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Statute of Limitations, Justifiable Reliance, and Loss Causation: Court Denies Summary Dismissal of Fraud Action Due to Material Issues Fact

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  • Posted on: Aug 27 2019

As readers of this Blog know, pleading and proving fraud is not easy. The law reporters (not to mention the pages of this Blog) are brimming with cases in which the courts have dismissed fraud actions due to pleading and proof deficiencies. Norddeutsche Landesbank Girozentrale v. Tilton, 2019 N.Y. Slip Op. 32470(U) (Sup. Ct., N.Y. County Aug. 20, 2019) (here), is a recent example of this phenomenon.

In Norddeutsche, Plaintiffs contended that they were defrauded into investing in two high-risk private equity funds that Defendants claimed were relatively safe “collateralized loan obligation” funds. Defendants moved for summary judgment on the grounds that: Plaintiffs’ claims were time-barred; Plaintiffs did not rely on Defendants’ representations (which, Defendants claimed were, in any event, truthful); Plaintiffs caused their own losses by selling the notes prematurely; and Plaintiffs’ claims were precluded by a judgment rejecting a nearly identical claim brought by the Securities Exchange Commission (“SEC”). As discussed below, the Court denied the motion, finding that there were disputed issues of fact that were material to Plaintiffs’ claims.

A Fraud Refresher

Fraud and the Statute of Limitations

In New York, an action for fraud must be commenced within “the greater of six years from the date the cause of action accrued or two years from the time the plaintiff … discovered the fraud, or could with reasonable diligence have discovered it.” CPLR § 213(8).

The defendant (i.e., the party most frequently making the motion) has the initial burden of establishing “that the time in which to commence the action has expired.” Zaborowski v. Local 74, Serv. Empls. Intl. Union, AFL-CIO, 91 A.D.3d 768, 768 (2d Dept. 2012). If the defendant meets that burden, the burden then shifts to the plaintiff to “aver evidentiary facts establishing that the action was timely or to raise a question of fact as to whether the action was timely.” Lessoff v. 26 Ct. St. Assoc., LLC, 58 A.D.3d 610, 611 (2d Dept. 2009).

Where a plaintiff relies on the two-year discovery rule of the statute of limitations, “[t]he burden of establishing that the fraud could not have been discovered prior to the two-year period before the commencement of the action rests on the plaintiff who seeks the benefit of the exception.” Von Blomberg v. Garis, 44 A.D.3d 1033, 1034 (2d Dept. 2007); Lefkowitz v. Appelbaum, 258 A.D.2d 563 (2d Dept. 1999) (“The burden of establishing that the fraud could not have been discovered before the two-year period prior to the commencement of the action rests on the plaintiff, who seeks the benefit of the exception.”). Accord Berman v. Holland & Knight, LLP, 156 AD3d 429, 430 (1st Dept. 2017); Aozora Bank, Ltd. v. Deutsche Bank Sec. Inc., 137 A.D.3d 685, 689 (1st Dept. 2016).

“A cause of action based upon fraud accrues, for statute of limitations purposes, at the time the plaintiff ‘possesses knowledge of facts from which the fraud could have been discovered with reasonable diligence.’” Oggioni v. Oggioni, 46 A.D.3d 646, 648 (2d Dept. 2007) (quoting Town of Poughkeepsie v. Espie, 41 A.D.3d 701, 705 (2d Dept. 2007)).

“[W]here the circumstances are such as to suggest to a person of ordinary intelligence the probability that he has been defrauded, a duty of inquiry arises, and if he omits that inquiry when it would have developed the truth, and shuts his eyes to the facts which call for investigation, knowledge of the fraud will be imputed to him.” Gutkin v. Siegal, 85 A.D.3d 687, 688 (1st Dept. 2011) (citation and internal quotation marks omitted). Courts look at whether the plaintiff should have discovered the alleged fraud objectively. Prestandrea v. Stein, 262 A.D.2d 621, 622 (2d Dept. 1999); Gorelick v. Vorhand, 83 A.D.3d 893, 894 (2d Dept. 2011). Mere suspicion will not suffice as a substitute for knowledge of the fraudulent act. Erbe v. Lincoln Rochester Trust Co., 3 N.Y.2d 321, 326 (1957).

This inquiry “involves a mixed question of law and fact, and, where it does not conclusively appear that a plaintiff had knowledge of facts from which the alleged fraud might be reasonably inferred, the cause of action should not be disposed of summarily on statute of limitations grounds.”  Berman, 156 A.D.3d at 430. “Instead, the question is one for the trier of-fact.” Id. See also Sargiss v Magarelli, 12 N.Y.3d 527, 532 (2009).

Justifiable Reliance

In Ambac Assur. v. Countrywide, 31 N.Y.3d 569, 579 (2018), the Court of Appeals described the justifiable reliance requirement as a “‘fundamental precept’ of a fraud cause of action.” As such, a “plaintiff must allege facts to support the claim that it justifiably relied on the alleged misrepresentations.” ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1044 (2015); see also id. at 1051 (Read, J., dissenting on other grounds) (describing the justifiable reliance requirement as “our venerable rule”).

