Almost three years ago, during a high point in the credit crisis, DDJ Management v. Rhone,1 a fraud case brought by a lender against a borrower for alleged misrepresentations in financial statements, wound its way to the New York Court of Appeals. Although the case originated well before the credit crisis, and the spate of litigation that has been filed in its wake, the Court of Appeals’ decision in DDJ Management has impacted the landscape of a wide body of fraud cases brought under New York law. In DDJ Management, the Court of Appeals seemingly clarified the pleading standard for establishing reasonable reliance in a fraud case. Up until that point, a sophisticated business entity was at pains to plead enough facts adequately to establish reasonable reliance. At the time that it issued DDJ Management, the Court of Appeals did not address whether it intended to usher in a shift in the law or whether the decision should be construed as a unique case limited to its facts. This article explores the impact of DDJ Management and how subsequent courts have interpreted it. Decisions issued in the wake of DDJ Management demonstrate that while in some cases, lower courts have interpreted the decision as lowering the threshold of reasonable reliance that must be pled by sophisticated parties, courts will nevertheless readily dismiss claims if the plaintiff has not demonstrated that, prior to entering into the relevant transaction, it took reasonable steps to protect itself against deception. In this sense, DDJ Management has been used effectively by defendants as limiting the circumstances in which a plaintiff may adequately plead reasonable reliance.

Background

The plaintiffs in DDJ Management were lenders that loaned a total of $40 million to the defendant, a re-manufacturer of automobile parts, and its corporate affiliates. The complaint alleged that the defendants defrauded the plaintiffs into making such loans by presenting false and misleading financial statements that were designed to inflate the borrower’s EBITDA (earnings before interest, taxes, depreciation and amortization).2 The defendants moved to dismiss the fraud claim on the ground that the plaintiffs, sophisticated entities, had an obligation to make a reasonable inquiry into the truth of the defendants’ financial statements and that the plaintiffs’ failure to do so precluded them, as a matter of law, from alleging a necessary element of fraud: reasonable reliance on the alleged misrepresentations. The trial court rejected the defendants’ position and permitted the plaintiffs to proceed to discovery on their fraud claims. On appeal, the Appellate Division, First Department, reversed, holding that the plaintiffs’ failure independently to inspect the borrower’s books and records precluded the plaintiffs from adequately alleging reasonable reliance.