Licensed To Defraud?

Sunday, January 1, 2006 - 01:00

Can a person misrepresent or withhold material information from settlement negotiations, and later have a court enforce a settlement agreement and release that was procured through such fraud or nondisclosure? Some courts, in limited contexts, have answered this question in the affirmative. These cases, primarily out of the Second Circuit and the Eleventh Circuit, hold that a party that settles a dispute involving allegations of fraud or dishonesty may not later ask a court to set aside the settlement on the basis of fraud or non-disclosure. See Pettinelli v. Danzig, 722 F.2d 706 (11th Cir. 1984); Mergens v. Dreyfoos, 166 F.3d 1114 (11th Cir. 1999), cert denied, 528 U.S. 820 (1999); Finz v. Schlesinger, 957 F.2d 78 (2nd Cir. 1992); Nycal Corp. v. Inoco PLC, 988 F.Supp. 296 (S.D.N.Y. 1997). If applicable, these cases create a "buyer beware" environment where a settling party cannot rely on the representations of his adversary in settling a business dispute.

In Pettinelli, the United States Court of Appeals for the Eleventh Circuit held that the plaintiffs could not set aside a settlement agreement and release, which resolved (among other things) underlying claims of fraud, by alleging that the plaintiffs were fraudulently induced to enter into the release. The plaintiffs in Pettinelli invested money in a land development corporation, Skyway, in exchange for yet-to-be-issued stock shares. The shares were never issued, and the plaintiffs threatened to bring a shareholder derivative action. The parties then settled, and executed a settlement agreement and release.

Thereafter, the plaintiffs sued, contending that prior to execution of the settlement agreement and release, Skyway fraudulently represented that it would pursue legal remedies against the former President of Skyway, and open its books for inspection. The Eleventh Circuit upheld the settlement agreement and release, and explained:

Even if representations were made that were false and did induce [plaintiffs] to enter into the release in reliance thereon, such reliance was unjustified . . . . In the instant case, the [plaintiffs] include . . . a New York attorney. He was involved in the negotiations and presumably had enough legal acumen to understand and protect his own and other appellants' interests. Throughout this negotiation period appellants knew from their own dealings that they should not rely on any representations made by defendants. Appellants also knew that by the Release terms, they would not know the condition of Skyway until they inspected the books. Appellants did not insist upon examining the books prior to the execution of the Release and did not insist upon the insertion of any specific written representations as to the financial condition of Skyway. As to action against [the former President], [plaintiffs] granted all authority to Skyway in its exclusive discretion.

Pettinelli, 722 F.2d at 710. Accordingly, the Court held:

When negotiating or attempting to compromise an existing controversy over fraud and dishonesty, it is unreasonable to rely on representations made by allegedly dishonest parties. Thus, the appellants have failed to make a prima facie case of fraud because they had no legal right to rely on these representations under these circumstances.

Id.

Likewise, in Mergens, the United States Court of Appeals for the Eleventh Circuit held that a settlement agreement and general release could not be voided by allegations of fraud, where the release settled underlying claims of fraud and unfair conduct. The plaintiffs in Mergens, minority shareholders in PEC Corporation, accused the majority shareholders in PEC of mismanagement and improper self-dealing. The plaintiffs then sold their interest in PEC to the defendants for $14.5 million. The purchase agreement contained a general release that released defendants from "any claim [plaintiffs] ever had, now have, shall or may have from the beginning of the world to the date [of the agreement]." After the note was paid, PEC sold its main asset, a television station, for $150-160 million.

The plaintiffs then sued, and claimed the release should be voided by fraud because the defendants misrepresented PEC's cash flow and other assets in order to purchase the assets at a price far below market value, and failed to advise the plaintiffs of the contemplated sale of the television station. The court upheld the release, noting that the plaintiffs were sophisticated, represented by counsel, and had been in an adversarial relationship with the defendants since well before the execution of the agreement. The court also noted that the settlement agreement was entered into, in part, to settle a lawsuit in which the plaintiffs claimed fraud. Based on the posture of the parties prior to the execution of the agreement, the plaintiffs "had no legal right to rely on the representations of [defendants]." Thus, the allegations of fraud were insufficient to void the express release of all claims. Mergens, 166 F.3d at 1118.

