July 31, 2013 Articles

Third-Party Reliance in New York: Navigating Conflicting Case Law

Lawyers have to pay special attention to their duty to cite contrary, controlling authority in this especially unsettled area.

By Michael Murtagh

Over the past 150 years, New York state and federal courts, from the New York Court of Appeals to the Second Circuit, have issued many contradictory decisions on the issue of third-party reliance under New York’s common law of fraud. Reliance is an element of fraud claims. The third-party reliance doctrine is implicated when a plaintiff sues for fraud based on statements made by the defendant to a third party that relied on those statements.

In the abstract, this seems like a straightforward factual scenario that would have a straightforward and settled answer. But consider two statements of law issued by New York’s federal courts within two years of each other:

•“[T]he doctrine of third-party reliance permits the plaintiff to show that a third-party relied upon a misrepresentation by the defendant, which resulted in injury to the plaintiff.” Prestige Builder & Mgmt. LLC v. Safeco Ins. Co. of Am., 2012 U.S. Dist. LEXIS 146085 (E.D.N.Y. Oct. 10, 2012).

•“[F]raud claims may not be premised on false statements on which a third party relied.” Fed. Treas. Enter. Sojuzplodoimport v. Spirits Int’l N.V., 400 F. App’x 611 (2d Cir. 2010).

This conflict has resulted in New York’s federal trial courts refusing to follow a clear statement of law set forth by the Second Circuit. The district court in Prestige Builder, for example,disagreed with the Second Circuit’s decision in Spirits International, and held that the third-party reliance doctrine was “good law in New York,” despite multiple conflicting Second Circuit decisions. One reason New York state courts feel compelled to recognize the third-party reliance doctrine is because there is a line of case law, beginning with Rice v. Manley, 66 N.Y. 82, 87 (1876), in which the New York Court of Appeals held that fraud claims maybe premised on statements made to third parties that result in injury to the plaintiff. This directly conflicts with the Second Circuit’s pronouncements on the issue. Thus, New York federal trial courts applying New York state law are currently bound by both the New York Court of Appeals and the Second Circuit, which dictate opposite outcomes. Not surprisingly, federal district judges have reached conflicting results.

This article explores the state of the law on third-party reliance in New York and an ethical dimension of this conflict. Although these decisions on third-party reliance generally reflect an effort by the trial judges to “do the right thing” in the face of contradictory authority, it would be very helpful if the New York Court of Appeals issued a decision resolving the question, as it did a few years ago when a similarly confusing conflict was brewing.

The Third-Party Reliance Doctrine
The decisions make the doctrine sound simple enough (no matter which result they reach). For example, in a case endorsing the third-party reliance doctrine, the Appellate Division, Second Department, simply states “Fraud . . . may also exist where a false representation is made to a third party, resulting in injury to the plaintiff.” Buxton Mfg. Co., Inc. v. Valiant Moving & Storage, Inc., 657 N.Y.S.2d 450, 454 (2d Dep’t 1997).

Perhaps the simplest exposition is as follows: A makes a representation to B. B relies on it. Then C is harmed by it. C sues A. A promptly moves to dismiss, arguing that C cannot have relied on A’s misrepresentation. In Rice, for example, the New York Court of Appeals recognized a fraud claim where the defendant (A), seeking to procure cheese from a cheese seller (B) that the plaintiff (C) had already contracted to purchase, sent the seller a fraudulent telegram in the name of the plaintiff, indicating that the plaintiff no longer wanted the cheese. The seller then sold the cheese to the defendant. The fraudulent statement was directed toward a third party—the seller—who relied on it, but the plaintiff was harmed in missing out on the cheese.

In the Buxton case mentioned above, the defendant Valiant was accused of making false “progress payment certifications” to the U.S. Department of Agriculture. These certifications falsely represented that all of Valiant’s subcontractors had been paid. Buxton, one of those subcontractors, had not been paid, and it alleged that Valiant’s false statement caused the department to pay Valiant in full for the contract, instead of setting aside enough money to cover Valiant’s debt to Buxton. Again, a third party—the Department of Agriculture—relied on the statement, but Buxton was harmed.

