Fraudulent Inducement: Exculpatory Clauses, Representations and Warranties, and Justifiable Reliance

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Posted on: Dec 11 2024

In today’s article, we revisit some familiar principles concerning claims of fraudulent inducement. We will also examine the impact of a contractual exculpatory clause on the viability of a fraud claim, as well as the impact of contractual provision that negates the basis for a fraud claim. Our examination of these issues and principles is centered on MREF REIT Lender 2 LLC v. FPG Maiden Holdings LLC, 2024 N.Y. Slip Op. 06161 (1st Dept. Dec. 10, 2024) (here), a case recently decided by the Appellate Division, First Department.

[Eds. Note: the background facts come from the parties’ briefing on appeal.]

MREF REIT concerned a mezzanine loan (“Mezzanine Loan”) by plaintiff MREF REIT Lender 2 LLC (“Mezzanine Lender”) to FPG Maiden Holdings, LLC (“FPG Holdings” or the “Mezzanine Borrower”) in connection with the debt refinancing of the One Seaport luxury residential development in Lower Manhattan (“One Seaport” or the “Building”). The loan was initially made pursuant to the Seaport Mezzanine Loan Agreement, dated September 24, 2018 (the “Mezzanine Loan Agreement” or the “Original Agreement”).

Thereafter, the Mezzanine Lender sued the FPG Holdings, FPG Maiden Lane, LLC (“Senior Borrower”), the developer of One Seaport, Fortis Property Group, LLC (“FPG”), an entity affiliated with the Senior Borrower, and Joel Kestenbaum (“Kestenbaum”) who executed certain guaranties in connection with the Mezzanine Loan (collectively, the “FPG Defendants”), claiming that it was fraudulently induced into entering into the Original Agreement. Among other things, the Mezzanine Lender alleged that these defendants misrepresented and concealed material facts relating to the Building, including that the Building was leaning several inches past vertical, which ultimately resulted in (a) the encroachment of the Building on adjoining parcels, and (b) the inability to install a glass curtain wall on the exterior of the concrete superstructure. The Mezzanine Lender alleged that those misrepresentations and omissions constituted fraud as well as a breach of the representations and warranties in the Mezzanine Loan Agreement.

To finance the project, an FPG affiliate, entered into a debt financing arrangement with a syndicate of investors (“Senior Lenders”) led by defendant Bank Leumi USA (“BLUSA”), which contemplated the phased funding of up to $120 million, secured by a mortgage encumbering One Seaport (the “Senior Loan”). Plaintiffs maintained that BLUSA knew of the structural issues at One Seaport through its role as Administrative Agent, made its own misrepresentations, and aided and abetted the FPG Defendants’ fraud for the purpose of inducing plaintiff to fund the Mezzanine Loan.

By January 2020, the One Seaport project was significantly delayed and over budget, which plaintiffs attributed, in large part, to the structural issues that had not been disclosed at the inception of the Mezzanine Loan. To address the issue, the parties concluded that a debt restructuring was necessary. To move forward with any restructuring, BLUSA allegedly demanded that the FPG Defendants contribute $20 million in additional equity to the project. The Mezzanine Lender maintained that since the FPG Defendants did not have the funds, the FPG Defendants convinced it to have an affiliate, Amity Lender (“Amity”), refinance another loan BLUSA had made to FPG-affiliated entities in connection with a different project in a different borough of New York City.

Plaintiffs agreed to the arrangement based on alleged promises by the Senior Lenders that they (a) would not enforce the temporary certificate of occupancy deadlines set forth in any amended loan documents, and (b) would continue to fund the senior loan going forward. Both of these representations were alleged to be central to the Mezzanine Lender and the Amity Lender moving forward with the restructuring. Plaintiffs contended that both of the foregoing representations were knowingly false when made.

Allegedly unaware of the claimed fraud, Amity funded a $40 million loan to various borrowers affiliated with FPG (the “Amity Loan”). The proceeds of the Amity Loan were used to repay over $20 million to BLUSA’s affiliate and to fund the FPG Defendants’ additional equity contribution to One Seaport, significantly de-risking the Senior Lenders.

According to plaintiffs, the Senior Lenders never again funded the One Seaport senior loan. Instead, the Senior Lenders delayed funding advances under the senior loan and called a default based on the Senior Borrower’s alleged failure to meet the deadlines that BLUSA promised would not be enforced. Further, said plaintiff, one of the most senior executives at BLUSA admitted that the restructuring had been a sham and that the Senior Lenders never intended to fund the Senior Loan, irrespective of what the amended loan documents provided.

