Franchisor’s Financial Projections Don’t Equal Fraud – Ill. Law

In many fraud cases, defendants reflexively assert some variant of the “forward looking” or “promissory” fraud defense: that the misstatement relates to a future event and is therefore a non-actionable statement of opinion.

Illinois fraud rules require a misrepresentation to be material and present-tense factual  to be actionable.  Statements of future intent – like a forecast or projection (“this company is gonna make millions within its first year!”) are considered opinions and do not equal fraud under the law.

The First District delves into the scope of promissory fraud in Avon Hardware v. Ace Hardware, 2013 IL App (1st) 130750, a franchise dispute between an independent store against a national chain.

The plaintiffs, two hardware store franchisees, sued Ace on various fraud theories after their franchises failed.  Plaintiffs claimed that Ace made false statements of past and future financial performance in several documents supplied by the hardware giant.

The documents all contained cautionary language warning the plaintiffs not to rely on them and said the financial projections were “mere estimates.”  They also contained a non-reliance clause explicitly stating the franchisee was not relying on any sales or profits guarantees.  ¶¶ 5-7.

Despite the rampant warnings, Plaintiffs sued Ace for fraud when the stores failed.  Plaintiffs claimed that in order to entice their investment, Ace painted a too-rosy financial picture of what plaintiffs could expect to earn from the franchises and distorted results of similar Ace franchisees.

Ace moved to dismiss based on the documents’ cautionary language and disclaimers. The trial court granted Ace’s motion to dismiss all complaint counts.

Held: Affirmed.

Rules and Application:

In Illinois, a fraud plaintiff must prove:  (1) a false statement of material fact; (2) knowledge of or belief in the statement’s falsity; (3) intention to induce the plaintiff to act on the statement; (4) reasonable reliance on the statement’s truth by the plaintiff; and (5) damage to the plaintiff resulting from the reliance. ¶ 15.

Negligent misrepresentation has the same elements as fraud except instead of proving defendant’s knowledge of falsity, plaintiff only has to show that defendant was careless or negligent in ascertaining the truth of the challenged statement.  ¶ 15.

Fraud and negligent misrepresentation claim must be based on a present statement of fact.  Financial projections are generally considered statements of opinion, not fact.  And while statements of future income are not actionable, statements of historical income of a business are sufficiently factual for fraud claims. ¶¶ 16-17.

The Court dismissed plaintiffs’ fraud claims because much of the challenged data was forward-looking and contained expansive cautionary language: the documents were “replete with warnings” that defendants shouldn’t rely on them.  Moreover, Ace’s documents contained anti-reliance language that stated that plaintiffs hadn’t received or relied on any Ace guarantees of future sales, profits or success.  ¶¶ 9, 21.

Taken together, the Ace documents’ glaring disclaimers prevented plaintiff from alleging Ace’s material misstatement or reliance – two necessary fraud elements.

Take-aways: Cautionary language or anti-reliance clauses in a contract will be upheld if the terms are textually clear and there’s no disparity in bargaining power between the parties.

The case also reaffirms that statements of future economic prospects are considered opinions; while statements of historical financial performance are factual enough for a fraud claim.

 

Illinois ‘Reverse Piercing’ Law: Can You or Can’t You?

image“Reverse piercing” involves the creditor of an individual shareholder attempting to reach assets of a corporation operated by that shareholder.  Illinois reverse-piercing law is unsettled.  Some cases allow  the remedy; others don’t.  When it is allowed, it usually involves a one-person corporation.

In Fish v. Hennessy, 2013 WL 577012 (N.D.Ill 2013), the Northern District rejected a creditor’s attempt to reverse-pierce in supplementary proceedings. The plaintiff obtained a nearly $1 million judgment against the defendant in Ohio Federal court and registered the judgment in the Illinois Northern District.  The plaintiff then filed a motion to reverse-pierce the corporate veil in order to reach the assets of two companies controlled by the debtor.  The debtor argued that the Court lacked jurisdiction to reverse-pierce the debtor.

Result: The Court dismissed the plaintiff’s reverse-piercing motion for lack of jurisdiction.  Plaintiff is given leave to file separate reverse-piercing action.

Rules/reasoning:

Illinois law (735 ILCS 5/2-1402, SCR 277) governs supplementary proceedings in Northern District cases.  FRCP 69(a).  Because Illinois supplementary proceedings are limited to finding assets of a debtor – either in his possession or in the hands of a third party -creditor piercing efforts are usually beyond the scope of supplementary proceedings.  Because of this, Illinois law requires the creditor to sue separately to pierce the corporate veil; naming the shareholder as a defendant in the underlying claims that would normally lie against a corporation.

The Court held that while some Illinois courts permit reverse-piercing, the creditor must file a  stand-alone action against the shareholder. Fish, *2.  Here, since the creditor tried to reverse-pierce in post-judgment proceedings, the motion was improper and the Court dismissed it for lack of jurisdiction.  Id.