Whether a plaintiff justifiably relied on a misrepresentation or omission is “always nettlesome” because it requires a fact-intensive analysis. DDJ Mgt., LLC v. Rhone Group L.L.C., 15 N.Y.3d 147, 155 (2010) (internal quotation marks omitted). As the Court of Appeals observed, “[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).

Sophisticated parties have a heightened responsibility. 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).

Causation

There are two components of causation: transaction causation and loss causation. “To establish causation, [a] plaintiff must show both that [the] defendant’s misrepresentation induced [the] plaintiff to engage in the transaction in question (transaction causation) and that the misrepresentations directly caused the loss about which [the] plaintiff complains (loss causation).” Laub v. Faessel, 297 A.D.2d 28, 31 (1st Dept. 2002).

Transaction Causation

“Transaction causation means that the violations in question caused the [plaintiff] to engage in the transaction in question.” AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202, 209 (2d Cir. 2000) (citation and internal quotation marks omitted). The term is often used by the courts synonymously with “but for” causation. Moore v. PaineWebber, Inc., 189 F.3d 165, 172 (2d Cir. 1999) (“To show transaction causation, the plaintiffs must demonstrate that but for the defendant’s wrongful acts, the plaintiffs would not have entered into the transactions that resulted in their losses.”) (citation omitted) (emphasis in original).

Loss Causation

The loss causation requirement is synonymous with the proximate cause concept found in other tort cases and in the federal securities context. See Emergent Capital Inv. Mgmt., LLC v. Stonepath Grp., Inc., 343 F.3d 189, 196-97 (2d Cir. 2003) (loss causation in common law fraud claims comparable to federal securities fraud claims); Laub, 297 A.D.2d at 31 (“[l]oss causation is the fundamental core of the common-law concept of proximate cause”) (citations omitted); accord AUSA Life, 206 F.3d at 209 (“Loss causation is causation in the traditional ‘proximate cause’ sense—the allegedly unlawful conduct caused the economic harm.”) (citation omitted). Thus, loss causation is “the causal link between the alleged misconduct and the economic harm ultimately suffered by [the] plaintiff.” Fin. Guar. Ins. Co. v. Putnam Advisory Co., 783 F.3d 395, 402 (2d Cir. 2015).

Whether the plaintiff satisfies the loss causation element requires a fact-intensive analysis, making a decision on a motion to dismiss generally inappropriate. See Metro. Life Ins. Co. v. Morgan Stanley, 2013 WL 3724938, at *18 (Sup. Ct. N.Y. Cnty. June 8, 2013) (holding proximate cause was not an appropriate issue on a motion to dismiss); see also Schroeder v. Pinterest Inc., 133 A.D.3d 12, 26 n.7 (1st Dept. 2015) (noting that “issues of proximate cause are for the trier of fact….”).

Norddeutsche Landesbank Girozentrale v. Tilton

Background

The action arose in 2005 with the investment by Norddeutsche Landesbank Girozentrale, a German financial institution, and Hannover Funding Company, a Delaware LLC and a commercial paper conduit administered by Norddeutsche (together “Plaintiffs”), in one of the two funds managed by Defendant Patriarch Partners (“Patriarch”). The funds at issue, Zohar II and Zohar III (the “Funds”), were created in January 2005 and April 2007, and had maturity dates of January 20, 2017, and April 15, 2019, respectively. Zohar II and Zohar III each issued over $1 billion in notes that were rated at issuance either AAA/Aaa or AA/Aal by S&P and Moody’s, respectively (the “Notes”).

Before purchasing the Notes, Plaintiffs received transaction documents, marketing materials, indentures, and collateral management agreements relating to each fund, as well as an offering memorandum for the Zohar III Fund. In January 2005, Plaintiffs purchased $75 million of Notes in Zohar II. In April 2007, Plaintiffs purchased $60 million of Notes in Zohar III.

The Zohar II Notes were “wrapped” by insurance from MBIA Insurance Corp. (“MBIA”). MBIA guaranteed full repayment of the Notes upon maturity if the Funds could not afford to do so.

The Funds performed poorly. Plaintiffs claimed that Defendants withheld fund performance and related information from them by furnishing fraudulent reports that concealed the actual performance of the underlying loans in the Funds. Plaintiffs sold their Notes for a loss of approximately $45 million in April 2012, before the maturity date of either fund. Plaintiffs claimed that they sold the Notes due to their poor performance, multiple ratings downgrades (of which they were aware), and the increasing capital requirements generated by the investment. Defendants claimed that Plaintiffs sold the Notes for independent business reasons.

Plaintiffs also alleged that instead of running the Funds as represented, Defendants Lynn Tilton (“Tilton”) and Patriarch ran the Funds as private equity funds. Plaintiffs maintained that Defendants used the money from the Funds to purchase equity in distressed assets, contrary to Defendants’ representations. Plaintiffs further alleged that Defendants collected management fees, dividends, preferred share buyouts, and income distributions from the companies that were owed to the Funds.

