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Fraud Notes: The Failure to Investigate When The Facts Require An Investigation, Disclaimers and Actionable Misrepresentations

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  • Posted on: Jan 20 2021

On January 19, 2021, the Appellate Division, First Department issued three decisions involving claims of fraud. See United Natural Foods, Inc. v. Goldman Sachs Grp., 2021 N.Y. Slip Op. 00276 (1st Dept. Jan. 19, 2021) (here); KS Trade LLC v. International Gemological Inst., Inc., 2021 N.Y. Slip Op. 00259 (1st Dept. Jan. 19, 2021) (here); and Itria Ventures LLC v. Provident Bank, 2021 N.Y. Slip Op. 00257 (1st Dept. Jan. 19, 2021) (here). Although these cases involved different elements of a fraud cause of action, the common thread among them is the justifiable reliance element of the claim. 

In today’s post, we examine two of the three cases: United Natural Foods and KS Trade. [Ed. Note: the discussion of both cases is based upon the First Department’s decisions, the motion courts’ orders, and the briefing on appeal.]

The justifiable reliance element of a fraud cause of action has been described as a “fundamental precept” (Ambac Assur. v. Countrywide, 31 N.Y.3d 569, 579 (2018)) and a “venerable rule”. ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1051 (2015) (Read, J., dissenting on other grounds) (describing the justifiable reliance requirement as “our venerable rule”).

The requirement is one of the five elements of a fraud cause of action: (1) a misrepresentation or a material omission of fact; (2) which was false and known to be false by the defendant(s); (3) made for the purpose of inducing another person to rely upon it; (4) justifiable reliance of the other party on the misrepresentation or material omission; and (5) damages. Pasternack v. Laboratory Corp. of Am. Holdings, 27 N.Y.3d 817, 827 (2016) (citation omitted).

The determination of whether a plaintiff justifiably relied on a misrepresentation or omission is a factually “nettlesome” one (DDJ Mgt., LLC v. Rhone Group L.L.C., 15 N.Y.3d 147, 155 (2010) (internal quotation marks omitted). As the Court of Appeals observed, “[n]o two cases are alike ….” Id. For this reason, the courts look to whether the plaintiff exercised “ordinary intelligence” in ascertaining “the truth or the real quality of the subject of the representation.” Curran, Cooney, Penney v. Young & Koomans, 183 A.D.2d 742, 743) (2d Dept. 1992). If the plaintiff fails to make use of the means available to discover the truth, his/her claim will be dismissed. ACA Fin. Guar., 25 N.Y.3d at 1044.

This inquiry “involves a mixed question of law and fact, and, where it does not conclusively appear that a plaintiff had knowledge of facts from which the alleged fraud might be reasonably inferred, the cause of action should not be disposed of summarily on statute of limitations grounds.”  Berman v. Holland & Knight, LLP, 156 A.D.3d 429, 430 (1st Dept. 2017). “Instead, the question is one for the trier of-fact.” Id. See also Sargiss v Magarelli, 12 N.Y.3d 527, 532 (2009).

“[W]hen the party to whom a misrepresentation is made has hints of its falsity, a heightened degree of diligence is required of it. It cannot reasonably rely on such representations without making additional inquiry to determine their accuracy.” Centro Empresarial Cempresa S.A. v. América Móvil, S.A.B. de C.V., 17 N.Y.3d 269, 279 (2011), quoting Global Mins. & Metals Corp. v. Holme, 35 A.D.3d 93, 100 (1st Dept. 2006), lv. denied, 8 N.Y.3d 804 (2007). 

Sophisticated parties also have a heightened responsibility to inquire of the truth. They must use due diligence and take affirmative steps to protect themselves from misrepresentations by employing whatever means of verification are available at the time. Such means include obtaining a prophylactic provision in a contract or other writing or making an additional inquiry into the representation. ACA Fin. Guar., 25 N.Y.3d at 1045; DDJ Mgt., 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). If they fail to do the foregoing, their complaint will be dismissed. 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).

