United States: Nuts And Bolts - Putting Together A Fraud Case

A client may walk into your office and state, "he told me it would be a great investment, but it turned out to be a lousy deal." This does not end the inquiry. Rather, it begins the inquiry as to whether your client was defrauded. As paraphrased, the client’s statement recaps a "mere expression of opinion" not a statement of fact.

Midland Nat. Bank, etc. v. Perranoski, 299 N. W. 2d 404, 412 (1981) (citations omitted).

The allegedly fraudulent statement complained of by the client does not reveal what expertise the speaker had, what the subject of the "deal" was, what made the transaction a "great deal," or what caused it to "turn out to be lousy." Thus, a thorough interview of the client and examination of documents describing the transaction must commence, to extract the details.

1. Material Fact Misrepresentation; e. g.:

1. "One of our biotech company’s scientists won the Nobel Prize in 1990 for her DNA research."
2. "Our company’s increase in sales of educational software last year was the largest in the industry."

2. Material Misrepresentation of Opinion; e. g.:

1. "Our company has the best scientists in the field of molecular biology."
2. "Our company has the most dynamic growth of any in the educational software industry."

Identify explicitly what true facts need to be proved to demonstrate falsity of misstatement or what true facts were concealed, e.g.:

1. The Nobel Prize- winning scientist, who wrote all of the company’s prior patents, has an inoperable brain tumor and has been advised by doctors that she will not survive more than two months.
2. The educational software company’s sales growth last year was 2,000% -- from $1.00 to $2,000, placing it $2 million behind the next worse company in total sales revenue.

1. Does any federal statute or law apply, what state laws apply and which state law will likely be chosen as the controlling state law?

2. Given that you are likely litigating or arbitrating in Washington, how much effort should you devote to pursuing punitive damage theories under other state laws, and will you be sufficiently familiar with the elements of those foreign state law claims and related discovery issues without local advisors?

a. Securities fraud: RCW 21.20.430 (referencing .010) and federal claims -- express remedies under Section 11 and 12 of the Securities Act of 1933 [15 U. S. C. Sections 77k and 77l] and the implied remedy under Securities Exchange Act of 1934 Section 10( b) (and Rule 1065 thereunder) [15 U. S. C. 78j].

Remedies such as the Washington State Securities Act (" WSSA") can greatly ease a plaintiff’s burden of proof. Compare for example common law fraud with its nine elements to a WSSA claim under 21.20.430:

1. A representation of an existing fact,
2. Its materiality,
3. Its falsity,
4. The speaker’s knowledge of its falsity or ignorance of its truth,
5. His intent that it should be acted on by the person to whom it is made,
6. Ignorance of its falsity on the part of the person to whom it is made,
7. The later’s reliance on the truth of the representation,
8. His right to rely on it, and
9. His consequent damage.

Pederson v. Bibioff, 828 P. 2d 113, 1120, citing Turner v. Enders, 15 Wn. App. 875, 878, 552 P. 2d 694 (1976).

A WSSA claimant will not have to prove "loss causation," an element not only of a common law fraud claim, but a Section 10( b) 1934 Act federal claim as well:

Huddleston v. Herman & MacLean, 640 F. 2d 534, 549 (5 th Cir. 1981), Aff’d. and Rev’d. not in relevant part, 459 U. S. 375 (1983) and Arrington v. Merrill Lynch Pierce Fenner and Smith, Inc., 651 F. 2d 615, 622 (9 th Cir. 1981).

In contrast, a WSSA plaintiff will only have to prove "transaction causation, not "loss causation." Hines v. Dataline, 114 Wn. 2d 127, 134- 35 (1990) (requiring proof of a material misrepresentation or omission relied upon by plaintiff in order to recover). Thus, a plaintiff under WSSA does not have to prove any fault. A defendant who made a material misrepresentation is liable even if it did not act intentionally or negligently. Id. and Haberman v. WPPSS 109 Wn. 2d 107, 124133 (1987) (discussing liability under Section 12 of the 1933 Act as well).

In fact, even persons vicariously liable for the securities fraud of another are liable under WSSA unless they can prove they were not negligent. RCW 21.20.430( 3) and Hines v. Dataline, 114 Wn. 2d at 135- 152.

b. The Washington Unfair Business Practices Act (" Consumer Protection Act"), also permits essentially strict liability for deception or unfair business practices; but RCW 19.86.090 also imposes the tricky burden of proving an impact on the "public interest." Hangman Ridge Training Stables, Inc. v. Safeco Title Ins. Co., 105 Wn. 2d 778, 780, 719 P. 2d 531 (1986).

