Kevin Schlosser Writes, “Representations and Warranties in LLC Buyout Contract Save Fraud Claim”

Courts have traditionally struggled with determining whether and under what circumstances contractual promises or obligations can amount to, or be relied upon to allege, a separate claim of fraud. See my post for a good example of an internal debate within the Appellate Division, First Department, in which the majority battled with the dissent over this issue, and my post in which the First Department ruled that the law was so unclear in this regard that an arbitration panel could not be deemed to have manifestly disregarded the law.

Having studied the case law on this topic for years, I see the most logical way of applying the concepts as follows: Breach of contract claims stem from an agreement between the parties with contractual obligations. Fraud is a species of “tort” law, which is derived from the “common law” – judicial decisions reflecting what the courts deem to be duties and obligations in a civilized society. Remedies for these two causes of action are different. Courts often adhere to the principle that a fraud claim cannot be based upon a simple breach of a contractual promise to do something in the future. Rather, a fraud claim should be based upon a material misrepresentation of an existing fact. There are also cases that recognize that if there is sufficient evidence that a party who makes a contractual promise had no present intention to abide by the promise when it was made, a fraud claim can be established as well.

Contractual Representations and Warranties

Then there is the situation where the contract contains representations and warranties of the truth and/or accuracy of certain information. Typically these are contained in transactional agreements such as asset purchase agreements, stock sales, buyouts and the like. Of course, the first place to look to determine the impact of such representations and warranties is the contractual language itself. If the contract limits the remedies or consequences of the representations and warranties, that should be given weight and enforced. Although, as noted, courts indicate contractual obligations cannot form the basis of a fraud claim, contractual representations and warranties have and should stand on different footing. That is, representations and warranties are not merely promises to perform something in the future, but an affirmation of the truth of an existing condition or fact. There is no reason why a party who has gone through the exercise of insisting upon and obtaining such a factual representation should not be permitted to rely on that for the basis of a common law claim of fraud to the extent the contract does not provide otherwise.

Case law bears this reasoning out. Wyle Inc. v. ITT Corp., 130 A.D.3d 438, 13 N.Y.S.3d 375 (1st Dep’t 2015) is an informative decision that tracks this reasoning, citing cases in support. The Court concluded:

It is of no consequence that some of the allegedly false representations are also contained in the agreements as warranties and form a basis of the breach of contract claim” (87 AD3d at 294 [citations omitted]). Such a rule makes sense, for, as we noted in MBIA, “ ‘[i]t simply cannot be the case that any statement, no matter how false or fraudulent or pivotal, may be absolved of its tortious impact simply by incorporating it verbatim into the language of a contract’ ” (id., quoting In re CINAR Corp. Sec. Litig., 186 F Supp 2d 279, 303 [ED NY 2002]).

Of course, evidencing how these issues challenge the courts, there was a dissent in Wyle, to which the majority responded as follows:

Although the dissent contends that the false representations in First Bank and MBIA were separate from the warranties contained in the contract, those representations were in fact warranted to be accurate at the time the contract was entered into and made for the purposes of inducing the plaintiffs to *442 purchase those loans. They were designed to be relied on to arrive at an accurate value of the loans, and the value of the company being purchased here. These misrepresentations did not merely evince “an insincere promise of future performance [but were] **3 instead . . . misrepresentation[s] of then present fact[s] that [were] collateral to the contract, and thus plaintiff sufficiently alleged a cause of action sounding in fraud” (GoSmile, Inc. v Levine, 81 AD3d at 81; see also Merrill Lynch & Co. Inc. v Allegheny Energy, Inc., 500 F3d 171, 184 [2d Cir 2007]; RKB Enters. v Ernst & Young, 182 AD2d 971, 972 [3d Dept 1992]). To hold otherwise would be a far too restrictive application of our precedents.

See my post for a recent bench trial decision in the Commercial Division, Suffolk County, elaborating on the relevant cases and sustaining a fraud claim based upon contractual representations and warranties. See also Lunal Realty, LLC v. DiSanto Realty, LLC, 88 A.D.3d 661 (2d Dep’t 2011)(contractual warranties basis for fraud claim).

