A potential client comes to you complaining about a business deal gone awry. In heated, likely scandalous terms, the potential client airs a grievance about being lied to, cheated, and generally taken advantage of.

It’s a compelling story. But is it fraud?

Business deals that don’t work out may lead to tremendous — and even financially ruinous — consequences. A buyer of a business may find it to be far less profitable than expected. A buyer of real or personal property may find its condition to be surprisingly poor. A contracting party may find its counterpart’s performance lacking, perhaps part of a well-planned scheme.

But that doesn’t mean there was fraud.

According to Michigan courts, unhappy investors or buyers — especially those sophisticated enough to be engaging in business transactions — bear significant responsibility for their post-transaction circumstances. This article focuses on the recently published case of DBD Kazoo, LLC v. Western Michigan, LLC., the reliance element of a fraud claim, and the red flag defense.¹

BASIC ELEMENTS OF A BUSINESS FRAUD CASE

A plaintiff in a fraud case has to prove:

1. the defendant made a representation that was material,
2. the representation was false,
3. the defendant knew the representation was false or the defendant’s representation was made recklessly without any knowledge of the potential truth,
4. the defendant made the representation with the intention that the plaintiff would act on it,
5. the plaintiff actually acted in reliance, and
6. the plaintiff suffered an injury as a result.²

The burden of proof is high. To prevail on a fraud claim, a plaintiff must first plead the claim with particularity and prove each element by clear and convincing evidence.³ Clear and convincing evidence is defined as evidence that produces “a firm belief or conviction as to the truth of the allegations sought to be established.”⁴ To put it colloquially, the defendant will likely get the benefit of the doubt.

WAS THERE A REPRESENTATION?

The first element of a business fraud case seems clear, but it presents a formidable hurdle: there must be a representation, or some statement of fact.⁵ Promises regarding the future are generally contractual and will not support a fraud claim.⁶ While a plaintiff may claim to have been misled by a promise of future action, such a promise only supports a fraud claim when made recklessly and/ or without a present intent to perform.⁷ If there are material misrepresentations of future conduct, a plaintiff may be entitled to rescission.⁸ Counsel must therefore identify both facts and promises and apply the appropriate standard to each.

In addition, counsel should evaluate the possibility of a silent fraud claim. The focus here is whether the client inquired about certain facts and received an incomplete response, indicating suppression of the truth.⁹ These circumstances could give rise to a claim for silent fraud since the inquiry or contract places a duty on the responding party to disclose the complete truth.

In DC Mex Holdings, LLC v. Affordable Land, LLC, for example, the state Court of Appeals affirmed a silent fraud judgment.¹⁰ The case involved a real estate development project in Mexico in which the defendant had made a side deal to settle litigation in Mexico related to the project but failed to reveal this deal to his partner (the plaintiff), who specifically asked about it. As a result, the plaintiff lost an opportunity to salvage the project. In support of its decision, the court focused on the duty to disclose created by the direct inquiry.

WAS THE REPRESENTATION FALSE?

Even if there is a misrepresentation or material omission, it must be knowingly false or reckless when made and not just mistaken.¹¹ To prove recklessness in the context of fraud, a plaintiff must prove the “functional equivalent of willfulness” by showing an indifference to whether harm will result as the equivalent of a willingness that harm will result.¹²

DID THE PLAINTIFF JUSTIFIABLY RELY — OR WAS THERE A RED FLAG?

Establishing a false representation may seem sufficient to file a fraud claim, but perhaps the most challenging element is proving that the plaintiff acted in reliance.¹³ The reason is simple: most business deals involve significant due diligence. Focusing on the purpose and scale of typical precontract investigations, Michigan cases provide an in-depth analysis of the reliance element.

The Michigan Court of Appeals most recently addressed the issue in DBD Kazoo, LLC v. Western Michigan, LLC.¹⁴ The facts are complicated, but the key fact is that the plaintiff (standing in the shoes of the lender as its assignee) alleged that the defendants provided false information and representations to the borrower/purchaser regarding the property’s physical and financial condition, thereby inducing the borrower/purchaser to purchase the property and also inducing the lender to make a nearly $20 million loan. The plaintiff sued for fraud.¹⁵

The lower court granted summary disposition to the defendants in part because there was no genuine issue of material fact about the reliance element, and the Court of Appeals affirmed. After reviewing the elements of a fraud claim, the court summarized the current state of the law in this area thusly:¹⁶

• Parties do not have an independent duty to investigate and corroborate representations unless they were presented with some information or affirmative indication that further investigation was necessary. For the purposes of this article, this will be called a “red flag.”¹⁷
• “A plaintiff cannot claim to have been defrauded where he had information available to him that he chose to ignore.”¹⁸
• There is no fraud where means of knowledge are open to the plaintiff and the degree of their utilization is circumscribed in no respect by defendant.