Additionally, Plaintiffs alleged they were told that Tilton and the Patriarch entities were supposed to pay for and own the underlying equity in the portfolio companies, while the Funds would make loans to the companies. Plaintiffs alleged that they understood the Funds would be entitled to an equity kicker in some cases (to participate in the upside if Defendants were successful in turning the companies around) but would not be exposed to the downside risk of holding equity positions.

On March 31, 2015, the SEC issued an order commencing an administrative proceeding against Defendants. According to Plaintiffs, the SEC investigation uncovered fraudulent behavior by Defendants, including that Defendants used the Funds to obtain control over portfolio companies, and that Defendants concealed their fraudulent behavior from investors such as Plaintiffs. The administrative proceeding was ultimately dismissed in September 2017 (the “SEC Decision”).

Defendants moved for summary judgment on four grounds: 1) Plaintiffs’ claims were time-barred; 2) Plaintiffs did not justifiably rely on any alleged misrepresentation by Defendants; 3) Plaintiffs could not prove loss causation; and 4) the SEC Decision collaterally estopped Plaintiffs’ claims. The Court denied the motion in its entirety.

The Court’s Decision

Statute of Limitations

Defendants argued that Plaintiffs were aware of the truth about the structure of the funds from the marketing materials distributed to them in 2004 and 2006. In particular, Defendants maintained that statements in these materials (e.g., the “equity upside” and “equity participation” of the Funds) sufficed to inform Plaintiffs that the Funds would hold equity and thus be at risk of suffering a loss. As such, Defendants contended that the claims were time-barred because Plaintiffs knew or should have known of the alleged fraud before 2005 and 2007, when they made their investments in the respective Funds. The Court rejected this argument.

The Court found that Defendants failed to “put forward incontrovertible evidence that the marketing materials and disclosures presented to Plaintiffs were sufficient to inform Plaintiffs of the alleged fraud.” Slip Op. at *6.  The Court explained that Defendants’ evidence could be interpreted in myriad ways and, therefore, did not disprove Plaintiff’s position that having some knowledge that the Funds had an equity component to them did not put them on notice of the alleged fraud prior to the SEC proceeding. Id., citing Norddeutsche Landesbank Girozentrale v. Tilton, 149 A.D.3d 152, 161-162 (1st Dept. 2017).

The Court also found that there were issues of fact as to whether Plaintiffs should have discovered the alleged fraud in 2012 when the SEC began its investigation into Defendants and/or through investor calls held in December 2011. Id. at *7.

Justifiable Reliance

Defendants argued that they made robust disclosures about the strategy of the Funds and that as sophisticated investors, Plaintiffs could have and should have done more to learn how the Funds operated. Thus, Defendants claimed, Plaintiffs could not have justifiably relied on the alleged fraudulent statements to induce them into investing in the Funds. Id. at *8.

The Court rejected Defendants’ argument. The Court held that Defendants did not conclusively show that Plaintiffs failed to make use of the means of verification that were available to them or did not put forth evidence showing conclusively that Plaintiffs failed to make any effort to verify the representations. Id.

Loss Causation

Defendants claimed that Plaintiffs could not prove that their losses were proximately caused by Defendants’ alleged misrepresentations and omissions. According to Defendants, Plaintiffs conceded during discovery that there was an independent reason for their losses – namely, the “heavy capital usage” imposed by the investment. Id. at *9. The Court rejected this contention:

A finder of fact could determine that the decision to sell was causally linked to the alleged fraud, which Plaintiff contends led it to assume a certain level of performance, credit rating, and capital requirements, which in tum impacted whether to hold or sell the notes. A finder of fact could also reasonably conclude that had Plaintiffs known about the actual Fund structure, they would never have entered into the transaction in the first place. While Mr. Weber’s testimony might be fodder for cross-examination, it is insufficient to establish a loss causation defense as a matter of law.

Id.

The Court also rejected Defendants’ contention that Plaintiffs could not demonstrate loss causation because the funds were insured by MBIA and Plaintiffs would have recovered their investment had they held the notes to maturity. Id. The Court explained that “a finder of fact could determine that Plaintiffs made their decisions based on facts traceable to the alleged fraud and in part on concerns about MBIA’s financial condition.” Id. at *10. “Defendants’ reasoning,” said the Court, “would preclude a finding of loss causation with respect to the sale of virtually any insured note.” Id. “That is not the law,” concluded the Court. Id.

Takeaway

Many elements of a fraud claim are inherently factual. For example, proving justifiable reliance is “always nettlesome” because it requires a fact-intensive analysis. DDJ Mgt., 15 N.Y.3d at 155 (2010) (internal quotation marks omitted). The same is true with regard to whether the plaintiff can satisfy the scienter and loss causation elements. For these reasons, proving fraud is not easy. And, as Norddeutsche shows, whether a fraud has been committed is often left for the trier of fact.

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