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Kevin Schlosser Authors, "Court Struggles With Distinguishing Breach of Contract from Fraud"

Sep 25, 2017Litigation & Dispute Resolution
Source: Here we go again. Of all the issues involving claims of fraud, the one that probably presents the most trouble for courts is distinguishing between a breach of contract and a fraud claim. See my other posts for examples. When defendant is accused of representing that it would perform a contractual obligation, which it later fails to perform, courts nearly always reject the attempt to assert a fraud claim, ruling that it is nothing more than a breach of that contractual obligation. The sticky part is when there is real evidence that the defendant made the contractual promise with a present, demonstrable, intent not to perform. Can that fly as a fraud, rather than mere breach of contract? Does the promise have to be “collateral” to the actual contractual obligation, and if so, what is considered “collateral”? A recent decision of the New York Appellate Division, First Department, the State’s most prodigious producer of descriptive fraud decisions, graphically shows the struggle that courts have with these issues. In Cronos Group Ltd. v XComIP, LLC, 2017 NY Slip Op 06515 (1st Dep’t Decided on September 19, 2017), three judges on the panel battled it out with the single dissent, coming to distinctly different conclusions applying the same existing case law. The decision is fascinating and a must read. Case Facts In Chronos, plaintiff and defendant entered into a telecommunications contract under which they both agreed to provide international telephone communication services to the other. The contract provided for offsetting charges of the other party if disputed, and an indemnity mechanism if a party incurred charges to the other for what is referred to as fraudulent calls. After the contract was entered into and during its performance, plaintiff notified defendant by email that fraudulent calls were made for which no charge should be rendered by defendant under the contract. Defendant’s managing member, a named individual defendant, allegedly represented to plaintiff that it would not be charged for these allegedly fraudulent calls. The key allegations are as follows: [Defendant Manager] promptly gave [plaintiff] oral assurances that [plaintiff] “would not need to compensate [defendant] for these fraudulent calls.” [Plaintiff] further alleges that, in reliance on these assurances, it continued to allow [defendant] to transmit its customers’ calls over [plaintiff]’s network, which resulted in [defendant] continuing to incur charges owed to [plaintiff]. However, on December 7, 2015, an employee of [defendant] notified [plaintiff] that [defendant] would not reverse the charges for the fraudulent calls. Thereafter, until December 17, [plaintiff] continued to demand that the charges for the fraudulent calls be annulled, while continuing to allow [defendant] access to its network in response to continued alleged promises from [the Manager] that [defendant] would “handle’ or deal with’ the problem.” Finally, on December 17, [plaintiff] terminated [defendant]’s access to [plaintiff]’s services. Through that date, [defendant] used the charges for the allegedly fraudulent calls, totaling $54,926.84, to offset the same amount of charges that [defendant] owed to [plaintiff] for the use of [plaintiff]’s network. Among other causes of action, plaintiff asserted a breach of contract claim in the amount of the charges for the fraudulent calls and costs under the indemnity provisions, and a fraud claim seeking the amount for the fraudulent calls. Plaintiff asserted that it reasonably relied upon the Manager’s assurances that plaintiff would not have to pay for the fraudulent calls, and that it was damaged when it continued to provide service to defendant instead of stopping the service. Motion to Dismiss and the Internal Court Battle on Appeal The court below denied defendants’ motion to dismiss these claims. The First Department reversed in part, sustaining the contract claim but dismissing the fraud claims in their entirety at the pleadings stage. The dissent agreed that the contract claim should survive, but forcefully maintained that the fraud claim should be sustained at the pleadings stage. The main point of contention between the majority and dissent was whether the Defendant Manager’s oral assurance that no charges for the calls in question were going to be insisted upon by defendant could form the basis of a fraud claim apart from the breach of the contract. The majority found that these assurances were nothing more than a promise to abide by an existing contractual obligation, and thus, merely a breach of contract. The majority relied upon plenty of case law that indicated that the alleged promise must be “collateral” to the contractual obligations (i.e., not contained in the contract itself). As such, the majority found that the Manager simply assured performance of what plaintiff alleged the contract required on its face. The majority also found that plaintiff had not adequately alleged the basis for claiming that the Defendant Manager had a present intent not to abide by the assurances he gave. Further, the majority rejected the dissent’s reasoning that since defendant disputed the contract provisions upon which plaintiff based its breach of contract claim, if it was found that the contract did not in fact require the charges to be rescinded, the Defendant Manager’s assurance would not be duplicative of any pre-existing contractual obligation. The majority concluded that plaintiff would not have been justified in relying on those mere assurances, which it characterized as nothing more than a “gift” if it was found there was no contractual obligation. (The majority’s dismissive view of such reliance appears out of step with the deference that the courts should give to allegations at the pleadings stage, but does show that courts scrutinize fraud claims even on motions to dismiss.) The dissent interpreted the case law as allowing a fraud claim when there is evidence of a present intent not to abide by contractual obligations, finding that this constitutes a misrepresentation of existing fact, and as such “collateral” to the contract. Both the majority and dissent picked the cases apart to try to find support for whether the Defendant Manager’s assurances were “collateral” and whether the allegations were sufficient to establish that he had a present intent not to abide by his assurances. The informative discussion shows there is certainly room to argue both sides of the issue. Commentary Interestingly, neither the majority nor dissent recognized that the assurances made by the manager were not given at the outset of the contract formation as in the typical factual scenario in these cases, but rather after the contract had already been entered into. This should make a difference. The reason why fraudulent inducement claims should not be allowed where the representation is merely the promise to abide by the contract is because that is precisely what the contract requires anyway and a party should not be permitted to claim fraud by being induced to sign the contract based upon such a contractual promise. In Chronos, however, plaintiff relied upon the assurances not to enter into the contract, but to keep providing service at a time it could have otherwise stopped, which ultimately resulted in losing the impending charges. That does amount to a factual basis for fraud, and it would appear the reliance was reasonable, at least at the pleadings stage. It is odd that neither the majority nor dissent, despite the lengthy discourse, picked up on this critical distinction. This would be an ideal case for the New York Court of Appeals to offer some very much needed guidance. There are certainly cases that have allowed fraud claims where there is evidence of a present intent not to perform a contract provision – even where the representation only concerns the actual contractual obligations. If a further appeal is pursued, the Court of Appeals should grant leave and clarify these issues, including what the courts have referred to as representations that are “collateral” to the contract or even whether there must be something that is “collateral.”