This post addresses the remarkably broad scope of legal remedies and consequences arising from the tort of fraud under New York law.
While misrepresentations can constitute a breach of contract, such as violating representation and warranty provisions of a contract, the common law cause of action for fraud constitutes a “tort” claim. Simcuski v. Saeli, 44 N.Y.2d 442 (1978); Clark-Fitzpatrick, Inc. v. Long Island Railroad Company, 70 N.Y.2d 382 (1987). As discussed below, fraud as a tort gives rise to powerful remedies as well as demanding standards of pleading and proof.
Elements of the Common Law Tort of “Fraud”
The necessary elements to allege and prove a claim of fraud have been firmly imbedded in New York jurisprudence for over a century. As the New York Court of Appeals recently recognized in Pasternack v. Laboratory Corporation of America Holdings, 2016 N.Y.Slip.Op. 05179 (June 30, 2016), quoting Mandarin Trading Ltd. v. Wildenstein, 16 N.Y.3d 173, 178 (2011): “The elements of a fraud cause of action consist of ‘“a misrepresentation or a material omission of fact which was false and known to be false by [the] defendant, made for the purpose of inducing the other party to rely upon it, justifiable reliance of the other party on the misrepresentation or material omission, and injury”’.”
There are significant legal consequences arising from and in relation to tort claims of fraud. As discussed below, proving the tort of fraud may lead to (1) a rescission of the transaction effected by the fraud, (2) the award of out-of-pocket and punitive damages, (3) establishing the predicate under federal statutes and expansive remedies they provide such as Civil RICO claims, and (4) preventing debts from being discharged in Bankruptcy. With such power, however, comes great responsibility – claims of fraud must be pleaded with specificity and proven by clear and convincing evidence, the highest level of proof in civil litigation.
A powerful remedy arising from the tort of fraud is “rescission.” That is, where a party to a contract can prove that it was induced to sign that contract by virtue of the fraud of the other party, it may be entitled to “rescind” or nullify the entire contract as though it never happened. See Sokolow, Dunaud, Mercadier & Carraras, LLP v. Lacher, 299 A.D.2d 65 (1st Dep’t 2002). For example, a party to an asset purchase agreement or stock purchase agreement, or other acquisition agreement could potentially return the parties to the position before the contract was entered into based upon a claim of fraudulent inducement. Fraudulent inducement has the same elements of the claim of fraud: “To sustain a claim for fraudulent inducement, there must be a knowing misrepresentation of material fact, which is intended to deceive another party and to induce them to act upon it, causing injury (see Jo Ann Homes at Bellmore v Dworetz, 25 NY2d 112, 119; Sorbaro Co. v Capital Video Corp., 168 Misc 2d 143, 148, affd 245 AD2d 364).” Id.
Rescission is not, however, an automatic remedy even if fraud is established. Courts look to how feasible and practical it would be to place the parties in the same position as though no contract occurred. Id. The wrongdoer, however, will not be allowed to avoid rescission simply by claiming it irrevocably changed its position in reliance on the contract. Id. The New York Court of Appeals has recognized that courts have discretion to award relief that is fair and equitable so as to prevent the proven wrongdoer from hiding behind its own wrongdoing. Butler v. Prentiss, 158 N.Y. 49 (1899).
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.
Fraud Can Serve As Predicate for Federal Statutory Remedies
Establishing a claim of fraud can also open the door to expansive remedies under federal law. For example, fraud can serve as one of the underlying predicate acts under the powerful Racketeer Influenced & Corruption Organization Act (known as civil RICO), which also allows the recovery of treble damages. 18 U.S.C. § 1964(c).
Significant civil penalties for fraud also arise under the federal Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), 12 U.S.C. § 1833a. A recent decision of the United States Court of Appeals for the Second Circuit addressed the interplay between the common law causes of action for fraud and FIRREA, which is the subject of a separate post. See United States Ex Rel. Edward O’Donnell v. Countrywide Home Loans, Inc., 15-496-CV(l), 15-499-CV(con) (May 23, 2016).
