Claimants alleging fraud face demanding standards of pleadings and proof. 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. Moreover, beyond the pleadings stage, at the point of actually proving fraud, the highest standard of proof in civil litigation applies. That is, fraud must be proved by “clear and convincing evidence,” a standard higher than a fair preponderance of the evidence. Gaidon v. Guardian Life Ins. Co. of America, 94 N.Y.2d 330, 704 N.Y.S.2d 177 (1999). On top of that, so-called “sophisticated” parties face an even more daunting task in establishing their claims for fraud.
Recent case in point: The First Department’s decision in MP Cool Invs. Ltd. v. Forkosh, 2016 N.Y. Slip. Op. 05944 (1st Dep’t Sept. 1, 2016). In MP Cool, the Supreme Court, New York County, granted defendants’ motion to dismiss a complaint brought by a so-called sophisticated investor seeking to allege common law fraud in connection with the production and sale of a commercial heating and ventilation system. The First Department affirmed the dismissal. The plaintiff had invested $70 million in a company that was involved in new technology for innovative heating, ventilation and air conditioning systems (HVAC). Given the size of that investment, the Court had little trouble finding that plaintiff was a “sophisticated investor.”
Claimed Misrepresentations and Omissions
Plaintiff alleged, among other things, that defendants, formerly controlling shareholders in the company, intentionally provided plaintiff with false information over an extended period of time, inducing it to repeatedly invest in the company. Plaintiff alleged that the defendant claimed the company possessed new technology for HVAC, that the units were more efficient than conventional units in the United States and that the products could be installed without any expensive on-site retrofitting. Plaintiff also alleged that defendants intentionally concealed and withheld critical information regarding mounting maintenance and quality problems with these HVAC systems and that all the data defendants provided, including economic and technical models and studies of current production installments, were false. Plaintiff made continuing investments from an initial investment by which it acquired 49% of the company for $30 million, and subsequent investments thereafter for a total of $70 million.
Plaintiff claimed that in the period before it purchased any interest in the company and during the two-year period after its first investment, when it acquired a majority interest in the company, “Defendants made numerous false representations and provided inaccurate data about [the company’s] air conditioning technology, financial condition and overall successes in the United States and other markets.” Plaintiff alleged that it relied on this information, which induced it to repeatedly invest in the company, believing it was a better performing company than it was.
Contractual Disclaimers and Acknowledgements of No Reliance
In assessing plaintiff’s claims, the Court found it critical that plaintiff was a “sophisticated investor.” As is often the case with claims of fraud in connection with substantial investments or asset purchase agreements, the transactional agreements in question provided several significant provisions relevant to the fraud claims. First, as the First Department noted, the agreement provided that before making any investment in the company, plaintiff had a 90-day due diligence period during which it was afforded full access to the company’s business operations, properties, technology data and plans. Plaintiff also had the right to direct access to all of the company’s customers (but contacted only one).
The Court also noted the contractual language of the purchase agreement in which plaintiff made several express representations, including that it had “substantial experience in evaluating and investing in securities of companies similar to [the company in questions] … .” The contract further provided that plaintiff had “such knowledge and experience in financial and business matters so that [it] is capable of evaluating the merits and risks of its investment in the Company.” The purchase agreement also noted the “highly speculative nature” of the very investment. Further, the purchase agreement set forth in detail all of the information and data to which plaintiff was given access in order to investigate its potential investment in the company. Among the provisions was an acknowledgment that the materials prepared by the company were “subject to change and that any projections included in such business plans or otherwise are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results.”
The “Sophisticated” Investor’s Claims Were Doomed
In the face of these contractual provisions and the sophisticated nature of the plaintiff, its claims of fraud were doomed. The First Department quoted prevailing law that “where the plaintiff is a sophisticated party, ‘if the facts represented are not matters peculiarly within the [defendant’s] knowledge, and the [plaintiff] has the means available to [it] of knowing, by the exercise of ordinary intelligence, the truth or the real quality of the subject of the representation, [the plaintiff] must make use of those means, or [it] will not be heard to complain that [it] was induced to enter into the transaction by misrepresentations’ (ACA Fin. Guar. Corp., 25 N.Y.3d at 1044).”
The First Department was not convinced that the allegations were particular enough to satisfy the detailed pleadings requirement of CPLR 3016(b). The Court summarized the allegations as follows: “Actual specific false factual statements are not identified. Nor is specific false concealment identified. Such bundled, bare-boned and conclusory allegations do not establish the basic elements of fraud, namely a ‘representation of material fact, the falsity of that representation, knowledge by the party who made the representation that it was false when made, justifiable reliance by the plaintiff, and resulting injury.’…”
The Court also rejected the claim for its failure to allege justifiable reliance: “Plaintiff is an experienced and sophisticated investor. It did not plead facts to support the justifiable reliance element of fraud … . Plaintiff had total, unfettered access to every aspect of [the company’s] information both before and after its initial investment, even before it held a controlling interest in [the company].” The Court also noted that through the due diligence it did conduct, plaintiff was well aware of frequent technological problems with the company’s products, some of them “severe,” yet still proceeded to invest in the company.
Finally, the Court found fault in plaintiff’s allegations regarding the element of “scienter” – or intent – even though this element is viewed most leniently by the courts. The Court held: “With respect to the scienter element of its claim, although ‘most likely to be within the sole knowledge of the defendant and least amenable to direct proof,’ plaintiff is still required to allege facts ‘from which it is possible to infer defendant[s’] knowledge of the falsity of [their] statements’ when they were made … . It has not done so. Plaintiff, based upon its own due diligence, concluded that [the company] presented a profitable, albeit speculative, investment opportunity given its development of new technology and registered patents. Although the company may not have performed as plaintiff expected, this does not support a reasonable inference that defendants knew that [the company] would fall short of its business projections. The parties’ agreement not only contained plaintiff’s express acknowledgment that success was speculative, but also a further acknowledgment that ‘any business plans prepared by the Company, have been, and continue to be, subject to change and that any projections included in such business plans or otherwise are necessarily speculative in nature. … .’”
The First Department’s comprehensive decision is yet another reminder that sophisticated parties are well-advised to document in the transactional agreements their proper and reasonable reliance upon data and information provided by the other party to the transaction. Obviously, contractual acknowledgments and disclaimers will be fatal to any subsequent fraud claims where sophisticated parties are involved.