JPMorgan Chase’s lawsuit claiming it was defrauded into purchasing a startup called Frank has led critics to suggest that the bank didn’t do enough due diligence before forking over $175 million for the young company, which purported to help college students get financial aid. As a teacher of contract law, I’m not so sure.
The defendants — Frank’s founder Charlie Javice and Olivier Amar, who was Frank’s chief acquisitions officer — deny any wrongdoing, and it’s not my purpose to adjudicate the matter. But if the allegations in the complaint are true, one might argue that JPMorgan is behaving just the way a buyer who has suffered fraud is supposed to, suing the seller for material false representations made in the course of the transaction.
The law of fraud exists to solve a basic information asymmetry that would otherwise be ruinous to markets: In sales transactions, whether the parties are negotiating over a used car or a large company, the seller will almost always possess more information than the buyer. To say that JPMorgan should have smoked out Frank’s lies — if they were lies — is to neglect the problem that it’s often expensive to acquire information that isn’t (as the jargon has it) easily observable.
Some markets — securities and real estate, for example — address this problem by requiring the seller to make some specific disclosures. Most of the time, however, buyers who want information must invest in uncovering it. We tend to invest more resources evaluating purchases that cost us more. We’ll do much more research before we buy a house or a car than before we buy a carton of milk.
According to the complaint, JPMorgan engaged in a fair amount of due diligence. Some critics argue that given the size of the transaction, the bank should have done more. I’m skeptical. For maybe 99.99% of us, the purchase price of $175 million indeed seems impossibly large. But in the fourth quarter of 2022 alone, JPMorgan reported net income of $11 billion on revenue of $35 billion. At that level, $175 million amounts to pretty much a rounding error. Literally! By rounding to the nearest billion, I just omitted millions of the bank’s quarterly revenue. (And a good thing, too: Even if it wins, JPMorgan has little chance of recovering the money.)
Besides, relying heavily on Frank’s representations wasn’t really a mistake. That’s one reason representations exist: to form the basis for a fraud suit should they turn out to be material to the transaction and false. There’s a lot less pressure to engage in due diligence when the seller’s key representations, if they turn out to be false, are actionable.
To put the matter the other way around, a rational buyer might be somewhat less on guard against potential lies when the cost of the lie to the liar is high. Yes, the cost of the lie to the liar must be discounted by the likelihood of getting caught. But if even a fraction of the allegations against Frank are true, the likelihood of getting caught was enormous.
Consider the issue that’s received the most attention: the size of Frank’s user base. JPMorgan contends that as part of due diligence — yes, the complaint uses the term — it requested confirmation of Frank’s claim to have 4.265 million customer accounts. According to the complaint, “Frank was almost 4 million customer accounts short of its representations.” As a result, says the bank, Javice and Amar resorted to fabricating email addresses — as JPMorgan discovered when it tried to contact a few hundred thousand of these “customers.” The bank complains that “just 1.1% of the delivered emails were opened, compared to 30% for a typical JPMC campaign.”
If the allegation is true, Frank’s response to the query was bizarre. Surely someone at the company should have realized that JPMorgan would eventually try to get in touch with the names on the list. If the intent was to defraud, the fraud was one that had no hope of success.
Fortunately, research suggests such flagrant lying is rare. Maybe people are afraid of legal liability; maybe they’re concerned about their reputation in future transactions; maybe they’re just being altruistic. The popular tendency to believe that markets are infested by liars is likely driven by the availability heuristic: We think automatically of the downfalls of Sam Bankman-Fried and Elizabeth Holmes.
But the reason those cases make the news is precisely that they’re so rare. Yes, there are liars out there, but if most founders lied, the event wouldn’t be newsworthy. And fear of being hoodwinked would long ago have convinced investors to steer clear of startups.
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Stephen L. Carter is a Bloomberg Opinion columnist. A professor of law at Yale University, he is author, most recently, of “Invisible: The Story of the Black Woman Lawyer Who Took Down America’s Most Powerful Mobster.”
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