Court Rejects Due Diligence Defense to Fraud Claim

On April 9, 2020, the First Department issued a decision in Knox, LLC v. Lakian, 2020 NY Slip Op. 02255, rejecting a lack of due diligence defense to a fraud claim, explaining:

Defendants contend that an issue of fact exists as to whether plaintiffs' reliance on the statements made to them by Lakian was justified.

Defendants argue that nonparty Donald J. Whelley, the sole manager and member of plaintiff DJW Advisors, LLC's expressed concerns about Capital L's accounting systems and back-office operations, but ignored these red flags, and that therefore plaintiffs bear the responsibility for that risk. However, Whelley's concerns were unrelated to the eventual fraudulent diversion of the funds. Defendants failed to demonstrate that Whelley had hints of Lakian's misrepresentations' falsity and therefore had a duty to probe further.

Defendants contend that Whelley should have inspected a full set of financial documents, but they failed to show that if he had done so he would have been alerted to the potential fraudulent diversion of funds. Their references to the tangled accounts and problematic transactions that Whelley would have seen had he reviewed unspecified documents are too vague to raise an issue of fact.

The record does not support defendants' contention that Whelley's expressed concerns were in fact concerns about where Capital L's money was going. Moreover, Whelley was certain that Capital L's record keeping and back-office problems had been solved by its acquisition of Capital Guardian Holding LLC; if Whelley had been concerned about a potential fraudulent diversion of funds, his concern would not have been alleviated by the acquisition of a new company.

Defendants contend that Whelley should have insisted on language in the subscription agreement to ensure that the investment would be used solely to acquire registered investment advisors. However, the fraudulent inducement claim is based not on defendants' use of plaintiffs' funds for general business operations instead of the acquisition of registered investment advisors but on the diversion of their funds for personal purposes. Defendants' argument that Whelley should have mistrusted them because they told him to wire investment funds to defendant JRL Investment Group, Inc. contradicts the argument they advanced before the motion court, i.e., that JRL was an innocuous, temporary repository for plaintiffs' funds before transfer to Capital L's accounts.

Defendants point out that plaintiffs' own expert readily detected the fraud. However, the expert was reviewing records incorporating and post-dating the investments at issue.

(Internal quotations and citations omitted).

Commercial litigation frequently involves fraud-based claims. Such claims have special pleading requirements or rules, including the rule that a sophisticated businessperson's reliance on a false statement must be reasonable. Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client think you have been defrauded, or if someone has accused you or a client of defrauding them.