Foreclosures—Lender Liability—Borrower’s Claims for Breach of Contract, Negligent Misrepresentation and Fraudulent Inducement Based on Lender’s Alleged Oral Agreement to Permit Borrower to Purchase Its Loan Dismissed—Partial Performance Exception to Statute of Frauds Must Be Unequivocally Referable to Alleged Agreement

An owner of two real properties had obtained $23.5 million in financing to develop the properties into residential apartment complexes. The owner alleged that the entire development cost was projected to be $90 million and that the $23.5 million was only a partial construction loan to cover demolition and early stage construction costs.

The owner and lender had subsequently agreed to divide the loan into two loans, i.e., one for the large property and one for the smaller property. As part of the refinancing, the lender reduced the interest rate on the new loans and the owner conveyed the small property to a separate entity that shared common ownership with the large property. The large property was then encumbered with a $13.5 million mortgage and the small property was encumbered with a $6 million mortgage lien. The lender received $500,000 as a pay down on the loan and the refinancing was documented by a “Restated Substitute Mortgage Extension, Modification and Security Agreement.”

The owner asserted that the modification was done to facilitate financing from other sources to finish the project. The owner had obtained a $5 million loan and some additional financing from “A” and had completed development of the small property. The owner sought to borrow an additional $40 million to complete development of the large property. However, each financial institution it approached sought to have the lender subordinate its mortgage to the new financing.

The owner alleged that the lender thereafter agreed to subordinate its mortgage and reduce the rate on the existing loan, “if the $6 million loan on the smaller property was completely satisfied.” The owner further alleged that the lender “offered it a right of first refusal to purchase [the lender's] position on its loan on the property.” Additionally, the owner claimed that it had paid a premium and associated fees for “A” “to pay off the $6 million loan on the smaller property in order to receive this right of first refusal” and to convince the lender “to agree to subordinate its loan on the property.”

The lender argued that although the owner had defaulted “by failing to tender the requisite monthly payment.” The owner countered that the lender “had changed its mind” and refused “to subordinate its loan unless [the owner] made a $2 million pay down of principal from $13.5 million to $11.5 million.” The owner also alleged that it had continued to negotiate with the lender in an attempt to get it to subordinate its loan and that the lender thereafter informed the owner that it had contracted to sell its loan and refused to continue negotiations with respect to the subordination. The owner asserted that although it had advised the lender that it had a right of first refusal with respect to the purchase of its loan, the lender assigned the loan to “B” for $12.5 million and “B” thereafter commenced a foreclosure action against the owner. That action was settled for $14.65 million. The owner then commenced the instant litigation, alleging claims against the lender for breach of contract, negligent misrepresentation and fraudulent inducement.

The lender moved to dismiss pursuant to CPLR 3211 (a) (1) and (7). The lender argued that the owner “always had a right of redemption,” and could have redeemed the property by paying all the sums due and owing to the lender. Further, the lender had been operating under a “Supervisory Agreement with the federal Office of Thrift Supervision, which as a matter of public policy, does not permit a financial institution to allow a defaulted borrower to benefit from its own misconduct in failing to repay a loan and then acquire it at a discount.”

The lender claimed that the owner’s breach of contract claim was “nothing more than an attempt to avoid…clear contractual provisions contained in the written agreement….” The alleged “oral, undocumented agreement” granting the owner a right of first refusal to purchase its loan was “precluded by the terms of the written agreement and note.” The loan documents barred oral modifications and contained merger clauses requiring that all agreed terms be contained in the writing.

The owner asserted that the alleged oral agreement had been entered into after the financing agreement had been entered into and cited the partial performance exception to the statute of frauds. However, such partial performance must be “unequivocally referable to an alleged oral modification of the written agreement.” The lender noted that “if partial performance can be reasonably explained by the possibility of other reasons for the conduct, the performance is equivocal and renders the oral modification unenforceable.”

The owner argued that its pay off of the $6 million loan prior to maturity unequivocally demonstrated its performance under the alleged oral agreement. The lender stated that such monies were due to the lender under the express terms of the note and that the early payment was attributable to the restructuring of the original loan. The court held that the early payment of the $6 million was not unequivocally referable to the alleged oral modification and granted the lender’s motion to dismiss the breach of contract claim.

