Finance Alert August 20, 2010 Authors: Steven H. Epstein steve.epstein@klgates.com +1.212.536.4830 Lorraine Massaro lorraine.massaro@klgates.com +1.212.536.4043 Aaron W. Menzi aaron.menzi@klgates.com + +1.212.536.4883 Deborah Pilar Low deborah.low@klgates.com NY Court of Appeals Affirms that Lender Reliance on Borrower Financial Representations without Independent Due Diligence Not Per Se Unreasonable Summary In an important recent decision for commercial lenders, the New York Court of Appeals unanimously reaffirmed long-standing New York law in finding that, in a fraud claim, it is not unreasonable as a matter of law for a sophisticated lender to rely on a borrower’s representations and warranties in commercial loan transactions even though the lender may not have independently verified those representations and warranties through means that were readily available to it.1 +1.212.536.4816 Background K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. The plaintiffs in the instant case were a group of investors that in 2005 made a $40 million loan to a now-defunct borrower called American Remanufacturers Holdings, Inc. (“ARI”). ARI filed for bankruptcy shortly after the making of the loan, causing the plaintiff-lenders to sustain a total loss. The lenders then brought suit against, among others, the majority shareholders of ARI and members of ARI’s management, alleging, among other claims, that the borrowers had committed fraud in connection with the loan by making material misrepresentations regarding ARI’s financial condition that painted a much rosier picture of ARI’s business and its assets than was the case.2 Fraud Allegations The lenders alleged that, among other things, the unaudited 2004 financial statements delivered by the borrowers falsely inflated ARI’s EBITDA through a manipulation of ARI’s inventory reserves,3 and that numerous employees of ARI were either aware of, or actively involved in fraudulently altering these inventory reserves specifically for the purpose of inflating the EBITDA.4 In fact, the opinion quotes several “striking details” as to the candor with which at least one ARI executive discussed the misstatements internally. One email from this employee of the borrower to another said, “I understand the financial reason to manipulate earnings,” while another, sent three weeks later between the same two parties says, “I realize we needed to make EBITDA for banks but we should understand … what our true EBITDA is.”5 The lenders further alleged that several representations and warranties contained in the loan agreement regarding the financial condition of ARI were untrue at the time they were made, including: Finance Alert (i) that the unaudited 2004 financial statements presented fairly in all material respects the financial position of ARI as at December 31, 2004 and the results of ARI's operations and cash flows for the period then ended and were prepared in accordance with GAAP; (ii) that between December 31, 2003 and March 22, 2005 [the closing date for the loan], no event occurred, which alone or together with other events, could reasonably be expected to have a Material Adverse Effect on ARI's business, assets, operations or prospects, or its ability to repay the loan; and (iii) that no information contained in the loan agreement, the other loan documents or the financial statements furnished to the lenders contained any untrue statement of a material fact or omitted to state a material fact necessary to make the statements contained therein not misleading in light of the circumstances under which they were made.6 The “You Should Have Known I Was Lying Defense” In response to the lenders’ claims, the borrowers argued that several significant inconsistencies in the unaudited 2004 financial statements should have led lenders to question the truthfulness of the information provided, but since lenders failed to dig deeper into the reality behind the financial statements (i.e., make a reasonable inquiry into the truth of the statements) and the representations made by the borrowers in the loan agreement, lenders were not justified in relying on the accuracy of the representations.7 Appellate Division Misconstrued Precedent Applicable to Sophisticated Lenders The lower court had allowed the fraud claims against certain of the plaintiffs to stand against a motion to dismiss, but on appeal by the borrowers, the Appellate Division reversed, claiming that certain New York decisions it viewed as precedent held that “[a]s a matter of law [emphasis added], a sophisticated plaintiff cannot establish that it entered into an arm’s length transaction in justifiable reliance on alleged misrepresentations if that plaintiff failed to make use of the means of verification