First City Did Not Act In Good Faith
This was an early transaction for First City in the go-go days of 1985, one of but three or four it embarked upon. First City and Greenberg prepared the forms, talked with the selling broker and arranged for the compensation as well as the 14% interest rate which included an undisclosed return to First City. Further, Greenberg knew that in the course of the transaction the referring broker, Cole, sought to terminate the relationship citing inconsistencies. Greenberg was put on notice that the transaction was being altered.
In Chemical Bank of Rochester v. Haskell, 51 N.Y.2d 85, 432 N.Y.S.2d 478, 411 N.E.2d 1339 (1980), it was said:
Thus, the inquiry is not whether a reasonable banker in Chemical's position would have known or would have inquired concerning the alleged breach by Stanndco of its partnership duties, but rather, the inquiry is what Chemical itself actually knew. If Chemical did not have actual knowledge of some fact which would prevent a commercially honest individual from taking up the instruments, then its good faith was sufficiently shown.
51 N.Y.2d at 92.
The term, "bad faith," has been defined as being "nothing less than guilty knowledge or willful ignorance" Manufacturers & Traders Trust Co. v. Sapowitch, 296 N.Y. 226, 230, 72 N.E.2d 166 (1947). See also Corporacion Venezolana de Fomento v. Vintero Sales, Corp., 452 F. Supp. 1108, 1119 (S.D.N.Y. 1978) ("bad faith" is "far more extreme than a failure to observe reasonable commercial standards or the standards of a reasonably prudent man"), remanded on other grounds, 607 F.2d 994 (2d Cir. 1979).
Even after Cole's April conversations, Greenberg concedes that he was unaware of any document signed by the Defendants authorizing any portion of their loan proceeds to be paid to First California or NCC, or to be kept by InterDiscount. Greenberg stated that if a borrower had said, "I don't want to be a participant in this limited partnership, I have a smell about it; I don't like it," that the loan to fund the borrower's investment would not have been made. Yet, he permitted this transaction to go forward, even though the "smell" message was the substance of Cole's conversation with Greenberg on April 9 or 10, 1986. As in Scarsdale Nat'l Bank & Trust Co. v. Toronto-Dominion Bank, 533 F. Supp. 378 (S.D.N.Y. 1982), the holder had not acted in good faith because of the surrounding circumstances.
First City, at the very least, after Cole's expression of reservation, admittedly failed to directly inquire of the Defendants if they wanted to proceed with the funding of their loans or how the loan proceeds were to be disbursed as part of a deliberate desire on its part to evade knowledge because of a belief or fear that investigation would disclose a defense arising from the transaction. See Corporacion Venezolana de Fomento, supra, at 1119; see also Savings Banks Trust Co. v. Federal Reserve Bank, 738 F.2d 573, 574 (2d Cir. 1984) ("knowledge and disregard of suspicious circumstances are sufficient to vitiate an assertion of good faith where negotiable instruments are concerned"); First City Federal Sav. Bank v. Bhogaonker, 684 F. Supp. 793, 797 (S.D.N.Y. 1988) ("Under [the] subjective standard, the existence of bad faith turns on whether the, holder of the note knew that the transaction was suspect."); Sundsvallsbanken v. Fondmetal, Inc., 624 F. Supp. 811, 818 (S.D.N.Y. 1985) ("notice of defenses against an instrument means actual subjective knowledge of defenses, and not the mere existence of suspicious circumstances"); In re Frigitemp Corp., 34 Bankr. 1000, 1013 (S.D.N.Y. 1983), aff'd, 753 F.2d 230 (2d Cir. 1985) (bank that accords provisional credits suspecting customer is engaged in check kiting does not become a holder in due course).
NCC Was An Agent For First City
Under the facts found above, First City, in utilizing NCC to carry out the loan transactions, exerted its power to control the acts of NCC throughout this transaction. See In re Shulman Transport Enterprises, Inc., 744 F.2d 293, 295 (2d Cir. 1984); Maritime Ventures Int'l, Inc. v. Caribbean Trading & Fidelity, Ltd., 689 F. Supp. 1340, 1353 (S.D.N.Y. 1988).
As in Federal Sav. & Loan Ins. Corp. v. Quality Inns, Inc., 674 F. Supp. 522 (D. Md. 1987), aff'd in part and vacated in part, 876 F.2d 353 (4th Cir. 1989), First City supplied NCC with all of the forms for execution and submission by the applicants and provided the financial grid and guidelines used in reviewing and analyzing their financial position, thereby creating an agency relationship.
