Justifiable Reliance: Even the Accountant Was Duped

• Posted on: May 26 2021

Sometimes a fraud is so undetectable that even an expert hired to assist in due diligence activities can be the victim of fraud. That’s what happened in VXI Lux Holdco, S.A.R.L. v. SIC Holdings, LLC, 2021 N.Y. Slip Op. 03294 (1st Dept. May 25, 2021) (here).

VXI Lux arose from plaintiff’s $112 million purchase of Symbio S.A. (“Symbio”) from defendants. Plaintiff alleged that defendants, faced with a Chinese government audit, engaged in fraud to hide the fact that they had underpaid the social insurance tax applicable to their employees in Chengdu, China. Defendants allegedly did this by falsifying documents, including by altering personnel files to make it look as though dozens of exempt employees based elsewhere were actually working in Chengdu. To complete the scheme, defendants allegedly bribed the auditing firm, by means of a $25,000 payment funneled through a sham construction contract.

Plaintiff alleged that the $3 million tax underpayment, which was an unaccounted expense, had the effect of inflating Symbio’s earnings before interest, taxes, deductions, and amortization (“EBITDA”) by the same amount. Thus, when Symbio presented its books to plaintiff, they allegedly contained several misrepresentations — expenses and tax liabilities were understated, and EBITDA was overstated. The inflation of the EBITDA likewise inflated Symbio’s apparent growth rate, which in turn inflated the company’s market valuation.

Even though plaintiff inspected Symbio’s financial statements and other corporate records during due diligence, plaintiff claimed, given the nature of the deception, the fraud was essentially undetectable. Thus, plaintiff alleged, even though it retained a major accounting firm, that accounting firm was also duped and issued a report which did not find the social insurance tax fraud.

The social insurance tax fraud allegedly inflated Symbio’s EBITDA, from about $3 million to a projected $8.8 million. The apparent EBITDA growth inflated the company’s revenue prospects, resulting in plaintiff overpaying for Symbio. Plaintiff alleged that, had it known all the facts, it would have offered much less. Plaintiff alleged that the resulting overpayment caused it to suffer significant financial loss.

Defendants moved to dismiss the fraud cause of action in plaintiff’s second amended complaint (“SAC”). The motion court granted the motion. On appeal, the Appellate Division, First Department “unanimously reversed, on the law”.

The primary issue considered by the Court was whether plaintiff satisfied the justifiable reliance element of its fraud cause of action. 

To satisfy the justifiable reliance element of a fraud claim, a plaintiff must demonstrate that he/she took steps to discover “the true nature of [the] transaction [that] he [or she] is about to enter into.” 88 Blue Corp. v. Reiss Plaza Assoc., 183 A.D.2d 662, 664 (1st Dept. 1992) (internal citations omitted). In other words, a plaintiff is required to take reasonable steps to protect against deception.

A sophisticated party, like the plaintiff in VXI Lux, must allege that it exercised due diligence and took affirmative steps “to protect itself against deception.” DDJ Mgt., LLC v. Rhone Grp. L.L.C., 15 N.Y.3d 147, 154 (2010). This means, for example, that a sophisticated party must employ whatever “means of verification were available at the time” of the alleged misrepresentations. VisionChina Media, Inc. v. Shareholder Representative Servs., LLC, 109 A.D.3d 49, 57 (1st Dept. 2013) (citation omitted). One way to do so is by obtaining a prophylactic provision in a contract or other writing or exercising due diligence to make an additional inquiry into the truth of the representation. ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1045 (2015); DDJ, 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). Thus, a sophisticated party cannot “argue justifiable reliance on defendants’ misrepresentation or omission where [it] had the means available to ascertain the status of the [transaction]” at issue and did not avail itself of those means. ACA Fin. Guar., 25 N.Y.3d at 1044; HSH Nordbank AG v. UBS AG, 95 A.D.3d 185, 194-195 (1st Dept. 2012).

