Party Cannot Skirt Out of the Very Fraud it Perpetrates

Edward Garber | Florida Construction Legal Updates

An interesting case came out of Florida’s Fourth District Court of Appeal that touches upon two important points.

First, the independent tort doctrine does not apply when there is not a contract between the parties.

Second, an officer cannot escape fraud simply by claiming his or her actions were done as an officer of the company when he or she actively participated in the fraud.

Both of these points are best explained by initially going into the facts of this case. As you will see, the Court’s rationale relates to the premise that a party should not be able to skirt out of the very fraud it perpetrates.

Factual Background

Costa Investors, LLC v. Liberty Grande, LLC, 48 Fla.L.Weekly D7b (Fla. 4th DCA 2022) involved the ultimate development and construction of four adjacent properties into the Costa Hollywood Hotel.  The properties were purchased by a company called Liberty Grande.  Its president / manager was also the president of Liberty Grande’s wholly owned subsidiary called Costa Hollywood Property. Liberty Grande transferred the properties to Costa Hollywood Property and the deed was signed by the president / manager.

Shortly after the properties were transferred to Costa Hollywood Property, a group of investors (EB-5 investors) entered into a loan agreement with Liberty Grande for the development of the Costa Hollywood Hotel. The investors were granted a security interest and mortgage in consideration for the loan.  However, the real properties at-issue subject to the loan and security interest were the properties Liberty Grande previously transferred to its wholly owned subsidiary, Costa Hollywood Property.  The loan agreement was signed by the president / manager.

Liberty Grande defaulted under its loan agreement with its investors. The investors learned that Liberty Grande’s president / manager’s representation that Liberty Grande owned the properties at the time of the loan agreement was untrue.  The investors filed an affidavit in the official records with a copy of the loan agreement stating they entered into the loan agreement for the development of the properties.

Costa Hollywood Property sued the investors for slander of title due to the recording of the affidavit. The investors filed a third-party complaint against Liberty Grande and its president / manager.  The investors claimed the president / manager committed fraud.

The president / manager moved for summary judgment arguing the fraud claim should be barred by the independent tort doctrine and because the president / manager was not a party to the loan agreement in his individual capacity. The trial court granted summary judgment for the president / manager.  This was reversed on appeal.

Fourth District Court of Appeal’s Opinion on Two Important Points

First, the Fourth District Court of Appeal held that the independent tort doctrine did NOT apply in this context.

The independent tort doctrine is a general principle of law that provides “a plaintiff may not recover in tort for a contract dispute unless the tort is independent of any breach of contract.”  “This principle only applies, however, to the parties to the contract.” 

Here, as [the president / manager] stated below in his statement of undisputed facts and as is apparent from the loan agreement, he was only the signatory for Liberty [Grande]; he was not a party to the Agreement. Accordingly, the trial court’s reliance on the independent tort doctrine to determine that [the president / manager] was not liable was error. 

Instead, the court should have analyzed the complaint to determine whether the evidence was sufficient to show that fraud occurred and whether [the president / manager] could be liable for fraud or negligent conduct when he actively participated in the fraud, even when he signed as a corporate officer.

Costa Investors, LLC, supra (internal citations omitted).

Second, the Fourth District Court of Appeal held that the president / manager was NOT excused from fraud simply because he signed the loan agreement in an officer (versus personal) capacity.

“As a general rule, ‘a false statement of fact, to be a ground for fraud, must be of a past or existing fact, not a promise to do something in the future.’ ”  “[F]raudulent (‘knowingly false’) representations . . . of a present fact . . . constitute[ ] fraud in the inducement.” 

The agreement and Borrower’s Certificate, both signed by [the president / manager] on behalf of Liberty [Grande], made false statements of “existing fact.” Prior to [the president / manager] signing those documents on behalf of Liberty [Grande], he had previously transferred title to the [properties] from Liberty [Grande] to another one of his entities, Costa Hollywood Property. The agreement represented Liberty [Grande] as the owner of [the properties] which was an existing false statement of fact, and the agreement falsely purported to give [the investors] a security interest and mortgage on the [properties]. The Borrower’s Certificate, which [the president / manager] also signed on behalf of Liberty [Grande], made additional false statements of existing fact, including that “all ‘representations and warranties’ made by Liberty [Grande] in the loan agreement were “true and correct in all material respects.” Thus, [the president / manager] was not entitled to summary judgment based upon the court’s conclusion that [he] had not made any false statements of material fact.

The central question is whether [the president / manager] can be held individually liable for this fraud evidenced by the agreement and certificate when he signed as the corporate officer of Liberty [Grande]. We hold that he can.

