Lawyers' Role Key to Preserving and Preventing Fraud Claims

Source: New York Law Journal

New York Fraud Claims

Recent New York case law graphically illustrates the key role lawyers can and should play in both preserving and preventing claims of fraud and breach of representations and warranties in complex commercial transactions involving sophisticated parties. Strategic contractual disclaimers, representations and warranties, releases, and provisions addressing remedies for fraud can significantly impact claims of fraud in a broad array of business transactions, including asset and stock purchases, mergers and acquisitions, investments, real property contracts and others.

Timely intervention by legal counsel is also vital in ensuring that claims of fraud are asserted within the statute of limitations periods and thereby preserved.

Provisions

The recent cases show that courts are extremely reluctant to allow fraud claims in the face of well-crafted contractual disclaimers and provisions disavowing reliance on representations or other information in complex transactions. For example, in MP Cool Invs. Ltd. v. Forkosh , 142 A.D.3d 286 (1st Dept. Sept. 1, 2016), the Appellate Division, First Department, affirmed the lower court's order dismissing a common law fraud claim brought by a sophisticated investor. The plaintiff had invested $70 million in a company that was involved in new technology for innovative heating, ventilation and air conditioning systems (HVAC).

Plaintiff claimed that in the period before it purchased any interest in the company and during the two-year period after its first investment, "Defendants made numerous false representations and provided inaccurate data about [the company's] air conditioning technology, financial condition and overall successes in the United States and other markets." Plaintiff alleged that it relied on this information, which induced it to invest repeatedly in the company, believing it was a better performing company than it was.

In assessing plaintiff's claims, the court found it critical that plaintiff was a "sophisticated investor" and that it had agreed to several significant contractual provisions relevant to the fraud claims. First, the First Department noted, before making any investment in the company, plaintiff had a 90-day due diligence period during which it was afforded full access to the company's business operations, properties, technology data and plans. Plaintiff also had the right to direct access to all of the company's customers (but contacted only one).

The court also noted plaintiff made several express contractual representations, including that it had "substantial experience in evaluating and investing in securities of companies similar to [the company in question]" and "such knowledge and experience in financial and business matters so that [it] is capable of evaluating the merits and risks of its investment in the Company." The purchase agreement also specified: (1) the "highly speculative nature" of the investment; (2) all of the information and data to which plaintiff was given access in order to investigate its potential investment; and (3) that the materials prepared by the company were "subject to change and that any projections included in such business plans or otherwise are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results."

Based on these contractual provisions and plaintiff's sophistication, its claims of fraud were rejected by both the lower court and the First Department, which relied on prevailing law that "where the plaintiff is a sophisticated party, 'if the facts represented are not matters peculiarly within the [defendant's] knowledge, and the [plaintiff] has the means available to [it] of knowing, by the exercise of ordinary intelligence, the truth or the real quality of the subject of the representation, [the plaintiff] must make use of those means, or [it] will not be heard to complain that [it] was induced to enter into the transaction by misrepresentations'."

Another graphic example is O.F.I. Imports Inc. v. General Electric Capital Corp., 15-CV-7231, NYLJ 1202768822850, at *1 (SDNY, Decided Sept. 26, 2016), involving a $21 million asset purchase deal, in which plaintiff alleged that defendant GE misled it into paying $5.64 million more than the purchased assets were worth. The court dismissed the amended complaint based upon a release and disclaimers agreed to by plaintiff.

The case involved plaintiff's purchase of frozen food and other assets being liquidated. GE was the primary secured creditor and "wholly in control of the liquidation and ultimate disposition of [the] assets."

Plaintiff entered into an asset purchase agreement (APA) with the seller, and two days later, GE and plaintiff entered into a credit agreement pursuant to which GE provided plaintiff with a revolving credit facility intended, in part, to finance the purchase.

Plaintiff alleged that it agreed to an excessive purchase price based on GE's emails that were false and misleading as to the value of the assets and indicating that the purchase price would be adjusted post-closing, no mention of which was in the APA or Credit Agreement. On the contrary, the APA provided that the sale to plaintiff was on an "'as-is, where-is'" basis and "without representation or warranty of any kind."

The APA further provided a disclaimer by the seller of any warranties regarding the "nature, quality…or condition of the Purchased Assets" and included an acknowledgment by plaintiff that it was "relying solely on its own investigation and not on any information provided or to be provided by any other Party…[and] that no independent investigation or verification has been or will be made by [the seller] with respect to any information supplied by [the seller] concerning the Purchased Assets…it being intended by the parties that [plaintiff] shall verify the accuracy and completeness of such information itself."

Similarly, the Credit Agreement included a broad release between plaintiff and GE as to "any and all claims…at law or in equity in respect of all prior discussions and understandings, oral or written, relating to the subject matter of [the Credit Agreement] and the other Loan Documents." The Credit Agreement also included a "merger clause" providing that it "embod[ies] the entire agreement of the parties."

In moving to dismiss plaintiff's fraud claims, GE argued that the broad release contained in the Credit Agreement precluded the lawsuit. Plaintiff argued that the release was inapplicable because it was the product of a "separate fraud"—GE Capital's false promise to make post-closing price adjustments. The court rejected plaintiff's argument that there was a separate fraud that rendered the release void.

