The New York Court of Appeals recently ruled that fraud claims brought by four lenders who allegedly made loans in reliance on their borrower’s false and misleading financial statements were adequate to survive a motion to dismiss. DDJ Mgmt., LLC v. Rhone Group LLC, 15 N.Y.3d 147 (2010). In reversing the decision of the Appellate Division, the Court found that the lenders’ fraud claims could proceed where the lenders took action to protect themselves by obtaining specific written representations and warranties, regardless of the level of due diligence conducted.

Background

The lenders alleged that in March 2005, they loaned $40 million to a remanufacturer of automobile parts, and that the borrower later defaulted on that loan. In addition to bringing suit against the borrower, the lenders brought claims, including a fraud claim, against various entities that owned or were otherwise affiliated with the borrower. The fraud claim alleged in part “that defendants presented [the lenders] with [borrower] financial statements that were false and misleading,” and more specifically that those financial statements “inflate[d] the number with which [the lenders] were most concerned — [the borrower’s] earnings before interest, taxes, depreciation and amortization (EBITDA).”

Defendants filed a motion to dismiss the complaint for failure to state a claim, arguing in part that the lenders had “failed to make a reasonable inquiry into the truth of what defendants said [in the borrower’s financial statements]” and therefore could not adequately allege that they reasonably relied on the alleged misrepresentations in those financial statements. While dismissing other claims, the trial court refused to dismiss the lenders’ fraud claim. On appeal, however, the Appellate Division saw things differently, dismissing the fraud claim by concluding that the lenders could not “properly allege reasonable reliance on the purported misrepresentations [in the borrower’s financial statements]” because they “never looked at [the borrower’s] books and records.” DDJ Mgmt., LLC v. Rhone Group LLC, 60 A.D.3d 421, 424, 875 N.Y.S.2d 17, 19 (1st Dep’t 2009). The lenders appealed to the New York Court of Appeals, the state’s highest court.

The Issue on Appeal

The Court of Appeals began its analysis by assuming without deciding “that the complaint adequately alleges that defendants made material misrepresentations,” noting that those allegations were “lengthy” and included “striking details,” including a series of alleged e‑mails sent by the borrower that discussed the possible manipulation of financial statements. The Court proceeded to frame the issue on appeal as “whether, if the complaint’s allegations are true, a jury could find that [the lenders] justifiably relied on those misrepresentations.”

As the Court explained, the question of whether reliance is justifiable or reasonable is always difficult because it is “so fact-intensive” and “[n]o two cases are alike in all relevant ways.” Defendants argued that the Court should apply the long‑standing rule that a plaintiff’s fraudulent misrepresentation claim should be dismissed where “the facts represented are not matters peculiarly within the [defendant’s] knowledge, and the [plaintiff] has the means available to him of knowing, by the exercise of ordinary intelligence, the truth.” Schumaker v. Mather, 133 N.Y. 590, 596, 30 N.E. 755, 757 (1892). The Court noted that “[t]his rule has been frequently applied in recent years where the plaintiff is a sophisticated business person or entity that claims to have been taken in [by unverified verbal assurances],” perhaps because in such circumstances the plaintiff “willingly assumed the business risk that the facts may not be as represented,” citing Global Minerals & Metals Corp. v. Holme, 35 A.D.3d 93, 824 N.Y.S.2d 210 (1st Dep’t 2006), and Lampert v. Mahoney, Cohen & Co., 218 A.D.2d 580, 630 N.Y.S.2d 733 (1st Dep’t 1995).

The Decision

The Court drew a line between cases like Global Minerals and Lampert and cases where the plaintiff alleged that it had obtained a written representation that certain facts were accurate:

Where, however, a plaintiff has taken reasonable steps to protect itself against deception, it should not be denied recovery merely because hindsight suggests that it might have been possible to detect the fraud when it occurred. In particular, 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.

Here, as a condition of the loan, the lenders “insist[ed] that [the borrower] represent and warrant [in writing in the loan agreement] that the financial statements were accurate.” Among other things, the borrower represented in the loan agreement that the financial statements “were prepared in accordance with generally accepted accounting principles” and did not contain “any untrue statement of a material fact or omit[] to state a material fact necessary to make the statements contained therein not misleading.”

The Court concluded that, by insisting on these written representations and warranties, the lenders had “made a significant effort to protect themselves against the possibility of false financial statements.” The Court reached this conclusion despite acknowledging that “there were hints from which [the lenders] might have been put on their guard in this transaction,” including “the sudden improvement in profitability in the last month of the year [reflected in the financial statements]” and that “it took an auditor until March of 2005 to complete an examination of the 2003 financial statements.”

The Court “decline[d] to hold as a matter of law that [the lenders] were required to do more — either to conduct their own audit or to subject the preparers of the financial statements to detailed questioning.” The ultimate issue of whether the lenders “were justified in relying on the warranties they received is a question to be resolved by the trier of fact,” not by a court adjudicating a motion to dismiss. Accordingly, the Court reversed the dismissal of the lenders’ fraud claim and remanded for further proceedings.

Implications

The New York Court of Appeals’ decision in DDJ Mgmt., LLC v. Rhone Group LLC makes clear that independent due diligence is not an absolute prerequisite to a lender bringing a fraud claim based on false financial statements, at least where the borrower represented in writing the accuracy of its statements. That said, lenders would be prudent to exercise caution when relying on borrowers’ financial statements in the absence of due diligence. While the lenders here lived to fight another day, the Court of Appeals decision only concerned the sufficiency of the complaint and, thus, the ultimate reasonableness of the lenders’ reliance in the face of their failure to conduct due diligence will remain an issue of fact to be determined at trial