The court rejected the plaintiff’s argument that it could rely on alleged oral misrepresentations and disregard the information it possessed that contradicted those misrepresentations. Instead, it pointed to the following evidence in the record:

1. the sellers provided routine financial documentation that accurately described tenant delinquencies and bad debt — there was no evidence the sellers cooked the books. This was a red flag;
2. the lender was able to inspect the physical condition of the property and received inspection reports, another red flag;
3. the lender obtained all information it requested to underwrite the loan;
4. the purchase agreements did not contain any warranties regarding the physical condition of the property;
5. the purchase agreement contained a merger clause;¹⁹ and
6. the loan documents did not require any specific performance metrics.

As a result, the court concluded that even if there were oral misrepresentations by the seller or its agents, the lender had accurate information in its possession before it closed the loan, contradicting the alleged misrepresentations — the lender saw a red flag and had “the unimpeded ability to know the truth but chose to ignore it.”20 Therefore, as a matter of law, the lender could not reasonably rely on any alleged misrepresentations by defendants.

The Court of Appeals just applied DBD Kazoo in 2701 Dettman, LLC v. RIGTV, LLC to dismiss a fraud claim based on failure to prove the reliance element.²¹ The plaintiff bought commercial property from the defendant and was authorized under the purchase agreement to inspect the property as part of its due diligence. The plaintiff alleged that when it questioned the defendant prior to closing about a payment due to the defendant’s tenant, the defendant misrepresented that the payment had been made. However, when the plaintiff followed up and asked for written confirmation, the defendant did not respond. In fact, the defendant had not made the payment; after closing, the tenant contacted the plaintiff demanding the payment, leading to the fraud claim. Citing DBD Kazoo, the court held that the plaintiff was on notice that additional investigation was required — there was a red flag. By contacting the tenant directly, the plaintiff would have learned the truth. As a result, the plaintiff could not establish that it reasonably relied on the alleged misrepresentation.

The Court of Appeals reached a similar result in Nino Salvaggio Investment Co Ltd v. Beaumont Hospital, Inc.,²² affirming a lower court’s dismissal of a fraud claim because the plaintiff could not have reasonably relied on the alleged misrepresentations. Certain allegedly false statements were inconsistent with express written statements, while others were contrary to known facts.

On the other hand, the Court of Appeals affirmed a jury verdict for silent fraud in Alfieri v. Bertorelli.²³ After discussing the general rules regarding reliance set forth above, the court concluded that the plaintiff had not been presented with any information that would have led him to believe additional inquiry was needed — there was no red flag.

Given the centrality of the reliance element and the red flag analysis, counsel for a client evaluating a potential business fraud case must take great care to assemble all information provided to the client before the transaction was consummated, review the relevant contracts for express representations, and evaluate the scope of a merger clause if there is one. Close attention should be paid to any potential red flags disclosed, especially ones relating to allegedly false representations or omissions. Even if the red flags were embedded in voluminous due-diligence documents, Michigan courts applying the analysis in DBD Kazoo will hold that the buyer should have noted them and followed up with additional investigation if necessary.

WAS THERE A SEPARATE LEGAL DUTY?

In addition to evaluating each element of a fraud claim, there is one more important obstacle to consider: whether the alleged claim simply restates the failure to perform a contractual duty. Parties to a contract generally cannot sue in tort over relationships governed by contract.²⁴ The “threshold inquiry is whether the plaintiff alleges violation of a legal duty separate and distinct from the contractual obligation.”^25,26 In MD Holdings LLC v. RL Deppman Co, the Court of Appeals affirmed summary disposition of a fraud claim.²⁷ After purchasing commercial real estate from the defendant, the plaintiffs had difficulty getting an occupancy permit for the premises, primarily because the physical state of the property did not match the approved site plan with the city. The differences were attributable to improvements previously made without getting permits or approvals from the City of Southfield.

Rejecting the fraud claim, the court held that the alleged misrepresentations were not extraneous to the defendant’s contractual promises. Rather, the subject matter of the misrepresentations was covered in the contractual warranties. The court also rejected the plaintiff’s silent fraud claim, holding that there was no duty independent from the contract to disclose. When fiduciaries are involved, however, courts may find an independent duty to disclose.

IS AN INDIVIDUAL LIABLE?

Finally, a word about individual liability for corporate action. An individual is liable for corporate torts they personally commit or participate in.²⁸ Therefore, when representing a potential plaintiff, counsel should fully investigate the identity of the individual(s) responsible for making misrepresentations or concealing material facts despite a duty to disclose them. Although adding an individual party may not have practical significance if the corporate entity is collectible, the dynamics of the litigation will nonetheless change if individual decision-makers must face their own potential liability. On the defense side, representing an individual defendant will certainly involve an effort to distance the individual from the allegedly fraudulent activity.

CONCLUSION

Proving business fraud is difficult. It should be. Damages for fraud can be significant; they may also be nondischargeable in bankruptcy.²⁹ Therefore, counsel litigating a business fraud case must carefully examine how the specific facts match the elements as described by Michigan courts, with special attention paid to the reliance element and the existence of red flags that would have put the plaintiff on notice to investigate further.