The Limits of Fraudulent Inducement
Due Diligence is:
The process of investigation by prospective parties to an outsourcing agreement. It usually is done after signature of a non-disclosure agreement and down-selection of the vendor from a field of potential service providers.
Failures in Due Diligence.
Failures in due diligence may occur where the customer or the service provider have not disclosed or discovered all material information relating to the outsourcing contract. Due diligence requires disciplined investigation.
As a legal matter, in a failed due diligence, one party discovers the material information after the contract is signed. Can this discovery be the basis for terminating the contract? Two recent New York court decisions remind the parties of the basic obligations of the parties. Not all failures in due diligence justify rescission or termination.
Fraud in the Inducement.
Essential elements.
To prove fraudulent inducement, the injured party seeking relief must prove four elements:
- a misrepresentation of material facts;
- scienter, namely, knowledge of the falsity of the misrepresentation and the expectation that the victim would reasonably rely upon the misrepresentation to the victim’s detriment;
- justifiable reliance by the victim on the misrepresentation as the basis for making a decision to enter into the contract; and
- injury or damages proximately arising out of the misrepresentation.
See Primedia Enthusiast Publication Inc. v. Ashton International Media, Inc., __ NYS 2d ___, NYLJ Oct. 6, 2003, p. 20, cols. 1-4 (S.D.N.Y. 2003), per Judge Baer; Sokolow, Dunaud, Mercadier & Carreras, LLP, v. Lacher, 299 AD 2d 64 (1st Dept. 2002); McGovern v. T.J. Best Bldg., and Remodeling Inc, 245 AD 2d 925, 926 (3d Dept. 1997); Computerized Radiological Svces. v. Syntex Corp., 786 F.2d 72, 76 (2d Cir. 1986).
Level of Burden of Proof.
A claim for fraudulent inducement into contract requires a high burden of proof. The plaintiff must prove the essential elements of the claim by a clear and convincing proof.
Negligent Misrepresentation.
Under New York law, a claim for negligent misrepresentation requires proof of five elements:
- the defendant had a duty, as a result of a special relationship, to give correct information;
- the defendant made a false representation that he or she should have known was incorrect;
- the information supplied in the representation was known by the defendant to be desired by the plaintiff for a serious purpose;
- the plaintiff intended to rely and act upon it; and
- the plaintiff reasonably relied on it to her detriment.
Hydro Investors, Inc. v. Trafalgar Power Inc., 227 F.2d 8, 20 (2d Cir. 2000).
In this context, a “special relationship” is “akin to a fiduciary relationship, but need not rise to that same level.” “Liability for negligent misrepresentation is imposed only on those ‘who possess unique or specialized expertise, or who are in a special position of confidence and trust with the injured party such that reliance on the negligent misrepresentation is justified.” Kimmel v. Schaefer, 89 N.Y.2d 257, 263 (1996), cited in Bombardier Capital Inc. v. Naske Air GmbH, ___ F.3d ___, NYLJ, Sept. 30, 2003, p. 20, cols. 1-2 (S.D.N.Y. 2003) per Judge Cote. Under Kimmel, the fact finder (a judge or an arbitrator applying New York law) must evaluate three conditions in determining whether the nature and caliber of the relationship was sufficient to establish a special relationship of confidence and trust:
- “whether the person making the representation held or appeared to hold a special expertise;
- “whether a special relationship of trust or confidence existed between the parties; and
- “whether the speaker was aware of the use to which the information would be put and supplied it for that purpose. Id.
In the context of outsourcing, one may ask whether the risk of negligent misrepresentation increases as the nature of the relationship shifts from one of “simple” administration of a technology or process to the exercise of discretion pursuant to guidelines required by the customer organization. This issue may arise in business process outsourcing, but it probably exists in virtually all kinds of outsourced services.
Best Practices in Due Diligence.
Given the costs, distractions, investment of management time and other hurdles in selecting a service provider and in negotiating and concluding outsourcing contracts, due diligence needs to be a disciplined process.
Assembling at Team.
To complete an outsourcing transaction, each party should assemble a team with the necessary expertise to evaluate the economic and commercial rationale for the proposed relationship, ascertain appropriate terms and conditions of pricing and service delivery and enable the negotiation and conclusion of an agreeable contract. Generally, the team includes persons with expertise in the customer’s industry, in the particular types of services to be delivered, in the actual methods of delivery of the services (both historically, from the customer’s perspective, and prospectively, from the service provider’s perspective).
Opportunity to Inspect the Service Provider’s Environment.
The customer should have an opportunity to inspect the customer’s service centers and to appraise their capability to serve the customer’s needs. Similarly, the service provider should have an opportunity to inspect the relevant facilities and documents. Each should have an opportunity to interview the competent persons in the other’s organization.
Specific Types of Disclosures.
Among professional advisers to outsourcing participants, there may be some debate about the suitability of the service provider’s request for the customer’s disclosure of relevant costs and operating procedures of the customer prior to signing the agreement. Since such information is material to the success of the transition from insourcing to outsourcing, and could have a material impact on the pricing and duration of the transition, “best practices” may include extensive disclosures. But customers normally resist such disclosures.
Materiality.
The parties should remember that a “material” element of the bargain is one that was essential, and without which one of the parties would not have entered into the contract. Primedia, NYLJ Oct. 6, 2003, at p. 25, col. 2.
Written Disclosures.
Each party should ask detailed questions and receive detailed written responses.
Written Confirmations of Verbal Disclosures.
Where verbal disclosures are material (i.e., critical) in a party’s decision making, it should make a written note and request the other party to confirm the accuracy of the disclosure.
Waiver Clauses.
Generally, a party is deemed to waive its rights to complain if it acknowledges that it has made all the necessary inquiries that it wanted to make and is not relying on any other matters. In securities and investment matters, such warranties are intended to eliminate the “victim’s” reasonable reliance, a necessary element of a fraudulent inducement claim. Such waivers acknowledge, for example, that the service provider is not relying upon any customer forecast of its demand for particular volumes or classes of service, or customer’s ability to perform any services other than those specifically set forth in the contractual allocation of roles and responsibilities. Typically, such waiver clauses are accompanied by an acknowledgment that the parties have not relied on any representations or warranties other than those expressly included in the agreement. Thus, “where a party specifically disclaims reliance upon a particular representation in a contract, that party cannot, in a subsequent action for common law fraud, claim that it was fraudulently induced to enter the contract by the very representation it has disclaimed reliance upon.” Emergent Capital Investment Mgt., LLC v. Stonepath Group, Inc., 195 F. Supp. 2d 551, 562 (S.D.N.Y. 2002), quoted in Primedia decision above.
Merger Clause.
For the same reason, the well-draft outsourcing agreement will include a “merger” clause. Sometimes called the “entire agreement” clause, this provision generally reads as follows:
This agreement (together with the schedules and exhibits hereto and documents referred to herein and therein) contains, and is intended as, a complete statement of all of the terms of the arrangements, undertakings, commitments and basis of the relationship between the parties with respect to the matters provided for herein and therein. This agreement supersedes all previous agreements, understandings and undertakings of the parties with respect to those matters.