In Desser v. Schatz, 581 N.Y.S.2d 796 (1st Dep’t 1992), the defendants were alleged to have falsely represented to a bank that a mortgage had been paid in full, causing it to issue a satisfaction of a mortgage, extinguishing the plaintiff’s interest in the property. The court permitted the fraud claim, noting that it is “of no moment . . . that the false representation was not made directly to [the] [p]laintiff.”

Other New York state courts have reached opposite conclusions. In Escoett & Co. v. Alexander & Alexander, 296 N.Y.S.2d 929 (1st Dep’t 1969), the First Department, with little discussion and ignoring Rice, held that a fraud claim was inadequately pleaded because “[t]he representations of which the defendant complains were made to third parties and not to it, and those representations were relied upon by those third parties and not by it.” The same conclusion has been reached in other cases, such as Garelick v. Carmel, 529 N.Y.S.2d 126 (2d Dep’t 1988), and Morris v. Castle Rock Entm’t, 246 F. Supp. 2d 290, 296 (S.D.N.Y. 2003). In the past 15 years, the Second Circuit has also issued three decisions holding that third-party reliance is insufficient to sustain a fraud claim, but never squarely confronting New York’s conflicting authority: Cement & Concrete Workers District Council Welfare Fund v. Lollo, 148 F.3d 194 (2d Cir. 1998), New York v. Smokes-Spirits.com, Inc., 541 F.3d 425 (2d Cir. 2008) and, most recently, the Spirits International decision.

These conflicting pronouncements have put federal trial courts in a tricky position. Ordinarily, federal trial courts adhere to the New York Court of Appeals as the ultimate authority on state law, deferring also to decisions of the Appellate Division unless there is strong evidence that the Court of Appeals would reach a different conclusion. But this is not an ordinary situation because the Second Circuit has issued several decisions that conflict with New York state court decisions on this subject. Federal district courts have reached conflicting results as well, some suggesting that the Court of Appeals’ decisions must be followed (e.g.ChevronPrestige Builder) and others suggesting that such claims should not be recognized in light of the Second Circuit’s opposition See, e.g.Rezende v. Citigroup Global Mkts., Inc., 2010 U.S. Dist. LEXIS 122354, at *8 (S.D.N.Y. Nov. 18, 2010).

Federal courts hearing state law claims based on diversity jurisdiction ought not reach a different result than a state court would on the same point of state substantive law. Yet, that is the exact situation that this confusion has engendered. Fraud claims premised on third-party reliance are on a fundamentally different footing if they are pending in federal court before federal judges, who must defer to the Second Circuit, than if they are pending in state court, before judges not so bound.

The lack of clarity regarding third-party reliance is reminiscent of a similarly confusing issue that was resolved a couple of years ago. For years, federal courts in the Second Circuit held that non-fraud claims based on facts that could support a claim under New York’s Martin Act (New York’s blue sky law), such as breach of fiduciary duty and negligent misrepresentation, were preempted by the Martin Act. See, e.g.Castellano v. Young & Rubicam, Inc., 257 F.3d 171, 190 (2d Cir. 2001). In the absence of authority from the New York Court of Appeals, courts reached varying results on this issue. Compare id. with Anwar v. Fairfield Greenwich Ltd., 728 F. Supp. 2d 354, 371 (S.D.N.Y. 2010). Some judges, such as Judge Marrero in Anwar, espoused a view of New York law that differed from the Second Circuit’s, believing his view to be more consistent with what the highest court in New York would do if it faced the issue. Others felt constrained to follow the Second Circuit. Eventually, the Court of Appeals issued a decision putting a stop to the confusion, holding that non-fraud claims that would also support a claim under the Martin Act are not preempted by that act when brought by private investors. Assured Guar. (UK) Ltd. v. J. P. Morgan Inv. Mgmt. Inc., 17 N.Y.3d 825 (2011).

