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This past March was a relatively quiet month for the judiciary in terms of noteworthy fraud decisions.  Not much to write about.  The Appellate Division Fourth Department did render a decision that is, although quite brief, worth some commentary.  The decision is Rugg v O’Donnell, 2018 NY Slip Op 02108 (4th Dep’t Decided on March 23, 2018).

Waiver of Defenses

The specific context of the Rugg decision is the enforcement of a promissory note.  The note contained a customary provision in which the obligors broadly waived any defenses against the note.  The question for the court was whether a defense of fraud could be asserted against the note.

Ordinarily, waivers of defenses in a contract such as a note are subject to claims of fraudulent inducement.  See Mishal v Fiduciary Holdings, LLC, 109 AD3d 885, 885-886 (2d Dep’t 2013).  That is, if the execution of the note was procured through fraudulent means, and the obligor was induced to sign the note by actionable fraud, then the note itself (and the waiver provisions contained in it) could be subject to rescission, and thereby rendered unenforceable.  (There is plenty of case law as to extent to which specific language in a promissory note or guaranty can bar even claims of fraudulent inducement, but that is beyond the scope of this current commentary.)

Rugg Decision

The interesting twist in Rugg was the fact that the promissory note was actually a consolidated note that derived from previous notes with a different obligee.  The original notes were given by the obligors in connection with the sale of real property.  One note was secured by a mortgage on the subject real property and the other note was secured by personal property.  The seller of the real property and original obligee on the notes then died.  The estate then discovered that the notes were in default.  At that point, the two notes were consolidated and the named obligees of the consolidated note were three other individuals apparently connected to the estate.  One of those obligees then assigned her interest to yet another individual.

Significantly, in connection with the consolidation of the notes, the parties to the consolidated note entered into a mortgage consolidation, extension, and modification agreement (CEMA). In the CEMA, the obligors agreed that there were no offsets or defenses to the notes, the mortgages, or the indebtedness, and they expressly waived any claim or defense that could be asserted as an offset to the indebtedness.

So that is the context of the decision: original notes get consolidated, and there are new obligees under the note.

When the obligors then default on the consolidated note, the new obligees seek to enforce their rights under the note.  In that action, the defendant-obligors claim that the original seller of the real property, and initial obligee, falsely represented to them that there were no underground tanks on the premises, nor was there environmental contamination.  Plaintiffs’ motion for summary judgment was denied by the lower court.  The Fourth Department reversed.

The Fourth Department acknowledged that ordinarily promissory notes and similar contracts that contain waivers of defenses against enforcement of the note/contract are subject to claims of fraudulent inducement.  However, the Court noted that the problem with the defense of fraud was that the alleged false representations upon which the claim of fraud was based came – not from the current obligees – but from the original obligee from whom they purchased the real property.  Here is the relevant portion of the decision:

We conclude that Supreme Court erred in denying the motion. Plaintiffs met their initial burden on the motion by submitting a copy of the note and evidence of nonpayment (see Wehle v Moroczko, 151 AD3d 1846, 1846 [4th Dept 2017]; Brandywine Pavers, LLC v Bombard, 108 AD3d 1209, 1209 [4th Dept 2013]). The burden then shifted to defendants to submit evidence establishing the existence of a triable issue of fact with respect to a bona fide defense to plaintiffs’ recovery on the consolidated note (see Wehle, 151 AD3d at 1846; Sun Convenient, Inc. v Sarasamir Corp., 123 AD3d 906, 907 [2d Dept 2014]). Although defendants submitted evidence in support of their affirmative defenses and counterclaims based on breach of contract and fraud, the broad language of the waiver contained in the CEMA unambiguously encompasses those defenses and counterclaims (see Petra CRE CDO 2007-1, Ltd. v 160 Jamaica Owners, LLC, 73 AD3d 883, 884 [2d Dept 2010]; Malsin v Stockman, 265 AD2d 533, 533 [2d Dept 1999]; Chemical Bank v Allen, 226 AD2d 137, 138 [1st Dept 1996]). Contrary to defendants’ contention, the waiver is not invalid with respect to their allegations of fraud. Although “a written waiver in any form cannot operate to shield a party from his [or her] own fraud” (Sterling Natl. Bank & Trust Co. of N.Y. v Giannetti, 53 AD2d 533, 533 [1st Dept 1976]; see Mishal v Fiduciary Holdings, LLC, 109 AD3d 885, 885-886 [2d Dept 2013]), here, the fraud was allegedly committed by a third party. Thus, the waiver does not operate to shield plaintiffs from their own fraud (cf. Sterling Natl. Bank & Trust Co. of N.Y., 53 AD2d at 533).

Commentary

Now, the Fourth Department could have found that the rights under the consolidated note simply derived from the original transaction and that the initial debt was subject to the defense of fraud from the outset, or that the subsequent obligees were in constructive privity with the original obligee, or were bound by defenses to the underlying transaction.  The critical factor was that the note in issue was given to new obligees, who did not make any of the alleged misrepresentations and did not otherwise fraudulently induce the defendant-obligors to sign the new CEMA.  And, defendants signed the CEMA without raising, alleging or attempting to preserve the underlying alleged fraud.  In fairness, therefore, they should not be permitted to get the benefit of the CEMA, acknowledge the enforceability of the new note and then claim later that the note was entirely unenforceable due to the alleged fraud of someone other than the current obligees, which allegedly occurred long ago.

A just result.  Kudos to the Fourth Department for reversing and granting plaintiffs summary judgment.