United Natural Foods, Inc. v. Goldman Sachs Group

United Natural Foods concerned a multi-billion-dollar financing transaction between sophisticated parties. Pursuant to the transaction, United Natural Foods, Inc. (“UNFI”) agreed to acquire SUPERVALU Enterprises, Inc. (“SUPERVALU”) for approximately $2.9 billion (the “Acquisition”). Under the terms of the transaction papers, UNFI agreed to pay approximately $1.3 billion in cash to SUPERVALU’s shareholders and the balance to SUPERVALU’s creditors to extinguish most of SUPERVALU’s debt. 

To navigate the Acquisition, UNFI engaged Goldman Sachs & Co., LLC, a subsidiary of defendant Goldman Sachs Group, Inc. (“GS Group”) and an affiliate of defendants Goldman Sachs Bank USA (“GS Bank”) and Goldman Sachs Lending Partners, LLC (“GS Lending”). GS Bank agreed to fund 45% of the Acquisition with a $2.15 billion Term Loan. GS Bank and GS Lending had the option to syndicate all or a portion of their commitment to fund the Term Loan to one or more banks, financial institutions, or other institutional lenders. UNFI could veto the investors selected for syndication, though it was obligated to cooperate with defendants’ syndication efforts. Whether defendants syndicated or not, they remained responsible for funding. 

During the syndication process, GS Bank passed along an investor request that UNFI add SUPERVALU as a co-borrower on the Term Loan. UNFI alleged that defendants understated the impact of adding SUPERVALU as a co-borrower, claiming that any impact was “muted”, when in reality UNFI “was subjected to Term Loan lenders with a significant incentive to force UNFI and SUPERVALU to default on the Term Loan.” UNFI alleged that GS Bank failed to provide a list of investors in the Term Loan. 

UNFI also claimed that when it inquired about the purpose of adding SUPERVALU as a co-borrower, defendants falsely represented that the co-borrower provision was important to “select accounts”. According to UNFI, defendants omitted to say that those select accounts were held by “[credit default swap] short sellers looking to preserve their bet that SUPERVALU would default on its borrowing.” 

UNFI filed suit, asserting causes of action for breach of contract, breach of the implied covenant of good faith and fair dealing, and fraud against all defendants. Defendants moved to dismiss. 

The motion court granted the motion (here). With regard to the fraud claim, the motion court held that UNFI failed to plead justifiable reliance.

As to the first allegation of fraud – i.e., whether adding SUPERVALU as a co-borrower would have a “muted” effect – the motion court found that UNFI “had the means available to it of knowing by the exercise of ordinary intelligence the truth or real quality of” the statement:

UNFI was also in position to undertake an “independent appraisal of the risk” associated with adding UNFI’s target as a co-borrower for what UNFI describes as the “most important undertaking in [its] history.” Yet, UNFI admits to failing to demand the list of investors before the Closing; UNFI did not learn the identities of the investors until after the closing. Nevertheless, UNFI failed to engage in a due diligence investigation or independently appraise this risk. Therefore, and in spite of UNFI’s theories of liability, these allegations of justifiable reliance are untenable. UNFI even admits in a footnote in the complaint that it had “another financial advisor on the transaction, Foros LLC” and legal counsel available to it for consultation. [Citations omitted.]

As to the second allegation of fraud – i.e., that adding SUPERVALU as the co-borrower was important to “select accounts” when in reality those were “[credit default swap] short sellers looking to preserve their bet that SUPERVALU would default on its borrowing” – the motion court found that UNFI failed to “exercise its veto power” over the investors selected.

UNFI appealed. 

The First Department affirmed, holding that “[t]he fraud claim was properly dismissed” due to plaintiff’s failure to sufficiently plead justifiable reliance. Slip Op. at *1. The Court found that “Plaintiff could have asked follow-up questions regarding what kind of an effect making Supervalu a coborrower would have and on which ‘select accounts,’ but did not do so … [and] failed to insist on a final list of investors prior to closing, even though it [was] undisputed that plaintiff had the contractual right to do so to facilitate exercise of its right to veto investors.” Slip Op. *1-*2. The Court explained that the failure to insist on the list of investors prior to closing was a “red flag that triggered a need to make additional inquiries, including with respect to whether any proposed investors had adverse interests to plaintiff.” Id. at *2.

 KS Trade LLC v. International Gemological Inst., Inc.