***

Generally, courts have applied an “active participation theory” in holding officers and directors individually liable when they actively participated in the torts of the corporation.  “Under the participation theory, the court imposes liability on the individual as an actor rather than as an owner . . . not predicated on a finding that the corporation is a sham and a mere alter ego of the individual corporate officer.”  “Instead, liability attaches where the record establishes the individual’s participation in the tortious activity.” 

***

[The president / manager] actively participated in the wrong, i.e., fraud and misrepresentation, by signing the agreement and Borrower’s Certificate purporting to show Liberty [Grande] as the owner of [the properties] when [he] had, on behalf of Liberty [Grande], previously transferred the title from Liberty [Grande] to another one of his entities. [The president / manager] actively participated in offering to [the investors] in the agreement a “security interest, Lien and mortgage” in the “assets that comprise the Project” including “the Land and Improvements thereon” in order to obtain loans from [the investors]. Under the active participation theory, [the president / manager] can be personally liable for his fraudulent statements even though he signed on behalf of Liberty [Grande].  Otherwise, [the president / manager] would be able to perpetrate this flagrant fraud and escape liability behind the shield of his representative character.

Costa Investors, LLC, supra (internal citations omitted).


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Don’t do this When it Comes to Construction Liens

David Adelstein | Florida Construction Legal Updates

When it comes to preparing and recording a construction lien, this case is an example of what NOT TO DO!   I mean it — this exemplifies what NOT TO DO!  It is also a case study of why a party should always work with counsel in preparing a construction lien so that you can avoid the outcome in this case–your lien being deemed fraudulent.

In Witters Contracting Company v. West, 2020 WL 4030845 (Fla. 2d DCA 2020), homeowners hired a contractor to renovate their home under a cost-plus arrangement where the contractor was entitled to a 10% fee on construction costs.  The contract also required extra work to be agreed in writing between the owner and contractor.

During construction a dispute arose.  The contractor texted the owner that it will cancel the permit and record a $100,000 construction lien if the owner did not pay it $30,000.   Shortly thereafter, the contractor’s counsel sent the homeowners a demand for $59,706 with back-up documentation.  Less than a week later, the contractor recorded a construction lien for $75,000.  The owners initiated a lawsuit against the contractor that included a claim for fraudulent lien.  The contractor then amended its construction lien for $87,239.

The trial court found that the contractor’s claim of lien was fraudulent because it was compiled “with such gross negligence as to the amount claims therein to constitute willful exaggerations.”   A trial was held on damages and $87,239 was awarded as punitive damages against the contractor, plus attorney’s fees and costs, all of which were permissible when a lien is deemed to be a fraudulent lien.

Think about it.  The contractor asked for $30,000 under the threat it will record a $100,000 lien.  It then sent a demand letter for $59,706.  Then it recorded a construction lien for $75,000.  Then it amended the construction lien to $87,239.  This was all in a very short time period.  And, this is likely why the lien was deemed to have been compiled with such gross negligence as the contractor, evidently, had no clue what he was owed under the cost-plus contract or, if he did, he went about it incorrectly.  It is possible the contractor was owed something, but the manner in which he went about it created the wrong perception.  It is unclear whether his counsel was involved in preparing the lien or why the lien was different from the amount in the demand letter sent by counsel.  Nevertheless, clearly, this is the perception you want to avoid and why working with counsel in preparing a lien is vital.

Contracts and Fraud Don’t Mix (Even for Lawyers!)

Christopher G. Hill | Construction Law Musings

In prior posts here at Construction Law Musings, I have discussed how fraud and contracts are often like oil and water.  While there are exceptions, these exceptions are few and far between here in Virginia.  The reason for the lack of a mix between these two types of claims is the so-called “source of duty” rule.  The gist of this rule is that where the reason money is owed from one party to another (the source of the “duty to pay”) is based in the contract, Virginia courts will not allow a fraud claim.  The rule was created so that all breaches of contract, claims that are at base a failure to fulfill a prior promise and could, therefore, be considered to be based on a prior “lie,” would not be expanded to turn into tort claims.  This rule has been extended to claims that most average people (read, non-lawyers) would consider fraud because there was no intent to fulfill the contract at the time it was signed.

Just so you don’t think that lawyers are exempt from this legal analysis, I point you to a recent case where a law firm sued a construction client of theirs for failure to pay legal fees.  In EvansStarrett PLC v. Goode & Preferred General Contracting, the Fairfax County Circuit Court considered a motion by the Plaintiff law firm seeking to add a count of fraud to its breach of contract lawsuit.  The Court considered the following facts.

The Plaintiff obtained a settlement between Defendant, Preferred, and another party.  As a provision of the settlement, the judgment debtor was to wire the full arbitration award plus attorney fees to EvansStarrett’s account.  Prior to that wire having been made, EvansStarrett alleged, Preferred, with the intent to mislead, requested that the full award and attorney fees (approximately $145,000) be wired instead to Preferred and that Preferred would then pay the attorney fees from its account.  Needless to say, Preferred didn’t pay the fees and EvansStarrett sued and then sought to amend its Complaint to add fraud based on Preferred’s request and promise described above.