In 2022, plaintiffs sued the FPG Defendants and the Senior Lenders to recoup the losses they claimed to have sustained as a result of defendants’ misconduct, alleging claims for, among other things, fraud, breach of contract, enforcement of guaranties, aiding and abetting fraud, and unjust enrichment.

On January 31, 2023, all defendants moved to dismiss the complaint. In August 2023, the motion court issued its decision and order denying in part and granting in part defendants’ motions. In particular, the motion court denied the FPG Defendants’ motion to dismiss plaintiffs’ contract, fraud and guaranty claims and denied the Senior Lenders’ motion to dismiss plaintiff’s contract claim and unjust enrichment claim. However, the motion court dismissed plaintiffs’ fraud-based claims against BLUSA .

All parties appealed.

The First Department modified the motion court’s order to: (a) dismiss the cause of action as against defendants FPG, the Senior Borrower, and Kestenbaum for fraudulent inducement of the Original Agreement (the first cause of action); (b) dismiss the cause of action against BLUSA for breach of the intercreditor agreement (the “ICA”) (the seventh cause of action), but only to the limited extent that the cause of action related to an express or implicit obligation to continue funding the senior loans; (c) reinstate the cause of action for aiding and abetting fraud (the fourth cause of action) as against BLUSA; and (d) dismiss the cause of action for unjust enrichment (the tenth cause of action) as against all the Senior Lender Defendants, and otherwise affirmed the order.

Claims Against the Borrower Defendants

The Court held that the motion court properly allowed the cause of action against the Mezzanine Borrower for breach of the representations and warranties in the Mezzanine Loan Agreement (the second cause of action) to proceed.[1] The Court noted that there was no dispute that the statements (i.e., representations and warranties that the building did not encroach upon adjoining land, and that there was no default or event that would give rise to a default under the Senior Loan Documents) in the Mezzanine Loan Agreement were false at the time that they were made, and that the Mezzanine Borrower knew them to be false.”[2]

The Court found the Mezzanine Borrower’s argument that “the language of the amendments constituted a waiver of the Mezzanine Borrower’s prior breaches, and the amendments generally precluded the Mezzanine Lender from claiming that the original Mezzanine Loan Agreement was breached” to be unavailing and unpersuasive.[3] The Court explained that there were ambiguities regarding the scope of the amendments to the Original Agreement, which precluded resolution of the issue on a motion to dismiss.[4]

The Court also held that the motion court “properly allowed the cause of action for fraudulent inducement against the Mezzanine Borrower to proceed (the first cause of action).”[5] “However,” said the Court, “based on the exculpatory clause, the [motion] court should have dismissed the claim with respect to the other borrower defendants — that is, FPG, the Senior Borrower, and Kestenbaum — as the exculpatory clause in the Mezzanine Loan Agreement unambiguously preclude[d] the Mezzanine Lender from pursuing remedies from any of the Borrower Defendants other than the Mezzanine Borrower.”[6]

The Court further held that the fraudulent inducement claim against the Mezzanine Borrower was properly sustained as it identified the who, what, when, where and how of the alleged fraud.[7] The Court found that the claim was “largely based on numerous extra-contractual representations made by the Mezzanine Borrower’s CEO during due diligence to purportedly induce the Mezzanine Loan.”[8] Thus, concluded the Court, “the Mezzanine Borrower [could not] credibly claim that it [did] not understand the basis for the fraud claim.”[9]

[Eds. Note: in prior articles, we examined the necessity of pleading the “who, what, when and how” of the alleged fraud. See, e.g., here, here, and here. As explained in those articles, pleading such information comports with the requirement that the plaintiff plead fraud with particularity. The requirement that a fraud claim be pleaded with particularity can be found in Section 3016(b) of the Civil Practice Law and Rules (“CPLR”). Under CPLR 3016 (b), the circumstances constituting fraud must be stated with sufficient detail “to permit a reasonable inference of the alleged conduct.”[10]]

Regarding the justifiable reliance element of the claim, the Court held that “the extent and adequacy of plaintiff’s due diligence present[ed] a factual issue that could not be resolved on the pleadings, particularly since the complaint allege[d] that the facts misrepresented by the Borrower Defendants were peculiarly within their knowledge.”[11]

