The Illinois Court of Appeals for the First District recently held a bank was not justified in relying on a borrowers' misrepresentations made during a loan modification process, where the borrowers' prior conduct presented the bank with reason to follow up on the borrowers' misrepresentations, and the misrepresentations would not have been hard to discover.
In so ruling, the Appellate Court also held that each of the elements of common law fraud must be proven by clear and convincing evidence.
A copy of the opinion is available at: Link to Opinion
The guarantor on a defaulted commercial loan pledged his right to receive membership distributions from two Delaware limited liability companies to entice a bank to enter into a fifth loan modification on a commercial loan.
The membership distributions from the limited liability companies were intended to service the loan, with the loan payments to be deducted from the distributions and any remaining balance to be remitted to the guarantor, who now became a borrower on the loan.
The borrower represented that the income from the two limited liability companies was "stable and monthly."
However, when no money came in, the bank discovered that the limited liability companies' income had already been pledged as collateral to a separate entity.
The borrowers (the guarantor/borrower and the president and director of the company) again defaulted, and the bank sued to collect, under breach of contract, fraud, and conspiracy to defraud.
Summary judgment was entered in the bank's favor on its breach of contract claim while the fraud and conspiracy to defraud claims against the borrowers proceeded to a bench trial.
At trial the bank testified that it relied on the borrowers' written and oral statements, and its own due diligence search, part of which turned up a list of 10 UCC-1 filings the bank did not review.
As you may recall, UCC-1 filings are forms filed with the state when a lender accepts an interest in certain types of collateral for a loan.
The bank testified that it was not its practice to review each UCC-1-filing because "it's very common for real estate people especially to have a number of UCCs against them," and the bank has "a number of borrowers that would produce tens if not hundreds of UCCs."
The trial court agreed with the bank that the borrowers had misrepresented the status of the collateral but found that the bank failed to prove that it was justified in relying on that misrepresentation or had suffered any damages as a result.
This appeal followed.
On appeal, the bank argued the trial court erred by (1) applying a clear and convincing evidentiary standard to the reasonable reliance and damages elements of fraud, (2) concluding that the bank failed to prove either of those elements, and (3) additionally concluding that the bank failed to prove that the borrowers conspired to conceal the guarantor/borrower's misrepresentations.
The Appellate Court began its analysis by establishing the elements of common law fraud: (1) a false statement of material fact (2) known or believed to be false by the party making it; (3) intent to induce the other party to act; (4) action by the other party in justifiable reliance on the truth of the statement; and (5) damage to the other party resulting from such reliance.
The bank argued that it only needed to prove reasonable reliance and damages by a preponderance of the evidence, meaning it need only show something is "probably true."
The borrowers, on the other hand, maintained that the trial court was correct in requiring proof of each element by clear and convincing evidence.
The Appellate Court acknowledged there is support for each sides position, as well as the unusual circumstance in which two alternative Illinois Pattern Jury Instructions exist that are completely at odds with one another.
The bank, arguing for a split standard of proof, relied on Gordon v. Dolin, 105 Ill. App. 3d 319, 324 (1982), for the proposition that justifiable reliance and damages need only be proved by a preponderance of the evidence.
In conflict with this case, and supporting a unified standard of proof, is National Republic Bank of Chicago v. National Homes Construction Corp., 63 Ill. App. 3d 920, 924 (1978), for the proposition that "[p]roof of each element in an action for fraud must be clear and convincing."
Having considered the authorities, the Appellate Court relied on the Illinois Supreme Court's decision in Racine Fuel Co. v. Rawlins, 377 Ill. 375 (1941), which both the Gordon and National Republic courts relied on as support for the diverging standards.
The court in Racine noted that "transactions are presumed to be fair and honest until the contrary is proved by clear and convincing evidence," "[f]raud is not presumed but must be proved like any other fact by clear and convincing evidence," and "[i]t is not sufficient that there be mere suspicion of fraud but fraud, if it exists, must be satisfactorily shown."
The Racine court then concluded that in support of a claim of fraud, as opposed to "an action merely for recovery of balance on account," the evidence presented at trial had been insufficient. Nowhere in its decision did the Racine court list the elements of a claim of fraud, differentiate between standards of proof necessary to establish each of those elements, or even mention the element of justifiable reliance.
Accordingly, the Appellate Court held that the trial court did not make an error in finding that each of the elements of common law fraud must be proved by clear and convincing evidence.
The Appellate Court next addressed the bank's reasonable reliance on the borrowers' false statements.
The bank conceded that it was required to take reasonable efforts to determine the veracity of the borrowers' statements, but insisted that it was not required to make every conceivable effort to uncover and ferret out a multi-year fraud.
In determining what constitutes justifiable reliance — a phrase used interchangeably with "reasonable reliance" in a given case, "courts consider all of the circumstances surrounding the transaction, including the parties' relative knowledge of the facts available, opportunity to investigate the facts and prior business experience." Hassan v. Yusuf, 408 Ill. App. 3d 327, 350 (2011).
The Appellate Court stressed this is a fact-specific inquiry. The Court first examined Gerill Corp. v. Jack L. Hargrove Builders, Inc., 128 Ill. 2d 179, 193 (1989) where the court allowed for recovery because the information included matters almost exclusively within the knowledge of the defendant and it would have been difficult, if not impossible, for the third-party purchaser to discover them.
The Appellate Court next examined Hassan where the court held there was sufficient evidence for justifiable reliance on the defendants' representations "without further inquiry or investigations" based on the plaintiff's relative inexperience, the trust of the defendants as a result of their longstanding friendship, the defendants experience, and lack of reason to suspect a misstatement.
The Appellate Court found that here, unlike in Hassan, the bank had reason to follow up on the borrowers' representations. Namely, the borrowers' continual inability to pay after representing an ability to pay with each of the loan modifications.
In addition, unlike in Gerill, the information regarding the UCC-1 filing was not exclusively within the borrowers' knowledge or something that it would have been difficult for the bank to discover.
Consequently, the trial court's determination that the bank should have conducted at least some investigation into the borrowers' representations was not against the manifest weight of the evidence.
Accordingly, due to its ruling that the bank failed to prove it justifiably relied on the borrowers' false statements, the Appellate Court did not consider the sufficiency of the evidence with regard to damages and affirmed the judgment of the trial court in favor of the borrowers.
Ralph T. Wutscher
Maurice Wutscher LLP
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