Kentucky Law: Contractual Due Diligence Clause

Is a Non-Disclosure Claim Under a Claim Purchase Agreement Viable Under Kentucky Law Where There is Contractual Due Diligence Clause?

By: Michael J. Gartland, Esq.

The assertion of a claim for failure to disclose material information after a closing under an asset purchase agreement is not out of the realm of possibility.  But is such a claim viable under Kentucky law?  I recently defended such a claim in connection with a purported binding agreement to sell a $22,886,139 allowed, general unsecured claim (the “Claim”) against American Airlines (“AA”) in an action pending in the United States District Court for the Eastern District of Kentucky (the “Court”) styled First Technology Capital, Inc. v. JPMorgan Chase Bank, N.A. v. James L. Bates, 5:12-cv-00289-REW (the “Action”).  First Technology Capital, Inc. (“FTC”) commenced the Action, seeking a declaratory judgment that it had not entered into an enforceable contract with JPMorgan Chase Bank, N.A. (“Chase”) as to FTC’s proposed sale of the Claim to Chase for 35.75% of the Claim, or approximately $8.1 million.  Chase foolishly asserted a counterclaim against FTC for breach of contract.  It also asserted flimsy fraud, negligent misrepresentation and unjust enrichment counterclaims against FTC and James L. Bates (“Bates”), FTC’s President and sole shareholder, and requested an award of compensatory and punitive damages.

After the close of discovery, FTC and Bates (the “FTC Parties”) and Chase filed cross motions for summary judgment on all counterclaims asserted by Chase.  The FTC Parties and Chase each filed approximately 100 pages of summary judgment briefs.  In a 52-page Memorandum Opinion and Order, the Court entered summary judgment for the FTC Parties and against Chase on all of Chase’s counterclaims.  First Technology Capital, Inc. v. JPMorgan Chase Bank, N.A., __ F. Supp. 3d. __, 2014 WL 5093395 (E.D. Ky. Oct. 9, 2014) (hereinafter, the “Opinion”).  This article discusses why the summary judgment ax severed Chase’s fraud claim.

The facts of the case were straight forward and not in dispute.  On September 30, 2010, FTC acquired one hundred percent of the beneficial interests in the Dougherty Air XVIII Investment Trust (the “Trust”), of which Dougherty Air Trustee, LLC (“Dougherty”) was the trustee.  Opinion at *1.  In order to acquire one hundred percent of the beneficial interests in the Trust, FTC executed and delivered to Tennessee Commerce Bank (the “Bank”) a Term Promissory Note dated September 30, 2010 in the original principal amount of $10,473,142 (the “Note”).  Id.  In order to secure the Note, FTC granted the Bank a security interest in all of FTC’s assets, including its beneficial interests in the Trust and the Trust’s assets, together with any ensuing proceeds.  Id.  The Note and nine related  documents are hereinafter referred to as the “Loan Documents.”

FTC infused all or substantially all of the funds lent by the Bank to FTC under the Note into the Trust.  On September 30, 2010, Dougherty, as trustee of the Trust, acquired a certain 1999 McDonnell Douglas DC-9-83 (the “Aircraft”), which was leased to AA under a certain lease (the “Lease”).  Opinion at *1.  Things ran smoothly until AA filed for Chapter 11 bankruptcy protection on November 29, 2011 and ceased making payments to the Trust under the Lease, a substantial portion of which flowed through to the Bank to reduce FTC’s indebtedness under the Note.  Id. at *2.  As if the AA bankruptcy was not bad enough, the Bank was closed by the Tennessee Department of Financial Institutions and the FDIC was appointed as Receiver of the Bank on January 27, 2012.  Id. at *2.  FTC thus became indebted to the FDIC under the Note and the FDIC held a lien on all of FTC’s assets, including its one hundred percent beneficial interest in the Trust and Trust’s assets, which included the Aircraft and Lease.  Id.  Because FTC had no experience in dealing with the FDIC, a proverbial 800-pound gorilla, FTC engaged Intuitive Processes and Controls (“iPAC”) to assist it in reaching an agreement with the FDIC to pay off all of FTC’s indebtedness under the Note at a discount.  Id.