KS Trade involved a dispute that arose after plaintiff, KS Trade LLC (“KS”), a New York-based jewelry designer and manufacturer, was unable to satisfy a purchase order from a large retail customer for 45 pieces of jewelry because it could not obtain grading reports from New York-based defendant, International Gemological Institute, Inc. (“IGI”), a corporation that grades diamonds and precious stones, and appraises jewelry.

KS alleged that defendants engaged in a scheme to create “illicit profits for itself and its accomplices at the expense of diamond dealers, jewelry manufacturers and the ultimate end-user consumers who purchase the jewelry.” KS claimed that defendants systematically over-graded diamonds at their overseas branches, and then sold these diamonds with false certificates, to U.S. based jewelry manufacturers. To be able to sell these diamonds, New York manufacturers had to obtain a New York conforming certification, which IGI would only provide if the manufacturers paid it illicit “fees.” If the fees were paid, the diamonds were then passed off to consumers as higher quality goods with fraudulent appraisals and certificates. KS alleged that it refused to pay the illicit fees and was left with diamonds with no New York grading certificates and was unable to complete sales to its customers.

KS filed suit alleging, inter alia, fraud.

Defendants moved to dismiss the fraud claim, arguing that KS failed to identify any misrepresentation and allege justifiable reliance. In response, KS maintained that defendant committed fraud when it issued the original certificates for diamonds that it over-graded. KS claimed that defendant “intentionally rejected the earlier gradings so that it could solicit illicit fees” from KS.

The motion court sustained the fraud claim. On appeal, the First Department affirmed.

First, the Court found that KS “sufficiently alleged misrepresentations of ‘accurate and objective’ gradings by the overseas IGI branches, as well as misrepresentations of ‘consistent’ gradings by IGI NY.” Slip Op. at *1-*2. 

Second, the Court found that KS “pleaded justifiable reliance on such misrepresentations in purchasing diamonds with overseas IGI certificates with the expectation that IGI NY would issue consistent appraisals.” Id. at *2. The Court explained that plaintiff satisfied this element of the claim because only defendants knew of the underlying fraud: “defendants had ‘peculiar knowledge’ of the underlying fraud.” Id. (quoting Basis Yield Alpha Fund Master v. Morgan Stanley, 136 A.D.3d 136, 145 (1st Dept. 2015)). As such, said the Court, “[t]he disclaimers in IGI Group’s website and IGI NY’s Client Agreement” did “not negate a finding of justifiable reliance.” Id. 

[Ed. Note: the disclaimers at issue addressed the nuances of evaluating gems in connection with jewelry appraisal services, explaining that grading of diamonds contained within finished jewelry may be less precise.]

Takeaway

Justifiable reliance is an essential element of a cause of action for fraud. ACA Fin. Guar., 25 N.Y.3d at 1044. As such, a plaintiff suing for fraud (and particularly a sophisticated plaintiff, such UNFI and KS) must establish that it “has taken reasonable steps to protect itself against deception.” DDJ Mgt., 15 N.Y.3d at 154. Such steps include availing oneself of the opportunity to verify the defendant’s representations through an examination of documents, corporate books and records, and other writings; asking questions; and/or insisting on prophylactic measures, such as representations and warranties in agreements. In United Natural Foods, UNFI failed to do any of the foregoing.

Where there is a disclaimer of reliance on a fact or set of facts, a fraud claim will not be dismissed unless the disclaimer is specific to the fact(s) alleged to be misrepresented or omitted. Thus, a general disclaimer will not insulate a defendant from allegations of fraud. See Dallas Aerospace, Inc. v. CIS Air Corp., 352 F.3d 775, 785 (2d Cir 2003). 

In KS Trade, the alleged disclaimers warned only that the grading and appraisal process could be imprecise – that is, “they specifically disclaimed guarantees of consistency”; they did not, however, warn against the manipulation of the grading and appraisal process – a manipulation that, as KS alleged, was intended to coerce cooperation with defendants’ scheme to defraud.

Even where a disclaimer is specific, as the First Department noted, it will not be deemed effective when the facts underlying the alleged misrepresentations are peculiarly within the defendant’s knowledge. Under such circumstances, as in KS Trade, the plaintiff has no reason to inquire into the representations and cannot investigate the facts. Basis Yield, 136 A.D.3d at 145. 

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