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Fraud Claim Dismissed Because Sophisticated Businessman Failed to Plead Justifiable Reliance

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  • Posted on: Nov 28 2018

Plaintiffs claiming that they have been the victims of fraud must satisfy heightened pleading standards to enter the courthouse.  Under the New York Civil Practice Law and Rules, CPLR 3016(b), and the Federal Rules of Civil Procedure, Rule 9(b), the circumstances constituting the alleged fraud must be stated in detail. [Ed. Note: in a recent post, this Blog addressed the differences between the CPLR and the Federal Rules with regard to the level of specificity required to withstand a motion to dismiss (here).]  Proving fraud in New York becomes even more difficult for plaintiffs – they must prove fraud by “clear and convincing evidence,” a higher standard than the preponderance of the evidence standard.  Gaidon v. Guardian Life Ins. Co. of Am., 94 N.Y.2d 330 (1999).

Where the plaintiff is “sophisticated,” the task of pleading and proving fraud becomes even more challenging. Last month, a sophisticated businessman learned this lesson in Unique Goals International, Ltd. v. Finskiy, 2018 NY Slip Op. 32788(U) (Sup. Ct., N.Y. County Oct. 29, 2018) (here), when his companies’ fraud claim was dismissed for failure to satisfy the justifiable reliance element.

The Law in New York

The elements of a fraud claim are well known to readers of this Blog: 1) a misrepresentation or an omission of material fact, 2) that was known to be false by the defendant, 3) made for the purpose of inducing the other party to rely upon it, 4) justifiable reliance of the other party on the misrepresentation or omission, and 5) injury. Mandarin Trading Ltd. v. Wildenstein, 16 N.Y.3d 173, 178 (2011); Pasternack v. Laboratory Corp. of Am. Holdings, 27 N.Y.3d 817, 827 (2016). To prevail on a claim of fraud, the plaintiff must plead and prove each element. But, as plaintiffs, especially sophisticated ones, often find that is not so easy.

In Ambac Assurance Corp. v. Countrywide Home Loans, Inc., 31 N.Y.3d 569 (2018), the New York Court of Appeals underscored the difficulty sophisticated plaintiffs encounter in trying to satisfy the justifiable reliance element of their fraud claim. In doing so, the Court reasoned that pleading and proving justifiable reliance discourages specious claims by sophisticated parties who claim that they had “been taken in”: “Public policy reasons support the justifiable reliance requirement. Where a sophisticated business person or entity . . . claims to have been taken in, the justifiable reliance rule ‘serves to rid the court of cases in which the claim of reliance is likely to be hypocritical.” Id. at 580. (Citation and internal quotation marks omitted.)  Thus, “[e]xcusing a sophisticated party … from demonstrating justifiable reliance,” concluded the Court, “would not further the policy underlying this ‘venerable rule.’” Id.

What constitutes justifiable reliance, however, is “always nettlesome” because it is so fact-intensive. DDJ Mgt., LLC v. Rhone Group L.L.C., 15 NY3d 147, 155 (2010) (internal quotation marks omitted). Sophisticated parties must show that they used due diligence and took affirmative steps to protect themselves from misrepresentations by employing what means of verification were available at the time. See, e.g., HSH Nordbank AG v. UBS AG, 95 A.D.3d 185, 194-95 (1st Dept. 2012). Accord, Ashland Inc. v. Morgan Stanley & Co., 652 F.3d 333, 337-38 (2d Cir. 2011) (“An investor may not justifiably rely on a misrepresentation if, through minimal diligence, the investor should have discovered the truth.”) (internal quotation marks and citation omitted).

In her dissenting opinion in ACA Financial Guaranty Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1051 (2015), which was endorsed by the majority in Ambac Assurance, Judge Read explained the rationale behind requiring sophisticated parties to affirmatively take steps to protect themselves:

Savvy commercial and financial players and inventive lawyers abound in New York. Our venerable rule requiring that the reliance necessary to establish fraud must be justifiable is designed to make sure that the courts “reject[] the claims of plaintiffs who have been so lax in protecting themselves that they cannot fairly ask for the law’s protection” and “may truly be said to have willingly assumed the business risk that the facts may not be as represented.” [Citation omitted.]

This Blog discussed Ambac Assurance here.