After AA threatened to reject the Lease in its Chapter 11 case, FTC and the AA entered into negotiations to restructure the Lease, which resulted in an executed term sheet (the “Term Sheet”).  On June 20, 2012, the Term Sheet was approved by the bankruptcy court presiding over AA’s Chapter 11 case.  Opinion at *2.  Under § 5.1 of the Term Sheet, the “Lessor” of the Aircraft under the Lease, Dougherty (not FTC) was granted the Claim, which was to be listed by AA on the claims register in its Chapter 11 case (the “Claims Register”).  Id.  About this time, FTC had reason to believe that an offer in compromise to the FDIC would be accepted and needed to sell the Claim in order to raise money to settle with the FDIC and satisfy all of its obligations under the Note.  Id.  The only problem was that FTC did own the Claim, Dougherty did under § 5.1 of the Term Sheet.

On June 22, 2012, W. Thomas Bunch (“Bunch”), a long-time attorney for the FTC Parties, approached Chase to see if it was interested in purchasing the Claim.  Opinion at *2.  Bunch’s initial email communication with Chase referred to FTC’s “beneficial interest” in the Aircraft leased to AA under the Lease.  Id.  Bunch also represented that FTC has been granted the Claim under § 5.1 of the Lease, which was incorrect.  Id.  Later on June 22, Chase offered to purchase the Claim for 33% of $22,886,139, or $7,552,425.87, which was not accepted by FTC.  Id.  Chase and Bunch exchanged emails over the course of the next six days concerning a possible transaction with regard to the Claim.  Things came to a head on June 28, 2012, when Chase extended its highest and best offer to purchase the Claim:

First, thank you again for giving JPMorgan the opportunity to bid on your claim, this is an important transaction for us.  I understand that you are on a conference call and can’t speak, so I spoke with our desk and JPMorgan is please [sic] provide you with a best and final bid at 35.75% on your $22mm allowed American Airlines, Inc. claim.  This bid is good until 5pm EST today, June 28, 2012 and is subject to review of your due diligence and execution of a Transfer of Claim agreement. We [sic] very interested in working with you on this opportunity and hope this is reflected in our bid.  Please confirm via email if we are done and you would like to lock in this price.

Opinion at *3 (bold and italicized words in original) (bold and underlined words with emphasis added).  Chase’s 35.75% bid (the “Bid”) was accepted by FTC through emails transmitted by Bunch, with FTC’s authorization.  Id.  The Bid and FTC’s acceptance are hereinafter referred to as the “Conditional Agreement.”

Early on June 29, a representative of Chase emailed Bunch with a Process Outline for closing the Conditional Agreement.  Opinion at *4.  By the email, Chase requested copies of an unredacted copy of the Term Sheet, the Loan Documents and any proof of claim filed with respect to the Claim.  Id.  Chase also informed Bunch that Chase would run a UCC lien search on FTC and would “need to understand and resolve any liens that may appear.”  Id.  The Chase email concluded:  “Once we review the basic documents, we will forward a draft Transfer of Claim Agreement.”  Id.

Between June 29 and July 6, 2012, Chase engaged in due diligence with respect to the Claim, obtained a UCC lien search on FTC (the morning after the parties entered into the Conditional Agreement), reviewed the unredacted Term Sheet and had received copies of all the Loan Documents.  Opinion at *4-6.  At no time between June 28, 2012—when FTC and Chase entered into the Conditional Agreement, and July 9, 2012—when Chase agreed to sell the Claim downstream to two different hedge funds for an $806,000  profit—did Chase ever discuss what terms would be contained in the transfer of claim agreement, which was one of the two contingencies to the Conditional Agreement becoming a binding agreement.  Only after doing its due diligence and seeing the Claim listed on the AA claims registers as “allowed” did Chase email Bunch a draft Transfer of Claim Agreement (the “Draft TCA”) on July 16, 2012.  Id. at *6.  One of the provisions of the Draft TCA was a representation and warranty by FTC that there were no liens, claims or encumbrances of any kind whatsoever on the Claim.  Id. at *7.

