Fraud Notes: You Win Some, You Lose Some

• Posted on: May 20 2022

By: Jeffrey M. Haber

In today’s Fraud Notes, we examine three decisions issued by the Appellate Division, First Department in which themes familiar to readers of this Blog are at issue: pleading fraud with particularity (e.g., here and here), making a material misstatement of present fact (e.g., here and here) duplication of a breach of contract claim (e.g., here, here and here), pleading justifiable reliance (e.g., here, here and here), and no reliance and disclaimer clauses (e.g., here and here). 

470 4th Ave. Fee Owner, LLC v. Adam Am. LLC

470 4th Avenue concerned the construction and purchase of a luxury residential building in Brooklyn, New York (“Building”).

Plaintiff alleged that defendant, Adam America LLC (“Adam America”), 470 4th Avenue Investors LLC (“Seller”) and Danya Cebus Construction LLC (“Danya Cebus”, together with Adam America and Seller, the “Defendants”) defectively developed and constructed the Building, then concealed and misrepresented those defects to induce Plaintiff to purchase the Building for $81 million. 

In July 2014, Seller hired Danya Cebus to begin construction of the Building. According to Plaintiff, “with Seller’s knowledge and acquiescence, Danya Cebus cut corners to save money,” which caused numerous defects in the construction that were “concealed and undiscoverable without destructive investigation”. These shortcuts “ultimately … resulted in severe water infiltration” inside the Building. 

In late 2014, Plaintiff entered into discussions with Adam America and Seller to purchase the Building. Plaintiff alleged that throughout the process, these defendants made misrepresentations about the quality of the construction. Although the sale and purchase agreement provided that the Building was being purchased “as is,” it also contained representations and warranties by Seller on which Plaintiff allegedly relied. After the closing, Plaintiff discovered extensive water damage to the Building and, despite numerous requests, Seller failed to repair the defects. 

Plaintiff commenced the action in December 2018, and filed an amended complaint in March 2019, asserting, among other claims, breach of contract, fraudulent inducement, fraudulent concealment and misrepresentation.

Defendants moved to dismiss. The motion court denied the motion.

Danya Cebus argued that Plaintiff failed to plead its fraud claims with particularity as required under CPLR § 3016(b). The motion court held the argument to be unavailing. The motion court explained that the amended complaint was replete with allegations showing that Danya Cebus (a) knowingly cut corners in the construction of the Building, (b) introduced and caused many construction defects in the Building, including defects in the foundation, roof, facade and fenestration systems, and (c) made material misrepresentations to Plaintiff that there were no problems despite knowing and causing the defects. The motion court also found that Plaintiff reasonably relied upon the alleged fraudulent representations and sustained damages thereby. 

AARE argued that the fraud claim was barred by a “no reliance” clause in the purchase and sale agreement (“PSA”), including representations with respect to the “present or future structural and physical condition of the Building”. AARE also argued that the waiver and release clause in the agreement was broad and barred Plaintiff’s fraud claim because it alleged misrepresentations about the quality of the Building’s construction. 

Under New York law, a party’s disclaimer of reliance on extra-contractual representations and omissions will not preclude a fraudulent inducement claim unless: (1) the disclaimer is specific to the fact alleged to be misrepresented or omitted; and (2) the alleged misrepresentation or omission does not concern facts peculiarly within the knowledge of the non-moving party.¹ Based upon the foregoing, the motion court rejected AARE’s argument, stating that the alleged misrepresentation concerned facts peculiarly within AARE’s knowledge – that is, latent defects that Plaintiff could not discover without conducting invasive testing. 

Regarding Plaintiff’s fraudulent concealment claims, the motion court held that Plaintiff sufficiently alleged that Danya Cebus, as the general contractor of the Building, had superior knowledge of the material facts relating to the alleged construction defects and knew of such defects but failed to disclose them to Plaintiff. The motion court also held that even though Danya Cebus was not a party to the PSA, it nevertheless had a “duty to disclose materially damaging information” and, therefore, could be held liable for the fraud.² 

The motion court also rejected AARE’s argument that the fraudulent concealment claim should be dismissed because of the “waiver and release” and the “no representation” clauses in the PSA. The motion court observed that the amended complaint showed that defendants, including AARE, concealed the latent construction defects, prevented Plaintiff from taking invasive measures to uncover them, and that there was a special duty to disclose material damaging information to Plaintiff. 

