In my prior post, What Do Fraud and Spiderman Have in Common? With Great Power Comes Great Responsibilities, I explained the extraordinary remedies and demanding requirements applicable to the tort of fraud. A “tort” is a judge-made cause of action under the common law that provides remedies to a party injured by the actions of others where the legal elements of the claim are established.
Punitive Damages for Fraud
As I explained in my post, if the misconduct is egregious enough, punitive damages may be awarded in a case in which the tort of fraud is established. This distinguishes fraud from a breach of contract claim, in which punitive damages are more difficult to recover. Thus, I explained the difference between punitive damages for fraud and breach of contract as follows:
When the circumstances underlying the fraud are egregious enough, punitive damages are available to the victim of fraud. In a case I handled on behalf of the plaintiffs in Supreme Court, Nassau County, Commercial Division, the lower court first denied and then on reargument granted the defendants summary judgment dismissing our claim for punitive damages. We alleged various tort claims, including fraud and breach of fiduciary duty in connection with a stock buyout transaction among shareholders of a New York corporation. The Appellate Division, Second Department, reversed the court below and reinstated our claim for punitive damages. Sieger v. Zak, 74 A.D.3d 1319 (2d Dep’t 2010). The Second Department held that the evidence we presented was sufficient for a jury to find that the defendant “engaged in ‘conduct having a high degree of moral culpability which manifest[ed] a conscious disregard of the rights of others or conduct so reckless as to amount to such disregard.’” (We went on to win at a jury trial and obtained a judgment of nearly $13 million on the contract claim, for which no punitive damages were ultimately awarded.)
Alleging fraud as a “tort” actually eliminates the additional requirements for obtaining punitive damages in a breach of contract case. That is, for a breach of contract claim, the plaintiff must prove not only that the defendant’s conduct rose to the level of egregious wrongdoing as stated by the court in Sieger as quoted above, but also that the defendant’s wrongful conduct was aimed at the public generally. New York University v. Continental Insurance Company, 87 N.Y.2d 308 (1995). Although some courts have been confused as to whether the defendant’s wrongful conduct must be directed at the public generally in order to justify punitive damages in a fraud cause of action, the correct rule is that there is no such requirement in fraud cases constituting a tort. See Wrap-N-Pack, Inc. v. Kaye, 528 F.Supp.2d 119 (E.D.N.Y. 2007). In fact, the New York Court of Appeals made clear over 40 years ago in Borkowski v. Borkowski, 39 N.Y.2d 982, 983 (1976): “It is not essential, as the Appellate Division stated, that punitive damages may be allowed in a fraud case only where the acts had been aimed at the public generally.”
For a fuller explanation of these principles please see my Litigation Review Column for the New York Law Journal. See K. Schlosser, “Clarifying Punitive Damage Confusion,” New York Law Journal, Jan. 22, 2008.
The Tort of Fraud Can Support Punitive Damages in Breach of Contract Claim
Even where a separate fraud cause of action has not been asserted in a case alleging breach of representations contained in a contract, if the conduct of the defendant amounts to the common law tort of fraud, that would serve to satisfy part of the elements to justify punitive damages for breach of contract. This was explained in the recent decision of the Appellate Division, First Department in Matter of Part 60 Put-Back Litig. [Deutsche Bank National Trust Company, etc., Plaintiff-Appellant, v. Morgan Stanley Mortgage Capital Holdings LLC, etc., et al., Defendants-Respondents], 2019 NY Slip Op 00368 (1st Dep’t Decided January 17, 2019).
In Matter of Part 60 Put-Back Litig., the action arose “from the securitization of subprime mortgages by Morgan Stanley & Co., Inc. in 2007, shortly before the housing market collapsed. The [Plaintiff sought] damages for the numerous loan defaults that occurred, rendering the residential mortgage backed securities (RMBS) it sold to outside investors virtually worthless.”
The complaint alleged, among other things, that the SEC issued a cease and desist order against Morgan Stanley entities based on findings that Morgan Stanley had made “misleading public disclosures regarding the number of delinquent loans” in the subject Trust and another similar trust created by Morgan Stanley. Plaintiff alleged that “the SEC order stated that by filing offering documents that materially understated current delinquencies, Morgan Stanley committed ‘fraud or deceit upon a purchaser of securities,’ in violation of Section 17(a)(3) of the Securities Act of 1933.”
Plaintiff asserted in its complaint a cause of action against Morgan Stanley for breach of representations and warranties in the contract concerning the quality of the loans, and sought compensatory damages, punitive damages, and attorneys’ fees and costs. (Plaintiff did not allege a separate cause of action for fraud.) As grounds for overcoming the sole remedy clause in the contract that barred claims for monetary damages or remedies not provided for in the contract, the complaint alleged that Morgan Stanley acted with “gross negligence” when it committed “widespread” breaches of the representations and warranties, and ignored its contractual duties to notify and repurchase, despite discovering the breaches. As grounds for punitive damages, the complaint relied on the SEC order alleging that Morgan Stanley defrauded the public by misrepresenting delinquency rates in the offering documents.
The court below dismissed the cause of action for breach of contract to the extent that it included a demand for compensatory and punitive damages. The court found that the “sole remedies” clause barred compensatory damages, and in dismissing the demand for punitive damages, the court concluded that “an independent claim of fraud [was] not pleaded; nor [did] the complaint plead a wrong aimed at the public, generally.”
The First Department reversed, reinstating the claim for compensatory damages because the allegations of “gross negligence” were sufficient to overcome the contractual “sole remedies” clause.
As to the claim for punitive damages, the First Department relied upon the alleged underlying fraudulent conduct of the defendants to satisfy part of the elements for punitive damages in a breach of contract case:
With respect to plaintiff’s demand for punitive damages, such a demand is properly made in a breach of contract action if all of the following elements are sufficiently pleaded: “(1) defendant’s conduct must be actionable as an independent tort; (2) the tortious conduct must be of [an] egregious nature . . .; (3) the egregious conduct [was] directed to plaintiff; and (4) it must be part of a pleaded pattern directed at the public generally” (New York Univ. v Continental Ins. Co., 87 NY2d 308, 316 ).
Here, the complaint reflects findings of the SEC sufficient to allege a fraud claim against defendants: that defendants committed “fraud and deceit” on the certificateholders, as the facts support a rational inference that defendants knowingly misrepresented in the offering documents the delinquency rates of the loans held in the Trust; that they did so in order to induce the investing public, and did induce the certificateholders, to buy the certificates that defendants knew did not meet their representations of quality and were therefore likely to cause significant losses to investors; and that the certificateholders purchased the securities in justifiable reliance on the misrepresentations, causing the Trust, and consequently the certificateholders, to suffer $495 million in losses (see IKB Intl. S.A. v Morgan Stanley, 142 AD3d 447 [1st Dept 2016] [holding that purchasers of 25 mortgage backed securities in 18 similar mortgage securitizations sufficiently stated a fraud claim based on allegations of misrepresentations in the offering documents that the loans were of good quality]). The complaint thus sufficiently alleges that defendants’ conduct was “egregious” and “part of a pattern directed at the public generally” to satisfy the first, second and fourth elements of a demand for punitive damages, respectively.
Obviously, seeking and obtaining punitive damages puts the case in an enhanced and more significant perspective for the plaintiff and raises substantial risks for the defendant. While alleging the tort of fraud as a distinct cause of action can support punitive damages where the conduct is egregious, underlying fraudulent conduct, even if not alleged as a separate cause of action for fraud, can support the award of punitive damages in a breach of contract case, in which the misconduct is directed at the public.