In Finz, the United States Court of Appeals for the Second Circuit found that a plaintiff could not set aside a release due to the defendant's allegedly incomplete disclosure of material facts. The underlying dispute in Finz involved the plaintiff's belief that he was covered by his former law firm's pension plan. After executing the release, the plaintiff learned of certain facts relevant to the plan's coverage which he had suspected, but not known, at the time he signed the release. In rejecting the plaintiff's attempt to set aside the release, the court explained:

[Plaintiff], who at all times believed that the defendants were misrepresenting his entitlement to benefits should not be permitted to strike a better bargain at this late date by claiming that he signed the agreement in reliance on defendants' misrepresentations.

Finz, 957 F.2d at 83, see also Nycal, 988 F.Supp. at 305. ("A party that settles a claim of fraudulent inducement cannot revisit that settlement agreement by asserting that the alleged defrauding party did not make a full disclosure of its own fraud.")

Most business disputes involve sophisticated businesspersons who are represented by legal counsel. Further, most business disputes involve at least some allegations of dishonest or improper conduct. Accordingly, the rule announced in Pettinelli, Finz and their progeny could have a significant impact on corporations negotiating business disputes. Under Pettinelli and Finz, when negotiating a business dispute involving claims of fraud or dishonesty, the burden is placed squarely on each party to perform its own independent due diligence prior to settlement. In other words, if you later find out your adversary lied to you, you could have no recourse.

One question that arises is the quantum of fraud or dishonesty that must be alleged prior to the settlement agreement, before a party is precluded from relying on the representations of his adversary in the settlement context. Thus far, the only court to analyze the rule announced in Pettinelli and Finz, and find it inapplicable, was the United States Court of Appeals for the Tenth Circuit in Chase v. The Dow Chemical Company, 875 F.2d 278 (10th Cir. 1989). In Chase, the court declined to apply the Pettinelli/Finz rule because the underlying lawsuit that the parties settled involved claims of property damage, not fraud or wrongful conduct, and the relationship of the parties at the time of the underlying settlement was not "adversarial." Chase, 875 F.2d at 283-84.

Chase provides some guidance as to what kinds of disputes fall within the rubric of Pettinelli and Finz, and what kinds of disputes do not; but questions remain. Does the Pettinelli/Finz rule apply where you merely believe that the party with whom you are negotiating has sharp business practices? Does the Pettinelli/Finz rule apply where you believe that the party with whom you are negotiating is dishonest? Or must the underlying dispute involve actual allegations of outright fraud for the Pettinelli/Finz rule to apply? The Second Circuit seems to believe that the underlying dispute must involve a specific claim of fraud. The Eleventh Circuit seems to take a broader view, that where you negotiate with people you believe to be dishonest, you cannot rely to your detriment on statements from those dishonest parties.

Regardless, whenever you negotiate a business dispute involving claims of fraud or dishonesty, the burden of due diligence is on your (or your client's) shoulders. Following the reasoning of Pettinelli and Finz, if you (or your client) decides to settle a claim involving fraud and dishonesty, you should be on notice that your adversary is not honest; and accordingly, you should not rely on any representations made by your adversary in the negotiations leading up to the settlement. Although this reasoning seems strange, and on its face could lead to potentially inequitable results, it is consistent with the "reliance" element traditionally required in fraud claims. Therefore, all representations made by your adversary should be independently reviewed and verified.

Another possibility is to contract out of the Pettinelli/Finz rule. This might be accomplished by including in any settlement agreement and release all representations made by the parties that are material to the transaction, including a statement that the parties are relying on all such representations, and including a statement that the settlement agreement and release may be voided if such representations turn out to be untrue.

Alternatively, if a party desires true finality without any further exposure to lawsuits claiming fraudulent inducement, it is advisable that such a party place an express provision in the settlement agreement and release stating that all prior, existing or future claims of fraud or dishonesty are covered by the release. If such a statement is included, it will be much more difficult for your adversary to attempt to set aside a settlement agreement and release by claiming fraud.

Andrew J. DeFalco is an associate in Stradley Ronon's Litigation Department focusing his practice on a wide array of complex commercial disputes, many of which involve claims of fraud, breach of fiduciary duty and corporate malfeasance. Mr. DeFalco also specializes in disputes involving products liability and mass tort, professional liability, insurance coverage and construction matters. His experience includes jury trials and arbitrations before both federal and state tribunals.

Please email the author at adefalco@stradley.com with questions about this article.