Court of Appeals Limits Negligent Misrepresentation Claims

In Sykes v. RFD Third Avenue 1 Associates, LLC, NYLJ 10/20/10, p. 28, col. 5, the Court of Appeals answered a question of considerable importance to home purchasers, and particularly to condominium purchasers: When does a purchaser have a claim against a party with whom the purchaser has never dealt when that party made a negligent misrepresentation on which the purchaser relied? In Sykes, the Court of Appeals, relying on dicta in past cases, held that a purchaser cannot prevail on such a claim unless the party making the representation was aware of the precise identify of the parties who would rely on that representation.

The Sykes Facts

In Sykes, the condominium offering plan included descriptions of the building's HVAC system, saying that it was capable of maintaining specified indoor temperatures in hot and cold weather. Condominium purchasers, dissatisfied with the building's HVAC system, brought an action against the engineering firm that designed the system, contending that statements made in the offering plan were false, attributable to the engineering firm, and negligently made. Moreover, purchasers contended that they had bought in reliance on these statements.

The engineering firm moved to dismiss purchasers' complaint, but Supreme Court denied the motion to dismiss. A divided Appellate Division reversed, holding that purchasers had failed to allege a relationship with the engineering firm that would sustain a negligent misrepresentation claim. Purchasers appealed to the Court of Appeals.

New York's Privity Doctrine

The primary doctrinal obstacle facing plaintiffs in cases like Sykes is the absence of privity of contract between the purchasers and the engineering firm that made the representation. The privity doctrine finds its source in Winterbottom v. Wright, 152 Eng. Rep. 402, an 1842 English case holding that a non-party to the contract could not recover from a party who had contracted to keep a mail coach in good repair. In denying recovery, the court expressed concerns about potentially limitless liability: “The only safe rule is to confine the right to recover to those who enter into the contract: if we go one step beyond that, there is no reason why we should not go fifty.”

Although the Court of Appeals abandoned the privity rule in many contexts, the court took a more measured approach with respect to negligent misrepresentation claims. In Ultramares Corp. v. Touche, 255 N.Y. 170, the Court of Appeals held that a lender could not maintain an action against an accounting firm for negligence in preparing a balance sheet for a soon-to-be-bankrupt borrower. Lender had made loans in reliance on the misinformation included in the balance sheet. Judge Cardozo's opinion for the court expressed concern that “[i]f liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability to an indeterminate amount for an indeterminate time to an indeterminate class.” Ultramares did not, however, hold that the absence of privity bars all claims based on negligent misrepresentations; the court cited and distinguished an earlier case, Glanzer v. Shepard, 233 NY 236, in which a public weigher made out a certificate of weight to its customer, the seller of goods, with a duplicate copy made out to the buyer, reciting that it was made by order of the seller for use of the buyer. In Glanzer, the court had held that privity did not bar the buyer's claim against the weigher.

The Credit Alliance Formula

The Court of Appeals revisited the negligent misrepresentation issue more than 50 years later, in Credit Alliance Corp. v. Arthur Andersen, 65 NY2d 536. In Credit Alliance and a companion case, as in Ultramares, lenders brought actions against their borrowers' accountants for negligently prepared financial reports. In Credit Alliance, the complaint alleged that the accountant “knew, should have known or was on notice that the 1977 certified financial statement was being shown to plaintiff” in order to induce plaintiff, the lender, to lend money to the accountant's client. The same allegation was made in the companion case, but the complaint in the companion case also alleged that the primary end of the accountant's audit was to provide the lender with information it needed to make loans to the client. Moreover, in the companion case, the accountant made representations directly to the lender. The court held that in the companion case, but not in Credit Alliance itself, the complaint stated a cause of action. The court emphasized that “[t]he parties' direct communications and personal meetings resulted in a nexus between them sufficiently approaching privity … to permit [the lender's] causes of action.”

Although both complaints alleged that the accountant knew that the particular lender had seen the reports, and although the court relied on the direct communications and personal meetings to justify liability in the companion case and not in Credit Alliance, the court in Credit Alliance articulated a test that focused in large measure on whether the accountants knew the identity of the party relying on the reports. The court wrote that three prerequisites were necessary for liability to attach: 1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes; 2) in the furtherance of which a known party or parties was intended to rely; and 3) there must have been some conduct on the part of the accountants linking them to the party or parties, which evinces the accountants' understanding of that party or the parties' reliance.” Id. at 551 (emphasis added). The three-factor test was largely dictum; factor (3) was enough to distinguish the two cases the court was actually deciding, and, as already noted, factor (2) was present in both complaints.