First City is responsible for the acts of NCC, whether acting under either real or apparent authority. See British American & Eastern Co. v. Wirth, Ltd., 592 F.2d 75, 80 (2d Cir. 1979). It is estopped from denying the existence of such relationship because First City gave NCC all of the trappings of being a legitimate part of First City's operations. See Fuller v. Fasig-Tipton Co., 587 F.2d 103, 107 (2d Cir. 1978); Hewett v. Marine Midland Bank, N.A., 86 A.D.2d 263, 270, 449 N.Y.S.2d 745 (2d Dep't 1982); Bank v. Rebold, 69 A.D.2d 481, 491, 419 N.Y.S.2d 135 (2d Dep't 1979).
In Cullen v. BMW of North America, Inc., 490 F. Supp. 249 (E.D.N.Y. 1980), it was said:
On the other hand, the principle of agency by estoppel is colorably applicable. Although no actual agency relationship exists, such an agency may arise where the party charged as principal permits the putative agent to act in such manner that a reasonable man might infer that an agency relationship in fact existed. See Restatement of Agency § 8, comment (d) (1958); 2 N.Y. Jurisprudence, Agency §§ 25, 87. See also S.S. Silberblatt, Inc. v. Seaboard Surety Co., 417 F.2d 1043, 1049 (8th Cir. 1969). Agency by estoppel may arise if "the person sought to be charged intentionally or carelessly caused the plaintiff to believe in the authority of the purported agent." Karavos Compania, etc. v. Atlantica Export Corp., 588 F.2d 1, 11 (2d Cir. 1978).
490 F. Supp. at 253.
Of course, since the facts establish a failure of consideration known to NCC as well as First City, NCC's status as agent deprives First City of its holder in due course status.
The Defenses Of Lack Of Consideration And Failure Of Performance Defeat Enforcement Of The Notes
UCC § 3-306 permits the Defendants to present the various defenses available to them to defeat the enforcement of the disputed Promissory Notes, stating:
Unless he has the rights of a holder in due course any person takes the instrument subject to
(a) all valid claims to it on the part of any person; and
(b) all defenses of any party which would be available in an action on a simple contract; and
(c) the defenses of want or failure of consideration, non-performance of any condition precedent, non-delivery, or delivery for a special purpose (Section 3-408); and
(d) the defense that he or a person through whom he holds the instrument acquired it by theft, or that payment or satisfaction to such holder would be inconsistent with the terms of a restrictive indorsement.
The claim of any third person to the instrument is not otherwise available as a defense to any party liable thereon unless the third person himself defends the action for such party.
L. 1962, c. 553.
In view of the conclusions earlier set forth, the Defendants may now assert all defenses which would be available to them "in an action on a simple contract" to specifically include "want or failure of consideration." See Key Bank of Southeastern New York, N.A. v. Strober Bros., Inc., 136 A.D.2d 604, 607, 523 N.Y.S.2d 855 (2d Dep't 1988); Fazio v. Loweth, 112 A.D.2d 135, 137, 490 N.Y.S.2d 859 (2d Dep't 1985).
The "want or failure of consideration" has already been described above. In order for a contract to be enforceable there must be valid consideration. Here the Defendants never received what they bargained for, a process resulting in all of their loan proceeds being transferred to Beam and no one else. See Roth v. Isomed, Inc., 746 F. Supp. 316, 319 (S.D.N.Y. 1990); Banque Arabe Internationale et Internationale D'Investissement v. Bulk Oil (USA), Inc., 726 F. Supp. 1411, 1419 (S.D.N.Y. 1989); Weiss v. Salamone, 116 A.D.2d 1009, 1010, 498 N.Y.S.2d 630 (4th Dep't 1986); Stone v. Blizzard, 137 Misc.2d 92, 93, 520 N.Y.S.2d 112 (1987).
Cases have held that "in order for fraudulent inducement to prevent enforcement of a promissory note, it generally must be based on misrepresentations concerning the terms or conditions of the loan itself." Thornock v. Kinderhill Corp., 749 F. Supp. 513, 518 (S.D.N.Y. 1990). The Defendants never saw or executed the Forged Engagement and Authorization Letter, apparently forged by Lobato.
Furthermore, when Staley confirmed to Wilcox in April of 1986 that Lobato was representing First City, that InterDiscount was the disbursing arm of the bank and that "the equipment had been placed in service," fraud in the inducement concerning the terms and conditions of the loan was established based on Wilcox's testimony that without Staley confirming these matters, he "would have withdrawn my loan application."
When Lobato was questioned by Zellner at the time he executed the loan documents on April 1, 1986, Zellner was also told by Lobato that InterDiscount was the disbursement arm of the bank, which gave him comfort for the safety of his loan proceeds and those of Krader and ZPCI.