On appeal, the First Department affirmed the denial of the motion with respect to the fraud claims.

The Court held that Plaintiff pleaded its fraud claims “with the specificity required under CPLR 3016(b)” by providing the “details about the allegedly fraudulent statements”.³ The Court also held that Plaintiff pleaded its justifiable reliance on the alleged false statements with the requisite specificity.⁴ 

The Court further held that the fraud claims were not duplicative of Plaintiff’s breach of contract claims, “since many of the allegations relate to acts predating the Purchase and Sale Agreement (“PSA”). Additionally, said the Court, the PSA did “not bar the fraud claims as against the seller” because “the claims [were] governed by the special facts doctrine.”⁵ 

Finally, the Court held that the fraud claims fell within the carve-out to the PSA’s release, which specifically stated that it did not apply to any acts constituting fraud.⁶

470 4th Ave. Fee Owner, LLC v. Adam Am. LLC, 2022 N.Y. Slip Op. 03204 (1st Dept. May 17, 2022), can be found here.

PanWest NCA2 v Rockland NCA2

PanWest arose out of an agreement to purchase and sell a power plant. Pursuant to the agreement, the parties agreed that the seller would share information with the buyer, and that the buyer would rely on that information and the representations and warranties of the seller in the agreement in entering into the transaction (except to the extent expressly addressed in the agreement). 

The parties also agreed that in the event that the representations and warranties in the agreement were not true at closing, the buyer did not have to close. The parties further agreed that the buyer was to do its own due diligence and limited the buyer’s reliance on the seller’s representations to those contained in the agreement (which included the obligations to provide accurate financial information and all environmental reports). The accuracy of the information was a condition to the buyer’s obligation to close. 

According to Plaintiff, after the agreement was signed, defendant provided Plaintiff with a summary of the annual operating budget for 2020. The budget contained a line item for certain non-annual maintenance (“NAM”) costs, which had been included as maintenance costs in defendant’s prior budgets. Defendant (through its investment banker) allegedly advised that the costs were mistakenly included in the 2020 budget and did “not reflect any view of expenses in 2020.” Thereafter, Defendant provided a revised 2020 budget without this line item. 

After the closing, Plaintiff was presented with an environmental survey of a pond that was conducted at Defendant’s direction and during Defendant’s ownership of the facility. The pond survey showed that the water level in the pond did not meet certain state requirements. 

According to Plaintiff, Defendant never disclosed the pond survey to Plaintiff, or made any mention of the lack of compliance with the state’s requirements. Plaintiff maintained that Defendant instructed plant staff to not discuss the pond compliance with Plaintiff during the due diligence period. In addition, Plaintiff contended that Defendant had been aware of the failure to meet the state’s requirements prior to entry of the agreement.  

On March 16, 2020, plaintiff sought an adjustment to the budget due to environmental maintenance and remediation costs. In response, defendant disputed the necessity for any adjustments. Defendant also disputed that it had an obligation to disclose the pond survey to plaintiff. 

Plaintiff alleged that defendant committed fraud and otherwise breached its obligations in the agreement by misrepresenting the NAM costs and failing to disclose the pond survey report. Defendant moved to dismiss. 

The motion court denied the motion.

First, the motion court held that plaintiff sufficiently alleged a breach of contract with regard to the NAM costs. The motion court found that certain representations in the agreement were not true, correct and complete at the time of the closing. The motion court explained that Defendant’s concealment of the new line-item NAM current liability and the pond survey report prevented Plaintiff from doing a complete analysis under the agreement and deprived Plaintiff of its contractual right to walk away from the transaction. Additionally, Defendant’s approval of the new line-item NAM current liability was not permitted without Plaintiff’s consent.

The motion court also held that Defendant failed to make available the pond survey report as set forth in the agreement. The motion court rejected Defendant’s argument that, among other things, the pond survey report was not material, explaining that the $2 million in estimated remediation costs demonstrated the materiality of the alleged breach. 

Second, the motion court held that the fraudulent inducement claims were viable and should not be dismissed. The motion court explained that Plaintiff adequately alleged a misrepresentation of fact, i.e., the false statement that the new NAM line-item charge should not have been in the budget.