that were available to it” and “[t]o sustain a claim for fraud, sophisticated investors, as here, must have discharged their own affirmative duty [emphasis added] to exercise ordinary intelligence and conduct an independent appraisal of the risks they are assuming.”8 The Appellate Division emphasized that the lenders never conducted any due diligence into ARI’s book and records underlying the 2004 financial statements on which lenders primarily relied in making the loan to ARI and having failed to do so, they could not properly allege reasonable reliance on the purported misrepresentations.9 Reasonability of Reliance is a Question for the Trier of Fact, Not a Per Se Determination as a Matter of Law In reversing the decision of the Appellate Division, the New York Court of Appeals (the state’s highest court) denied the imposition of such a due diligence burden on lenders as a matter of law by holding that, where a plaintiff has taken “reasonable steps [emphasis added] to protect itself against deception, it should not be denied recovery merely because hindsight suggests that it might have been possible to detect the fraud when it occurred”10, instead noting that no duty to make an independent investigation arose as soon as “hints of any possibility of falsehood” came to light, but rather that it was a question for a trier of fact as to whether a plaintiff was reasonable in relying on the information received.11 In addition, the Court of Appeals made note of the fact that that the precedents relied on by the Appellate Division were derived from a series of cases intending to deny lenders relief from fraud claims where (i) the lenders neglected to take reasonable and available measures to protect themselves, (ii) sophisticated business entities made so-called hypocritical reliance claims where it was truly apparent that they knew that the representations and information provided to them were false but nonetheless claimed to have been “taken in” and (iii) the lenders were so lax in protecting themselves that they were not deserving of the law’s protection.12 Perhaps even more significant was the argument of the Loan Syndications and Trading Association, the Clearing House Association and the Commercial Finance August 20, 2010 2 Finance Alert Association in an amicus brief filed on behalf of the lenders, that in the decisions cited by the Appellate Division the lenders did not use representations and warranties obtained from the borrowers to justify reliance on unaudited financial statements.13 Importantly, the Court of Appeals acknowledged that the lenders in Rhone could have followed up on the hints of fraudulent conduct, but emphasized that specifically bargaining for representations and warranties regarding the reliability of financial information being provided, as the plaintiffs in Rhone did, could support a jury finding that the plaintiffs had ample justification for accepting such statements as being true. “Indeed, there are many cases in which the plaintiff’s failure to obtain a specific, written representation is given as a reason for finding reliance to be unjustified.”14 The Impact of Rhone on the Commercial Lending Market Had the Court of Appeals upheld the decision of the Appellate Court, it would have had significant ramifications on the commercial lending market. As argued in the amicus brief, imposing an affirmative duty of investigation on lenders would dramatically change the lending market by forcing lenders to undertake time-consuming and costly measures to independently verify financial information provided by a borrower. Additionally, the amicus brief noted that such a change in commercial finance law would create a staggering burden on the credit industry and would “upset lenders’ settled expectations in countless existing loan obligations...at a time when commercial lending is already painfully restricted.”15 The amicus brief also made the argument that the lenders in Rhone had followed generally accepted commercial practices in making the loan in March 2005 (whether these practices continue to be generally accepted today with the hindsight of the financial crisis is unclear). An important point made by the amicus brief nevertheless is that the rule announced by the Appellate Division did not take into account the realities of commercial lending, arguing that commercial lenders are not auditors of their prospective borrowers or purchasers of the borrower’s businesses and in general are not equipped to undertake such costly and timeconsuming examinations before making loans. The brief further stated that the law of New York regarding the purpose and function of warranties would be rendered pointless by the Appellate Division’s rule.16 Would a Lender’s Failure to Obtain