Unique Goals International, Ltd. v. Finskiy

Background

Unique Goals concerned a series of investments made by Plaintiffs in a publicly-traded Canadian gold mining company, White Tiger Gold, Ltd. (“White Tiger”), now known as plaintiff Mangazeya Mining Ltd. (“Mangazeya”, also sometimes referred to as “White Tiger”).

In 2009, Defendant Maxim Finskiy (“Finskiy”) invested millions of dollars in White Tiger and its subsidiary, Century Mining Corporation (“Century”). By the end of 2010, Finskiy had taken control of both companies and, beginning in 2011, arranged for a series of intra-company and third-party financing. Among the financial transactions executed was a $33,000,000 Deutsche Bank Gold Forwarding Facility pursuant to which Century agreed to deliver 61,183 ounces of gold to Deutsche Bank over five years in exchange for a $33,000,000 loan, secured by virtually all of Century’s mining assets (the “Deutsche Bank Loan Agreement”). The Deutsche Bank Loan Agreement was amended twice over the course of 2011 as Century amended its estimates of resources available and its mines produced significantly less output than anticipated. Notwithstanding these amendments, Century defaulted on its obligations under the agreement in late 2011 and again in March of 2012. In May of 2012, White Tiger announced that Deutsche Bank would be taking control of Century’s mines in Peru and Quebec due to Century’s continuous default. The mines were seized by a receiver on behalf of Deutsche Bank and shut down. Following this seizure, White Tiger was left with only one operational mine in Russia: the Savkino mine.

In 2011, Finskiy arranged for White Tiger and/or its subsidiaries to make and receive several loans from various entities, including those owned by his friends and business associates. Plaintiffs alleged that to secure the loans, Finskiy misrepresented the future prospects of the company knowing that White Tiger was in financial distress. In July 2011, White Tiger obtained a commitment for a loan of up to $150 million from VTB Capital PLC (“VTB”) to fund exploration, development, and production activities in Russia (the “VTB Facility”). However, pursuant to VTB’s conditions on the loan, White Tiger had to obtain feasibility studies on its Savkino and Nasedkino mines before receiving any funding.

Plaintiffs alleged that Finskiy knew obtaining such studies would be problematic because a November 2010 technical report indicated that, as of September 2010, the Savkino mine had 113 thousand ounces of proved and probable gold reserves, which was insufficient to secure the VTB loan (the “Micon Report). As a result, Finskiy retained a different entity, J.S.C TOMS International (“TOMS”), a local Russian geological consulting company, to prepare an updated mineral resource and reserve study on the Savkino mine. TOMS was given little more than three weeks to prepare its entire study, which Plaintiffs claimed was an insufficient amount of time to conduct an independent investigation of a mine’s feasibility. As a result, TOMS was allegedly forced to rely on data provided by White Tiger and other third-party sources to reach its conclusions. The TOMS report (the “TOMS Report”) found that the amount of reserves was 380% higher than what was reported in the Micon Report and estimated the Savkino mine gold reserves as 438.9 thousand ounces. Plaintiffs claimed the TOMS Report was falsely presented as a technical report based on a thorough investigation and independent analysis when, in fact, it was a “Preliminary Economic Assessment” or “Scoping Study,” which is generally much less accurate.

On February 2, 2012, White Tiger entered into the VTB Facility. The facility was divided into three tranches: $40 million to fund exploration, $40 million for development, and $70 million for production activities. Plaintiffs alleged, however, that Defendants never intended to use the funds as required by the terms of that loan. Rather, the money was used to prop up other entities and repay loans on behalf of Finskiy-affiliated companies, including loans that were not yet due and had lower interest rates. About $25 million of that money ended up being returned to Defendant Kirkland Intertrade Group (“Kirkland”). The second tranche of the Deutsche Bank loan was drawn down in October of 2012 and, according to Plaintiffs, used to “make payments to sham corporations and pay improper bonuses to White Tiger executives.”

Simultaneously, in 2012, Finskiy started selling his White Tiger shares and Kirkland began turning its loan to White Tiger into equity, allowing it to divest. Plaintiffs claimed that Finskiy began to target Sergey Yanchukov (“Yanchukov), a Russian citizen and businessman, and friend of Finskiy, to take White Tiger off of his hands.

In September of 2010, Plaintiff, Faith Union Industries, Ltd. (“Faith Union”), entered into the first of three subscription agreements to purchase shares of Century for a total of Cdn $5 million. Between November of 2010 and November of 2011, Faith Union spent an additional $3.8 million on Century shares. In April of 2011, after Finskiy allegedly talked up Century’s prospects, Faith Union purchased an additional 10.3 million shares of Century stock.