In order to plead negligent misrepresentation, a plaintiff must allege the existence of a special or privity-like relationship imposing a duty on the defendant to impart correct information to the plaintiff, that the information was incorrect and the plaintiff reasonably relied on such information. A plaintiff must show that it took action it would not have otherwise taken and such action was the direct and proximate cause of the losses incurred.

Although the lender argued that the parties merely had an “arm’s-length” relationship, the owner alleged that it had a special relationship to the lender “with whom it already had extensive business dealings with” and the issue of “whether a special relationship exists is usually a question of fact that cannot be resolved prior to discovery.”

The court explained that “[a] special relationship exists when (1) the parties are in a relationship of trust and confidence, or (2) one of the parties has superior knowledge….” Moreover, the “requisite ‘special relationship’ does not exist between sophisticated commercial entities that enter into an agreement through an arm’s-length business transaction.”

The New York Court of Appeals has acknowledged that “a duty to speak with care may be imposed in a commercial transaction, but only ‘on those persons 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.’” Moreover, “the relationship of trust and confidence must have existed prior to the very contractual relationship giving rise to the alleged wrong, and not as a result of it.”

Here, the court found that the facts “simply do not support the finding of a special relationship.” Rather, “sophisticated commercial entities engaged in” nothing “more than an arm’s length business transaction.” The relationship between the owner and the lender was “solely a debtor and creditor relationship” and the owner had failed to allege “that it had a longstanding relationship of trust and confidence with [the lender] prior to the transaction at issue.” Thus, the court dismissed the negligent misrepresentation claim.

Finally, the court dismissed the claim that the lender had fraudulently induced the owner into an agreement by representing that it would grant it a right of first refusal and subordinate its loan. “[T]o state a claim for fraudulent inducement, there must be a knowing misrepresentation of material present fact, which is intended to deceive another party and induce that party to act on it, resulting in injury.” The lender emphasized that the allegations involved a “prediction or expectation” of what the lender would do in the future and the owner’s early payment of the $6 million was “consistent with its legal obligations under the note and thus, it cannot claim to have been defrauded into doing what it was already legally obligated to do.” Thus, the fraudulent inducement claim was also dismissed.

Comment: As this case illustrates, commercial borrowers who argue that written contracts which embody merger and integration clauses should not be enforced in accordance with the contractual terms because of “oral agreements” or oral agreements coupled with “part performance” have heavy burdens to overcome. Lenders usually defend such claims by citing specific contract language, the statute of frauds and asserting that alleged part performance is not specifically referable to the alleged oral agreement. The courts are generally skeptical about these types of claims, especially when dealing with sophisticated parties who are usually represented by sophisticated counsel. However, these cases will be decided based on the specific facts of each case, as evidenced by the parties’ relationships and specific conduct.

50-01 Realty v. Brooklyn Federal Savings Bank, 8562/11, NYLJ 1202549247285, at *1 (Sup., KI, decided March 28, 2012), Schmidt, J.

Continued Receipt of J-51 Tax Benefits by Owner of Housing Complex After Complex’s Withdrawal From Mitchell-Lama Program Did Not Trigger Rent Stabilization Law Since Benefits Had Been Unauthorized From the Moment of Withdrawal and Were Retroactively Repaid

The subject residential housing development was built in 1974 under the Mitchell-Lama Program. The program provided low interest mortgage loans and real estate tax exemptions to owners “who develop low- and middle-income housing,” and who “agree to regulation of rents and profits.” The development was entitled to receive tax abatements from the City of New York, known as J-51 benefits, for major renovations.

In 1998, the development “received a J-51 tax abatement amounting to $7,550 per year for 12 years, for making $90,600 worth of major capital improvements.” Owners of developments built after May 1, 1959 were entitled to withdraw from the program after 20 years “by paying the remaining balance of a property’s mortgage.” In June 2003, the New York City Department of Housing Preservation and Development (HPD) and the development’s tenants were notified of the owner’s intent to exit the program.