Representations and Warranties Justify a Finding of Unreasonable Reliance? The Court of Appeals ruling in Rhone is also significant in its emphasis on the importance of including specific and comprehensive representations and warranties in agreements, particularly representations and warranties relating to the truthfulness of the facts specified therein. In deciding that lenders in the Rhone case could have been justified in relying on the truthfulness of the financial statements provided by borrowers, the Court of Appeals focused on the fact that the lenders had specifically negotiated for the borrowers’ representation that certain facts were true, and noted that this step could justify reliance without requiring further inquiry. In contrast, as noted above, the court noted several cases where a plaintiff’s failure to obtain such a specific written representation was grounds for finding that the plaintiff was not justified in relying on information provided by the defendant. Effect of Ruling The ruling in Rhone clearly validates and underscores the value of a commercial lender obtaining representations and warranties as to the adequacy and truthfulness of financial and other relevant disclosure by borrowers. Under certain factual circumstances, lenders will be able to rely on these representations in bringing successful fraud actions against borrowers. Nonetheless, lenders should not assume that obtaining such representations and warranties is a substitute for customary due diligence in all circumstances or a substitute for proper inquiry in situations where the lenders may have some indication that information provided by borrowers may be inaccurate or incomplete. August 20, 2010 3 Finance Alert 1 DDJ Management, LLC v. Rhone Group L.L.C., 2010 Westlaw 2516811 (N.Y.), 2010 N.Y. Slip Op. 05603. 2 Id. 3 Id. The accounting change that resulted in the vastly improved 2004 EBITDA number was solely due to the fact that 2003 reserves were taken for items remaining unsold for at least one year and 2004 reserves were taken only for items unsold for over two years and plaintiffs were never informed of this change as between the two periods. 4 Id. 5 Id. 6 Id . 7 Id. 8 DDJ Management, LLC v. Rhone Group L.L.C., 60 A.D.3d 421, 875 N.Y.S.2d 17 (N.Y. App. Div. 1st Dep’t 2009), N.Y. Slip Op. 01575 citing UST Private Equity Invs. Fund v. Salomon Smith Barney, 288 A.D.2d 87, 88, 733 N.Y.S.2d 385 (N.Y. App. Div. 1st Dep’t 2001). 9 Id. 10 DDJ Management, LLC v. Rhone Group L.L.C., 2010 Westlaw 2516811 (N.Y.), 2010 N.Y. Slip Op. 05603. 11 Id. While the court noted that as a matter of law, the plaintiffs could have been justified in relying on the representations and warranties of the defendants, the case was remanded to determine whether the facts of this case supported that reliance. 12 Id., citing Global Mins. & Metals Corp. v. Holme, 35 A.D.2d 93, 100, 824 N.Y.S.2d 210 (N.Y. App. Div. 1st Dep’t 2006) and Lampert v. Mahoney, Cohen & Co., 218 A.D.2d 580, 582 (N.Y. App. Div. 1st Dep’t 1995). 13 Brief of Loan Syndications and Trading Association et al. as Amici Curiae Supporting Plaintiffs-Appellants, DDJ Management, LLC v. Rhone Group L.L.C., 2010 Westlaw 2516811 (N.Y.), 2010 N.Y. Slip Op. 05603. 14 DDJ Management, LLC v. Rhone Group L.L.C., 2010 Westlaw 2516811 (N.Y.), 2010 N.Y. Slip Op. 05603 citing Curran, Cooney, Penney v. Young & Koomans, 183 A.D.2d 742, 743-744 (N.Y. App. Div. 2d Dep’t 1992); Rodas v. Manitaras, 159 A.D.2d 341, 343 (N.Y. App. Div. 1st Dep’t 1990); Emergent Capital Investment Management, LLC v. Stonepath Group, Inc., 343 F.3d 189, 196 (2d Cir. 2003). See also Merrill Lynch & Co. v. Allegheny Energy, Inc., 500 F.3d 171, 181-182 (2d Cir. 2007); Barron Partners, LP v. Lab 123, Inc.; 2008 WL 2902187, 2008 U.S. Dist. LEXIS 56899 (S.D.N.Y. 2008); JPMorgan Chase Bank v. Winnick, 350 F. Supp. 2d 393 (S.D.N.Y. 2004); Faller Group, Inc. v. Jaffe, 564 F. Supp. 1177 (S.D.N.Y. 1983). The Court of Appeals then noted that it is harder to find cases holding that a plaintiff who did obtain representations could not justifiably rely on them, noting one where the plaintiff’s attorney actually knew that the representation in question was false. Ponzini v. Gatz, 155 A.D.2d 590 (N.Y. App. Div. 2d Dep’t 1989). 15 Brief of Loan Syndications and Trading Association et al. as Amici Curiae Supporting Plaintiffs-Appellants, DDJ Management, LLC v. Rhone Group L.L.C., 2010 Westlaw 2516811 (N.Y.), 2010 N.Y. Slip Op. 05603. 16 Id. Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London Los Angeles Miami Moscow Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d’Alene Taipei Tokyo Warsaw Washington, D.C. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. 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