[Eds. Note: in prior articles, we discussed the justifiable reliance element of a fraud claim and, in particular the special facts doctrine. See, e.g., here, here, here, and here. “Under the special facts doctrine, a duty to disclose arises where one party’s superior knowledge of essential facts renders a transaction without disclosure inherently unfair.”[12] The party invoking the doctrine must demonstrate that “the material fact was information peculiarly within [the] knowledge of [the other party],” and “the information was not such that could have been discovered by [the party invoking the doctrine] through the exercise of ordinary intelligence.”[13]]

Finally, the Court held that there was no duplication between plaintiffs’ breach of contract claim and fraud claims: “Because a warranty in an agreement is a ‘statement of present fact … a fraud claim can be based on breach of contractual warranties notwithstanding the existence of a breach of contract claim.’”[14] “For these same reasons,” noted the Court, the motion court “properly allowed the cause of action for breach of the recourse guaranty agreement against defendant Kestenbaum (third cause of action) to go forward.”[15]

Claims against the Senior Lender Defendants

The Court held that the motion court “improperly dismissed the cause of action for aiding and abetting the fraudulent inducement of the Mezzanine Loan Agreement against BLUSA.”[16] The Court found that plaintiffs sufficiently alleged that “(1) the Borrower Defendants defrauded the Mezzanine Lender into entering the Mezzanine Loan (i.e., the underlying fraud); (2) BLUSA provided substantial assistance to the underlying fraud through the misrepresentations in the ICA that there were no structural issues with the Building; and (3) BLUSA concealed and failed to disclose the existence of the structural issues at One Seaport when BLUSA knew that Mezzanine Lender was unaware of them.”[17] Thus, said the Court, plaintiffs “sufficiently pleaded the elements of an underlying fraud against the Borrower Defendants (for the same reasons as explained above), as well as substantial assistance and actual knowledge.”[18]

[Eds. Note: we previously examined a claim for aiding and abetting a fraud, here. To plead a claim of aiding and abetting fraud, the complaint must allege: “(1) the existence of an underlying fraud; (2) knowledge of this fraud on the part of the aider and abettor; and (3) substantial assistance by the aider and abettor in achievement of the fraud.”[19] Although actual knowledge of the fraud may be averred generally, to plead “substantial assistance”, plaintiffs must allege that the defendant (1) affirmatively assisted, helped conceal, or by virtue of failing to act when required to do so enabled the fraud to proceed, and (2) the defendant’s actions as an aider/abettor proximately caused the harm on which the primary liability is predicated.[20] Knowledge can be averred through circumstantial evidence.[21]]

The Court noted that the motion court incorrectly added the justifiable reliance element of a fraud claim to the elements of an aiding and abetting claim: “Supreme Court’s only articulated bases for dismissal of the fraud claims, all of which were plainly targeted at the justifiable reliance element of a standard fraud claim, do not pertain to an aiding and abetting claim.”[22] “There is no requirement to plead or to prove justifiable reliance in connection with an aiding and abetting claim, so long as there is an underlying cause of action for fraud against another party,” said the Court.[23]

“However,” the Court held that the motion court “properly dismissed the cause of action for fraudulent inducement of the ICA against BLUSA (the fifth cause of action).”[24] The Court noted that “the purpose of the ICA was to ‘reconcile the priority of the liens granted by the borrower to the parties,’ not to create independent funding obligations.”[25] Plaintiffs contention that BLUSA’s affirmative misrepresentations and material omissions fraudulently induced the Mezzanine Lender to enter into the ICA and, as a result, to extend the $66 million Mezzanine Loan to the Borrowers in September 2018, was without merit, observed the Court.[26] “Thus,” concluded the Court, “even assuming that the Mezzanine Lender was wrongly induced into entering the ICA, it would not have directly resulted in the Mezzanine Lender extending the Mezzanine Loan.”[27]

Finally, the Court held that the motion court “properly dismissed the Amity Lender’s cause of action for the fraudulent inducement of the Amity Loan (the sixth cause of action).”[28] The Court explained that Amity failed to satisfy the justifiable reliance element of the claim because the alleged fraud was “‘negated by the terms of a contract executed by the allegedly defrauded party.’”[29] The Court explained that “[w]hile the Amity Lender contend[ed] that it would not have loaned money to the Borrower Defendants if it had known that BLUSA would enforce project deadlines and decline to fund, Mezzanine Lender signed a written agreement — the Second Amended Intercreditor Agreement — which expressly consented to the deadlines set forth in the Senior Loan Documents.”[30] Therefore, the Court concluded that the terms of the ICA negated any fraud.[31]

[Eds. Note: we previously examined cases in which the courts rejected allegations of justifiable reliance because the parties’ contract negated the falsity of the subject representation. See, e.g., here, here, here, and here.]

