediate compliance  is essential to insure a complete and effective defense.