If you’re going to move money around from one project to another when your company is insolvent, i.e., “when the present fair salable value of his assets is less than the amount of that will be required to pay his probable liability on his existing debtors as they become absolute and matured,” you do so at your own peril.

“Why?” you ask.

Because a New York court may invalidate the transfers retroactively, finding that they are a fraudulent conveyance – even if these transfers were made innocently – if the conveyances were made without fair consideration.

And the danger doesn’t end there; if the court finds that the funds were commingled with individuals’ accounts (among other things), then the court may allow the plaintiff to pierce the corporate veil and hold those people behind it personally liable for these debts. (For more on this topic, please see “Piercing the Corporate Veil – Critical Facts that You Will Need to Prove Your Case Under New York Law“).

That’s not to say that a court will allow a corporate veil to be pierced lightly; as we pointed out previously, there are several facts that a plaintiff will need to prove in order to successfully pierce the corporate veil. And this is a difficult burden of proof.

But on the other hand, as happened in the recent decision of Fernbach, LLC v. Calleo, a court may also be disinclined to dismiss these claims out of hand at the beginning of the case.

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Earlier today, I got what was hands-down, the most ridiculous phone call seeking legal services in New York that I have ever received. Here are the pertinent facts:

This guy (we’ll call him “A’) was mistakenly over-billed by a company (we’ll call them “C”) for services that they rendered. Simple enough, right?

But this was no ordinary mistake. Instead of billing him $700, they billed him $700,000.

Oops.

C then tries to rectify the situation by reversing the process. Only now, they erroneously credit A with $700,000.

This is where I get called. A asks, “Shouldn’t C have to negotiate with me in order to get their money back?”  After I finish scanning the room for the Candid Camera and my laughter ebbs, I respond, “No; you realize you actually have to return the money because it was never yours to begin with.”

But wait – it gets better. (And here’s the REAL reason for the call).

“Well, Mr. Cooper, what if I told you that I already spent some of the money?” (More laughter ensues).

After my laughter subsides a second time and I got off the phone with this guy (and hopefully convinced him that he has to return every last penny) I was troubled by something he said. You see, he had started off our conversation by telling me that he read a lot of my articles online.  And, if what he said was true, I had to wonder: what – if anything – gave him the impression that I – or anyone for that matter – would help him?

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Lending further credence to our earlier article, “Why Many (If Not Most) Business Fraud Claims Are Dismissed By New York’s Courts,” a New York County trial judge recently dismissed a plaintiff’s fraudulent misrepresentation claims.

You might be inclined to ask, “Isn’t fraudulent misrepresentation materially different than garden-variety fraud (which was discussed in the article above)?”

The short answer is no, it’s not really different.

As the Court noted in North River Restaurant LLC v. Paratoree:

“The elements of a cause of action for fraudulent misrepresentation are the same as for fraud. Mandarin Trading Ltd. v. Wildenstein, 65 A.D. 3d 448, 459 (1st Dept 2009). The elements of a cause of action for fraud are: 1) a material misrepresentation of a fact; 2) knowledge of its falsity; 3) an intent to induce reliance; 4) justifiable reliance by the plaintiff; and 5) damages. Eurycleia Partners, LP v. Seward & Kissel, LLP, 12 N.Y. 3d 553, 559 (2009).”

(For more on the elements needed to prove a fraud claim under New York law, please see “How to Prove a Successful Business Fraud Claim Under NY Law“).

But in this case – as in many cases revolving around fraud, the Court found that the plaintiff failed to meet his burden of proof, stating:

“There is no indication or inference that would lead the court to believe that Plaintiff justifiably relied on Paratore’s statement. Eurycleia, 12 NY3d at 559. “As a matter of law, a sophisticated plaintiff cannot establish that it entered into an arm’s length transaction in justifiable reliance on alleged misrepresentations if that plaintiff failed to make use of the means of verification that were available to it.” DDJ Mgt, LLC v. Rhone Group LLC, 60 A.D. 3d 421, 424 (1st Dept 2009).”

Having established that the plaintiff failed to meet one of the central criteria for a fraud claim, the court was obliged to dismiss the claim. Which it did.

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As you may recall from my earlier articles, “Why Many (If Not Most) Business Fraud Claims Are Dismissed” and “How to Prove a Successful Business Fraud Claim Under NY Law,” it is very tough to prevail on a fraud claim in New York, because the pleadings (i.e., the allegations you make in your court papers) require a lot of specificity, and your evidentiary burden is greater than most cases.

Adding to this pressure is another question: how much time do the courts allow you to start an action based on fraud?  After all, in many cases, the fraud is concealed, and you don’t learn about it until much later. So when does the clock start to run?

