Justifiable Reliance and the Counterclaim That Wasn’t

• Posted on: May 22 2019

This Blog has written about the justifiable reliance element of a fraud cause of action on many occasions. We have noted that whether a plaintiff justifiably relied on the misrepresentations and omissions of a defendant is a fact-intensive inquiry. DDJ Mgt., LLC v. Rhone Group L.L.C., 15 NY3d 147, 155 (2010). In today’s post, we look at Buechel v. Sovereignty, LLC, 2019 N.Y. Slip Op. 31372(U) (Sup. Ct. Tompkins County May 16, 2019) (here), a case in which the issue was decided at trial.

What is The Justifiable Reliance Element?

The justifiable reliance element of a fraud causation of action has been described as a “fundamental precept” (Ambac Assur. v. Countrywide, 31 N.Y.3d 569, 579 (2018) (here)) 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).

Because the determination of whether a plaintiff justifiably relied on a misrepresentation or omission is a factually “nettlesome” one (DDJ Mgt., 15 N.Y.3d at 155), “[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.

“[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. If they fail to do so, 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).

With the foregoing principles in mind, the Court in Buechel found that the defendants failed to satisfy their burden of proving by clear and convincing evidence (Simcuski v. Saeli, 44 N.Y.2d 442 (1978)) that they justifiably relied on the plaintiff’s alleged misrepresentations.

Buechel v. Sovereignty, LLC

Background

Buechel arose from the sale of IP Custom Plastics, Inc. (“IP”) to Zachary Shulman (“Shulman”) and his business entity, Sovereignty, LLC (“Sovereignty” and together with Shulman, the “Defendants”). IP was wholly owned by Richard E. Buechel and Sharon Buechel (collectively, the “Buechels” or “Plaintiffs”). The terms of the sale were memorialized in an agreement dated January 5, 2016. The transaction closed on March 1, 2016.

Pursuant to the agreement, Shulman agreed to purchase the assets of IP, but not its property, which was retained by the Buechals and leased to Defendants. Shulman financed the transaction through, among other things, a mortgage on his home for $226,000, the proceeds of which were paid to the Buechels at the closing. Shulman and Sovereignty gave the Buechals three promissory notes for the remainder of the purchase price: $120,000, $80,000 and $56,600. The $120,000 note was payable at 4% interest in monthly payments of $1,214.94 for a term of 10 years with payments to commence on April 1, 2016. The $80,000 note was payable at 4% interest in monthly payments of $809.96 for a term of 10 years with payments to commence on April 1, 2016. The $56,000 note was payable at $2,830 per month from July 1, 2016 to February 1, 2018 at which time the entire principal balance was due.

Defendants defaulted on the installment payments that came due on July 1, 2016. The Buechels accelerated the maturity of the notes.

Thereafter, on October 12, 2016, the Buechels commenced the action. Plaintiffs asserted three causes of action for payment of the three notes at 4% interest. The fourth cause of action was for a breach of a training agreement wherein Richard Buechel agreed to provide instruction and training at $30.00 per hour and claimed $300.00 in unpaid fees. The Fifth Cause of action was effectively mooted by the eviction of Defendants from the subject property and subsequent sale.

Issue was joined by the filing and service of a verified answer with counterclaims and third-party claims against IP on November 2, 2016. Sovereignty ceased doing business in December of 2016. The counterclaims and third-party claims sounded in fraud, negligent misrepresentation, breach of warranty and indemnification. Defendants sought rescission of the purchase agreement and monetary damages.

The parties did not dispute the authenticity of the notes that Shulman signed. Rather, Defendants argued that they were not payable due to fraud and misrepresentation.

After a bench trial and post-trial briefing, the Court ruled that Defendants failed to satisfy their burden of proving that they justifiably relied on Plaintiff’s alleged misrepresentations.

The Court’s Decision and Analysis

Pursuant to the asset purchase agreement, the parties agreed that the Buechels would make available various documents including tax returns, payable and receivable receipts and internal balance sheets related to statements of income. Defendants claimed that the last category of documents contained materially false information. Specifically, Defendants alleged that Plaintiffs withheld statements pertaining to sales for 2015, which showed a 20% drop in gross revenue. Defendants claimed that had they known the truth, they would have “either renegotiate[d] the agreement or withdraw[n] the purchase offer.” Slip Op. at *4.

The Court found that Defendants were on notice of the decline in gross revenue from the documents and evidence that were made available to them. For example, Defendants were made aware that “there was a clear trend line of decreased sales to Hi-Speed [a major customer and a significant source of revenue for IP] which was readily apparent to Shulman.” Id. at *5.

In response, in late December of 2015, Moore advised him that Hi-Speed business was down from $349,000 in 2014 to $261,000 in 2015… Moore further advised sales revenue had also declined from 2013 to 2014… In other words, Defendants were made aware of a decrease in sales to Hi-Speed of $159,000 from 2013 thru 2015… In 2013, Hi-Speed accounted for approximately 67% of the gross sales of the business, and in 2014 approximately 66% of gross sales. Between 2014 and 2015, overall gross sales for IP fell by approximately $101,000, $88,000 of which was attributable to the decline in sales to Hi-Speed of which Shulman was advised.

Id.

The Court also found that although Defendants were not given printed reports concerning 2015 sales, they were given access to the sales figures by the Buechels. Id. at *6.

Regarding the 2015 sales figures, Sharon Buechel testified that they were not available at, or before, Romer’s financial review on January 21, 2016. She did not print a report of 2015 sales. However, she did testify that her QuickBooks program was open and made available to Romer. She was unsure whether he reviewed it.

Id.

Finally, the Court found that Defendants’ decision to proceed with the transaction despite knowing that sales to IP’s most significant customer were trending downward between 2014 and 2015, and without investigating further (i.e., insisting on the 2015 sales reports), negated any argument that Defendants justifiably relied on the alleged misrepresentations.

Defendants chose to proceed notwithstanding their knowledge of the significant decrease in sales to IP’s biggest customer between 2014 and 2015. This single customer decrease ultimately accounted for 89% of lP’s gross sales reduction. Moreover, Defendants proceeded without insisting on the production of 2015 sales figures prior to closing.  

                                         *          *          *

Shulman, with the assistance of counsel and an accountant, knowingly proceeded to close despite not having 2015 gross sales figures. Defendants failed to exercise due diligence in the time leading to the closing. It might be suggested that Shulman accepted the risk of not knowing what the sales figures were for 2015. However, in reality, he was fully aware of the drop in sales to Hi-Speed which accounted for the vast majority of the 2015 shortfall. 

Id. at **6-7.

Accordingly, “the Court [held] that Defendants failed to establish, by clear and convincing evidence …, that Plaintiffs fraudulently induced them purchase IP. Id. at *7.

Takeaway

Plaintiffs that have a hint of falsity have an obligation to investigate the matter further. As shown in Buechel, such hints of falsity come in many forms. They can be manifest in documents and discussions with others. And, hints of falsity can arise in the course of due diligence performed by professionals. Buechel makes clear that proceeding with a transaction in the wake of information suggesting falsity, and the failure to investigate such information, negates any reliance, justifiable or otherwise, on the representations of the alleged wrongdoer.