The court first noted: "If a defendant establishes that a release applies to a plaintiff's claims, the burden shifts to plaintiff to 'show that there has been fraud, duress or some other fact which will be sufficient to void the release.'" The court then found that "GE Capital's alleged promise to make a post-closing purchase price adjustment is not a fraud 'separate from the subject of the release.'" Rather, the court ruled: "The Credit Agreement release applies to 'any and all claims' 'relating to the subject matter of [the Credit Agreement]'" and that the APA was part of the "subject matter" of the Credit Agreement.

Further, the court held that even "assuming that GE Capital's promise was a 'separate fraud,' [plaintiff] has not plausibly pled the elements of a claim for fraudulent inducement." The court found that plaintiff's argument that it reasonably relied on the allegedly inaccurate inventory reports and purchase price analysis provided by GE was "foreclosed by the specific disclaimer of reliance in the APA, in which [plaintiff] agreed that it was relying 'solely on its own investigation and not any information provided or to be provided by any other Party.'"

Finally, the court noted that "a sophisticated entity engaging in a significant transaction may not rely on the peculiar knowledge exception when it could have bargained for contractual protection but chose not to do so."¹

Contractual Limitations

Counsel also must be aware that even carefully crafted contractual provisions seeking to address remedies for breach of representations and warranties can run afoul of overriding dictates of public policy as pronounced by the courts.

Deutsche Bank Natl. Trust Co. v. Flagstar Mkts. Corp., 653048/13, 2016 NY Slip Op 05780 (1st Dept. Aug. 11, 2016) involved representations and warranties as to loans underlying residential mortgage-back securities. The court noted that the six-year statute of limitations for breach of representations and warranties accrues on the date the allegedly false representations and warranties were made. The parties agreed to a set of conditions that would have delayed the accrual of the statute of limitations, based upon "discovery" of the material breach of any of the representations and warranties.

Relying upon Court of Appeals' decisions, the First Department ruled that "the accrual provision is unenforceable as against public policy, because it is tantamount to extending the statute of limitations based on an imprecise 'discovery' rule, which the Court of Appeals has consistently rejected in the commercial sphere."

In summarizing the public policy of statute of limitations, the court observed: "'Statutes of limitation not only save litigants from defending stale claims, but also express[ ] a societal interest or public policy of giving repose to human affairs.'"

Timely Action by Counsel

A fraud claim can be brought within six years from the date the fraud was committed or two years from when the fraud was discovered or could have been discovered with due diligence, whichever period is longer. See CPLR 203(8).

Taking timely and prudent action not only to prevent the fraud, such as through strategic contractual provisions as discussed above, but also to detect it as soon as possible, is key to preserving fraud claims. Thus, parties must be vigilant in investigating suspicious circumstances as they arise and engage counsel from the earliest moment to preserve rights and obtain the full scope of legal remedies for fraud.

The First Department has recently shed light on whether the fraud in question could have been discovered within the two-year statute of limitations. The subject fraud claims were brought by Aozora Bank, Ltd., a Japanese commercial bank that invested in complex financial products backed by mortgages, including $430 million in collateralized debt obligations (CDOs).

In both cases— Aozora Bank v. Deutsche Bank Sec. , 137 A.D.3d 685 (1st Dept. 2016) and Aozora Bank v. Credit Suisse Group , 2016 NY Slip Op 07259 (1st Dept. Nov. 3, 2016)—the First Department concluded that Aozora could have discovered the alleged fraud more than two years before it brought the claims, and was therefore barred under the statute of limitations from suing.

In Aozora v. Deutsche, the IAS court found that Aozora's fraud claims were untimely under the two-year discovery rule, concluding that Aozora was on inquiry notice of the alleged fraud when a Senate Report disclosed circumstances of the fraud. The court also found that Aozora failed to raise an issue of fact as to whether it had exercised reasonable diligence in an effort to discover its fraud claims, ruling that the information, publicly available, should have alerted Aozora that something was amiss with its investment.

In affirming the lower court's dismissal of Aozora's fraud claims, the First Department noted: "'[W]here the circumstances are such as to suggest to a person of ordinary intelligence the probability that he has been defrauded, a duty of inquiry arises, and if he omits that inquiry when it would have developed the truth, and shuts his eyes to the facts which call for investigation, knowledge of the fraud will be imputed to him.'"

The First Department followed the same analysis in affirming the lower court and dismissing similar claims that Aozora asserted against Credit Suisse inAozora Bank v. Credit Suisse Group , 2016 NY Slip Op 07259 (1st Dept. Nov. 3, 2016). The First Department found it particularly damning that Aozora delayed engaging legal counsel to help it investigate the underlying fraud despite being on notice of suspicious circumstances.

These cases show that staying abreast of the law and implementing appropriate and timely strategies are essential in preserving and defeating fraud claims.

Other recent examples are chronicled at http://nyfraudclaims.com/category/sophisticated-parties/.

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Kevin Schlosser is a Shareholder at Meyer, Suozzi, English & Klein, P.C., where he is Chair of the Litigation and Alternative Dispute Resolution Department which has a full roster of available private judges from virtually all disciplines of law. Mr. Schlosser also authors the popular blog, “New York Fraud Claims,” which analyzes the latest developments concerning civil fraud claims under New York law.

Reprinted with permission from the December 02, 2016 issue of New York Law Journal. 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.