[Ed. Note: we have addressed the justifiable element of a fraudulent inducement claim viz-a-viz a sophisticated party here, here and here, for example.]

In VXI Lux, the Court held that “plaintiff adequately pleaded that it justifiably relied on the documents presented by Symbio during due diligence,” by “taking diligent steps” to uncover any misstatements or omissions. Slip Op. at *1. Such steps included retaining “an accounting firm for review” of the company’s financial statements and corporate records. Slip Op. at *1-*2 (citing Basis Yield Alpha Fund Master v. Morgan Stanley, 136 A.D.3d 136, 141-43 (1st Dept 2015)). As made clear in the Court’s discussion of plaintiff’s fraudulent concealment allegations (Slip Op. at *2), “given the hidden nature of the fraud, which turned on falsified records and bribed auditors, and the practical impossibility of discovering the fraud through ordinary diligence”, it could not be said that plaintiff failed to take affirmative steps “to protect itself against deception.” DDJ Mgt., 15 N.Y.3d at 154.   

The Court also rejected the individual defendants’ argument that the fraud claim should be dismissed as against them because plaintiff used group pleading to assert those allegations. Slip Op. at *1. As noted in our last article on the subject (here), group pleading occurs when a plaintiff lumps defendants together rather than attributes specific misrepresentations or wrongdoing to a particular defendant. Such pleading violates the particularity requirement of CPLR § 3016(b), unless the fraud alleged is detailed and pervasive. AIG Fin. Prods. Corp. v. ICP Asset Mgt., LLC, 108 A.D.3d 444, 446-447 (1st Dept. 2013). In VXI Lux, the Court held that the fraud was pervasive and pleaded “in great detail”. As such, the individual defendants’ knowledge of the fraud could be inferred. Slip Op. at *1. 

The Court also rejected the argument that plaintiff’s fraud claim duplicated its contract claim. Slip Op. at *2. The Court noted that “Defendants’ alleged deception also breached numerous warranties set forth in the governing stock purchase agreement, including that Symbio’s financial statements were materially complete and correct, that its EBITDA projections were reasonable and made in good faith, that it had no material undisclosed liabilities, and that it conducted its business in compliance with applicable law.” Id. The Court explained that a breach of warranty is not the same as a breach of an obligation to perform – the former is a misrepresentation of present fact. Id. (noting, “[a] warranty is not a promise of performance, but a statement of present fact”) (quoting First Bank of Ams. v. Motor Car Funding, 257 A.D.2d 287, 292 (1st Dept. 1999)). “Accordingly, a fraud claim can be based on a breach of contractual warranties notwithstanding the existence of a breach of contract claim.” First Bank of Ams., 257 A.D.2d at 292. Accord Wyle Inc. v. ITT Corp., 130 A.D.3d 438, 439, 441 (1st Dept. 2015). Thus, concluded the Court, “the fraud claim [did] not duplicate the contract claim.” Slip Op. at *2 (citing GoSmile, Inc. v. Levine, 81 A.D.3d 77, 81-82 (1st Dept. 2010), lv. dismissed, 17 N.Y.3d 782 (2011)). 

Takeaway

A plaintiff suing for fraud (and particularly a sophisticated plaintiff, such as VXI Lux) must establish that it “has taken reasonable steps to protect itself against deception.” DDJ Mgt., 15 N.Y.3d at 154. Typically, this means that a plaintiff claiming to have been fraudulently induced to purchase a business, or to lend to a business, must allege that, before entering into the transaction, it availed itself of the opportunity to verify the seller’s or borrower’s representations through an examination of the entity’s books and records.

In VXI Lux, plaintiff satisfied this requirement. As discussed, plaintiff retained a major accounting firm to examine Symbio’s financial statements and other corporate records during due diligence. Because of the deception alleged, plaintiff had no way of discovering the truth about Symbio’s financial condition. Under such circumstances, the justifiable reliance element of plaintiff’s fraud claim was satisfied.