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Scienter and Justifiable Reliance: Two Elements of a Fraud Claim That Can Sink a Lawsuit

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  • Posted on: Sep 13 2016

On May 31, 2016, the Appellate Division, First Department, issued MP Cool Investments Ltd. v. Forkosh, 2016 NY Slip Op. 05944, a case involving allegations of fraud in connection with the production and sale of a commercial heating and ventilation system by an Israeli-based company.  In the decision, the First Department unanimously affirmed the motion court’s dismissal of the plaintiff’s fraud claims because they were not pleaded with particularity, did not establish justifiable reliance on the defendants’ misrepresentations, and failed to demonstrate scienter or an intent to deceive.

The Factual Background of MP Cool:

The plaintiff, a Manhattan-based private equity fund with $4.3 billion in assets under management, is an admitted sophisticated investor that specializes in capturing value in distressed companies in less efficient markets around the world. In December 2009, MatlinPatterson entered into an agreement with DuCool, Ltd., an Israeli company that claimed to have had breakthrough dehumidification technology, to obtain a majority interest in the company.  Pursuant to the agreement, MatlinPatterson invested $30 million in DuCool, giving it an initial 49% interest in the company. By 2012, MatlinPatterson had invested $70 million in DuCool and acquired a 72% majority interest in the company. Subsequent investments brought MatlinPatterson’s equity interest in DuCool to 90%.

As permitted under the purchase agreement, MatlinPatterson had a 90-day due diligence period during which it was given full access to DuCool’s business operations, properties, technology data and plans. MatlinPatterson was also given direct access to all of DuCool’s customers, though it only approached one customer.

To conduct the agreed upon due diligence, MatlinPatterson, among other things, hired two consultants: QuinetiQ, to perform technical evaluations of DuCool’s technology, manufacturing facility, and installation sites; and McKinsey, to evaluate DuCool’s business model, financial information, and market potential. McKinsey drafted a proposed business plan for the company that was included in the parties’ initial purchase agreements. After the initial investment, but before the second investment, MatlinPatterson appointed three of the seven members of the board of directors and two of McKinsey’s representatives were installed as officers of DuCool.

The Allegations and the Motion Court’s Ruling

MatlinPatterson claimed that in the period before it purchased any interest in DuCool (pre-investment) and during the two-year period after its first investment (i.e., 2010 through 2012), when it acquired a majority interest in DuCool, the defendants made numerous false representations and provided inaccurate data about DuCool’s air conditioning technology, financial condition and overall successes in the United States and other markets. MatlinPatterson alleged that it relied on the representations and data, inducing it to repeatedly invest in DuCool, believing it was a better performing company than represented.

MatlinPatterson also alleged that after it invested in DuCool, the defendants deceived it by intentionally concealing known problems with DuCool’s installations in at least three major sites in the United States and Costa Rica and made numerous false statements about energy cost savings in an April 2011 “study” that touted DuCool products’ performance and cutting edge technology.

The defendants moved to dismiss the complaint.  The motion court granted the motion and the plaintiff appealed.

The Appellate Ruling

As an initial matter, the First Department noted that the plaintiff failed to allege fraud with particularity as to each individual defendant and the various time periods involved. The Court observed that the complaint simply “bundled, bare-boned and conclusory allegations” – the type of allegations that do not suffice to plead a fraud claim.

Turning to the justifiable reliance element – one of the two elements highlighted by this post – the Court noted that MatlinPatterson is a sophisticated investor that conducted extensive due diligence both before and after its initial investments.  Such sophistication and knowledge undermined any claim of justifiable reliance:

Plaintiff is an experienced and sophisticated investor. It did not plead facts to support the justifiable reliance element of fraud. Plaintiff had total, unfettered access to every aspect of DuCool’s company information both before and after its initial investment, even before it held a controlling interest in DuCool. Although learning through the due diligence conducted by its own technology and business consultants that there were frequent technological problems with DuCool products, some of them “severe,” plaintiff proceeded to invest in the company. Thereafter, as the 49% shareholder, plaintiff had the largest percentage ownership of any individual shareholder and it had access to information concerning the operations of the business. There is no factual basis on which to conclude that the alleged fraud involved matters peculiarly within defendants’ knowledge, because plaintiff had the means to discover the truth behind any false claims about the condition of the company and whether this was a feasible investment.

Slip op. at 3 (citations omitted).

Regarding the scienter element – the second element highlighted by this post – the Court found that the due diligence conducted by the plaintiff negated any inference that the defendants knew DuCool would fall short of projections:

With respect to the scienter element of its claim, although “most likely to be within the sole knowledge of the defendant and least amenable to direct proof,” plaintiff is still required to allege facts “from which it is possible to infer defendant[s’] knowledge of the falsity of [their] statements” when they were made. It has not done so. Plaintiff, based upon its own due diligence, concluded that DuCool presented a profitable, albeit speculative, investment opportunity given its development of new technology and registered patents. Although the company may not have performed as plaintiff expected, this does not support a reasonable inference that defendants knew that DuCool would fall short of its business projections. The parties’ agreement not only contained plaintiff’s express acknowledgment that success was speculative, but also a further acknowledgment that “any business plans prepared by the Company, have been, and continue to be, subject to change and that any projections included in such business plans or otherwise are necessarily speculative in nature. . .”

Slip op. at 3-4 (citations omitted).

Takeaway:

Unfortunately, there are times when an acquired business or investment does not live up to expectations.  When this happens, the acquiring or investing party sues. MP Cool stands as a reminder that in New York (and some other jurisdictions) an aggrieved party cannot come to court claiming fraud when it has conducted due diligence and obtained information that undermines the strength of its claim. Though sophisticated parties can be the victim of fraud, they cannot complain if they have knowledge of the very fraud of which they complain.

MP Cool also reminds us that scienter is a very difficult element to plead. In fact, the scienter element is the hardest to plead because the evidence of intent most often rests solely with the defendant. Because of this difficulty, intent is often inferred from circumstantial evidence. Pludeman v. N. Leasing Sys., Inc., 10 N.Y.3d 486, 488 (N.Y. 2008).

Notwithstanding, as the First Department made clear, scienter must be plead with particularity. Slip op. at 3. Conclusory allegations, such as those in MP Cool, will not suffice. The plaintiff must allege facts from which there is some “rational basis for inferring that the alleged misrepresentations were knowingly made.” Houbigant, Inc. v. Deloitte & Touche LLP, 303 A.D.2d 92, 93 (1st Dep’t 2003). As MatlinPatterson learned in MP Cool, the failure to meet this hurdle will result in dismissal.

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