No Discharge in Bankruptcy
Fraud can also stand in the way of obtaining the discharge of debts in Bankruptcy. That is, a debt “for money, property, services … to the extent obtained by (A) false pretenses, a false representation, or actual fraud…” may not be discharged in Bankruptcy. 11 U.S.C. § 523(a)(2)(A).
A recent case of the Supreme Court of the United States analyzed the requirements of establishing “actual fraud,” in order to prevent discharge of a debt in bankruptcy. See Husky International Electronics, Inc. v. Ritz, No. 15-145, May 16, 2016. I discuss that decision in more detail in another post.
With Great Power Comes Great Responsibility
In view of the powerful remedies afforded to those who can prove fraud, and because being accused of fraud is a serious matter, the law imposes special, more demanding requirements on those alleging fraud.
Under both New York rules of practice, CPLR 3016(b), and the Federal Rules of Civil Procedure, FRCP 9(b), the circumstances constituting the alleged fraud must be stated in detail in the pleading asserting this cause of action or claim. In a case I handled on behalf of the defense, the Supreme Court, Nassau County, Commercial Division dismissed claims of fraud and fraudulent inducement at the pleadings stage of the case because we had established that the allegations against our clients did not meet the demanding standards of pleadings under CPLR 3016(b). The Appellate Division, Second Department, upheld that dismissal in a lengthy and instructive decision. High Tides, LLC v. DeMichele, 88 A.D.3d 954 (2d Dep’t 2011).
The one element of the cause of action for fraud for which courts afford more flexibility and less scrutiny under the heightened pleading standard is establishing fraudulent intent, or that the defendant intended to commit the fraud. The courts recognize that because “intent” is uniquely within the possession of the defendant, a pleading need not allege details supporting that element, and it may be alleged through fair inferences. As the First Department recently recognized in IKB International S.A. v. Morgan Stanley, 2016 N.Y.Slip.Op. 05779, Aug. 11, 2016: “The element of scienter, that is, the requirement that the defendant knew of the falsity of the representation being made to the plaintiff, is, of course, the element most likely to be within the sole knowledge of the defendant and the least amenable to direct proof.” The court continued: “All that is required to defeat a motion to dismiss a fraud claim for lack of scienter is ‘a rational inference of actual knowledge.’” Id.
Courts also relax the special pleading standard where circumstances of the fraud are uniquely within the defendant’s possession or knowledge. Etzion v Etzion, 62 AD3d 646, 880 NYS2d 79 (2d Dept 2009) (specificity requirement of CPLR 3016 is relaxed where it is alleged that the particular circumstances of the claimed fraud are exclusively within defendant’s knowledge).
In addition to the more demanding pleading standard, fraud must also be proven by a higher standard of proof than other civil claims. The burden of proof is met by “clear and convincing evidence,” a standard higher than a fair preponderance of the evidence. Gaidon v Guardian Life Ins. Co. of America, 94 NY2d 330, 704 NYS2d 177, 725 NE2d 598 (1999). The New York Pattern Jury Instructions describe this standard of proof as follows: “This means evidence that satisfies you that there is a high degree of probability…” and that “the evidence makes it highly probable that [what is claimed] is what actually happened.” NYPJI §1:64.
Because the remedies for the tort of fraud are so powerful, courts recognize that a breach of contract cannot be transformed into a cause of action for fraud when the alleged misrepresentation is simply part of the contractual promises. In a case I handled on behalf of the defense, for example, the Appellate Division, Second Department, upheld the dismissal of the claims attempting to allege “fraudulent inducement” against my clients. The Court held: “Generally, a cause of action alleging breach of contract may not be converted to one for fraud merely with an allegation that the contracting party did not intend to meet its contractual obligations.” Refreshment Management Services Corp. v. Complete Office Supply Warehouse Corp., 89 A.D.3d 913, 916 (2d Dep’t 2011).
The tort of fraud is a powerful legal creature. Vast legal consequences arise. Yet with such power, comes great legal responsibility.