Another advantage of a statutory fraud claim under the WSSA or the CPA is that each statute expressly provides a remedy that includes damages and attorney fees -- prejudgment interest is expressly included in WSSA, as well. RCW 19.86.090 and 21.10.430.

c. Similar advantages may be found in claims under the Uniform Franchise Protection Act, RCW 19.10.190 (but a prevailing defendant may get attorney fees) and federal unfair competition statutes, such as the Lanham Act, 15 U. S. C. Sections 1114 and 1117 (providing for award of the defendant’s infringing profits, as an alternative to lost profits, and attorney fees plus potentially treble damages if trademark infringement or unfair competition/ false advertising was willful).

None of the statutory remedies referenced above requires a standard of proof other than the usual "preponderance of the evidence" test, in contrast to a common law fraud claim.

2. Negligent Misrepresentation.

If no statutory claim lies— e. g. fraud in purchase of assets instead of stock— a negligent misrepresentation claim presents some advantages over common law fraud, but some key elements are common to both. J& J Food Centers, Inc. v. Selig, 76 Wn. 2d 304, 309- 11 (1969).

A surprising element of negligent misrepresentation is the standard of proof -- not a "preponderance of the evidence," but, like common law fraud, "clear, cogent and convincing" evidence. Havens v. C& D Plastics, 124 Wn. 2d 158, 180 (1994) (citing Sprague v. Sumitomo Forestry Co., 104 Wn. 2d 751, 762 (1985).

In addition, a negligent misrepresentation theory, like fraud, but unlike WSSA liability, also requires proof of "loss causation," not just reliance (" transaction causation"). Haberman v. WPPSS, supra, 109 Wn. 2d at 161- 62 (citing Restatement (Second) of Torts, Section 552( e)( 2) (1977).

At the outset, other theories should be examined, before they are rejected as too far fetched, or inconsistent with the theories at the heart of the case: e. g. breach of fiduciary duty, breach of contract, breach of warranty under the UCC, racketeering 15 U. S. C. 1962 et. seq.

4. Explore "Justifiable Reliance" Issues.

A defendant can avoid liability under any fraud theory (regardless of level of culpability— strict liability, negligence or intentional deception)— if the defendant can show that the plaintiff did not "justifiably rely" on the alleged misrepresentation. Thus, there are many cases barring recovery by a plaintiff who alleges reliance on an oral misrepresentation that was contradicted by disclosure in the transaction documents. E. g., Acme Propane, Inc. v. Tenexco, Inc., 844 F. 2d 1317, 1322 (7 th Cir. 1988); Kennedy v. Josepthal & Co., 814 F. 2d 798, 804- 5 (1 st Cir. 1987) (" blind faith cannot vitiate [a plaintiff’s] opportunity to detect the fraud"); Zobrist v. Coal- X, Inc., 708 F. 2d 1511, 1518- 19 (10 th Cir. 1983); and Allan v. State of Washington, 118 Wn. 2d 753, 759 (1992) (affirming summary judgment dismissal of claim as a matter of law under statute of limitations "discovery rule" where "the facts were all available for [plaintiff] to discover through the exercise of due diligence").

1. Juxtapose the material misrepresentations or omissions against the true set of facts. E. g.:

1. Defendant represented that its top scientist won the Nobel Prize in 1990 for her DNA research, but failed to disclose that she had an inoperable brain tumor and had only two months to live.
2. Defendant represented that its increase in educational software sales last year was the largest in the industry; [when, in fact, it was the smallest by a wide margin in terms of dollar volume] or [when, in fact, its sales rose from the negligible amount of $1 to the almost negligible amount of $2,000, but still lagged $2 million behind its nearest competitor].

Pleading material misrepresentations of fact separately from material omissions of fact may enhance the flow of the complaint, and may deliver a more compelling account of the alleged deceit.

2. Before pleading all of the elements of the legal theories selected for your complaint, obtain all relevant jury instructions, with annotations. The annotated jury instructions should be used as a checklist to ensure that all elements required for each legal theory are pled. Procuring the annotated jury instructions in advance also helps to prevent discovery "holes." When framing interrogatories and document requests and in deposing witnesses, referring to annotated jury instructions will help you "cover all the bases."

3. Give some thought to the affirmative defenses that apply to each of your liability theories. For example, a negligent misrepresentation claim is susceptible to a comparative negligence defense, but a statutory securities fraud claim is not. As another example, if your client’s true damage objective is to secure the benefit of a bargain that far exceeds an investment loss, do not claim statutory securities fraud, which permits only recovery of funds contributed, less any funds returned (plus 8% interest), when a sensible fraud or breach of contract theory might secure a "benefit of the bargain" remedy for a much larger profit that was usurped by defendant.

