Kevin Schlosser Authors, "First Department Recognizes Muddy Law on Fraud Claims Based Upon Contractual Representations"

In my June 19, 2017 post, I wrote about an interesting decision of New York County Commercial Division Justice Charles Ramos in Daesang Corp. v. The NutraSweet Co., 2017 NY Slip Op 50646(U), 55 Misc 3d 1218(A), 655019/2016, NYLJ 1202788875727, at *1 (Sup., NY, Decided May 15, 2017). Although the case involved many interesting issues, as relevant here, Justice Ramos refused to enforce a portion of an arbitration award, ruling it was rendered in manifest disregard of the law, because the arbitration panel did not recognize fraud claims based upon representations that were also contained in a contract. More on that below.

The Appellate Division, First Department, has now reversed that ruling, in Matter of Daesang Corp. v NutraSweet Co., 2018 NY Slip Op 06331, (1^st Dep’t Decided September 27, 2018). The First Department’s decision is not only very important as to the limited grounds to challenge arbitration awards under the Federal Arbitration Act, but also for recognizing the muddy nature of the law on fraud claims in New York.

The Lower Court Decision

NutraSweet, which sought to challenge the award of the arbitration panel (ICC), argued that the ICC manifestly disregarded the law when it concluded that NutraSweet’s defense and counterclaim seeking equitable rescission based on fraudulent inducement does not give rise to an actionable fraud claim under New York law because it was based solely on the contractual representations in the parties’ agreements, and NutraSweet was merely seeking contract damages.

Justice Ramos determined that the ICC manifestly disregarded New York law in dismissing NutraSweet’s claim for fraudulent inducement seeking the remedy of equitable rescission. Justice Ramos found that the ICC “chose to disregard the well-established principle that a fraud claim can be based on a breach of contractual warranties where the misrepresentations are of present facts (in contrast to future performance) and cause the actual losses claimed (see Wyle Inc. v. ITT Corp., 130 AD3d 438 [1st Dept 2015]; GoSmile, Inc. v. Levine, 81 AD3d 77 [1st Dept 2010], dismissed 17 NY3d 782; MBIA, Ins. Corp. v. Credit Suisse Sec. [USA] LLC, 33 Misc3d 1208[A] [Sup Ct, NY County 2011], reversed on other grounds 102 AD3d 488 [1st Dept 2013]).” He continued: “The fact that Daesang represented to NutraSweet in contract documents that it had ‘complied in all material respects with applicable laws…in connection with the operation of the Business and the ownership and use of the Purchased Assets’ (APA, §f), does not render NutraSweet’s fraudulent inducement claim non-viable as redundant because NutraSweet demonstrated that Daesang misrepresented present facts which induced it to enter into the transaction.”

Noting that a “‘warranty is not a promise of performance, but a statement of present fact’ (Wyle Inc., 130 AD3d at 441)’” Justice Ramos found that “by giving false representations about its criminal conduct pertaining to the operation of its business, Daesang was not making a promise of future performance-the breach of which would clearly constitute solely a breach of contract claim, but rather, misrepresenting a present, material fact designed to induce NutraSweet to enter into the transaction. The present intent to defraud at the outset of the transaction is what distinguishes NutraSweet’s fraudulent inducement claim from a mere breach of contract claim. Thus, because rescission is clearly a viable remedy where one party demonstrates that it was fraudulently induced to enter into a contract (Gosmile, Inc., 81 AD3d at 82), the [ICC’s] dismissal of the fraudulent inducement claim lacks even a ‘barely colorable justification’ in black letter law (compare Wien & Malkin LLP, 6 NY3d at 480-81).”

First Department Reverses

Basing its decision on Second Circuit case law limiting challenges to arbitration awards under the “manifest disregard” standard, the First Department reversed and upheld the arbitration panel’s rejection of the fraud claim. While the Court did not comment directly on the merits of the award, it did note that the law on fraud claims based upon contractual representations is not exactly a picture of clarity when it comes to deciding whether an alleged misrepresentation is “collateral or extraneous to the contract” – a necessary element of such a fraud claim. The Court recognized that claims of this nature require a fact-intensive and thorough analysis, and therefore the arbitrators did not so clearly disregard the law so as to render their award ineffective.