Fortunately, New York’s legislature foresaw this difficulty, and allowed for the possibility that some frauds may be hidden. Therefore, they articulated the rule as follows:

§ 213. Actions to be commenced within six years

The following actions must be commenced within six years:

***
8. an action based upon fraud; the time within which the action must be commenced shall be the greater of six years from the date the cause of action accrued or two years from the time the plaintiff or the person under whom the plaintiff claims discovered the fraud, or could with reasonable diligence have discovered it.

Bear in mind, however, that this two-year extension of time for the discovery only applies to cases involving actual fraud, but does not apply to cases involving constructive fraud, which is still limited to a six-year statute of limitations. See, e.g., Orr v. Kinderhill Corp., C.A.N.Y.1993, 991 F.2d 31. An example of this would include a lawsuit brought by creditors to set aside conveyances made without fair consideration.

For additional information on constructive fraud, please see “Constructive Fraud: A Lesser-Known, But Powerful Tool in New York to Recover Money That You’re Owed.”

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Reading the appellate court’s rendition of the facts in this breach of contract, breach of non-competition agreement and fraudulent inducement/concealment case, it is clear that the court empathized with the plaintiff, and wanted to allow the plaintiffs their day in court. The sordid details are as follows:

In GoSmile, Inc. v. Levine, the defendant founded the plaintiff corporation, which develops and sells tooth-whitening and oral hygiene products, and, he, together with his wife, were the company’s sole stockholders, directors and employees. In 2003, they sold a majority interest in the company to investors (the plaintiffs).

At that time, the defendants executed confidentiality and non-competition agreements that granted plaintiff exclusive ownership rights of all intellectual property, and prohibited defendants from using this information to compete with the company. In exchange for a cash payment, the defendants became at-will employees, directors and minority owners of plaintiff.

After the parties became embroiled in arguments over the company’s financial difficulties, the defendants were terminated, and later resolved their wrongful termination lawsuit arising therefrom via a settlement agreement with plaintiff and several other parties “which contained a broad mutual release of all claims of all kinds, whether known or unknown, that the parties ever had or now had.”

As part of the settlement agreement, plaintiff insisted upon – and defendant warranted – that he had neither breached the 2003 confidentiality and non-compete agreement in the past, and was also not in breach of those agreements at that time. That settlement agreement resulted in a payout to defendants of over $3 million, and an additional payout of $1 million over the following 4 years in exchange for the remainder of defendant’s stock in the company.

Later plaintiffs learned that defendant had, in fact, breached his fiduciary duties to the company, and used this confidential information to unfairly compete with the plaintiff. In other words, he deliberately lied about (in legalese, misrepresented) his breach of fiduciary duty and breach of the non-compete agreement to the plaintiff company in order to fraudulently induce them into entering into the settlement agreement, and pay him over $3 million.

Although the Court was required to sidestep some general rules in order to reach this result, and allow the plaintiff’s claims for breach of contract, rescission and fraudulent inducement to succeed, are you surprised that they did so?

I thought not.

(But if you’re interested in the legal nitty-gritty of why, see “How Breach of a Non-Compete Can Sustain Both Fraud & Breach of Contract Claims in NY“).

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In GoSmile, Inc. v. Levine, a decision that was handed down on December 21, New York’s Appellate Division, First Department (which covers New York and Bronx Counties) was confronted with the following question:  “whether a plaintiff is permitted to assert claims for both fraud and breach of contract, where the fraud claim is based upon allegations that defendant induced plaintiff to enter into that contract based on misrepresentations of present facts.”

The short answer: yes.

“Isn’t that kind of obvious?’, you ask. No, it isn’t.

Because there are some general rules at play in breach of contract cases in New York that would suggest the opposite conclusion:

(1) You can’t convert a breach of contract claim into a tort, such as fraud (which is an intentional tort); and,

(2) You can’t pursue a breach of contract or fraudulent misrepresentation or concealment claim if you waive those claims as part of a disclaimer or settlement agreement.

So why did the Court go the opposite way in this case?  Two reasons:

(1) “In the instant matter, plaintiff’s allegation that defendant knowingly misrepresented that he did not breach the confidentiality and non-compete provisions of the 2003 agreement is not merely an insincere promise of future performance. It was instead, a misrepresentation of then present facts that was collateral to the contract, and thus plaintiff sufficiently alleged a cause of action sounding in fraud“; and,

(2) The general release did not act as a bar to plaintiff’s fraud and breach of contract claims because plaintiff specifically sought defendant’s express warranty that he didn’t breach his non-compete agreement, and the general release stated clearly that it did not extend to claims which “[plaintiff] does not know or suspect to exist in his favor at the time of executing the release.” After reading the court’s rendition of the facts of this case (for more on this, see “When a Fiduciary Breaches a NY Non-Compete Agreement and Lies About It”), however, no one should be surprised at the outcome.

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As a corollary to our blog article “When You Can Incur Personal Liability for a Debt in New York,” the question arises as to what New York’s courts will do when a claimant tries to hold a corporate officer personally liable in either breach of contract or fraud.