1. Include the "maker" of a false statement. See Haberman, 109 Wn. 2d at 16162 and Restatement of Torts section 552.

2. The individual who makes a fraudulent statement is personally liable as a maker, even if acting as an agent for his/ her principal. E. g., Gould v. Mutual Life, 37 Wn. App. 756 (1984) (" The law is clear that corporate officers and agents can incur personal liability under the Consumer Protection Act . . . and that an insurance company [the principal] which breaches its duty to act in good faith is subject to liability under Act"); Wilkinson v. Smith, 31 Wn. App. 1 (1982) (realty company liable under CPA for representations of agents); and Reeves v. Teusher, 881 F. 2d 1495, 1502 (9 th Cir. 1989) (holding both principal and agent liable for CPA violations).

E.g., a company president defrauds plaintiff through oral statement or letter on company stationery signed by president, acting within scope of employment for company— president is liable and company is liable vicariously for president’s fraud. For all you know, the president has been drawing down or encumbering all of the assets of the company for years, as a prelude to taking your plaintiff’s money by deceit. Where is the "deep pocket" then? Moreover, defending both the president and the corporation may pose a conflict of interest, potentially separating the interests of the corporation and president, and with good fortune, turning one of them in some way against the other, prompting assistance to your plaintiff in some fashion.

3. Under some statutes, principals are not the only targets liable for the actions of their agents. For example, persons who "control" a violator of a securities fraud statute may be liable by virtue of their ownership of a significant amount of stock, even though the primary violator was employed by the corporation, not the stockholder. E. g., RCW 21.20.430( 3), Section 15 of the Securities Act of 1933, 15 U. S. C. Section 770, and Section 20 of the Securities Exchange Act of 1934, 15 U. S. C. Section 78t.

In a financial fraud case, potential targets include accountants, managerial consultants, engineering and other professional consultants, and like it or not, attorneys. E. g., Hines v. Data Line, supra, and Haberman v. WPPSS. Often, these professionals have liability insurance.

Be cautious about naming professionals who were not directly involved in the misrepresentations leading to the fraudulent transaction. Moreover, professional advice or involvement after the fraudulent transaction is irrelevant, as are any representations made by principals. Roberts v. Pete Marwick, Mitchell & Co., 857 F. 2d 646 (9th Cir. 1988).

Some affirmative defenses accomplish the effect desired by every defendant— make the plaintiff a defendant too. Ratification, estoppel and laches defenses do precisely that. They enable you to highlight any unfairness, hypocrisy or licentious greed, which could destroy jury sympathy or threaten summary judgment. E.g., Royal Air Properties v. Smith, 312 F. 2d 210, 214 (9 th Cir. 1962). The purpose of the securities laws "is to protect the innocent investor, not one who loses his innocence and then waits to see how his investment turns out before he decides to invoke the provisions" of the securities laws). See also, Wagner v. Wagner, 95 Wn. 2d 94 (1980) and Skagit State Bank v. Rasmussen, 109 Wn. 2d 377 (1987):

Id., 109 Wn. 2d at 381.

Pleading a fiduciary duty on the part of defendant may help to overcome a plaintiff’s disregard of fully disclosed facts. E.g., Midland Nat. Bank etc. v. Perranoski, supra, 299 N. W. 2d 404 at 413:

Thus, cases can be found to support the proposition that the dumber your plaintiff, the more difficult for the defendant to avoid fraud liability by carefully documenting the transaction.

Affirmative defenses such as waiver, accord and satisfaction, comparative negligence and "in pari delecto" may work, but they do not evoke the same flavor of malevolence by the plaintiff that estoppel, ratification and laches do.

The "in pari delecto" defense, which appeared to have died in Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U. S. 299, 86 L. Ed. 2d 215 (1985) was restored by Pinter v. Dahl, 486 U. S. ____, 100 L. Ed. 2d. 658, 672- 78 (1988). The Pinter v. Dahl case dealt with section 12 under the Securities Act of 1933, which was used as an analog for the WSSA in Haberman v. WPPSS, 109 Wn. 2d at 125. Thus, the "in pari delecto" defense may apply to WSSA claims under RCW 21.20.430 and to claims under the CPA, RCW Chap. 19.86 or other statutes. "The doctrine [of in pari delecto] traditionally has been applied in any action based on conduct that ‘transgresses statutory prohibitions’ . . . courts have recognized the defense in cases involving strict liability offenses. . . ." 100 L. Ed. 2d at 674. In Pinter v. Dahl, the Court held that whether the in pari delecto defense applied in a securities transaction depended on, "Whether the plaintiff in a particular case is primarily an investor or primarily a promoter." Id. 100 L. Ed. 2d at 677.