In Westbury Small Business Corporation v. Ballarine, 125 A.D.2d 462, 509 N.Y.S.2d 569 (2d Dep't 1986), the Appellate Division affirmed the dismissal of plaintiff's action for recovery on a promissory note as the result of its fraudulent misrepresentation:
We agree with the trial court's finding that the plaintiff and Power Test Petroleum Distributors, Inc. (hereinafter Power Test), are arms of each other, and that Power Test fraudulently misrepresented material facts to the defendant to induce him to enter into a franchise agreement for a certain retail gasoline station. The record also indicates that Power Test knowingly failed to provide the defendant with the gallonage volume history and list of names and addresses of any dealers who operated the station during the previous three years as required under General Business Law § 199-b.
Power Test's failure to disclose and fraudulent misrepresentation not only vitiated the franchise agreement, but also the promissory note executed simultaneously as a part of the same transaction. As the plaintiff is indisputably not a holder in due course, the trial court properly dismissed its action for recovery on the promissory note.
125 A.D.2d at 462. See also, Millerton Agway Coop., Inc. v. Briarcliff Farms, Inc., 17 N.Y.2d 57, 61, 268 N.Y.S.2d 18, 21, 215 N.E.2d 341 (1966) (parol evidence of fraudulent misrepresentation is admissible to avoid agreement induced by such fraud); Pan Atlantic Group, Inc. v. Isacsen, 114 A.D.2d 1022, 495 N.Y.S.2d 458, 459 (2d Dep't 1985) ("since there is no contention by plaintiff that it held the note in due course, the defense of fraudulent inducement may be asserted against it"); Westbury Small Business Corp. v. Giglio, 122 A.D.2d 49, 504 N.Y.S.2d 683, 685 (2d Dep't 1986) (because plaintiff was not a holder in due course, defendant's defense of fraud against payment of a note to third party was also good against plaintiff); Magi Communications, Inc. v. Jac-Lu Assoc., 65 A.D.2d 727, 410 N.Y.S.2d 297, 299 (1st Dep't 1978) (when complaint states cause of action for fraud, parol evidence rule is not bar to showing fraud despite general disclaimer in contract).
The Defendants have established that they were fraudulently induced through Lobato, as to the terms and conditions of the Notes and, therefore, the Notes are unenforceable.
The Waiver, Hold Harmless And Release Language Found In The Promissory Notes And Borrowers Letters Are Unenforceable
The Notes executed by the Defendants contained a provision on the second page stating:
Bank and each Borrower and indorser, in any litigation (whether or not relating to Obligations) in which Bank and any of them shall be adverse parties, . . . and each Borrower and indorser waives the right to interpose any set-off or counterclaim of any nature or description.
In addition, the "Investment Knowledge" paragraph found on the second page of the Borrowers Letter states:
I agree to hold the Bank harmless and do hereby release the Bank from any and all claims that I may have relating to or arising out of my investment.
However, neither the Promissory Notes nor Borrowers Letters contain a "merger clause," and the Borrowers Letters contain no prohibition against an oral modification.
The Defendants may maintain all of their claims against First City based on the holding in Parnes v. Mast Property Investors, Inc., 776 F. Supp. 792 (S.D.N.Y. 1991), wherein it was stated:
In New York, a party does not waive his or her right to bring a late legal action for fraud if that party had no knowledge of the alleged fraud at the time the release was signed. See Rockwood Computer Corp. v. Morris, 94 F.R.D. 64, 68 (E.D.N.Y. 1982) (under New York law, "it is clear that if the plaintiff had no knowledge of the defendant's fraud when it entered into the release, the existence of the release would not insulate the defendant from liability on the plaintiff's claim for breach of fiduciary duty") (and cases cited).
776 F. Supp. at 799.
Under New York law, a release or waiver clause may be attacked and set aside, even if it is clear on its face, for substantive flaws in its execution, such as fraud in the inducement, illegality, duress, or mutual mistake. See Barrett v. United States, 660 F. Supp. 1291, 1309 (S.D.N.Y. 1987); Omaha Indem. Co. v. Johnson & Towers, Inc., 599 F. Supp. 215, 291 (S.D.N.Y. 1984); du Pont v. Perot, 59 F.R.D. 404, 410 (S.D.N.Y. 1973); Skluth v. United Merchants & Mfrs., Inc., 163 A.D.2d 104, 559 N.Y.S.2d 280, 283 (1st Dep't 1990); Goldsmith v. National Container Corp., 287 N.Y. 438, 442-43, 40 N.E.2d 242 (1942).