The motion court also held that the fraudulent concealment claims were viable and should not be dismissed. The motion court found that as pleaded, Defendant concealed the pond survey report, which would have disclosed the imminent need for remediation. The motion court explained that Defendant had such information months before the agreement was executed. The failure to disclose the report and the allegations that plant employees were told not to discuss the pond survey report, said the motion court, was more than sufficient to state a claim of fraud and fraudulent concealment. 

On appeal, the First Department modified the motion court’s order to grant the motion as to the causes of action for fraud and otherwise affirmed the order as to the breach of contract claims.

The Court held that the fraud claims should have been dismissed. With respect to the NAM costs, the Court found the claims to be “duplicative of the breach of contract claims; even though the alleged misstatements and omissions related to matters of present fact.…” The Court explained that “the matters in question were not collateral to the purchase agreement but were within the scope of the parties’ rights and obligations under the terms of the purchase agreement.”⁷ 

Panwest NCA2 Holdings LLC v. Rockland NCA2 Holdings, LLC, 2022 N.Y. Slip Op. 03328 (1st Dept. May 19, 2022), can be found here.

Pope Investments II LLC v. Belmont Partners, LLC

Pope involved a series of transactions (the “SMT Transactions”) in which plaintiffs invested in Aamaxan Transport Group, Inc. (the “AAXT Investment”) with the intention of owning a significant interest in Shanghai Atrip Medical Technology (“SMT”).

Plaintiffs rested their claims on defendants’ actions or inactions, which allegedly enabled Shao Gan Hua (“Shao”), a non-party, to embezzle AAXT Investment’s proceeds, less fees paid to Guzov (a law firm), Belmont, and the Deheng Law Firm (“Deheng”), a non-party to the action.

The series of transactions began in 2007, when Helen Lv (“Lv”), a partner of Deheng, contacted Darren L. Ofsink (an employee of Guzov) about jointly seeking U.S.-based investors to organize an investment transaction in SMT. Ofsink solicited Belmont to act as the investment banker on the transactions and Belmont solicited the investors for the AAXT Investment.

Before, and allegedly in anticipation of, the AAXT Investment, Kamick Assets Limited (“Kamick”), a British Virgin Islands company solely owned by Shao, transferred 100% of the outstanding equity of its subsidiary ABM in exchange for shares in AAXT (the “ABM Transaction”). A Share Exchange Agreement, dated April 14, 2008, documented the ABM transaction. As a result of the ABM Transaction, ABM became a wholly owned direct subsidiary of AAXT, and Anhante, a wholly foreign owned enterprise of ABM, became a wholly owned subsidiary of ABM.

A Securities Purchase Agreement, dated April 14, 2008, documented the AAXT Investment. Plaintiffs, along with other investors not named as plaintiffs, invested approximately $12.5 million in AAXT in exchange for shares of AAXT’s Series A Senior Convertible Preferred Stock. Of the $12.5 million, approximately $10.1 million was left in net proceeds after fees were paid to Deheng and named defendants Guzov and Belmont.

In conjunction with the closing of the AAXT Investment, AAXT and SMT entered into the China Control Agreement. SMT transferred all of the economic benefits and liabilities of its business to Anhante in exchange for the net proceeds of the AAXT Investment, namely, $10,132,522.35. Pursuant to the China Control Agreement, AAXT effectively became the indirect beneficial owner of SMT.

As part of the SMT Transactions, Chen Zhong (“Chen”), the principal owner of SMT, also became the Chairman and CEO of AAXT. Chen and Shao, the sole owner of Kamick, entered into a Call Option Agreement, dated April 14, 2008. Pursuant to the terms of the Call Option Agreement, Chen had the option of purchasing all of Kamick’s outstanding stock over approximately two years for a total purchase price of less than thirty dollars. Although Chen held himself out as the CEO and Chairman of Kamick, Shao was the controlling shareholder of Kamick, subject to the Call Option Agreement.

The SMT Transactions made Shao essentially the majority shareholder of AAXT. Kamick was the majority shareholder of AAXT and Shao was the sole owner of Kamick subject to the Call Option Agreement. AAXT was the only shareholder of ABM and the only shareholder of Anhante, the entity that entered into the China Control Agreement with SMT. While Shao and Kamick were nominees of ABM, they were not supposed to have any control over ABM. Chen was supposed to have control of ABM as CEO of AAXT.