The Court framed the issues as follows:

We turn first to the arbitrators' dismissal of NutraSweet's second and third counterclaims for equitable rescission of the transaction based on fraud in the inducement. As previously noted, Supreme Court set aside this determination, and remanded the two equitable rescission counterclaims to the arbitrators for redetermination, on the ground that the tribunal had manifestly disregarded the law in holding that these claims, based on allegedly false representations made by Daesang in the APA and the Processing Agreement, were contractual in nature and therefore could not be pursued by NutraSweet on a theory of fraud. In so doing, Supreme Court plainly erred. At most, the tribunal "state[d] an intention to apply a law, and then misapplie[d] it," which constitutes nothing more than a mere error of law for which "[an] award will not be set aside" (Matter of Sprinzen [Nomberg], 46 NY2d 623, 629 [1979]).

As to the substance of the law of fraud based upon misrepresentations that are also contractual representations, the First Department observed (emphasis and highlighting added):

In debating whether the second and third counterclaims could be maintained on a theory of fraud, each side relied on an opposing line of decisional authority. One of the cases on which NutraSweet placed primary reliance was Merrill Lynch & Co. Inc. v Allegheny Energy, Inc. (500 F3d 171 [2d Cir 2007]). In dismissing the equitable rescission counterclaims in the partial award, the arbitrators quoted and applied (whether correctly or incorrectly) the following standard set forth in Merrill Lynch for resolving the issue presented:

"[U]nder New York law, parallel fraud and contract claims may be brought if the plaintiff (1) demonstrates a legal duty separate from the duty to perform under the contract; (2) points to a fraudulent misrepresentation that is collateral or extraneous to the contract; or (3) seeks special damages that are unrecoverable as contract damages" (id. at 183).

***

That the arbitrators did not accept NutraSweet's view of how the relevant legal principle applies to the facts of this case does not amount to "refus[ing] to apply [the principle] or ignor[ing] it altogether" (Wien & Malkin, 6 NY3d at 481 [internal quotation marks omitted]). The arbitrators' ruling, whether or not we agree with it on the merits, more than meets the requirement that there be at least "a barely colorable justification for the outcome reached" (id. at 479 [internal quotation marks omitted]). Even if a thorough analysis of the underlying legal issue (which we do not propose to undertake here) would lead us to conclude that NutraSweet was correct on the merits, a finding of manifest disregard of the law "requires more than a simple error in law or a failure by the arbitrators to understand or apply it" (id. at 481 [internal quotation marks omitted]). On this record, NutraSweet can show nothing more than this.

Moreover, it cannot be said that the point of law at issue was sufficiently "well defined" (id. [internal quotation marks omitted]) to give rise to a claim that the award was rendered in manifest disregard of the law. The meaning of the rule that an alleged misrepresentation is actionable as fraud if it is "collateral or extraneous to the contract" (Merrill Lynch, 500 F3d at 183) — which NutraSweet unsuccessfully argued to the tribunal that its second and third counterclaims satisfied — is not necessarily transparent from the quoted words alone and must be drawn out through detailed analysis of cases in which the rule has been applied. Even if the arbitrators erred in concluding that NutraSweet's fraud claims were not "collateral or extraneous" to the contractual representations in the APA and the Processing Agreement, the arbitrators did not manifestly disregard the law by according to the quoted decisional language what may have reasonably seemed to them its natural meaning. Certainly, any error by the arbitrators in deciding this issue (and, again, we make no determination as to whether they in fact erred) was far from "obvious and capable of being readily and instantly perceived by the average person qualified to serve as an arbitrator" (Merrill Lynch, Pierce, Fenner & Smith, Inc. v Bobker, 808 F2d 930, 933-934 [2d Cir 1986]), which is the standard for a showing of manifest disregard of the law.

Commentary

Courts often struggle with whether a claim of fraud can be based upon a misrepresentation that also happens to be a breach of a representation and/or warranty contained in the contract sought to be rescinded for the alleged fraud. In particular, courts have difficulty deciding whether the misrepresentations are “collateral or extraneous to the contract.” Not only did the arbitrators in NutraSweet have trouble with these issues (apparently getting the result wrong), but it is interesting that the First Department recognized how difficult the law can be both to articulate and to apply to particular facts. Counsel should make sure they are aware of the different decisions on this point and be careful to rely on and take advantage of the favorable decisions to apply to the facts of their case.

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