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Fraud Notes: Hints of Falsity and Failure to Plead Damages

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  • Posted on: Apr 10 2020

In today’s Fraud Notes, we examine two cases decided by the Appellate Division, First Department: Knox, LLC v. Lakian, 2020 N.Y. Slip Op. 02255 (1st Dept. Apr. 9, 2020) (here), and WCapital Invs. LLC v CWCapital Cobalt VR Ltd., 2020 N.Y. Slip Op. 02240 (1st Dept. Apr. 9, 2020) (here). Knox concerned the justifiable reliance element of a fraud claim and WCapital Invs. concerned the damages element of a fraud claim. 

Hints of Falsity

New York law imposes an affirmative duty on sophisticated investors to protect themselves from misrepresentations made during business acquisitions by investigating the details of the transactions and the businesses they are acquiring. See, e.g., Abrahami v. UPC Constr. Co., 224 A.D.2d 231, 234 (1st Dept. 1996) (sophisticated businessmen had a duty to exercise ordinary diligence and conduct an independent appraisal of the risk they were assuming). When the party to whom a misrepresentation is made has hints of its falsity, a heightened degree of diligence is required of it. Banque Franco-Hellenique de Commerce Intl. et Mar., S.A. v. Christophides, 106 F.3d 22, 27 (2d Cir. 1997). It cannot reasonably rely on such representations without making additional inquiry to determine their accuracy. Keywell Corp. v. Weinstein, 33 F.3d 159, 164 (2d Cir. 1994). When a party fails to make further inquiry or insert appropriate language in the agreement for its protection, it has willingly assumed the business risk that the facts may not be as represented. Rodas v. Manitaras, 159 A.D.2d 341, 343 (1st Dept. 1990). Under those circumstances, a claim for fraudulent inducement will be dismissed.

In Knox, LLC v. Lakian, 2020 N.Y. Slip Op. 02255 (1st Dept. Apr. 9, 2020) (here), the Appellate Division, First Department affirmed the entry judgment against the defendants on the grounds that, inter alia, the plaintiffs justifiably relied on the defendants’ misrepresentations. 

Plaintiffs sought to recover the investments they made in nonparty Capital L Group, LLC (“Capital L”), which were diverted to personal bank accounts held by Capital L’s chief executive officer, defendant John R. Lakian (“Lakian”). Plaintiffs claimed that they were fraudulently induced into making the investments and sought summary judgment on that cause of action.

Defendants contended that an issue of fact existed as to whether plaintiffs’ reliance on the statements made to them by Lakian was justified. In that regard, Defendants argued that nonparty, Donald J. Whelley (“Whelley”), the sole manager and member of plaintiff, DJW Advisors, LLC, expressed concerns about Capital L’s accounting systems and back-office operations, but ignored those “red flags” in deciding to make the investments. Therefore, Defendants said, plaintiffs were responsible for that risk. The Court rejected this argument, finding that “Whelley’s concerns were unrelated to the eventual fraudulent diversion of the funds.” Slip Op. at *1. As such, Defendants “failed to demonstrate that Whelley ‘ha[d] hints of [Lakian’s misrepresentations’] falsity’ and therefore had a duty to probe further.” Id. (citation omitted).

The Court rejected Defendants’ contention that Whelley should have inspected a full set of financial documents because “they failed to show that if he had done so he would have been alerted to the potential fraudulent diversion of funds.” Id. (citing UST Private Equity Invs. Fund v. Salomon Smith Barney, 288 A.D.2d 87, 88 (1st Dept. 2001). The Court concluded that Defendants’ “references to the ‘tangled accounts’ and ‘problematic transactions’ that Whelley would have seen had he reviewed unspecified documents [were] too vague to raise an issue of fact.” Id.

The Court also rejected Defendants’ contention that Whelley’s expressed concerns about Capital L’s accounting systems and back-office operations “were in fact concerns about where Capital L’s money was going.” Id.  The Court observed that Whelley was certain that Capital L’s record keeping and back-office problems had been solved by its acquisition of Capital Guardian Holding LLC. Id. “If Whelley had been concerned about a potential fraudulent diversion of funds,” reasoned the Court, “his concern would not have been alleviated by the acquisition of a new company.” Id.

Finally, the Court rejected Defendants’ contention that Whelley should have insisted on language in the subscription agreement to ensure that the investment would be used solely to acquire registered investment advisors.” Id. The Court explained that “the fraudulent inducement claim [was] based not on defendants’ use of plaintiffs’ funds for general business operations instead of the acquisition of registered investment advisors but on the diversion of their funds for personal purposes.” Id. at *1-*2.

The Failure to Plead Damages

To allege a cause of action based on fraud, a plaintiff must allege “a misrepresentation or a material omission of fact which was false and known to be false by defendant, made for the purpose of inducing the other party to rely upon it, justifiable reliance of the other party on the misrepresentation or material omission, and injury.” Lama Holding Co. v. Smith Barney, 88 N.Y.2d 413, 421 (1996) (citations omitted). Each element of the claim must be pleaded in order to withstand a challenge to the cause of action. In WCapital Invs. LLC v CWCapital Cobalt VR Ltd., 2020 N.Y. Slip Op. 02240 (1st Dept. Apr. 9, 2020) (here), the Appellate Division, First Department reversed the denial of defendants’ motion to dismiss the fraudulent inducement claims because plaintiffs failed to allege damages.

