Almost three years ago, during a high point in the credit crisis, DDJ Management v. Rhone,1 a fraud case brought by a lender against a borrower for alleged misrepresentations in financial statements, wound its way to the New York Court of Appeals. Although the case originated well before the credit crisis, and the spate of litigation that has been filed in its wake, the Court of Appeals' decision in DDJ Management has impacted the landscape of a wide body of fraud cases brought under New York law. In DDJ Management, the Court of Appeals seemingly clarified the pleading standard for establishing reasonable reliance in a fraud case. Up until that point, a sophisticated business entity was at pains to plead enough facts adequately to establish reasonable reliance. At the time that it issued DDJ Management, the Court of Appeals did not address whether it intended to usher in a shift in the law or whether the decision should be construed as a unique case limited to its facts. This article explores the impact of DDJ Management and how subsequent courts have interpreted it. Decisions issued in the wake of DDJ Management demonstrate that while in some cases, lower courts have interpreted the decision as lowering the threshold of reasonable reliance that must be pled by sophisticated parties, courts will nevertheless readily dismiss claims if the plaintiff has not demonstrated that, prior to entering into the relevant transaction, it took reasonable steps to protect itself against deception. In this sense, DDJ Management has been used effectively by defendants as limiting the circumstances in which a plaintiff may adequately plead reasonable reliance.
The plaintiffs in DDJ Management were lenders that loaned a total of $40 million to the defendant, a re-manufacturer of automobile parts, and its corporate affiliates. The complaint alleged that the defendants defrauded the plaintiffs into making such loans by presenting false and misleading financial statements that were designed to inflate the borrower's EBITDA (earnings before interest, taxes, depreciation and amortization).2 The defendants moved to dismiss the fraud claim on the ground that the plaintiffs, sophisticated entities, had an obligation to make a reasonable inquiry into the truth of the defendants' financial statements and that the plaintiffs' failure to do so precluded them, as a matter of law, from alleging a necessary element of fraud: reasonable reliance on the alleged misrepresentations. The trial court rejected the defendants' position and permitted the plaintiffs to proceed to discovery on their fraud claims. On appeal, the Appellate Division, First Department, reversed, holding that the plaintiffs' failure independently to inspect the borrower's books and records precluded the plaintiffs from adequately alleging reasonable reliance.
The Court of Appeals began its analysis by reciting the century-old principle that where a plaintiff "has the means available to him of knowing, by the exercise of ordinary intelligence, the truth of the real quality of the subject of the representation, he must make use of those means, or he will not be heard to complain that he was induced to enter into the transaction by misrepresentations."3 The court recognized that this principle had "been frequently applied" against a plaintiff who is a "sophisticated business person or entity that claims to have been taken in" and thus, courts will "reject the claims of plaintiffs who have been so lax in protecting themselves that they cannot fairly ask for the law's protection."4 Nevertheless, the court emphasized that this rule of diligence is inapplicable when "a plaintiff has taken reasonable steps to protect itself against deception[.]"5 Included in such reasonable steps, the court held, was negotiating for and obtaining a "written representation that certain facts are true[.]"6 Thus, the court concluded that the plaintiffs could adequately allege justifiable reliance, having "made a significant effort to protect themselves against the possibility of false financial statements: They obtained representations and warranties to the effect that nothing in the financials was materially misleading."7 In turn, the court reversed the Appellate Division decision dismissing the plaintiffs' fraud claim and remanded "for consideration of questions raised but not determined on appeal to that court."8
DDJ Management thus appeared to have opened the door for a sophisticated business plaintiff to argue a basis for reasonable reliance without establishing that it investigated the counterparty's representations prior to transacting business together. While some courts have relied upon DDJ Management in connection with denying motions to dismiss fraud claims at the pleading stage, other New York courts have applied DDJ Management in granting motions to dismiss where particular facts as alleged in the complaint did not establish a plausible claim of reasonable reliance. DDJ Management must also be read in tandem with Centro Empresarial Cempresa S.A. v. América Móvil, S.A.B. de C.V.,9 wherein the Court of Appeals found that the plaintiffs were too "lax in protecting themselves" because they "knew that defendants had not supplied them with [sufficient] financial information" prior to entering into the relevant transaction.10 The manner in which courts have treated DDJ Management is illustrative of the challenges facing parties in pleading and defending against the element of reliance in a fraud claim governed by New York law.
In MBIA Insurance v. GMAC Mortgage,11 for example, the plaintiff, a monoline insurer, asserted that the defendant fraudulently induced it into executing three financial guaranty insurance agreements to cover various RMBS transactions. Specifically, the plaintiff alleged that during the negotiation of the insurance agreements, the defendant provided false and misleading documents concerning the issuer's underwriting guidelines, as well as concerning the credit ratings of the RMBS themselves. The defendant moved to dismiss on the ground that "[b]ecause MBIA was a sophisticated entity, it could not reasonably rely on GMAC's purported representations…."12
In rejecting the defendant's argument, the court relied upon DDJ Management for the proposition that "during the pleading stage, the reasonable reliance element can be inferred where a plaintiff has taken reasonable steps to protect itself against deception, such as specific, written representations."13 The court held that such precedent was dispositive because "much like in DDJ Management, MBIA has pled that it relied on specific written representations as to the accuracy of the loan information and credit ratings."14 Thus, the court denied the defendants' motion to dismiss the plaintiff's fraud claims.