The Court also noted that the “cause of action [was] also subject to dismissal because it fail[ed] to allege any affirmative representation by BLUSA that was made directly to plaintiffs regarding an alleged promise not to enforce the project deadlines.”[32]

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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.

[1] Slip Op. at *1-*2.

[2] Id. at *2.

[3] Id.

[4] Id. (citing Jefpaul Garage Corp. v. Presbyterian Hosp. in City of N.Y., 61 N.Y.2d 442, 446, 448 (1984)).

[5] Id.

[6] Id. Plaintiffs argued that the exculpatory clause violated public policy. Kalisch-Jarcho, Inc. v. City of N.Y., 58 N.Y.2d 377, 384-85 (1983); see also Gross v. Sweet, 49 N.Y.2d 102, 106 (1979) (agreements that “purport to grant exemption for liability for willful or grossly negligent acts” are “wholly void”). In response, defendants argued that the clause did not limit or restrain the Mezzanine Lender from pursuing any claim against the counterparty to the Original Agreement, which it had done. Instead, said defendants, the provision limited the Mezzanine Lender’s ability to pursue claims against certain non-parties to the contract rather than provide blanket immunity for intentional wrongdoing.

[7] Id.

[8] Id. (noting, plaintiffs “sufficiently pleaded the source of the misrepresentations, the content of the misrepresentations, the context in which the misrepresentations were made, and the entity to whom the misrepresentations were made” and citing Epiphany Cnty. Nursery Sch. v. Levey, 171 A.D.3d 1, 9 (1st Dept. 2019)).

[9] Id. (citing MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 87 A.D.3d 287, 295 (1st Dept. 2011)).

[10] Pludeman v. Northern Leasing Sys., Inc., 10 N.Y.3d 486, 491 (2008) (citation omitted).

[11] Slip Op. at *2-*3 (citing China Dev. Indus. Bank v. Morgan Stanley & Co., 86 AD3d 435, 436 (1st Dept. 2011); TIAA Glob. Invs., LLC v. One Astoria Square LLC, 127 A.D.3d 75, 89 (1st Dept. 2015)).

[12] Swersky v. Dreyer & Traub, 219 A.D.2d 321, 327 (1st Dept. 1996) (internal quotation marks and citations omitted), rearg denied, 232 A.D.2d 968 (1st Dept. 1996), appeal withdrawn, 89 N.Y.2d 983 (1997).

[13] Jana L. v. West 129th St. Realty Corp., 22 A.D.3d 274, 278 (1st Dept. 2005) (internal quotation marks and citation omitted).

[14] Slip Op. at *3 (quoting First Bank of Ams. v. Motor Car Funding, Inc., 257 A.D.2d 287, 292 (1st Dept. 1999)).

[15] Id.

[16] Id. at *4.

[17] Id.

[18] Id. (citing William Doyle Galleries, Inc. v. Stettner, 167 A.D.3d 501, 505 (1st Dept. 2018)).

[19] Stanfield Offshore Leveraged Assets, Ltd. v. Metro. Life Ins. Co., 64 A.D.3d 472, 476 (1st Dept. 2009).

[20] Id.

[21] Houbigant, Inc. v. Deloitte & Touche, 303 A.D.2d 92, 98- 99 (1st Dept. 2003).

[22] Slip Op at *4 (citing William Doyle Galleries, 167 A.D.3d at 505).

[23] Id.

[24] Id.

[25] Id. at *5 (citing Steinway Capital Mgt. II L.P. v. Ironshore Specialty Ins. Co., 126 A.D.3d 522, 522 (1st Dept. 2015)).

[26] Id. at *4-*5.

[27] Id. at *5.

[28] Id.

[29] Id. (quoting FPG Maiden Lane, LLC v. Bank Leumi USA, 211 A.D.3d 528, 529 (1st Dept. 2022)); see also Perrotti v. Becker, Glynn, Melamed & Muffly LLP, 82 A.D.3d 495, 498-499 (1st Dept. 2011).

[30] Id.

[31] Id.

[32] Id.