WCapital Invs. involved a 2007 collateralized debt obligation (“CDO”) in which various classes of notes were issued by defendant, CWCapital Cobalt VR Ltd. (“Cobalt”). The transaction was governed by an indenture and a collateral management agreement (“CMA”). Under the CMA, plaintiff, CWCapital Investments LLC (“CWCI”), was named as collateral manager and appointed as Cobalt’s “exclusive agent” to provide Cobalt with certain services, including exercising the right to appoint or act as the controlling class representative or directing holder (together the “CCR”). CWCI exercised that right by appointing itself as the CCR. It served in that role since the inception of the CDO in 2007.

During the course of the CDO, the notes were transferred several times. In August 2016, pursuant to five separate sale agreements, former defendant Merrill Lynch, Pierce, Fenner and Smith Incorporated sold certain notes to defendants, OZ Master Fund, Ltd., OZ Enhanced Master Fund, Ltd., OZ Credit Opportunities Master Fund, Ltd., OZ GC Opportunities Master Fund, Ltd. and OZSC, L.P. (collectively, the “OZ Funds”). Among other things, the OZ Funds promised not to aid in the removal of the collateral manager. Plaintiff Galaxy Acquisition LLC (“Galaxy”), CWCI’s parent, which purportedly had the power to veto any transfer of the notes, approved the sales.

Shortly thereafter, the OZ Funds transferred the notes to defendant, Carbolic, LLC (“Carbolic”). In connection with that transaction, Carbolic wrote five letters to Galaxy (the “letter agreements”) in which it made the same promises that the OZ Funds had made in the sale agreements.

In April 2018, Cobalt sent notice letters designating Carbolic as the new CCR. Thereafter, CWCI and Galaxy commenced the action alleging that in replacing CWCI with Cobalt as the CCR, the various defendants breached the indenture, the CMA, the sale agreements and the letter agreements, and engaged in tortious conduct. They also alleged breach of contract and fraud in connection with the sale of the notes to the OZ Funds. By separate motions, Cobalt and Carbolic, and the OZ Funds and the OZ Management defendants, moved to dismiss the amended complaint. In January 2019, after the motions were briefed but before the motion court’s decision, Cobalt withdrew its appointment of Carbolic as the CCR. Carbolic never took over as the CCR; CWCI has always retained that role. After supplemental briefing, the motion court denied the motions. Defendants appealed.

The Court held that the fraud claims (in addition to the other claims) should have been dismissed because plaintiffs failed to allege damages. “Although a plaintiff is not obligated to show, on a motion to dismiss, that it actually sustained damages,” noted the Court, “it must plead ‘allegations from which damages attributable to [defendant’s conduct] might be reasonably inferred.’” Slip Op. at *4 (quoting InKine Pharm. Co. v. Coleman, 305 A.D.2d 151, 152 (1st Dept. 2003) (internal quotation marks omitted). The Court held that plaintiffs failed to do so.

The Court found that plaintiffs failed to “explain how they sustained damages as a result of Cobalt’s designation of Carbolic as the new CCR.” Id. Indeed, noted the Court, “the notice letters appointing Carbolic as the CCR were never given effect, the appointment of Carbolic was withdrawn, and CWCI continued operating as the CCR.” Id.  “Because cognizable damages cannot be reasonably inferred,” the Court concluded that the fraud causes of action “should be dismissed.”  Id. (citing Arts4All, Ltd. v. Hancock, 5 A.D.3d 106, 110 (1st Dept. 2004).

The Court also rejected plaintiffs’ argument that it incurred damages because “they were allegedly forced to engage in ‘costly litigation.’” Slip Op. at *4. Under settled law, held the Court, “attorneys’ fees . . . are not recoverable unless authorized by statute, court rule, or written agreement of the parties” and plaintiffs failed to allege any of the foregoing. Id. (quoting Reif v. Nagy, 175 A.D.3d 107, 131 (1st Dept 2019) (internal quotation marks omitted)). 


A claim for fraudulent inducement requires a plaintiff to establish a misrepresentation of a material fact, which was known by the defendant to be false and intended to be relied on when made, and which plaintiff justifiably relied on, resulting in damages. Ventur Group, LLC v. Finnerty, 68 A.D.3d 638, 639 (1st Dept. 2009) (internal quotation marks and citation omitted). As this Blog has often noted, the justifiable reliance element is typically the most difficult to satisfy. This is especially so when the plaintiff is sophisticated, such as in Knox. When there are hints of falsity, the obligation to root out the fraud is heightened. For this reason, plaintiffs often fail to satisfy the justifiable reliance element. 

In Knox, the alleged fraud – i.e., the diversion of funds – could not have been discovered with reasonable, indeed heightened, diligence. As noted by the Court, review of the financial records and concerns about accounting systems and back-office operations were not themselves sufficient to put plaintiffs on notice that funds had been diverted for personal use. In fact, as the Court observed, the red flags identified by defendants “were unrelated to the … fraudulent diversion of funds.” Slip Op. at *1. 

WCapital Invs. reminds us of the importance of pleading recoverable damages resulting from the misrepresentation or omission. As noted, although a plaintiff is not required to demonstrate, on a motion to dismiss, that it actually sustained damages, he/she must plead facts from which damages are reasonably inferred. The failure to do so will, as in WCapital Invs., result in dismissal.

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