Other "iffy" defenses include assertions that plaintiff’s losses were caused by other defendants or nonparties. Of course, if a defendant is jointly and severally liable for the acts of another, and is unable to achieve separate liability under the comparative fault statute (RCW 4.22.070), blaming another defendant for a loss may go nowhere, particularly in front of a jury. Proving that an intervening cause of the loss occurred, may work, however. E. g., in the earlier example of the scientist with an inoperable brain tumor and two months to live, consider the outcome if the plaintiff had invested because the defendant’s top scientist was a Nobel Prize winner and had not been told that she had inoperable brain cancer, but the scientist had been killed in a car accident two days after the investment. (Perhaps one of these cases will spark Fred Huebner’s next mystery novel.)

Statute of Limitation defenses had better be summary judgment material, because they are not likely to play well to a jury. Tactically, a defendant should move to dismiss expired claims in summary judgment motions and at the close of plaintiff’s case outside the presence of the jury. This will preserve some of the arguments for appeal. Submitting jury instructions on these defenses, however, and filing motions for dismissal notwithstanding the verdict, may dilute the potency of an otherwise impressive defense.

1. Examine complaint for conformity with Rule 9( b) specificity. For the sake of efficiency, prior to bringing dismissal motion, consider contacting plaintiff’s attorney, to attempt a stipulation under which defendant forebears expense of 9( b) motion, on condition that plaintiff adds detail to complaint by agreed deadline. Most successful 9( b) dismissal motions simply evoke an order granting leave to amend within 30 days.

2. Consider failure to state a claim, e. g. "puffery," "justifiable reliance" and "bespeaks caution" cases.

3. Consider motion for a more definite statement, but, like 9( b) motion, consider consensual resolution.

Each fraud case is unique, yet virtually all revolve around written records.

In addition to the usual request for applicable financial statements and accounting system records, keep in mind applicability of travel receipts (to establish who went where and when), entertainment receipts (to establish who was at what location when fraudulent representations were made, on what date, and with whom).

Other adjuncts to accounting system records include: director and shareholder meeting minutes, tax returns, communications with banks regarding loans, applications, credit cards, etc. and accounts with other types of financial institutions such as securities brokerage firms, insurance applications and correspondence, and communications with any consultants.

1. There is perhaps no better source of records than a party’s accountant. Accountants usually keep records in an orderly fashion and store work papers supporting the final documents (financial statements, tax returns or special reports). While a defendant may have "lost" records from several years back, the defendant’s accounting firm has likely kept those records, including perhaps that special report on internal audit system weaknesses and breakdowns that looks like a "smoking gun" to a securities fraud plaintiff.

The same is true for a defendant. An "impoverished, unsophisticated" plaintiff, may have an accountant whose records reveal a mega- millionaire with a securities portfolio like Warren Buffet’s.

Another "windfall" that may result from a subpoena to the other party’s accountant is a pile of correspondence between the adverse party and its attorney. Too often, individuals and companies treat their accountants as lawyers, and some routinely copy their accountant with what would have been attorney- client privileged correspondence. Revelation of the attorney- client correspondence may prompt a belated explanation that the material is privileged because the attorney had retained the accountant as a consultant to assist in supplying legal advice. If this is a fabrication, it should fall apart under scrutiny. Discovering attorney correspondence in the accountant’s file may spark complications that impel candor or prompt settlement.

Nowadays, virtually all records, whether they reflect correspondence or internal accounting journal entries, were created on a computer— e. g. using "Word" to create a letter or "Quicken" to create an accounting entry. Even invoices and purchase orders may be found on a computer hard drive, as well as in hard copy form.

Requesting copies of computer records is problematic. Accepting a disk copy is one thing, retaining a computer forensic expert to inspect the adverse party’s computer main frame or other database facility is quite another in terms of expense. Moreover, if one party copies files from another party’s computer system, and includes in the copying process not simply the other party’s data, but the software programs used to manipulate the data, copyright infringement of nonparties may occur. Of course, the party subjected to this discovery, when it learns of any copyright violation, will be eager to exploit such an error.

Losing control of documents almost assures losing a fraud case. Virtually every fraud case requires exhaustive document retrieval and forensic analysis.