On July 20, 2012, Bunch informed Chase that Dougherty, the owner of the Claim, did not agree to the proposed sale of the Claim to Chase.  Opinion at *6.  This created a huge problem for Chase because it claimed that it sold the Claim to two hedge funds on July 9th, and needed to close the Conditional Agreement with FTC in order to convey the Claim to the hedge funds.  Id. at *5.  On July 11, 2012, the FDIC rejected FTC’s offer in compromise, which meant that marketable title to the Claim could not be conveyed to Chase even if FTC and Dougherty wanted to close the Conditional Agreement.  On August 1, 2012, Bunch emailed Chase and informed it that he could not advise FTC to execute the Draft TCA because of the FDIC’s lien on the Claim.  Id. at *7.  After Chase threatened to sue FTC if it did not execute and deliver the Draft TCA, FTC filed a  declaratory judgment complaint and Chase asserted, among other things, a fraud counterclaim against the FTC Parties and requested an award of punitive damages in connection therewith.  Id.

The crux of Chase’s fraud claim were alleged affirmative misrepresentations by the FTC Parties and their legal counsel as to FTC’s ability to deliver marketable title to the Claim to Chase, and the FTC Parties’ failure to disclose material facts about the FDIC’s lien on the Claim and the need to obtain a release of the lien before FTC could convey marketable title to the Claim to Chase.  Opinion at *17.  Like all flimsy fraud claims, Chase’s fraud claim morphed over time (id.), but never got any better.  Chase’s fraud claim was based on two theories:  fraud by misrepresentation and fraud by omission.  Id. at *18.  While each theory has its own distinct elements, they have a common reliance element in that Chase was required to show by clear and convincing evidence “actual reliance on the communication [or lack thereof] with good reason.”  Id.  In other words, the reliance must be reasonable and/or justifiable.  Id.  The Court held that Chase failed to prove reasonable reliance because it knew that the Claim was encumbered by the FDIC’s lien on June 29th—within 18 hours of the time that the parties entered into the Conditional Agreement—and also knew for a fact that Dougherty, not FTC, was the owner of the Claim well “before jumping onto the hook as a downstream seller [on July 9th]”  Id. at *22-25.

The Court rejected Chase’s fraud by omission claim out of hand.  Such a claim turns on a party’s duty to disclose.  Opinion at *19.  Kentucky recognizes a duty to disclose in four instances:  (1) a duty arising from a confidential or fiduciary relationship; (2) a duty imposed by statute; (3) a duty arising from partial disclosure of material facts to an opposing party where the alleged fraudster creates the impression of full disclosure; and (4) where a party has superior knowledge and is relied upon to disclose same.  Id.  Chase’s fraud by omission claim was predicated solely on categories 3 and 4.  The Court found, as a matter of law, that the relationship between FTC and Chase created “no disclosure duty” whatsoever.  Id. at *21.  Crucial to this finding was the due diligence contingency provision of the Conditional Agreement:

By premising its bid on unfettered due diligence review, Chase expressly determined that it would rely on its own satisfactory review, not the analysis or representations of FTC, in determining whether to buy the AA Claim.  Chase pursued the right by demanding that FTC provide for review all manner of Claim-related materials.  Acting for its own protection, Chase immediately procured a lien search.

Opinion at *21.  Simply put, “Chase’s intended contractual approach expressly was not to rely on FTC’s characterizations (or lack of characterization) of any aspect of the deal, outside of the TCA [transfer of claim agreement] itself, but rather to verify and rely on its independent and adequate analysis.”  Id.  Chase’s contractual right to unfettered due diligence review with respect to all aspects of the Claim was the death knell to its fraud by omission claim.  Chase is one of the largest banks in the entire world with more than 260,000 employees and hundreds of billions of dollars in assets.  As the Court noted, Chase “sits at the apex of the trade claims market.  Id. at *16.  Under these circumstances, Chase should have been embarrassed to claim that FTC—a first-time claim seller—had superior knowledge concerning the Claim and that Chase was relying on FTC to disclose the same.  Could any claim be more preposterous?

Parting Thoughts

Virtually every purchase and sale agreement as to any asset has or should have a due diligence clause.  Counsel for asset sellers should insist on the inclusion of an unfettered due diligence provision for the benefit of the buyer in an asset purchase agreement.  Such a provision might cut off fraud by omission claims after a transaction closes under Kentucky law and FTC.

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