The Court denied the amendment.  After a great review of the case law relating to the economic loss and source of duty rules, including cases where a deliberate false representation was made and still no fraud claim could follow, the Court stated:

Whatever monies Defendant owed Plaintiff for legal fees and costs arose wholly from their contractual relationship. The fact that there was [a] dispute about the amount owed is a contractual dispute, nothing more.

Because there would have been no duty to pay fees without the fee agreement between the parties, no fraud could be claimed.

The interactions of tort and contract can be complicated, and sometimes there are exceptions to this rule.  I recommend this case for your reading and suggest that you consult an experienced Virginia construction lawyer if you have a construction claim that could involve fraud.

How Contractors Can Prevent Fraud in Their Workforce

Sarah Hofmann | Construction Executive | June 14, 2019

The word fraud might conjure up images of Wall Street executives led out to police cars in cuffs, or sleazy conmen with slicked-back hair. While these ideas might be popular in movies and TV, and often in the news, many small and large businesses fall victim to fraud. Whether it’s a trusted site manager who needed a little extra cash to cover an unexpected bill or the accountant who’s been on board for years and has been slowly siphoning an extra paycheck through a ghost employee each month, fraud might be hitting businesses without them even knowing it. 

The construction industry is hardly immune to such schemes. According to the ACFE’s 2018 Report to the Nations on Occupational Fraud and Abuse, organizations lose an estimated 5% of their revenue each year to fraud. The median amount lost per instance of fraud was $130,000 across all industries, but fraud cases in the construction industry cost almost twice that much at $227,000 per fraud. They also last longer on average: fraud schemes in the construction industry continue for 24 months before being detected versus the overall median average of 16 months. The more time a scheme continues, the more money is lost for organizations. 

WHAT TYPES OF FRAUD SCHEMES ARE MOST COMMON IN THE CONSTRUCTION INDUSTRY?

The construction industry is more susceptible to certain types of fraud than other industries due to the nature of the work. The companies may be smaller in size leading to fewer resources to combat fraud and more trust among employees. Also, construction companies inherently deal with many vendors, subcontractors, bidding organizations and other various third parties, which can all pose fraud risks. 

Here’s how the two most common umbrella schemes of corruption and asset misappropriation affect the construction industry.

Corruption

The most common fraud scheme that affected the construction industry was corruption, representing 42% of all fraud cases. Corruption is defined as the wrongful use of influence to procure a benefit. With all those third parties involved in construction projects, there are many opportunities for corruption. At different points in a construction project, certain individuals may have more influence, such as inspectors or estimators. If they apply their influence unethically, they can be susceptible to bribery or kickbacks. 

Asset Misappropriation

Asset misappropriation is a blanket term for someone either misusing or stealing an asset that does not belong to them. For construction companies, the most common schemes in this category are billing fraud and expense reimbursement fraud, representing 37% and 23% of the fraud cases, respectively. 

Billing fraud schemes can include using shell companies, using company assets to make personal purchases or colluding with vendors. Expense reimbursement can include billing for fictitious expenses, mischaracterizing expenses or submitting multiple requests for reimbursement.

WHY DO PEOPLE COMMIT FRAUD?

The Fraud Triangle is a model for explaining the factors that cause someone to commit occupational fraud. It consists of three components that, together, lead to fraudulent behavior:

  1. Perceived financial need;
  2. Perceived opportunity; and
  3. Rationalization.

Financial need may come in the form of a gambling or drug addiction, or perhaps mounting medical bills for a family member. Perceived opportunity can be when they realize they have the power to sign and approve checks. Rationalization is the thought that they’ll pay the money back as soon as they can or that the organization is taking advantage of them and won’t miss that money. If these three factors are present, it does not necessarily mean a person will commit fraud; it’s just that these three factors tend to need to be present for a person to act.

DEMOGRAPHICS OF FRAUDSTERS IN THE CONSTRUCTION INDUSTRY

For fraud schemes in the construction industry, the perpetrators tended to work in the accounting or purchasing department, representing 31% and 11% of cases. Forty-five percent of them were employees, rather than managers (29%) or owners/executives (23%). The largest red flag they displayed was living beyond their means (42%), followed by experiencing financial difficulties (31%), or having an unusually close association with a vendor or customer (22%). 

One thing that set the construction industry apart was that younger employees who committed fraud stole more than older employees. Data from other industries almost always show older employees stealing more money, as they tend to be in higher positions of power in the organization and have more tenure. This may point to construction companies needing to keep a closer eye on newer, or younger, employees.

HOW CAN CONSTRUCTION COMPANIES PROTECT THEMSELVES AGAINST FRAUD?

