Court Rules That A Plaintiff Cannot Reasonably Rely on A Term Sheet That Explicitly Says The Parties Are Not Contractually Bound Until Execution of A Definitive Agreement

• Posted on: Oct 30 2020

As readers of the Blog know, when it comes to fraud-based actions, we like to write about them. While many of the cases we examine fall into similar patterns, sometimes a case deviates from the norm. King Penguin Opportunity Fund III, LLC v. Spectrum Group Mgt. LLC, 2020 N.Y. Slip Op. 06230 (1st Dept. Oct. 29, 2020) (here), is such as case.

King Penguin concerned, among other claims, a fraudulent inducement claim arising from the execution of a term sheet for a proposed loan. The Court affirmed the dismissal of plaintiff’s fraud claim because plaintiff could not demonstrate justifiable reliance on any alleged false statement made by defendant. In so holding, the Court held that because the parties did not enter into a written definitive agreement, only a term sheet that required the execution of such a writing, plaintiff could not rely upon defendants’ promises to proceed with the transaction. Slip Op. at *1.

“Term sheets”, “letters of intent”, “memoranda of understanding” and “agreements in principle” outline the fundamental terms of the transaction being negotiated. They may constitute an enforceable agreement if the writings include all the essential terms of an agreement. Sullivan v. Ruvoldt, 16 Civ. 583, 2017 WL 1157150 at *6 (S.D.N.Y. Mar. 27, 2017). This is so even if “the parties intended to negotiate a ‘fuller agreement’”. Conopco, Inc. v. Wathne Ltd., 190 A.D.2d 587, 588 (1st Dept. 1993). Thus, if the informal writings contain the necessary elements of an enforceable contract, e.g., an offer, acceptance, consideration, mutual assent and intent to be bound, courts will enforce the writings as if they were a formal, written agreement.

However, a term sheet, letter of intent or a memorandum of understanding will be rendered ineffective where material terms are left for future negotiation or the writing expressly reserves the right not to be bound until a more formal agreement is signed. Bed Bath & Beyond Inc. v. IBEX Constr., LLC, 52 A.D.3d 413, 414 (1st Dept. 2008); Emigrant Bank v. UBS Real Estate Sec., Inc., 49 A.D.3d 382, 383-384 (1st Dept. 2008).

The term sheet in King Penguin explicitly required “‘satisfactory completion of Lender’s due diligence and execution of written loan documents’ before the parties [were] contractually bound.…” Slip Op. at *1. In particular, the term sheet provided that it was “for discussion purposes only and [did] not constitute a binding commitment to provide credit.” Any binding commitment was “contingent upon satisfactory completion of Lender’s due diligence and execution of written loan documents.” The terms sheet also highlighted the fact that it was “not comprehensive” such that “[t]he written loan commitment or loan agreement [would] contain provisions not included in th[e] Term Sheet.” Therefore, held the Court, “it was ‘unreasonable as a matter of law’ for plaintiff to rely upon the representations in the term sheet to proceed with the transaction.” Id. (citations omitted).

The Court rejected plaintiff’s contention that “the nonbinding effect of the term sheet should be ignored because the term sheet did not specifically disclaim reliance on defendant’s prior oral representations.…” Id. (citing Basis Yield Alpha Fund [Master] v Goldman Sachs Group, Inc., 115 A.D.3d 128, 137 (1st Dept. 2014)). The Court explained that “[a] specific disclaimer of reliance, however, [was] not necessary to find lack of justifiable reliance.…” Id. (relying on (StarVest Partners II, L.P. v. Emportal, Inc., 101 A.D.3d 610 (1st Dept. 2012)). The Court concluded that plaintiff could not “logically argue that defendant’s oral misrepresentations fraudulently induced it to execute the term sheet, which was expressly nonbinding.”

The Court also rejected plaintiff’s argument that it could disclaim reliance on misrepresentations of facts that were peculiarly within defendant’s knowledge. According to plaintiff, it had no way of knowing that defendant did not intend to issue a loan under the terms set forth in the term sheet. The Court found the argument “unavailing” because “defendant had made clear in the term sheet that it had no intent to issue a loan until satisfaction of due diligence and execution of written loan documents.” Slip Op at *1.

Finally, the Court held that plaintiff failed to allege any misrepresentation of fact. Instead, said the Court, plaintiff merely alleged an intent not to perform “under the proposed terms in the term sheet.” Id. Under New York law, “[g]eneral allegations of lack of intent to perform are insufficient; [instead], facts must be alleged establishing that the adverse party, at the time of making the promissory representation, never intended to honor the promise.” Perella Weinberg Partners LLC v. Kramer, 153 A.D.3d 443, 449 (1st Dept. 2017); see also Cronos Grp. Ltd. v. XComIP, LLC, 156 A.D.3d 54, 71 (1st Dept. 2017).

Takeaway

To plead a claim for fraudulent inducement, a plaintiff must allege a “misrepresentation of a material fact, which was known by the [adversary] to be false and intended to be relied on when made, and that there was justifiable reliance and resulting injury.” Perella Weinberg, 153 A.D.3d at 449).

As we have discussed in the past, the justifiable reliance element is often the most difficult one to satisfy. This is especially so where, as in King Penguin, sophisticated parties are involved.

Sophisticated parties “must show they used due diligence and took affirmative steps to protect themselves from misrepresentations by employing what means of verification were available at the time.” VisionChina Media, Inc. v. Shareholder Representative Servs., LLC, 109 A.D.3d 49, 57 (1st Dept. 2013) (citation omitted). A sophisticated party satisfies this requirement by obtaining a prophylactic provision in a contract or other writing or exercising due diligence to make an additional inquiry into the representation. ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1045 (2015); DDJ, 15 N.Y.3d at 154 (holding that in contract negotiations between sophisticated parties, justifiable reliance element sufficiently alleged where plaintiff “has gone to the trouble” of insisting on warranties in the written agreement that certain facts were true). Such prophylactic measures are difficult to implement when, as in King Penguin, a non-binding term sheet or other preliminary agreement is involved. As the First Department observed in King Penguin and StarVest Partners, “[w]here a term sheet or other preliminary agreement explicitly requires the execution of a further written agreement before any party is contractually bound, it is unreasonable as a matter of law for a party to rely upon the other party’s promises to proceed with the transaction in the absence of that further written agreement.” King Penguin, at *1; StarVest Partners, 101 A.D.3d at 613.