The Many Facets of a Fraudulent Inducement Claim

• Posted on: Jan 11 2023

By: Jeffrey M. Haber

We start the new year off examining Dragons 516 Ltd. v. Knights Genesis Inv. Ltd., 2023 N.Y. Slip Op. 50020(U) (Sup. Ct., N.Y. County Jan. 6, 2023) (here), a case involving many of the themes we often consider in our discussion of fraud and fraudulent inducement claims.

[Ed. Note: The factual discussion comes from the Court’s decision and order.]

Dragons involved a dispute between a lender and a borrower. Plaintiff, Dragons 516 Limited (“Dragons”), alleged that defendants fraudulently conspired to misrepresent the ownership structure of a real estate development project (the “Project”) for the purpose of inducing it to provide financing for the Project. In the complaint, Plaintiff asserted causes of action for, inter alia, fraud and conspiracy to defraud.

In early 2017, defendant, Knights Genesis Investment Limited (“Knights Genesis”), approached Dragons with an opportunity to finance the Project. At the time, Dragons declined to loan the money. 

In May 2017, Knights Genesis and GDC SPV – a special purpose vehicle created by Knights Genesis’s wholly owned subsidiary, defendant Genesis Development Company LLC (“GDC”) –renewed its efforts to secure a loan from Dragons. Knights Genesis/GDC intended to use the loan to finance GDC SPV’s 8.5% preferred interests in defendant, Project Co., the owner of the Project. Other investors were to provide capital to finance the Project. 

In connection with the financing, Knights Genesis/GDC allegedly represented that Dragons’ loan would be backed by pledge agreements and a ‘put right’ option, such that if the loan was not repaid when due, Dragons would stand in place of GDC SPV with respect to its preferred interests in Project Co., or alternatively, Dragons could put GDC SPV’s preferred interests to defendant SMI-USA, which would be obligated to purchase the preferred interests and pay the purchase price directly to Dragons. According to Dragons, it relied on the foregoing representations. 

On June 1, 2017, the parties entered into a facility agreement (“Facility Agreement”), which was also executed by GDC and SMI-USA. In pertinent part, the Facility Agreement provided that the loan was intended solely to fund GDC SPV’s 8.5% preferred interest in Project Co. In addition, it contained several representations concerning the ownership interests of many of the defendants. Moreover, the agreement contained the “put right” provision discussed above. Dragons alleged that the “put right” provision, along with other facts and circumstances, materially enhanced the creditworthiness of the Project and provided significant reassurance to Dragons without which it would have never funded the loan.

Under the Facility Agreement, Dragons was not obligated to fund the loan until the satisfaction of various conditions precedent, including the receipt of various due diligence reports. As part of this due diligence process, Knights Genesis/GDC allegedly provided Dragons with numerous documents, which Dragons claimed turned out to be fake and/or contained false information. These documents included, among others, an Amended and Restated Limited Liability Company Agreement for Project Co., dated February 28, 2017 (“February 28, 2017 LLC Agreement”), which echoed the representations in the Facility Agreement concerning the ownership interests in Project Co. 

In addition, Knights Genesis/GDC allegedly provided Dragons with letters of undertaking from SMI-USA, which were intended to enhance Dragons’ confidence in the Project by emphasizing that SMI-USA was managing the project, providing liquidity support, and securing financing. 

Dragons further alleged that, in response to its due diligence questions regarding the Project, Knights Genesis/GDC provided non-public information and documents, which included, among other things, financial account records for Project Co., zoning reports, contracts for interior design, architect and construction management agreements, and construction reports. Many of the documents provided were allegedly addressed to, or executed by, the Ceruzzi defendants.

Finally, Dragons alleged that, when it raised issues concerning the Project with Knights Genesis/GDC, SMI-USA immediately conveyed those concerns to, and sought an explanation from, the architect and the construction manager for the Project. Dragons alleged that the dissemination of this information demonstrated that SMI-USA and Knights Genesis/GDC were acting in concert to induce Dragons to loan the money.

