A recent New York Court of Appeals decision provides some guidance of relevance to all transactional lawyers and clients relating to potential causes of action for contractual representations and warrantees, which prove to be untrue.
In DDJ Management, LLC, et al., v. Rhone Group L.L.C., et al., 15 N.Y.3d 147___N.Y.S.2d___ (June 24, 2010), the New York Court of Appeals addressed the following questions in its decision to allow Plaintiff DDJ Management’s $40 million fraud claim to proceed to a jury:
- When can a recipient of written representations from a company, which prove to be untrue, sue third parties, such as shareholders and officers of the company making the representations?
- In what circumstances does neglecting to conduct a due diligence investigation impede the recipient of contract representations from bringing a fraud claim?
The basic facts, in a nutshell, are as follows: Plaintiffs had loaned a total of $40 million to American Remanufacturers Holdings, Inc. (“ARI”), which remanufactured auto parts. ARI’s stock was owned 45% by Rhone Group, LLC (“Rhone”) and 55% by Quilvest S.A. (“Quilvest”). ARI failed to repay the loan and Plaintiffs brought claims against Rhone, Quilvest, as well as members of ARI management and its outside accountants. On appeal, the one claim at issue was that Rhone and Quilvest defrauded plaintiffs into making the loans.
Who May be Sued for Fraud and Under What Circumstances?
In bringing a claim for fraud Plaintiffs alleged that persons and entities who owned and controlled ARI, together with the accounting and auditing firm, conspired to falsify ARI’s financial records and otherwise misrepresent and conceal its actual prospects. The trial court noted that although “corporate officers may not be held liable for mere negligent failure to discover misrepresentations made on the company’s behalf, liability will attach if they participate in or have actual knowledge of the fraud.”
The Court noted that although disclosure is not usually required between parties where no fiduciary relationship exists, such a duty arises (i) where one party has special, superior knowledge not readily available to the other and knows that the other is acting on the basis of mistaken belief, (ii) where one party’s superior knowledge of essential facts renders a transaction without disclosure inherently unfair or (iii) where the defendant has communicated a half-truth or made some other misleading partial disclosure.
In this case, Rhone and Quilvest voted, through agents, as shareholders of ARI on resolutions approving specific provisions of the proposed loan documents (which contained the series of representations and warranties) and authorizing their execution.
The trial court found that the pleadings had sufficiently described “a coordinated, conscious effort by the defendants to manipulate ARI’s records and to then mislead Plaintiffs regarding the company’s financial condition and prospects, and regarding the identity, competence and tenure of its management,” and thus all the Defendants could be liable for the alleged fraud. This portion of the decision was not appealed.
Must Plaintiffs Conduct Due Diligence to Demonstrate Justifiable Reliance?
Plaintiffs’ allegation that ARI made material misrepresentations was not contested. Defendants acknowledged that ARI’s financials had been cooked, its EBITA having been grossly overstated in significant part through a manipulation of ARI’s inventory reserves. And there were “smoking gun” e-mails showing that the management and company directors knew of the false EBITA. During the months before the financial statements in question were completed, Plaintiffs had also participated in several conversations with ARI in which they were given reassuring information, and had made calls to participants in the industry to get information about ARI's management, which were also reassuring.
In attacking Plaintiffs’ fraud claim, on the other hand, Defendants relied on the following old rule, arguing that Plaintiffs could not show reasonable reliance as a matter of law, even in the face of the material misrepresentations:
[I]f the facts represented are not matters peculiarly within the party’s knowledge, and the other party has the means available to him of knowing, by the exercise of ordinary intelligence, the truth or the real quality of the subject of the representation, he must make use of those means, or he will not be heard to complain that he was induced to enter into the transaction by misrepresentations.
Schumaker v. Mather, 133 N.Y. 590, 596 .