After the AAXT Investment closed, Guzov placed the net proceeds in an HSBC account under ABM’s name for holding before they were transferred to SMT. Plaintiffs alleged, however, that Shao and/or Kamick retained control of AMB and the bank account at issue, and that they were not aware that Shao and/or Kamick could exercise control over the net proceeds. The complaint alleged that Shao embezzled most or all of the money in the ABM account within several days.

The complaint also alleged that Shao and Lv had been conspiring to embezzle the money invested in AAXT since 2007. On September 18, 2008, Lv informed the AAXT Investors that their investment had been invested elsewhere, contrary to the Transaction Documents and SEC filings. After Deheng had advised Kamick to transfer the net proceeds out of ABM’s account, Lv informed the AAXT Investors on October 9, 2008, that Deheng would no longer be representing Kamick. According to the complaint, after the net proceeds were removed from ABM’s account, the funds were deposited into Shao’s personal bank account, accounts of entities controlled by Shao, and an account controlled by Lv.

Plaintiffs asserted claims for, among other things, fraudulent inducement. They alleged that defendants fraudulently induced them to purchase shares of AAXT. Plaintiffs further claimed that Guzov and Ofsink were responsible because of the alleged material misrepresentations they made in a legal opinion that the transactions were legal and binding. Specifically, plaintiffs alleged that defendants fraudulently induced them to invest in AAXT by misrepresenting that they had fully vetted Shao and Kamick, and by not disclosing that Shao and Helen Lv were close friends with the intent to defraud and deceive plaintiffs.

Defendants moved to dismiss.

The motion court denied the motions. 

On appeal, the First Department affirmed. The Court held that the “motion court correctly determined that the amended complaint adequately stated claims for fraudulent inducement by alleging, among other things, that but for defendants’ misrepresentations that the nonparties who embezzled plaintiffs’ investment were trustworthy and that the transactions were properly structured, plaintiffs would not have agreed to complete the transactions.”⁸ 

Pope Invs. II LLC v. Belmont Partners, LLC, 2022 N.Y. Slip Op. 03334 (1st Dept. May 19, 2022), can be found here.

Takeaway

As noted in the introduction, the cases examined today address several issues commonly found in fraud litigations. The issue that stands out to us, however, is the particularity requirement of CPLR § 3016(b). 

Under CPLR § 3016(b), the circumstances constituting fraud must be stated with sufficient detail “to permit a reasonable inference of the alleged conduct.”⁹ To satisfy the particularity requirement, the plaintiff must allege such facts as the time, place, and content of the defendant’s false representations, as well as the details of the defendant’s fraudulent acts, including when the acts occurred, who engaged in them, and what was obtained as a result. In other words, the complaint must identify the “who, what, where, when and how” of the alleged fraud.

The Court of Appeals has explained, however, that CPLR § 3016(b) “should not be so strictly interpreted as to prevent an otherwise valid cause of action in situations where it may be impossible to state in detail the circumstances constituting a fraud.”¹⁰ Therefore, at the pleading stage, a complaint need only “allege the basic facts to establish the elements of the cause of action.”¹¹ Thus, as noted, a plaintiff will satisfy CPLR § 3016(b) when the facts permit a “reasonable inference” of the alleged misconduct.¹²

As today’s discussion shows, factual allegations devoid of specificity will not suffice to satisfy CPLR § 3016(b).

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

References

1. Basis Yield Alpha Fund [Master] v. Goldman Sachs Group, Inc., 115 A.D.3d 128, 137 (1st Dept. 2014). See also Danann Realty Corp. v. Harris, 5 N.Y.2d 317, 323 (1959); MBIA Ins. Corp. v. Merrill Lynch, 81 A.D.3d 419 (1st Dept. 2011).
2. Citing, Standish-Parkin v. Lorillard Tobacco Co., 12 A.D.3d 301, 303 (1st Dept. 2004).
3. Slip Op. at *1.
4. Id.
5. Id. (citation omitted).
6. Id.
7. Slip Op. at *2 (citing, Orix Credit Alliance v. Hable Co., 256 A.D.2d 114, 115 (1st Dept. 1998)
8. Slip Op. at *1.
9. Pludeman v. Northern Leasing Sys., Inc., 10 N.Y.3d 486, 491 (2008) (citation omitted).
10. Id. (internal quotation marks and citation omitted).
11. Id. at 492.
12. Id