Regardless of whether one agrees with the Assured Guaranty decision, it resolved the uncertainty. A decision of the Court of Appeals—taking account of the conflicting authority and either validating or rejecting the third-party reliance doctrine—would be similarly helpful here. Until then, decisions going both ways, attempting to reconcile the contrary authority, should continue to be the norm.

Ethical Concerns Arising from Conflicting Case Law 
New York lawyers are required to “disclose to the tribunal controlling legal authority known to the lawyer to be directly adverse to the position of the client and not disclosed by opposing counsel.” N.Y. Rule of Prof’l Conduct 3.3(a)(2). For a federal court defendant moving to dismiss a fraud suit based on third-party reliance, this rule can lead to an absurd result, requiring careful and candid disclosure of two conflicting rules. Under one of the rules, the defendant wins the motion; under the other, the defendant loses and the case proceeds. Given that the federal district court is generally bound by, and deferential to, decisions of the Second Circuit, counsel may be tempted to cite only the Second Circuit decisions (which do not even hint at the differences between the Second Circuit and New York decisions). However, relying on this helpful authority without disclosing the antiquated, but adverse and on-point, Court of Appeals authority would likely violate Rule of Professional Conduct 3.3(a)(2). Thus, lawyers are required to cite both the decision they want the court to apply and the contrary decision that they’d like the court to reject.

Not surprisingly, this conflicting mandate can be difficult to apply and is not always done. In many cases, the other side is likely to find the contrary authority and cite it, and the court may well consider both rules. But the other side doesn’t always make good arguments, particularly when those arguments are based on very old Court of Appeals decisions. Nor do courts always note the varying standards (such as in the Morris case). Failing to cite the other source of potentially controlling authority—particularly when it is a Court of Appeals decision close to 150 years old—leads to a risk that neither the other side nor the court will find it.

The fact that lawyers must sometimes advance two contradictory arguments does not mean it cannot be done effectively. Good lawyers frequently make the strongest argument they can for their client, while acknowledging, and trying to defuse or distinguish, contrary authority. The trick with an issue like third-party reliance is doing so while acknowledging to the court that it is bound by two mutually exclusive rules, but giving the court a good reason to pick one of the standards over the other. Not only does this comply with Rule of Professional Conduct 3.3(a)(2), but it does a far greater service to the parties and the court than arguing for the standard that benefits one’s client and ignoring the other.

In the context of third-party reliance, some judges have reached their own peace and found ways to reconcile the seemingly conflicting decisions. In Rezende, for example,Judge Baer followed the Second Circuit in dismissing a fraud claim based on third-party reliance, holding that this claim in the modern day is not a viable tort because what he viewed as the prototypical third-party reliance situation—the one presented in Rice with the cheese thief—is now treated as intentional interference with contract. The fact that Judge Baer found a way to reconcile and distinguish the conflicting lines of authority was likely helped along by the arguments of parties, who thoughtfully and candidly engaged with both rules. Similarly, the judges who have recently ruled in favor of third-party reliance conducted thorough analyses of decisions reaching both results—something made far more difficult when parties do not properly alert the court to contrary authority.

Conclusion
The New York state and federal courts’ repeated, conflicting decisions on third-party reliance have gone on for some time, and as was true of Martin Act preemption, this is likely to continue until the Court of Appeals confronts the issue again. Until it is resolved, lawyers will have to pay special attention to their duty to cite contrary, controlling authority in this especially unsettled area. Although this duty can lead to a seemingly absurd result in light of the two arguably “controlling” rules governing third-party reliance, it actually offers an opportunity for counsel to confront the contrary authority and more persuasively explain why it should not be followed.

Keywords: litigation, business torts, fraud, Second Circuit, New York Court of Appeals, controlling authority, contrary authority Rules of Professional Conduct

Michael Murtagh – July 31, 2013