Four years later, in Ossining Union Free School District v. Anderson LaRocca Anderson, 73 N.Y.2d 417, the court quoted the Credit Alliance formula in holding that a school district had stated a cause of action against engineering consultants who had negligently represented to an architectural firm that a school building had serious structural weaknesses, leading the school to undertake substantial and unnecessary expenditures. It was clear in Ossining that the consultants knew the school district's identity, and knew the district would rely on the representations. Hence, neither Credit Alliance nor Ossining actually dealt with a case in which plaintiff failed to allege that the defendant knew of the plaintiff's specific identity.

Astor Terrace

Against that background, the First Department decided Board of Managers of the Astor Terrace Condominium v. Schuman, Lichtenstein, Clamon & Efron, 183 A.D.2d 488. In Astor Terrace, condominium purchasers sued engineering design professionals who allegedly were aware that the substance of their reports would be distributed to prospective purchasers, who in turn would rely on them in making purchase decisions. The Appellate Division held that the complaint stated a cause of action, emphasizing that prospective condominium purchasers were “known parties” within the meaning of the Credit Alliance formula because the engineering professionals knew they would rely on the reports.

Note that none of the prior Court of Appeals cases had decided whether a party who makes a misrepresentation would be liable to a class of people whose existence was known to the party, and who were virtually certain to rely on the representation. The First Department's decision in Astor Terrace, then, rested on a plausible reading of Credit Alliance, albeit a reading not compelled by the latter.

In Sykes, however, the Court of Appeals made it clear that the Credit Alliance formula is to be read strictly: For liability to attach, the party making the representation must know the specific identity of the party who might rely on the representation. As a result, representations made to a condominium sponsor, even if those representations make their way into the offering plan, will not subject the consultants who make those representations to any liability.

Stewart E. Sterk, Mack Professor of Law at Benjamin N. Cardozo School of Law, is Editor-in-Chief of this newsletter. The author wishes to thank Jillian McNeil, who provided research assistance in the preparation of this article.

In Sykes v. RFD Third Avenue 1 Associates, LLC, NYLJ 10/20/10, p. 28, col. 5, the Court of Appeals answered a question of considerable importance to home purchasers, and particularly to condominium purchasers: When does a purchaser have a claim against a party with whom the purchaser has never dealt when that party made a negligent misrepresentation on which the purchaser relied? In Sykes, the Court of Appeals, relying on dicta in past cases, held that a purchaser cannot prevail on such a claim unless the party making the representation was aware of the precise identify of the parties who would rely on that representation.

The Sykes Facts

In Sykes, the condominium offering plan included descriptions of the building's HVAC system, saying that it was capable of maintaining specified indoor temperatures in hot and cold weather. Condominium purchasers, dissatisfied with the building's HVAC system, brought an action against the engineering firm that designed the system, contending that statements made in the offering plan were false, attributable to the engineering firm, and negligently made. Moreover, purchasers contended that they had bought in reliance on these statements.

The engineering firm moved to dismiss purchasers' complaint, but Supreme Court denied the motion to dismiss. A divided Appellate Division reversed, holding that purchasers had failed to allege a relationship with the engineering firm that would sustain a negligent misrepresentation claim. Purchasers appealed to the Court of Appeals.

New York's Privity Doctrine

The primary doctrinal obstacle facing plaintiffs in cases like Sykes is the absence of privity of contract between the purchasers and the engineering firm that made the representation. The privity doctrine finds its source in Winterbottom v. Wright , 152 Eng. Rep. 402, an 1842 English case holding that a non-party to the contract could not recover from a party who had contracted to keep a mail coach in good repair. In denying recovery, the court expressed concerns about potentially limitless liability: “The only safe rule is to confine the right to recover to those who enter into the contract: if we go one step beyond that, there is no reason why we should not go fifty.”