The Court of Appeals noted that this rule rejects claims of plaintiffs who have been so lax in protecting themselves that they cannot fairly ask for the law’s protection – such as loaning funds based on vague verbal assurances – because such plaintiffs are considered to have willingly assumed the business risk that the facts may not be as represented. In addition, the rule was noted to “rid the courts of cases in which the claim of reliance is likely to be hypocritical” in the circumstances surrounding the claim.
In factual support of their argument, Defendants pointed out various circumstances and features of the financials that might have aroused concern in a skeptical reader who examined them carefully. Specially, the financials showed a significant increase in the value of ARI’s inventory over the previous year; a modest amount of cash on hand, equal to the amount of ARI’s bank overdraft; and a remarkable increase in the company’s apparent profitability in the last month of the year. Essentially, Defendants argued that in the face of these facts, Plaintiffs should have been tipped off as to the falsity of the financials, and thus their failure to conduct any due diligence prevented them from showing justifiable reliance under the rule proclaimed in Schumaker.
Plaintiffs did not allege that they asked questions about these or other aspects of the financial statements, or that they asked to look at ARI’s underlying records. However, Plaintiffs did insist that ARI represent and warrant, in substance, that the financial statements were accurate. Specifically, that the financial statements “present fairly in all material respects the financial position of ARI as at December 31, 2004 and the results of ARI's operations and cash flows for the period then ended”; that “between December 31, 2003 and March 22, 2005 [the closing date], no event has occurred, which alone or together with other events, could reasonably be expected to have a Material Adverse Effect” on ARI’s business, assets, operations or prospects or its ability to repay the loans; that the statements were prepared in accordance with GAAP; and that “no information contained in the loan agreement, the other loan documents or the financial statements being furnished to the Plaintiffs contains any untrue statement of a material fact or omits to state a material fact necessary to make the statements contained therein not misleading in light of the circumstances under which they were made.” As noted, all of these representations and warranties later proved to be false.
In 2009, the Appellate Division sided with the Defendants and dismissed the claim, emphasizing that Plaintiffs “never looked at ARI’s books and records” and concluding that, having failed to do so, they “cannot now properly allege reasonable reliance on the purported misrepresentations.”
However, the Court of Appeals reversed the Appellate Division, noting:
It can be inferred from the allegations of the complaint that plaintiffs believed Rhone and Quilvest would not knowingly cause a company they controlled to make false representations in a loan agreement as to the accuracy of financial statements. We cannot say as a matter of law that this was an unjustifiable belief.
The Court of Appeals thus found that that in these circumstances, it was up the jury to decide if the Plaintiffs’ reliance was reasonable.
In arriving at its decision that the claim should go to a jury, the Court of Appeals stated that where a “plaintiff has taken reasonable steps to protect itself against deception, it should not be denied recovery merely because hindsight suggests that it might have been possible to detect the fraud when it occurred.” In this particular case, the Court found that this principle was especially true because the Plaintiffs had gone to the trouble “to insist on a written representation that certain facts are true,” and in such circumstances, a plaintiff will often be justified in accepting that representation rather than making its own inquiry. Though there may have been hints that the financials were incorrect, the Court declined to dismiss the claim because of the steps that Plaintiffs took to protect themselves through insisting of the contractual warranties and representations. It held:
We decline to hold as a matter of law that plaintiffs were required to do more — either to conduct their own audit or to subject the preparers of the financial statements to detailed questioning. If plaintiffs can prove the allegations in the complaint, whether they were justified in relying on the warranties they received is a question to be resolved by the trier of fact.
Thus, the answer to this second question is: it depends. On a spectrum of knowing that a representation is false, which would prevent a plaintiff from showing justifiable reliance, and insisting on contractual representations and warranties in the face of some facts that might raise suspicions as to the falsity of the representations, it is difficult to know where the line will be drawn by a court. However, under the guidance of DDJ Management, it is likely to be left to a jury to decide the question of reasonable reliance, at least where a plaintiff takes some steps to protect himself from deception, such as insisting on contractual warranties and representations.