30 June 2010
Late last week the Court of Appeals of New York unanimously reversed an intermediate court’s ruling in DDJ Management, LLC, et al. v. Rhone Group L.L.C., et al. that would have limited a lender’s ability to rely on representations received from a borrower. Contrary to the intermediate court’s ruling that required lenders to conduct their own due diligence with respect to a borrower’s financial statements, the Court of Appeals held that lenders are not, as a matter of law, required to do more than receive and rely on applicable representations.
In DDJ Management, LLC v. Rhone Group L.L.C., a group of lenders sued the owners of a bankrupt borrower, together with other defendants, for fraud, among other claims. The plaintiffs made a $40 million loan to American Remanufacturers Holdings, Inc. (ARI) and, in connection therewith, ARI sent DDJ Management, LLC, who acted as agent for the plaintiffs, its unaudited financial statements. The plaintiffs alleged that, in order to convince the plaintiffs to enter into the loan transaction, the defendants intentionally drafted the financial statements to falsely report ARI’s earnings in a positive light. Pursuant to the loan documentation, ARI represented that the financial statements were prepared in accordance with generally accepted accounting principals (GAAP), consistently applied throughout the period covered, and that they fairly presented ARI’s financial position.
The intermediate court dismissed the fraud claim, stating that the plaintiffs could not claim reliance on the representations unless they performed their own due diligence as to the financial statements by looking at the books and records of the borrower.
The Court of Appeals, however, while acknowledging that the record does not show that the lenders did their own due diligence, found that the lenders “made a significant effort to protect themselves against the possibility of false financial statements” by requiring the borrower to make specific representations with regard to the financial statements. The representations made by the borrower included representations that nothing in the financial statements was materially misleading and that the financial statements were prepared in accordance with GAAP.
According to the court, “where a plaintiff has gone to the trouble to insist on a written representation that certain facts are true, it will often be justified in accepting that representation rather than making its own inquiry.” In addition, the fact that hindsight suggests that a plaintiff might have been able to detect deception if it had taken additional actions does not mean that the plaintiff cannot prevail in a lawsuit as long as it took reasonable steps to protect itself.
In reversing the intermediate court and ruling in favor of the plaintiffs, the Court of Appeals affirmed a common practice followed by many sophisticated lenders, thereby preventing many lenders from having to change their practices. All lenders should ensure, however, that their practices are reasonable, and should recognize that additional diligence may be necessary in certain situations, including if they have not received appropriate representations or if they know or suspect that the representations that they have received are inaccurate.
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