In March 2004, before its formal withdrawal from the program, the owner entered into an agreement with the tenants’ association. The association agreed to try to cause every tenant to apply for a so-called “enhanced voucher” under Section 8 of the United States Housing Act of 1937, which would provide “eligible low-income families with extra housing assistance to subsidize any market-based rent increase following the development’s withdrawal” from the program. The owner agreed that tenants who received such assistance would be given leases at a rental value determined by HPD, so that the amount that the tenants were required to pay would remain the same. The tenants who were denied such assistance would receive benefits under a “Landlord Assistance Program,” i.e., their rents would increase in accordance with Rent Guideline Board (RGB) increases for the first nine years after the development withdrew from the program, “for the 10th-12th years, their rents would increase by the RGB increases plus 3.33 percent, and for every year thereafter, their rents would increase by the RGB increase plus 1 percent.” Additionally, “those tenants’ families would be granted succession rights.”

By letter dated June 28, 2004, the owner advised the Department of Finance of its withdrawal as of that date from the program and that consequently “‘the Property shall forthwith be restored to a full taxpaying position’ effective as of that date.” However, “no action was taken by DOF to terminate…J-51 benefits, and these benefits continued until March 23, 2006, when, following consideration prompted by [the owner's] inquiries, HPD informed DOF that [the owner's] J-51 benefits should have been terminated as of June 28, 2004.” In April 2006, the owner repaid all J-51 benefits it received after June 28, 2004, plus interest.

On Sept. 28, 2004, after the owner withdrew from the program, the association and 20 tenants who had been denied enhanced Section 8 vouchers commenced an action, initially seeking leases in accordance with their prior agreement. Thereafter, they sought a declaration that their apartments were rent-stabilized. Additionally, an action was commenced by tenants who had entered into market-rate leases at the development after it withdrew from the program. Those tenants claimed that the owner’s “post-exit receipt of J-51 benefits rendered their apartments rent-stabilized, and sought single damages, treble damages, attorney fees, lease reformation, and a declaratory judgment.”

The court in both actions had remanded the litigation to the New York State Division of Housing and Community Renewal (DHCR) for a determination as to the development’s status under the Rent Stabilization Law (RSL). DHCR found that the development was not subject to the law. The agency reasoned since “HPD terminated the J-51 tax abatement effective as of the dissolution date…, the complex was not effectively receiving benefits subsequent to leaving Mitchell Lama regulation and, therefore, [RSL] 26-504c [sic] would not be applicable… Since [the development] did not become subject to rent stabilization in the first place, 28 RCNY (5-03(f)(3) [sic] the provision of HPD’s J-51 regulation that mandates continued rent regulation when J-51 benefits are revoked or waived would accordingly not be applicable to this matter, since according to HPD the benefits never attached after dissolution.”

The parties then moved for summary judgment on their claims as to whether the apartments became rent-stabilized on June 28, 2004, based on the owner’s continued receipt of J-51 benefits. The trial court had rejected DHCR’s reasoning and granted the plaintiffs’ motions for summary judgment to the extent of holding that as a result of the owner’s continued receipt of J-51 benefits, the apartments became subject to the rent stabilization law on the development’s withdrawal from the program. However, the Appellate Division, First Department, on April 3 reversed. The court held that the claim was not time-barred and that the trial court was not required to defer to DHCR’s determination. The court noted that “DHCR was not interpreting its own regulations.”

The issue was whether “continued receipt of those benefits after [the owner's] exit from the [program], which occurred because DOF took no action to restore [the owner] to full taxpaying status as of June 28, 2004, caused rent stabilization protection to spring into existence the moment the protection of the Private Housing Finance Law ceased.”

At the time when the owner withdrew from the program in 2004, HPD’s rule then in effect then in effect provided that “if a building ceased to be subject to rent regulation, the Commissioner shall withdraw J-51 benefits.” Here, the owner “ceased to be subject to the only rent regulations covering it, namely, the Private Housing Finance Law, and at that moment the City was required to stop allowing it J-51 benefits.”

The plaintiffs argued that the withdrawal of J-51 benefits was not mandatory, but discretionary. However, the appellate court found “nothing in the mandatory language of the rule as it then stood that may be read to give the agency discretion as to whether an owner’s J-51 benefits could survive the building’s withdrawal from Mitchell-Lama, where no other rent regulation was ever applicable.” The court cited, in contrast, 28 RCNY §5-07(e), which expressly gave HPD discretion in other types of circumstances. The appellate panel emphasized that the owner “became ineligible to continue receiving J-51 benefits, as a matter of law, at the moment it exited Mitchell-Lama.”