New Fourth Department Case

In Dillon v Peak Envtl., LLC, 2020 NY Slip Op 05332 (4^th Dep’t Decided Oct. 2, 2020), the Court permitted the plaintiff to base its fraud claim on contractual representations and warranties as to the financial condition of the subject entity. The transaction at issue was the buyout of an LLC member by the other member. The Court looked to the buyout agreement to assess not only plaintiff’s breach of contract claim, but also his fraud claim as well.

The Court affirmed summary judgment against plaintiff on the contract claim, ruling that the indemnity provision did not apply to the claimed damage plaintiff asserted.

As to the fraud claim, the analysis was a bit more complicated. The buyout agreement contained certain provisions under which defendant sought cover. Plaintiff alleged that defendant made misrepresentations in a letter that was outside the contract. As to that claim, the Fourth Department agreed that the disclaimer in the contract barred reliance on those alleged extraneous representations:

Initially, we reject plaintiffs’ assertion that alleged misrepresentations made by defendants in a separate letter may serve as a basis for establishing fraudulent inducement in execution of the liquidation [buyout] agreement. “While a general merger clause is ineffective to exclude parol evidence of fraud in the inducement, a specific disclaimer defeats any allegation that the contract was executed in reliance upon contrary . . . representations” (Barnaba Realty Group, LLC v Solomon, 121 AD3d 730, 731 [2d Dept 2014]; see Danann Realty Corp. v Harris, 5 NY2d 317, 320-321 [1959]). Here, the liquidation agreement specifically provided that the parties made no agreements, warranties, or [*2]representations other than those expressly set forth in the liquidation agreement (see Barnaba Realty Group, LLC, 121 AD3d at 731; Sperry v Papastamos, 195 AD2d 1031, 1033 [4th Dept 1993]).

As to plaintiff’s reliance on representations actually made in the contract, defendant asserted that the release contained in the buyout agreement barred that claim. The Fourth Department reversed the dismissal of that claim. It held that the contract itself excluded from the release obligations that were contained in the contract. And since defendant made the representations and warranties in the contract, the Court permitted plaintiff to rely on those contractual obligations to base his fraud claim:

A claim of fraudulent inducement is viable where, as here, the plaintiffs “allege that [the defendants] knew at the time of the estimate that the [financial cost of a] project would substantially exceed the amount of the estimate, that [the defendants] intentionally misstated the estimate in order to induce [the plaintiffs] to enter into the contract, that [the plaintiffs] relied on the misrepresentation, and that [the plaintiffs] were damaged as a result” (Wright v Selle, 27 AD3d 1065, 1067-1068 [4th Dept 2006]). With respect to justifiable reliance, “[t]he determination of whether a party’s reliance is reasonable is always nettlesome because it is so fact-intensive” (Lunal Realty, LLC v DiSanto Realty, LLC, 88 AD3d 661, 665 [2d Dept 2011] [internal quotation marks omitted]; see DDJ Mgt., LLC v Rhone Group L.L.C., 15 NY3d 147, 155 [2010]). Here, defendants’ own submissions establish that plaintiffs “made a significant effort to protect themselves against the possibility of false financial statements: they obtained representations and warranties to the effect that nothing in the financials was materially misleading” (DDJ Mgt., LLC, 15 NY3d at 156; cf. Pappas v Tzolis, 20 NY3d 228, 233 [2012], rearg denied 20 NY3d 1075 [2013]), i.e., that Peak had no material liabilities beyond those disclosed in the financial statements and no circumstances existed that could reasonably be expected to result in such a material obligation. Thus, “[i]f 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” (DDJ Mgt., LLC, 15 NY3d at 156; see Lunal Realty, LLC, 88 AD3d at 665). We therefore modify the order by denying that part of defendants’ motion seeking summary judgment dismissing the first cause of action and reinstating that cause of action.

Commentary

Contractual representations and warranties play a special role in connection with common law fraud claims. Parties are free to agree among themselves just how those representations and warranties will affect the contracting parties’ rights and remedies. Parties should consider contractual releases, disclaimers and other limitations so that future claims are defined by the parties themselves. If the contract does not so limit or address future fraud claims, there may be a viable claim for common law fraud, especially based upon the representations and warranties contained in the contract at issue.