By Peter Janovsky

 

Peter Janovsky is a partner at Zeichner Ellman & Krause in New York

 

In connection with the sale of real property, the president and sole shareholder of the seller corporation stated on a pre-closing disclosure form that he was not aware that the premises were located in a flood zone or that the corporation had flood insurance for the premises.  After closing on the sale, the premises flooded as a result of a rainstorm, and the buyer LLC learned only then that the premises were located in a 100-year flood plain. The buyer LLC then sued the corporation and its president for breach of contract and fraud.  Should the fraud claim survive against the corporation?  Should it survive against the president?

These are the questions posed in LIUS Group International Endwell, LLC v. HFS International, Inc.,[1] a 2012 New York case that demonstrates the interplay of contract and fraud claims among contracting and third parties. 

Fraud Claims Against a Contracting Party

Contract and fraud are separate and often mutually exclusive remedies.  Fraud can be the more powerful claim, carrying with it the possibility of punitive damages and the reputational risk of an action framed as misrepresentation or even deceit.  The essential elements of a fraud claim are “[1] a material misrepresentation or a material omission of fact which was false and known to be false by defendant, [2] made for the purpose of inducing the other party to rely upon it, [3] justifiable reliance of the other party on the misrepresentation or material omission, and [4] injury.”[2]

Once parties enter into a contract, however, the likelihood of a fraud claim between the contracting parties decreases substantially because courts presume that the contract encapsulates all of the representations and promises made by each party.  New York’s highest Court has therefore held that a contract action “cannot be converted to one for fraud merely by alleging that the contracting party did not intend to meet its contractual obligations."[3] 

In other words, a fraud claim against a contracting party will fail if it is based solely on the allegation that a party entered into a contract never intending to perform its obligations.[4]  The complaining party must allege additionally that it was fraudulently induced to enter into the contract by a promise completely independent from the promises set forth in the contract and that “the plaintiff seeks "compensatory damages which are not recoverable for breach of contract."[5]  This is a very high bar for a contracting party to meet.

Fraud Claims Against a Third Party or Non-Contracting Party

But what if someone who is not a party to the contract is the one that has made a false promise to induce a party to sign a contract?  In this case, the doctrine barring fraud claims between contracting parties does not apply, because the alleged fraudster is not a party to the contract.  These were the facts of Lius Group, above.  In that case, the New York Court denied Lius’s fraud claim against HFS, the defendant corporation, but upheld the fraud claim against its president, based on his misrepresentations.  Two essential factors were present, according to the Court:  First, the president was not himself a party to the contract; and second, the damages for the fraud claim were not recoverable under the plaintiff’s breach of contract claim.[6]

This doctrine of third-party fraud liability has been applied in other very recent cases, including Sun Products Corporation v. Bruch, decided by the United States Court of Appeals for the Second Circuit in January 2013.[7]  In Bruch, the sole shareholder of the defendant corporation admitted that he deliberately understated his company's sales in order to deceive the plaintiff.   The federal court held that the corporation could not be liable for fraud because the contract contained the representations on which the fraud claim was based.  However, the shareholder could be liable for fraud because he was not a contracting party.[8]

The Separate Damages Requirement

The requirement that a fraud plaintiff prove damages that cannot be recovered under the contract may be daunting. The plaintiff in Lius succeeded because its fraud damages were based on its losses because it entered at all into a contract for a property located on a 100 year flood plain.  These damages were clearly not recoverable under the contract for the sale of property.  Similarly, in Introna v. Huntington Learning Ctrs., Inc.,[9] an allegation that a school misrepresented that its instructors were licensed teachers gave rise to different damages than those recoverable under the contract in the case.

In another scenario, the parties have already entered into a contract, but a third party, based on certain non-contractual promises, induces one of the parties to amend the contract to its detriment.  If that detriment can be quantified and the third party fails to fulfill its promises, the third party risks fraud liability.

Summary

Courts have significantly narrowed the circumstances under which a contracting party can sustain a fraud claim against the other party to the contract.  However, they appear to be increasingly open to upholding claims based on fraudulent inducement by a non-party to the contract, such as a principal or parent company of a contracting party.

 

 



[1] 92 A.D.3d 918 (2d Dep’t. 2012).

[2] Lama Holding Co. v. Smith Barney Inc., 88 N.Y.2d 413, 421 (1996).

[3] Rocanova v. Equitable Life  Assurance Soc'y, 83 N.Y.2d 603, 614 (N.Y. 1994).

[4] New York Courts are not completely consistent on this point.  An earlier Court of Appeals case, Sabo v. Delman, 3 N.Y.2d 155, 160  (1957)  held that “if a promise was actually made with a preconceived and undisclosed intention of not performing it, it constitutes a misrepresentation of ‘a material existing fact’ upon which an action for rescission may be predicated.”

[5] Introna v. Huntington Learning Ctrs., Inc., 78 A.D.3d 896, 899, 911 N.Y.S.2d 442 (2d Dept. 2010)

[6] Lius, supra at 614.

[7] 507 Fed. Appx. 46; 2013 U.S. App. LEXIS.

[8] Id.

[9] Introna, supra at 898-899.