The panel further stated that 28 RCNY 5-03[f][3] did not “operate here to provide the tenants with rent-stabilized status, because that rule prohibits the termination of rent regulation by revocation or waiver of J-51 benefits, and here it was defendants’ withdrawal from the Mitchell-Lama program that terminated rent regulation, not the revocation or waiver of their J-51 benefits…. An entity cannot waive that which it is not entitled to receive.”

The appellate panel acknowledged that the subject issue was recently presented to the U.S. District Court for the Southern District of New York, “in the context of a qui tam complaint brought by [a tenant] on behalf of the United States against [the owner] and the owners of another similarly situated housing development. The federal government sought reimbursement for the enhanced Section 8 subsidies it paid to [the owner]” and the court agreed with the federal court’s reasoning that the owner’s “ continued receipt of J-51 benefits after it exited the Mitchell-Lama program was merely the erroneous result of DOF’s failure to adjust [owner's] tax liability following its receipt of notice that the property would be restored to full taxpaying status as of June 28, 2004. That error did not create rent stabilized status for a development that was not otherwise subject to the [RSL].”

The state appellate court acknowledged that receipt of J-51 benefits could “trigger the applicability of [RSL] (Administrative Code) §26-504(c), which provides that the [RSL] shall apply to dwelling units in a building receiving J-51 benefits, as long as that building is not owned as a cooperative or a condominium and is not subject to rent control.” The court explained that if the owner had “intentionally sought and obtained J-51 benefits when no other rent regulation applied to its units, its receipt of those benefits would have triggered rent stabilization.” Here, however, the owner “sought and obtained J-51 benefits while it was subject to the Private Housing Finance Law, so the [RSL] did not become applicable to it by virtue of those payments.”

Finally, the appellate panel held that an order which denied the defendants’ motion to remand to DHCR the causes of action which sought enforcement of rights under the parties’ original March 2004 agreement, was correct. Nothing raised in such agreement was subject to DHCR review, since those claims sought relief under the parties’ agreement rather than under the RSL.

The appellate division noted that in view of its determination, “those issues may now require litigation,” Thus, the court reversed.

A judge dissented in part, saying the plaintiffs’ appeal in one of the litigations should have been dismissed. That appeal was from an order that denied the defendants’ motion for an order remanding the first through sixth causes of action to DHCR. The plaintiffs had submitted answering papers requesting that the motion be denied in its entirety. The dissent believed that the appeal should be dismissed because the plaintiffs “were not aggrieved by the denial of the remand they opposed.”

The dissent explained that “[a]lthough the remand that defendants requested was denied, plaintiffs have taken this appeal because in dictating its decision on the record the court commented that ‘there is nothing to remand.’ In light of the fact that plaintiffs’ claims are still pending, there is no merit to their argument that the court thereby ‘effectively dismissed’ their causes of action. There are no grounds for appeal where the successful party has obtained the full relief sought, ‘even where that party disagrees with the particular findings, rationale or the opinion supporting the judgment or order below in his favor.’” The dissent otherwise agreed with the majority’s conclusions “in all other respects.”

Comment: The court had also noted that 28 RCNY 5-007(f)(3), which at the relevant time provided that if a building ceased to be subject to rent regulation, the commissioner shall withdraw J-51 benefits that had been “eliminated by amendments announced in the City Record effective April 15, 2010.” The court considered that deletion of 28 RCNY 5-007(f) “a substantive change, and therefore” would not “permit plaintiffs to rely on this amendment, which became effective almost six years after the events in question.”

Denza v. Independence Plaza Assoc., 117673/05, NYLJ 1202547968643, at *1. (Panel included Mazzarelli, J.P., Saxe, DeGrasse, Román, JJ. All concur except DeGrasse, who dissents in part in an opinion. App. Div., 1st, decided April 3, 2012), Saxe J.

Scott E. Mollen is a partner at Herrick, Feinstein and an adjunct professor at St. John’s University School of Law.