One of the easiest and cost-effective ways to prevent fraud in any organization is to implement an anti-fraud policy and set an ethical tone at the top. When organizations discuss fraud and teach their employees, and clients/customers, about fraud prevention or detection tools, they are more likely to prevent fraud before it happens. 

Another great way to prevent fraud is to institute a hotline or similar anonymous reporting method. Only 34% of construction organizations in the Report to the Nations used a hotline, versus 63% of organizations across all industries. The most common way fraud was detected overall in the larger study was through a tip (40). Construction organizations only had tips account for 19% of fraud detected. Even establishing a simple anonymous online form, or email address, and telling employees, vendors and clients about it can greatly cut down on fraud.

Contractors/Owners: Watch What You Say When a Dispute Arises

Earl K. Messer | Taft Stettinius & Hollister LLP | August 14, 2018

After carefully negotiating the precise terms of a construction contract, parties sometimes let down their guard and become much less careful with communications regarding problems as the project proceeds. This can result in costly mistakes and litigation. A recent case illustrates how imprecise wording in a contractor’s attempt to collect outstanding payments resulted in costly litigation and allegations of fraud. Although the fraud claim ultimately was defeated, the parties went through the costly process of document exchanges and review and depositions, detailed motions and an appeal.

In Parmatown South Association v. Atlantis Realty Co., Ltd., a property owner sued a then defunct construction company’s principals for fraud following an incomplete construction project. During construction, the property owner stopped making payments to the contractor who, in turn, stopped making payments to subcontractors.

In a 2009 letter, the contractor requested that the property owner pay $21,000 to satisfy outstanding pay applications and two change orders. The contractor wrote that once the payment was made the contractor would “be willing to return and complete the work.” The contractor noted, “[T]here is no way…to get subs back onsite without ‘cash in hand.’” Additionally, the letter stated that full payment plus consideration for re-mobilization costs, subcontractor replacement costs, and material price changes would also be due upon completion of the project.

The property owner made the $21,000 payment, but the contractor never completed the project. Then, an unpaid subcontractor filed a mechanic’s lien on the property. When a third party filed a foreclosure action on the property, the property owner sued the contractor for breach of contract. Before the lawsuit was resolved, the contractor ceased operations.

Because the general contractor became insolvent, any breach of promise claim against the general contractor would be worthless. The property owner went after the contractor’s principals instead. The property owner claimed that the principals committed fraud by falsely representing that the contractor would complete the project in return for the $21,000 payment when, to the contrary, the principals allegedly had no intention of having the general contractor finish the project. The trial court granted the principals’ motion for summary judgment that there was no basis for a fraud claim. The property owner appealed the decision.

The appellate court found that the communications from the principals of the general contractor did not support a claim for fraud. The proof that is necessary to succeed on a claim for fraud is much higher than it would have been if the claim had been against the general contractor for breach of a promise. To prove fraud, the owner was required to present credible evidence that the principals made promises that they did not intend to keep, that the owner reasonably relied on those promises and paid the $21,000 on that basis. If the claim had just been against the contractor for breach of promise, the proof necessary would have been meaningfully less: that a promise was made and the owner relied up it to its detriment.

The lesson for a contractor from this case is twofold. Inducing an owner to make payment based on representations of what may happen as a result of such a payment may (1) land individuals who actually made the statements in court as defendants facing a fraud claim—which they ultimately may well win because fraud claims are hard to prove, but which costs precious time and money to address; and (2) land the general contractor in court as a defendant in a breach of promise claim—which is easier to prove and which may take a full-blown trial to resolve.

Parmatown could have been decided very differently if the contractor’s letter used only slightly different language, especially if it had not been a fraud claim against the individuals. Imagine that the phrase “would be willing to return and complete the work” was replaced with “will return and complete the work.” With a small language change, no more than a spelling check suggestion or auto-correction, the contractor’s letter would have read like a promise to complete the project. This small difference could have created a large impact on litigation costs and, perhaps, the ultimate liability of the principals in this fraud case, or of the general contractor had it been a breach of promise case.

The importance of precise language in construction disputes is not exclusive to contractors. Property owners and other parties also need to be conscientious and disciplined communicators. For example, a property owner might tell subcontractors that she will “take care” of the subcontractors if they complete work when a general contractor has not paid them. Such a communication could create the complications seen in the Parmatown decision.

Finally, this case is also a reminder of the time and expense of the litigation that can result from dispute communications. Small misstatements or missteps can have long-lasting and expensive effects. In Parmatown, the contractor and its principals had to defend against the property owner’s claims in a trial court. Despite winning in the trial court, the contractor’s principals also had to defend against an appeal. Nearly nine years passed between the contractor sending its letter requesting the $21,000 payment and the appellate court decision. In a claim involving ambiguous or less favorable language, litigation could last as long as the Parmatown case or involve a full trial.