As soon as possible, a lawyer intimately familiar with the claims should review all documents as they are collected during discovery. Entrusting this task to a paralegal, even a sophisticated one, is risky. There is, however, a reward for suffering this burden. Useless documents can be set aside. The document load can be repeatedly lightened, in phases, enabling the attorney to narrow the focus continuously as discovery progresses.

When documents are controlled conscientiously, the truly significant documents can be sorted out by the time of trial. This enables the fraud attorney to limit the trial exhibits to compelling evidence, and to resist the temptation to burden a jury with a mountain of 500 exhibits, when 50 will do. The "top 50" will be more digestible, less diluted, and have far greater impact on a jury than they would if intermingled among the "top 500." Given that jurors tend not to be Rhodes Scholars, it is impossible to expect that they "learn" the facts in your case anywhere nearly as well as you, when they have one or two weeks, in contrast to your one or two years.

There are computer data base programs now on the market, that are well worth the trouble to use for indices.

Most databases can set up a variety of fields, which enable sorting of documents by subject, date, key words and other categories. One of the distinct advantages of using a document index is the ability to list out important documents in chronological order. In a fraud case, it can be vital to arrange documents in a manner that clarifies contemporaneously who knew what and when it was known.

For example, to become ever more organized and efficient as the case progresses, the attorney reviewing documents could exclude from the list any document that is not in some fashion "useful" for discovery purposes. "Useful" documents, those which stimulate the reviewing attorney, could be labeled "key" documents. These "key" documents can then be sorted from the remainder.

Vital documents can be labeled "vital" or "trial," for example, at any stage in maintaining the index, so that the most important documents can be sorted. In this manner, documents can be segregated for consideration as trial exhibits, along the way, after depositions, to save attorney time. In addition, the important documents not identified as trial exhibits may be labeled and segregated for cross- examination purposes. Thus, in the appropriate field in the database, the term "cross" or "crossexam" could be used to identify documents designated for that purpose, and a separate group sorted for that purpose at trial.

A field for "attorney comments" can be used to note questions and analysis for use in depositions and to prepare for examination at trial. This enables the reviewing attorney to note questions while looking at the document, e. g., on a yellow "post- it" sticker attached to a document, which is then logged into the index, and preserved in an organized fashion – in chronological order.

A. Washington Pattern Instructions.

Be realistic. Whether you represent a plaintiff or defendant in a fraud case, the instructions the trial judge will likely use will be the pattern instructions for the applicable state and federal law. B. Ninth Circuit Instructions. Our federal judges in Seattle and Tacoma rarely use any instruction other than a Ninth Circuit pattern instruction. If you believe a Ninth Circuit instruction has become obsolete or for some reason needs to be tailored, do not build your case around your hopes. See suggestion to develop case from the outset based on standard jury instructions. Opinions vary, but a federal court in this area that revises a Ninth Circuit instruction is likely to refer to Restatement pronouncements. ABA model instructions are published, but are rarely used except in the daydreams of defense attorneys.

Follow standard practices and instincts in voire dire questions, e. g., seeking out signs of bias, laziness or lack of patience and attention to detail called for by a fraud case. It would not hurt if your questions raise a few inferences favorable to your contentions.

Given the amount of documentation in a fraud case, evidentiary battles are all the more likely. State of mind is an issue, so additional evidentiary battles develop over exceptions to the hearsay rule when documents may prove lack of knowledge or knowledge. Avoid reference to risky evidence, and especially avoid highlighting such evidence, because your adversary will not forget in closing that you were unable to provide the (rejected) evidence you referenced in opening.

As an aside, if you have an option to arbitrate rather than litigate, and there is ample hearsay evidence to support your position, consider arbitration. Hearsay is admissible in virtually any arbitration forum, but is always a problem in court, despite the numerous exceptions to the general rule. Although arbitrators give less weight to hearsay than to testimony subjected to cross- examination, at least it can be used.

There will be no effort to supply a comprehensive trial strategy here. However, there is one tactic that has often backfired on clever lawyers. Some plaintiff's attorneys call the defendant to the stand at the outset. Their intention is to destroy the defendant with a withering cross- examination, and start out their case with a bang. Unfortunately, at that point the jury has read nothing and only heard descriptions of the case once— in opening statements. The opening statement is usually not sufficient to drill the jury with the facts, and enable them to study and grasp the transaction in time to understand the "withering cross- examination." Too often, the jury is left confused, irritated with the plaintiff and somewhat sympathetic to the defendant, who will now have an opportunity on redirect and later in the defense case to spend time teaching the jury entirely different lessons.

The conservative approach would be to present a likable, sensible, and knowledgeable witness at the outset, who can deliver a "big picture" for the jury. Having done that, other tactics throughout the trial should be more effective.