Although the Court of Appeals abandoned the privity rule in many contexts, the court took a more measured approach with respect to negligent misrepresentation claims. In Ultramares Corp. v. Touche , 255 N.Y. 170, the Court of Appeals held that a lender could not maintain an action against an accounting firm for negligence in preparing a balance sheet for a soon-to-be-bankrupt borrower. Lender had made loans in reliance on the misinformation included in the balance sheet. Judge Cardozo's opinion for the court expressed concern that “[i]f liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability to an indeterminate amount for an indeterminate time to an indeterminate class.” Ultramares did not, however, hold that the absence of privity bars all claims based on negligent misrepresentations; the court cited and distinguished an earlier case, Glanzer v. Shepard , 233 NY 236, in which a public weigher made out a certificate of weight to its customer, the seller of goods, with a duplicate copy made out to the buyer, reciting that it was made by order of the seller for use of the buyer. In Glanzer, the court had held that privity did not bar the buyer's claim against the weigher.

The Credit Alliance Formula

The Court of Appeals revisited the negligent misrepresentation issue more than 50 years later, in Credit Alliance Corp. v. Arthur Andersen , 65 NY2d 536. In Credit Alliance and a companion case, as in Ultramares, lenders brought actions against their borrowers' accountants for negligently prepared financial reports. In Credit Alliance, the complaint alleged that the accountant “knew, should have known or was on notice that the 1977 certified financial statement was being shown to plaintiff” in order to induce plaintiff, the lender, to lend money to the accountant's client. The same allegation was made in the companion case, but the complaint in the companion case also alleged that the primary end of the accountant's audit was to provide the lender with information it needed to make loans to the client. Moreover, in the companion case, the accountant made representations directly to the lender. The court held that in the companion case, but not in Credit Alliance itself, the complaint stated a cause of action. The court emphasized that “[t]he parties' direct communications and personal meetings resulted in a nexus between them sufficiently approaching privity … to permit [the lender's] causes of action.”

Although both complaints alleged that the accountant knew that the particular lender had seen the reports, and although the court relied on the direct communications and personal meetings to justify liability in the companion case and not in Credit Alliance, the court in Credit Alliance articulated a test that focused in large measure on whether the accountants knew the identity of the party relying on the reports. The court wrote that three prerequisites were necessary for liability to attach: 1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes; 2) in the furtherance of which a known party or parties was intended to rely; and 3) there must have been some conduct on the part of the accountants linking them to the party or parties, which evinces the accountants' understanding of that party or the parties' reliance.” Id. at 551 (emphasis added). The three-factor test was largely dictum; factor (3) was enough to distinguish the two cases the court was actually deciding, and, as already noted, factor (2) was present in both complaints.

Four years later, in Ossining Union Free School District v. Anderson LaRocca Anderson , 73 N.Y.2d 417, the court quoted the Credit Alliance formula in holding that a school district had stated a cause of action against engineering consultants who had negligently represented to an architectural firm that a school building had serious structural weaknesses, leading the school to undertake substantial and unnecessary expenditures. It was clear in Ossining that the consultants knew the school district's identity, and knew the district would rely on the representations. Hence, neither Credit Alliance nor Ossining actually dealt with a case in which plaintiff failed to allege that the defendant knew of the plaintiff's specific identity.

Astor Terrace

Against that background, the First Department decided Board of Managers of the Astor Terrace Condominium v. Schuman, Lichtenstein, Clamon & Efron , 183 A.D.2d 488. In Astor Terrace, condominium purchasers sued engineering design professionals who allegedly were aware that the substance of their reports would be distributed to prospective purchasers, who in turn would rely on them in making purchase decisions. The Appellate Division held that the complaint stated a cause of action, emphasizing that prospective condominium purchasers were “known parties” within the meaning of the Credit Alliance formula because the engineering professionals knew they would rely on the reports.

Note that none of the prior Court of Appeals cases had decided whether a party who makes a misrepresentation would be liable to a class of people whose existence was known to the party, and who were virtually certain to rely on the representation. The First Department's decision in Astor Terrace, then, rested on a plausible reading of Credit Alliance, albeit a reading not compelled by the latter.

In Sykes, however, the Court of Appeals made it clear that the Credit Alliance formula is to be read strictly: For liability to attach, the party making the representation must know the specific identity of the party who might rely on the representation. As a result, representations made to a condominium sponsor, even if those representations make their way into the offering plan, will not subject the consultants who make those representations to any liability.

Stewart E. Sterk, Mack Professor of Law at Benjamin N. Cardozo School of Law, is Editor-in-Chief of this newsletter. The author wishes to thank Jillian McNeil, who provided research assistance in the preparation of this article.