The plaintiff creditor argued that after its 2008 amendment, Code Section 2-1402(c)(3) allows a creditor can bring a (straight) piercing motion in supplementary proceedings against a corporate debtor.  However, since defendant was an individual, not a corporate debtor, this section didn’t apply.  In addition, the Court found no Illinois case reading amended Section 2-1402(c)(3) to allow reverse-piercing in post-judgment proceedings.  Id., *2.

Take-aways: A creditor of an individual can’t reverse-pierce (to attach corporate assets of companies run by the debtor) in judgment enforcement proceedings.  Instead, the creditor must file a separate lawsuit against the corporate entity controlled by the shareholder.  Fish‘s discussion of Code Section 2-1402(c)(3) suggests that a judgment creditor may now be able to bring a piercing-type claim against a corporate debtor in supplementary proceedings.  While this is welcome news to creditors’ counsel (since they won’t have to file entire new piercing suits), it still runs counter to “good” Illinois caselaw (see Pyshos (above), Conserv v. Von Bergen Trucking, 2011 IL App (2d) 101225U (2011)), that clearly disallow piercing claims in supplementary proceedings.  Even so, the Fish Court didn’t have to categorically rule on this issue since the defendant was an individual and not a corporate debtor.  As a result, amended Section 2-1402(c)(3) didn’t apply to the case’s facts.

 

Single-Page Spreadsheet Doesn’t Satisfy Business Records Rule (Illinois 2nd Dist.)

In In Re Estate of Good, 2013 IL App (2d) 120875-U,  the Second District strictly construed the business records hearsay exception and held that a single-page spreadsheet (the “Spreadsheet”), prepared specifically for litigation by one of the parties from various print and electronic sources, didn’t satisfy the business records admissibility rules.

Facts: The plaintiff real estate auction company sued its deceased founder’s estate alleging the founder misappropriated company funds totalling about $1.5M over a multi-year period.  Good, ¶ 4.  The Plaintiff’s key piece of evidence – the Spreadsheet – was prepared specifically for the  litigation and supposedly summarized various company financial records and itemized the amounts decedent allegedly took from the  company.

The trial court granted the defendant estate’s summary judgment motion on all complaint counts.

Held: Affirmed.

Q: Why?

A: The Spreadsheet was inadmissible hearsay under the prevailing business records rules:

– Evidence which is inadmissible at trial is not admissible in support of or opposition to summary judgment motion;

– Illinois Evidence Rule 803(6) provides that “records of regularly conducted activity” are exceptions to the hearsay rule as long as they consist of a record or data compilation in any form made at or near the time from information transmitted by someone with knowledge if (a) kept in course of regularly conducted business activity and (b) if it was the regular practice of that business activity to make the record or data compilation;

– A business records proponent must also lay a foundation for the records.  To authenticate a document, the party must offer evidence that shows the document is what the party claims it to be;

– A business record’s evidence foundation requires proof that the record (1) was made in regular course of business and (2) made at or near the time of the event or occurrence;

– The foundation for admitting business records can come via affidavit or trial testimony of a records custodian or other person familiar with the business and its mode of operation;

– A summary print-out prepared specifically for trial can satisfy business records rule (and be admissible) IF the underlying data on which the summary is based are (i) kept in regular course of business, (ii) the data was entered contemporaneous to the event, and (iii) there’s nothing to indicate the source of the information is untrustworthy.

Application:

The Spreadsheet didn’t satisfy the  business records exception.  First, it was mathematically inaccurate: the numbers didn’t match up.  Also, plaintiff’s witnesses admitted in depositions that Spreadsheet was cobbled together from different electronic and printed sources – but they couldn’t specifically identify the sources.  ¶¶ 67-70.

Also, the Spreadsheet wasn’t itself a business record: it was a “one-shot” summary document prepared for the summary judgment motion at the direction of a plaintiff  and was “essentially created from scratch.” ¶ 70.

The Court also held that plaintiff failed to lay a proper foundation for the other financial documents (aside from the Spreadsheet) to support its claims.

The Court pointed to the records custodian’s deposition testimony where he couldn’t specifically identify any documents that supported plaintiff’s damage claims and offered only vague testimony about check requests and invoices that he supposedly reviewed. ¶ 74.

Take-aways:

Good illustrates that numerical accuracy is important when seeking summary judgment on damage claims.

A summary of damages document can meet the business records test – but only if the underlying data is regularly recorded and entered by someone with knowledge of the recorded event.

Good also shows that it’s vital for a deponent (or affiant) to sufficiently identify and explain the underlying data that underlies a damages summary.  It’s clear that the conflicting testimony from plaintiff’s agents concerning the underlying Spreadsheet information played an important rule in the Court excluding plaintiff’s evidence.