Likewise, in Federal Housing Finance Agency v. JPMorgan Chase,15 the Federal Housing Finance Agency (FHFA), as conservator for Fannie Mae and Freddie Mac, asserted that various large financial institutions committed, inter alia, common law fraud in connection with the sale of RMBS to Fannie and Freddie. Specifically, FHFA alleged that the offering documents presented by the defendants during the sale process contained materially false and misleading representations concerning whether the underlying loans complied with underwriting guidelines and standards and whether the borrowers would be able to repay their loans. The defendants moved to dismiss on various grounds, including that Fannie and Freddie were "highly sophisticated players in the mortgage-backed securities market" and that such sophistication "precludes [FHFA] from establishing that [Fannie and Freddie] justifiably relied on the allegedly fraudulent statements that defendants included in the Offering Documents."16 The district court noted that, under DDJ Management, "even sophisticated plaintiffs are not required as a matter of law to conduct their own audit or subject their counterparties to detailed questioning where they have bargained for representations of truthfulness."17
The U.S. District Court for the Central District of California went even further in applying DDJ Management in Allstate Insurance v. Countrywide Financial.18 There, the plaintiffs acquired RMBS and subsequently alleged that such acquisition was fraudulently induced by the defendants' misrepresentations concerning, inter alia, the relevant underwriting standards, loan to value statistics and sufficiency of borrower income. The defendants moved to dismiss on the ground that Allstate was "not justified in relying on a misrepresentation when other, more detailed, information should have alerted a reasonable party of the representation's falsity."19 In rejecting this argument, the court noted that under DDJ Management, the "steps that a plaintiff takes to avoid deception" may permit the party to prove justifiable reliance.20 The court then noted that the pleadings were silent as to whether Allstate took sufficient steps to protect itself and therefore "reserve[d]" that issue "for summary judgment." Thus, the Allstate court construed DDJ Management to mean that a sophisticated plaintiff does not even need to allege affirmatively what measures of self-protection it employed so long as the allegations of the complaint do not portray carelessness. While this decision appears to be an outlier, it bespeaks a broad reading of DDJ Management.
Notwithstanding that DDJ Management has been used effectively in some cases by sophisticated plaintiffs to avoid dismissal, the protection offered by DDJ Management does have its limits. Courts will still dismiss such claims where the plaintiffs cannot plead that prior to entering into the relevant transaction, they took reasonable steps to protect themselves against deception. Thus, in Centro Empresarial Cempresa,21 the Court of Appeals rejected a claim of justifiable reliance on the ground that the "plaintiffs have been so lax in protecting themselves that they cannot fairly ask for the law's protection."22 There, the plaintiffs argued that the defendants could not rely upon a release that the parties had previously executed in connection with a corporate acquisition on the ground that the release was fraudulently induced. The court noted that "[p]laintffs here are large corporations engaged in complex transactions" and that as "sophisticated entities, they negotiated and executed an extraordinarily broad release with their eyes wide open."23 Moreover, the court emphasized that the "plaintiffs knew that defendants had not supplied them with the financial information necessary to properly value" the relevant assets and thus failed to protect themselves in the manner required under DDJ Management to assert validly that their reliance was justifiable.24
This limitation on DDJ Management has also been applied in the RMBS context. In HSH Nordbank AG v. UBS AG,25 the plaintiff alleged that the defendants fraudulently induced it into entering certain credit default swap transactions pursuant to which the plaintiff assumed the risk of losses on a $3 billion portfolio of RMBS and other real estate securities. The underlying transaction documents, however, expressly provided that the plaintiff and the defendants were "dealing with each other at arm's length" and that plaintiff "was not entering into the deal in reliance on any advice" from defendants.26 In such circumstances, the Appellate Division, First Department, held that the trial court erred in denying the defendants' motion to dismiss for failure to allege justifiable reliance adequately. Specifically, the Appellate Division held that the plaintiff's reliance upon the defendants' alleged misrepresentations was not justifiable and that DDJ Management was "[r]eadily distinguishable" because "in this case, [the defendants] never issued any warranty concerning any of the matters [the plaintiff] claims were misrepresented but, at the time, failed to investigate for itself."27
Courts have reached the same results in traditional commercial and real estate disputes. Thus, in Laxer v. Edelman,28 the Appellate Division, Second Department, affirmed dismissal of the plaintiff's fraudulent inducement claim in connection with a real estate acquisition on the ground that the underlying sale documents expressly disclaimed reliance on the defendant's representations. The court held that in such circumstances, any reliance was not reasonable, citing, among other authorities, DDJ Management.
These cases provide a few examples of a developing trend in the wake of DDJ Management and Centro Empresarial Cempresa. Courts may be more inclined to deny motions to dismiss attacking the reasonableness of a plaintiff's reliance as long as the plaintiff took affirmative measures to protect itself against disclosure. By the same token, courts have not eschewed an inquiry into the specific factual allegations of each case to determine whether reasonable reliance is adequately pled. And, Centro Empresarial Cempresa confirms that the Court of Appeals did not intend DDJ Management to be construed as a bar to pleading motions as to the issue of reasonable reliance. If anything, DDJ Management and Centro Empresarial Cempresa may be read together as providing defendants with a roadmap to bar certain cases from proceeding to discovery. The lesson to be learned for corporate practitioners is that it is important to include, if feasible in the context of a complex negotiation, the type of specific disclaimers analyzed by the court in DDJ Management. For litigators, the lesson is to emphasize the existence or absence of such provisions in pleadings alleging fraud and justifiable reliance.
Michael C. Hefter and Daniel S. Meyers are complex commercial litigation partners at Bracewell & Giuliani in New York. Elizabeth Tillotson, an associate, assisted in the preparation of this article.
1. DDJ Mgt. v. Rhone Group, 15 N.Y.3d 147 (2010).
2. The plaintiffs' fraud claim was one of several contained in the complaint. All other claims, which are not relevant to the topic of this article, were dismissed by the trial court in response to the defendants' motion to dismiss. Id. at 153.