A plaintiff or counterclaimant must establish five distinct elements of fraud to set aside a release or waiver:
1) there was a misrepresentation or active wrongful concealment of a material fact;
2) the representation was in fact false and was known to be at the time it was made or the concealment was intentional;
3) the misrepresentation was made for the purpose of inducing plaintiff to rely on it or the concealment was done to mislead the plaintiff;
4) plaintiff did, in fact, rely on the misrepresentation or she would have acted differently had she known of the concealment; and
5) plaintiff was caused injury as a proximate result of the misrepresentation or concealment.
Barrett, 660 F. Supp. at 1309.
However, once a plaintiff or counterclaimant has put into the record at least "some evidence" showing there has been fraud, duress, or some other fact that is sufficient to void the release, the party asserting the release as a defense must come forward with "real evidence" to sustain its burden regarding the legality of the release on pain of suffering a directed verdict. See Fleming v. Ponziani, 24 N.Y.2d 105, 111, 299 N.Y.S.2d 134, 140, 247 N.E.2d 114 (1969). The party asserting the release as a defense must prove by a preponderance of the evidence that the release was valid at its inception, and this burden does not shift at any time during the case: JVAA had the burden of persuading the Court in its role as fact-finder that the Defendants, when they signed the release, knew the legal effect of their acts and intended the release to cover the injuries they now counterclaim on as falling within the release's scope. See id., 24 N.Y.2d at 112-113, 299 N.Y.S.2d at 141.
Thus, despite the similarities in the Notes and waiver clauses at issue here and in Joint Venture Asset Acquisition v. Bhogaonker, 769 F. Supp. 532, 537 (S.D.N.Y. 1991), the outcomes of the two cases are distinctly different: The clauses are set aside here, while they were enforced in Joint Venture. This divergence of outcomes is readily explained by the difference in the evidence offered by the parties in the two cases. In Joint Venture, this Court held that the notes were enforceable because "the Defendants have not established that the Bank ever misled them about any of the terms and conditions of the Notes," id. at 536; and that the waiver clauses were valid because "at trial the Defendants offered no evidence that they did not understand the implications of this waiver when they signed the Borrower's Letters," id. at 537.
In the matter at hand, the Defendants not only established the fraudulent inducement by the Plaintiffs but also offered extensive and unchallenged evidence that they did not understand the waiver clauses and had no knowledge of the significance of the "Investment Knowledge" paragraph at the time they signed the Borrowers Letters. Therefore, under New York state law, the waiver clause is not valid. See Generale Bank, New York Branch v. Choudhury, 779 F. Supp. 306, 309-10 (S.D.N.Y. 1991); Thornock, 749 F. Supp. at 519; Citibank, N.A. v. Plapinger, 66 N.Y.2d 90, 94-95, 495 N.Y.S.2d 309, 311, 485 N.E.2d 974, 976 (1985); Danann Realty Corp. v. Harris, 5 N.Y.2d 317, 321, 184 N.Y.S.2d 599, 157 N.E.2d 597 (1959); First City Nat'l Bank & Trust Co. v. Heaton, 165 A.D.2d 710, 563 N.Y.S.2d 783 (1st Dep't 1990); First City Nat'l Bank & Trust Co. v. Tobias, 156 A.D.2d 267, 548 N.Y.S.2d 655 (1st Dep't 1989); Seaman-Andwall Corp. v. Wright Machine Corp., 31 A.D.2d 136, 295 N.Y.S.2d 752 (1st Dep't 1968), aff'd, 29 N.Y.2d 617, 324 N.Y.S.2d 410, 273 N.E.2d 138 (1971).
The Defendants have shouldered their burden of proof by establishing each of the requisite elements of fraud by a clear preponderance of the evidence, see Barrett, 660 F. Supp. at 1309, and by demonstrating a lack of understanding regarding the terms and conditions of the waiver clause, see Thornock, 749 F. Supp. at 519. The Plaintiffs, however, have failed to discharge their corresponding burden of persuasion of showing the validity of the release from its inception and the knowledge of the Defendants regarding the scope and nature of the waiver clause.
In addition, the principle of equitable estoppel bars the use of the waiver clause. Application of equitable estoppel rests on notions of essential fairness and sound discretion of court, Indyk v. Habib Bank, Ltd., 694 F.2d 54 (2d Cir. 1982); the doctrine is invoked successfully against a party who has occasioned a loss through an obvious lack of care or an affirmative act fairly identified as the cause of the loss. See Hammelburger v. Foursome Inn Corp., 54 N.Y.2d 580, 446 N.Y.S.2d 917, 431 N.E.2d 278 (1981). Such is the case here.
The amended complaint is dismissed with costs to the Defendants. Submit judgment on notice.
It is so ordered.
New York, N. Y.
November 19, 1992
ROBERT W. SWEET