To that end, in a November 18 decision in Liang v. Sollecito, a Civil Court in New York County held that “The officers of a corporation may be held personally liable for torts committed on behalf of the corporation, but cannot be held personally liable on contracts provided that they did not bind themselves individually.” Thus, where there are no allegations that the officer had any direct involvement in the contract, or that he personally made any fraudulent misrepresentations with regard to the contract, then the complaint should be dismissed – even before formal discovery begins.

Which is precisely what happened in Liang.

And this should come as no surprise; After all, how often do you think corporate officers stick out their necks to render themselves personally liable? Even more challenging, of those times that it may have actually occurred, how easy do you think it will be to prove it?

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If the unsubstantiated claims of this plaintiff are actually true, then I feel bad for the plaintiff.

But, as noted by the Court, therein lies the problem: the allegations are unsubstantiated.

In Lecce Penn Co. SPA v. Adrenaline Marketing & Promotions, Inc., the plaintiff sued in breach of contract and fraud to recover over $300,000 that they were purportedly owed. Fair enough.

But the plaintiff took it a step further: they tried to sue one of the shareholders of the defendant corporation personally.  Unfortunately for the plaintiff, they had no competent proof that this individual did anything that should have resulted in his being held personally liable for the corporate debt; in fact, the plaintiff did not even allege that he did anything that should have entitled them to pierce the corporate veil.

The thing that troubles me about this case is simply this: while I can understand that there are instances where the proof you expected to become available to support your claim doesn’t materialize, I don’t understand how the complaint itself can even fail to have any of the requisite allegations to support a claim seeking to pierce the corporate veil. That’s just poor draftsmanship.

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In my earlier blog post “Why Fraudulent Concealment Claims Are So Tough to Win in New York,” I pointed out that one of the challenges of these claims is posed by contractual language that the purchaser signs stating that they didn’t rely on any representations by the seller. As a New York trial court recently noted,

“Where sophisticated businessmen engaged in major transactions enjoy access to critical information but fail to take advantage of that access, New York courts are particularly disinclined to entertain claims of justifiable reliance.” Grumman Allied Industries, Inc. v. Rohr Industries, Inc., supra at 737. Stated differently, “‘[a]s a matter of law, a sophisticated plaintiff cannot establish that it entered into an arm’s length transaction in justifiable reliance on alleged misrepresentations if that plaintiff failed to make use of the means of verification that were available to it.’ (UST Private Equity Invs. Fund v. Salomon Smith Barney, 288 AD2d 87, 88…[2001]).”

But what if the information that was concealed was within the unique knowledge of the seller?

In that case, the claim may not be D.O.A. after all; in legal terms, this is called the “peculiar knowledge” exception, which applies “not only where the facts allegedly misrepresented literally were within the exclusive knowledge of the defendant, but also where the truth theoretically might have been discovered, though only with extraordinary effort or great difficulty.” DIMON Inc. v. Folium, Inc., 48 F.Supp. 2d 359, 368 (SDNY 1999). See also, JPMorgan Chase Bank v. Winnick, 350 F.Supp. 2d 393 (SDNY 2004).

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Under New York law, when a seller deliberately hides information that is critical to the buyer’s decision to invest or not to invest, this is generally referred to as “fraudulent concealment.” A word of caution is in order, however: this type of claim is particularly challenging because in addition to the traditional elements of proof required in a fraud case (including intent to defraud and reasonable reliance),  a plaintiff alleging fraudulent concealment must also demonstrate that the defendant had a special, or fiduciary, relationship with the plaintiff that imposed upon the defendants a duty to disclose material information. Albion Alliance Mezzanine Fund, L.P. v. State Street Bank and Trust Co., 8 Misc. 3d 264, 269 (Sup. Ct., NY Co. 2003), aff’d 2 AD3d 162 (1st Dep’t 2003).

The difficulties with this type of claim do not end there.

In many instances, the parties have executed a detailed agreement that contains a disclaimer stating that the purchaser is not relying upon any of the seller representations, which often will sound the death knell to any claim that the plaintiff/purchaser reasonably relied upon the seller’s representations. “[W]here a party specifically disclaims reliance upon a representation in a contract, that party cannot, in a subsequent action for fraud, assert it was fraudulently induced to enter into the contract by the very representation it has disclaimed.” Grumman Allied Indus. Inc. v. Rohr Indus., Inc., 748 F.2d 729, 734-35 (2d Cir. 1984); see also, Danann Realty Corp. v. Harris, 5 NY2d 317 (1959).

Not surprisingly, there are exceptions to this rule as well, such as where the concealment pertains to matters that were exclusively within the defendants’ knowledge, and could only have been discovered by the plaintiff through great difficulty (this topic will hopefully be the subject of a separate article that I intend to publish shortly).

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