On June 15, 2017, Dragons funded the loan. Dragons alleged that, after the loan was funded, Knights Genesis/GDC provided Dragons with additional non-public documents and information about the [Project], such as financial statements as well as construction and design reports in connection with the Project. 

In the fall of 2017, Dragons allegedly learned that, in violation of the Facility Agreement, Project Co. had taken on additional debt and undergone organizational changes that resulted in a new tier of ownership. To address Dragons’ concerns, Knights Genesis/GDC allegedly proposed that the parties enter into a guaranty agreement (“Guaranty Agreement”) under which SMI-USA would guarantee all of GDC SPV’s obligations under the Facility Agreement. The Guaranty Agreement was executed on March 6, 2018.

On September 14, 2018, following various breaches of the Facility Agreement, Dragons sent a demand letter to Knights Genesis/GDC and GDC SPV, accelerating the loan.

On March 21, 2019, Dragons commenced a lawsuit to enforce the Facility Agreement and the Guaranty Agreement against GDC SPV and SMI-USA (the “Contract Action”). 

On February 3, 2020, the court in the Contract Action entered judgment against GDC SPV in the amount of $41,138,614.84 for breach of the Facility Agreement and ordered GDC SPV to comply with the terms and provisions of a pledge agreement (the “Pledge Agreement”). 

In February 2020, Dragons learned that the $30 million loan was used by GDC SPV to invest in Project Co., and that GDC SPV was, in fact, an investor in Project Co. Dragons claimed that GDC SPV had no assets or property to satisfy the judgment entered in the Contract Action. Additionally, Dragons claimed that the collateral for the Pledge Agreement was non-existent because GDC SPV did not – and never had – any ownership interest in the Project. 

In May 2021, Dragons commenced the action (on which we write).

Defendants moved to dismiss the complaint. 

The SMI defendants contended that the fraud claim was duplicative of the breach of contract claims in the Contract Action. In addition, they argued that the claim failed because Dragons did not allege any misrepresentation that the SMI defendants purportedly made. Rather, the SMI defendants claimed that any misrepresentations were made by Knights Genesis/GDC with whom Dragons exclusively dealt. The SMI defendants maintained that to obscure this pleading failure, Dragons improperly engaged in group pleading (i.e., making allegations against a broad category of defendants without differentiation), a form of pleading that does not conform to the particularity requirement of CPLR § 3016(b).¹

[Ed Note: this Blog examined group pleading, for example, here and here.]

In response, Dragons argued that the fraud claim was not duplicative of the contract claims in the Contract Action because the fraud claim was based on a more expansive set of facts, involving misrepresentations collateral to the Facility Agreement, and was seeking recovery from defendants who were not parties to the Facility Agreement. In addition, Dragons claimed that the damages were not duplicative of the contract damages because it sought to recover pecuniary loss only, and did not include contractual interest. Dragons further argued that the complaint alleged that the SMI defendants executed documents that contained material misrepresentations about the Project and that the SMI defendants intended for Dragons to rely on such documents. 

The Court agreed with Dragons.

First, the Court said that the fraud claim was not duplicative of the breach of contract claims in the Contract Action because, although SMI-USA was a party to the Facility Agreement, “the agreement did not give rise to [a] contract claim against it”.² “Its obligation under the put right provision—requiring it to purchase GDC SPV’s 8.5% preferred interest in Project Co. from Dragons—could not be triggered in light of the alleged fraud.”³ Moreover, said the Court, the fraud claim was not duplicative of the breach of the Guaranty Agreement claim in the Contract Action because “SMI-USA claim[ed] that the Guaranty Agreement [was] a forgery”.⁴ As such, said the Court, “Dragons should be permitted to assert the fraud claim in the alternative pursuant to CPLR 3014”.⁵ 

Additionally, held the Court, “the complaint sufficiently allege[d] the false statements that the SMI defendants allegedly made to induce Dragons to fund the loan.”⁶ And, said the Court, the complaint “point[ed] to numerous documents purportedly executed by the SMI Defendants, which further reassured Dragons of the truthfulness of the previous representations”.⁷ 

The Court rejected the SMI defendants’ claim that those documents could not “form the basis of a fraud claim against them, since it [was] alleged that ‘Knights Genesis/GDC (through William Chen) provided Dragons with [those] documents[, which were] intended to induce Dragons to fund the loan”.⁸ The Court noted that “indirect communication can establish a fraud claim, so long as the statement was made with the intent that it be communicated to the plaintiff and that the plaintiff rely on it”.⁹ The Court found that statements in certain documents, which made specific reference to the Facility Agreement, were communicated to Dragons with the intention that they be communicated to, and relied on by, Dragons.

