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Court of Appeals Resurrects Lenders' Fraud Claim as "Reasonableness" Could Not be Determined as a Matter of Law, Despite Apparent Lack of Due Diligence, Where Lender Required Representations and Warranties as to Accuracy of Financial Statements

DDJ Mgt., LLC v. Rhone Group LLC, ___ N.E.2d ___, 2010 WL 2516811 (N.Y.), 2010 N.Y. Slip Op. 05603 (June 24, 2010), involved four companies ("plaintiffs") that loaned a total of $40 million in March of 2005 to the now defunct American Remanufacturers Holdings, Inc. and affiliated companies ("ARI"). Plaintiffs brought suit against ARI's shareholders and others ("defendants"), alleging, among other things, that defendants defrauded plaintiffs into making the loans through the use of material misrepresentations in financial statements provided to plaintiffs. Although the financial statements on which the plaintiffs relied "contained some features that might have aroused concern in a skeptical reader who examined them carefully," plaintiffs had also insisted that ARI represent and warrant that the financial statements were "accurate." Plaintiffs claim that all of these representations and warranties later proved to be false.

Defendants moved for dismissal of all plaintiffs' causes of action under CPLR ยง 3211. The Supreme Court (New York County) dismissed all of the claims except the claim of fraud. The Appellate Division (First Department) modified the Supreme Court decision and dismissed that claim as well, emphasizing that "plaintiffs never looked at ARI's books and records" and concluded that, having failed to do so, they could not then "properly allege reasonable reliance on the purported misrepresentations." The Court of Appeals granted leave to appeal and reversed.

Defendants claimed that, under the rule stated in Schumaker v. Mather, 133 NY 590, 596 (1892), plaintiffs had the means of knowing, "by the exercise of ordinary intelligence, the truth or the real quality of the subject of the [statements]," and, as such, were required to "make use of those means [in order to conserve a] complain[t] that [plaintiffs were] induced to enter into the transaction by misrepresentations."

The Court distinguished cases in which that rule had been applied against sophisticated business persons or entities claiming to have been defrauded, stating that "where a plaintiff has gone to the trouble to insist on a written representation that certain facts are true, it will often be justified in accepting that representation rather than making its own inquiry."

The Court cited JP Morgan Chase Bank v. Winnick, 350 F.Supp.2d 393 (S.D.N.Y. 2004), in holding that the facts of several state and federal cases applying New York law did "not support the interpretation that a duty to inquire is necessarily triggered as soon as a plaintiff has the slightest 'hints' of any 'possibility' of falsehood." The Court also agreed with the JP Morgan Court that it was unable to say as a matter of law that "a reasonable lender of equivalent experience should have inquired further" into defendants' financial statements after having obtained representations and warranties to the effect that nothing in the financial statements was materially misleading. As such, the Court held that whether the plaintiffs were justified in relying on the warranties they received is a question better resolved by a trier of fact.

The Court stated that in order to sustain its claim, plaintiffs must prove that the representations and warranties were false and that the shareholder defendants knew the financial statements gave an untrue picture of ARI's financial condition. This claim, however, would survive the pleading stage because a plaintiff alleging that it has been a victim of fraud should not be "denied recovery merely because hindsight suggests that it might have been possible to detect the fraud when it occurred."


Daniel J. Gocek, Law Student at University of Virginia School of Law

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