Fraud Claim Survives Split Decision Regarding When Plaintiff Could Have Discovered Claim

On February 23, 2017, the First Department issued a decision in Norddeutsche Landesbank Girozentrale v. Tilton, 2017 NY Slip Op. 01482, affirming the denial of a motion to dismiss a fraud claim because of questions of fact regarding when the plaintiff became aware of the fraud.

In Norddeutsche Landesbank Girozentrale, the majority found that there were questions of fact regarding when the plaintiff became aware of the fraud, explaining:

Here, it is undisputed that, when plaintiffs commenced the action, six years had passed since plaintiffs made their investments in the Funds. The question, then, is whether plaintiffs discovered, or could with reasonable diligence have discovered, the fraud more than two years before commencement.

The inquiry as to whether a plaintiff could, with reasonable diligence, have discovered the fraud turns on whether the plaintiff was possessed of knowledge of facts from which the fraud could be reasonably inferred. Generally, knowledge of the fraudulent act is required and mere suspicion will not constitute a sufficient substitute. Where it does not conclusively appear that a plaintiff had knowledge of facts from which the fraud could reasonably be inferred, a complaint should not be dismissed on motion and the question should be left to the trier of the facts.

At the same time, it is well settled that if a party omits an inquiry when it would have developed the truth, and shuts his eyes to the facts which call for investigation, knowledge of the fraud will be imputed to him.

Defendants maintain that plaintiffs should have inferred the existence of the fraudulent scheme they allege as early as 2009, based on the various documents and events they present in support of their motion. Plaintiffs counter that the "clues" defendants contend they should have picked up were insufficient for them to establish the crux of their complaint, which is that the Funds were not CDOs, but rather a method by which defendants could use borrowed money to enrich themselves by plundering the Portfolio Companies. Giving to plaintiffs, as we must, the most favorable interpretation of defendants' evidence, we find that plaintiffs had insufficient facts before the SEC proceeding to plead their causes of action.

(Internal citations omitted) (emphasis added).

The dissent, on the other hand, would have ordered the dismissal of the plaintiff's claims, explaining:

The majority concludes that until the SEC proceeding was commenced in March 2015, plaintiffs had insufficient facts to plead these claims. At the heart of this finding is the majority's belief that plaintiffs' knowledge of the existence of some equity holdings in the Funds was not something that warranted further inquiry because the Funds were permitted to hold incidental equity interests, such as "equity kickers," and that the evidence presented by defendants, which can be interpreted in a myriad of ways, was not enough to alert plaintiffs to the true nature of the Funds.

However, the Zohar II Indenture disclosed in 2005 that Zohar II, at its inception, would purchase equity interests in 24 portfolio companies from another fund of the Patriarch defendants. A February 2007 Patriarch presentation, which plaintiffs received, stated that Zohar II was created "in order to purchase companies," that it focused on the "[a]cquisition of [*9]companies during periods of transition," and that the Zohar Funds provide "[p]urchasing power to acquire companies." The presentation also disclosed that the Funds had acquired or were going to acquire equity interests in 37 portfolio companies, including majority stakes in 23, and 100% stakes in seven.

Furthermore, in a December 12, 2011 Investor Call relating to Zohar III, in which plaintiffs participated, Tilton told plaintiffs that it was "really important to understand" that the Funds were "not like in any way typical CDOs", that the Funds "will be made and broken by the ultimate value of the companies, which truly includes all the equity value in these companies, and that you're never going to see until these companies are sold and the cash has come in," and that the monthly reports provided to investors did not include the equity interests held by the Funds. The transcript of the call also shows that plaintiffs were aware that Zohar III's equity holdings were not subject to the various quality tests mandated in the Fund documents and that investors were told that "[t]he only thing we can do is continue to manage these deals for cash, for the cash test, and to try to increase the value of the underlying companies, such that when we sell them, they'll be a huge benefit to the value of the equity which you don't see." While the call was for Zohar III, it also put plaintiffs on inquiry notice with respect to their investment in Zohar II, since much of Tilton's discussion was directed to the Funds generally and since the investment strategies for both Funds appear to be substantially similar.

Thereafter, in 2012, Patriarch publicly filed a Form ADV with the SEC which disclosed that "[o]ften, [Patriarch] seeks to make opportunistic investments on behalf of its CDO clients with the primary purpose of obtaining influence over or control of financially-troubled companies, focusing on turning around' these Assets by restoring their value . . . ." Numerous filings in unrelated lawsuits, bought between 2009 and 2011, also referred to the Funds' direct acquisition of equity interests in portfolio companies. Moreover, plaintiffs knew that the Funds were underperforming when Moody's downgraded them twice before February 2011 and the S & P downgraded the CDOs in 2010.

This satisfied defendants' burden of establishing prima facie that plaintiffs were on inquiry notice of their fraud claims more than two years before the action was commenced in May 2015.

Noting that the investments were marketed as blind funds that did not identify the portfolio companies, plaintiffs argue that since defendants controlled all of the information that was produced in the monthly reports, no investors could have discovered the fraud until the SEC revealed the details of its investigation on March 30, 2015. In this regard, plaintiffs maintain that the disclosures defendants point to, at most, created a mere suspicion of fraud, which is insufficient to impute knowledge of the fraud (see CSAM Capital, Inc. v Lauder, 67 AD3d 149, 156 [1st Dept 2009]). Plaintiffs reason that while investors were told that there could be "equity kickers," which plaintiffs describe as a "small piece of equity granted to a lender in order to improve the rate of return or otherwise incentivize the lender to take on the risk of lending," defendants did not disclose that their investments would be used to purchase controlling equity interests. Thus, plaintiffs posit that it was not until the SEC made public its investigation that they were prompted to conduct their own investigation in which they learned that defendants were operating a risky private equity venture that they were using to generate excessive management fees.

While the majority adopts these arguments, defendants' evidentiary submissions, viewed as a whole, are not consistent with plaintiffs' understanding that the Funds would only receive equity that was "acquired incidentally." Rather, they show that an integral purpose of the Funds was to acquire majority stakes in portfolio companies. While plaintiffs contend that only the possibility of equity kickers was disclosed, the evidentiary materials demonstrate that the Funds were "anything but typical [CDOs], for better or for worse" and had or would obtain majority or [*10]100% stakes in many portfolio companies, putting plaintiffs on notice that the Funds were or would be operating far differently from what they purportedly believed, and that recovering on their investment would depend, at least in part, on "the sale of [the Portfolio] Companies" (see K-Bay Plaza, LLC v Kmart Corp., 132 AD3d 584, 590 [1st Dept 2015] [the plaintiff was on inquiry notice due to discrepancy between expected proceeds and proceeds actually received]; see also Gutkin, 85 AD3d at 688 [the plaintiff "had constructive knowledge of the alleged fraud" from quarterly reports that did not reflect the plaintiff's understanding of the terms of the agreement]). Moreover, none of the disclosures relied on by defendants, which show that the Funds were acquiring controlling interests in portfolio companies, was in defendants' unique possession and plaintiff has not shown how the existence of a blind trust prevented plaintiffs' from discovering the alleged fraud had they exercised due diligence.