[Ed. Note: this Blog previously examined whether a plaintiff could satisfy the reliance element of a fraud claim when the false statements are made through indirect communications. E.g., here.]

The Court further found that Dragons satisfied the remaining elements of the fraud claim.

The Ceruzzi defendants contended that their motion to dismiss should be granted, because: (1) the fraud was duplicative of the breach contract claims in the Contract Action; (2) there were no allegations the Ceruzzi defendants made any material misrepresentations; (2) there were no factual allegations from which scienter could be inferred; instead, the complaint relied on the conclusory allegation that the Ceruzzi defendants must have known of the fraud; and (3) Dragons could not demonstrate justifiable reliance, having failed to contact the Ceruzzi defendants during the due diligence process.

[Ed. Note: This Blog examined the scienter element here and here and most recently the justifiable reliance element here, here, here, and here.]

In response, Dragons argued that the complaint contained sufficient factual allegations to permit a reasonable inference of the Ceruzzi defendants’ participation in the fraud. Regarding the reliance argument, Dragons maintained that the contention that it could have discovered the fraud by contacting the Ceruzzi defendants earlier was speculative and presumed that they did not participate in the fraud. 

The Court agreed with the Ceruzzi defendants.

The Court held that there were no direct communications between these defendants and Dragons. Noting, again, that indirect communication can establish a fraud claim, the Court found that Dragons failed to allege any facts showing that the Ceruzzi defendants intended to communicate any alleged false statements to Dragons. None of the documents cited by Dragons, said the Court, were “addressed to Dragons” or “acknowledge[d] Dragons or the Facility Agreement in any way”.¹⁰

The Court also found that because documents that referenced the Facility Agreement were executed after the loan was made, Dragons could not satisfy the reliance element of the claim.¹¹  

Although the Court held that Dragons failed to plead a fraud claim against the Ceruzzi defendants, it nevertheless held that Dragons stated a claim against these defendants for conspiracy to commit a fraud. The Court found that “there [were] a number of factual allegations [in the complaint] that, combined, permit[ted] a reasonable inference that the Ceruzzi defendants conspired with the SMI defendants to defraud Dragons”.¹²

Footnotes

1. The Court rejected the group pleading argument, finding the complaint contained numerous specific allegations to place defendants on notice of the precise tortious conduct charged to each defendant”. Slip Op. at *13 (citing, Bernstein v. Kelso & Co., 231 A.D.2d 314, 321 (1st Dept. 1997); and Pludeman v. Northern Leasing Sys., Inc., 40 A.D.3d 366, 367-368 (1st Dept. 2007), aff’d, 10 N.Y.3d 486 (2008)).
2. Id. at *12.
3. Id. (record citation omitted)
4. Id.
5. Id. (citing, Shear Enters., LLC v. Cohen, 189 A.D.3d 423, 424 (1st Dept. 2020) (reversing the dismissal of the fraud claim as duplicative of the contract claim and permitting the plaintiff to plead it in the alternative)).
6. Id. (identifying the specific statements).
7. Id.
8. Id.
9. Id. (quoting, Pasternack v. Laboratory Corp. of Am. Holdings, 27 N.Y.3d 817, 828 (2016); and citing Securities Inv. Protection Corp. v. BDO Seidman, 95 N.Y.2d 702, 710 (2001) (noting the “the general and unremarkable principle that liability for fraud can be imposed through communication by a third party”)).
10. Id. at *13.
11. Id.
12. Id. at *19.

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.