Defendants accused of fraud often rely upon the “justifiable reliance” element of fraud to challenge the claim for fraud. This is a ripe area of litigation. Defendants often move to dismiss at the pleadings stage arguing that plaintiff had not adequately alleged that its actions were justified in relying on any alleged misrepresentations of the defendant.
In the August 11, 2016 decision of the Appellate Division, First Department, the Court addressed the elements of both justifiable reliance and the “scienter” requirement for fraud claims in IKB International S.A. v. Morgan Stanley, 2016 N.Y.Slip.Op. 05779 (Aug. 11, 2016).
In IKB, plaintiff was an international financial institution that had purchased over $132 million in residential mortgage backed securities. The First Department ultimately ruled that the plaintiff had adequately pleaded the elements of fraud by alleging that “defendants knew that the offering documents misrepresented critical characteristics of the underlying mortgage loans, and that they fraudulently concealed the inferior quality of those loans by means of misstatements, misrepresentations, and omissions of material fact in the offering documents, and that plaintiffs undertook appropriate due diligence before purchasing the securities.”
Defendants moved to dismiss the complaint by arguing that “plaintiffs are sophisticated investors and have not adequately alleged the justifiable reliance element of their claims, because they made a substantial investment without conducting any due diligence of their own to independently appraise the risks attendant to the [securities] in which they invested.”
In addressing defendant’s argument, the First Department did acknowledge that “a sophisticated investor claiming that it has been defrauded has to allege that it took reasonable steps to protect itself against deception by, for example, examining available financial information to ascertain the true nature of a particular transaction or facts averred.”
On the issue of justifiable reliance, the First Department noted that the complaint had alleged that the plaintiff investors analyzed the securities based upon information in the prospectuses and offering documents, but that plaintiffs lacked the underlying mortgage loan files because regulations prevented them from receiving them based upon personal information of the borrowers contained therein. Plaintiffs further alleged that defendants cautioned not to rely on anything other than the offering documents. Nevertheless, defendants argued that in order to establish justifiable reliance, plaintiffs were required to allege that they sought additional information from defendants about the truthfulness of the representations made in the offering documents or that they requested the loan files. The First Department rejected this argument, observing: “The level of due diligence advocated by defendants requires a prospective purchaser to assume that the credit ratings assigned to the securities were fraudulent and to verify them through a detailed retracing of the steps undertaken by the underwriter and credit rating agency. We do not require this heightened due diligence standard to support justifiable reliance in a pleading concerning such sales of securities by prospectus.”
The resolution of whether “justifiable reliance” has been adequately alleged and ultimately established can be a very fact-intensive analysis. As shown by the First Department’s decision in IKB, the decision often turns on the level of due diligence exercised by the plaintiff, where an all-out investigation is often not required.