Thereafter, throughout 2012, Finskiy allegedly caused Yanchukov to provide additional financial support for Century and White Tiger by, among other things, making a number of allegedly false and misleading statements about Century’s prospects and “short term liquidity cris[e]s.”

In January 2013, White Tiger announced it had not produced enough gold to satisfy the gold sales covenant of the VTB Facility. Nonetheless, Finskiy reassured Yanchukov that White Tiger had sufficient gold reserves, and the still-functioning mine would provide enough gold to fulfill the company’s obligations and provide a return on investment. That same month, Unique Goals commissioned SRK Consulting (“SRK”) to prepare a report on the mines, including the open mine, Savkino. Based on the limited data provided by Defendants, SRK reached a preliminary conclusion that it was possible to turn the economic situation at White Tiger around. This conclusion, however, was allegedly based on the false and/or inflated data provided by Defendants and the true state of the mines was, therefore, not revealed to Plaintiffs by SRK’s report.

After Plaintiffs purchased Defendants’ interest in White Tiger in April 2013, they commissioned a financial audit of the company as well as a new geological study of the company’s mines. The audit revealed that $30 million was misappropriated from the company rather than being used for drilling work and that the company’s management team had received “unreasonable and unwarranted bonuses” despite the dire economic situation facing White Tiger.

In August of 2013, White Tiger, now known as Mangazeya, attempted to renegotiate the terms of the VTB Facility, but was unable to do so in a way that would allow it to become profitable and was forced to buy out the VTB debt at market value (i.e., for $59 million). White Tiger also performed an inventory of the Savkino mine, which revealed that the ore on the site was only half of what the company had previously reported, and the mine itself would only produce for four more years, not enough to satisfy the VTB Facility and not enough for Plaintiffs to make a profit. At this point, Plaintiffs attempted to revise the terms of their purchase of Defendants’ interest in White Tiger, but Defendants refused to negotiate. Mangazeya lacked the funds to repay the loans previously extended to it by Faith Union and Unique Goals. Faith Union and Unique Goals settled their debt by purchasing shares in Mangazeya at a premium to its then current stock price in order to enhance the company’s liquidity and improve its prospects for raising additional capital.

Plaintiffs filed a complaint against Defendants, alleging four causes of action: fraud, conspiracy to commit fraud, unjust enrichment and breach of fiduciary duty.

Defendants moved to dismiss the complaint.

The Court’s Decision

As to the fraud claim, the Court granted the motion, holding that Plaintiffs failed to plead justifiable reliance.

As an initial matter, the Court determined that Yanchukov, Plaintiffs’ controlling shareholder, was “a sophisticated businessperson with access to plentiful resources to protect himself and his investments.” The Court rejected the notion that because he lacked experience in the mining industry, he was not a sophisticated businessman.

Although the complaint here attempts to cast Yanchukov as a newcomer to the mining business who relied on his close, personal friend Finskiy to guide him, Yanchukov, plainly, is a sophisticated businessperson with access to plentiful resources to protect himself and his investments, to obtain the requisite inspections and perform the necessary due diligence. While he may have lacked experience in the mining industry, he clearly had the resources necessary to obtain expert advice or, indeed, do an investigation.

The Court held that because Yanchukov was a sophisticated businessman, he should have taken affirmative steps to protect himself from Defendants’ misrepresentations “by employing what means of verification were available at the time.” The Court found that he did not. His failure to conduct any due diligence was, therefore, fatal to Plaintiffs’ fraud claim. MAFG Art Fund, LLC v. Gagosian, 123 A.D.3d 458, 459 (1st Dept. 2014) (where a sophisticated plaintiff conducts no due diligence, he cannot demonstrate reasonable reliance as a matter of law).

Takeaway

In Ambac the Court of Appeals sent a strong message to sophisticated parties claiming fraud: if the person or entity has the means of knowing, by the exercise of ordinary intelligence, the truth of the subject of the alleged false representation, that person or entity must make use of those means, or he/she/it will not be heard to complain that he/she/it was the victim of fraud. Thus, where a person or entity, especially a sophisticated one, does not verify and investigate the truthfulness of assurances and representations, or is lax in doing so, the claim should be dismissed for failing to satisfy the justifiable reliance element. In Unique Goals, the Court heeded this message.

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