Court Declines Pre-Action Discovery Due to The Failure to Plead a Fraud Cause of Action

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Posted on: Aug 21 2024

Often, in the pre-action investigation of a client’s claims, it becomes evident that discovery would materially aid the client in framing his/her complaint or in learning the identities of the persons against whom the complaint should be brought. Obtaining pre-action discovery from the court, however, is not easy. As discussed below, the plaintiff must demonstrate the existence of a meritorious cause of action against the proposed defendant and the materiality and necessity of obtaining the information.

Under Section 3102(c) of the CPLR, a plaintiff can obtain discovery “before an action is commenced … to preserve information” or “to aid in bringing an action ….”[1] However, such discovery can be secured only by court order.[2]

Importantly, “while pre-action disclosure may be appropriate to preserve evidence or to identify potential defendants, it may not be used to ascertain whether a prospective plaintiff has a cause of action worth pursuing.”[3] In other words, a would-be plaintiff cannot use Section 3102(c) to fish for a cause of action.

New York courts have explained that the foregoing “limitation” on the use of pre-action disclosure is “‘designed to prevent the initiation of troublesome and expensive procedures, based upon a mere suspicion, which may annoy and intrude upon an innocent party.’”[4] However, where “the facts alleged state a cause of action, the protection of a party’s affairs is no longer the primary consideration and an examination to determine the identities of the parties and what form or forms the action should take is appropriate.”[5]

Thus, “[p]re-action discovery is not permissible as a fishing expedition to ascertain whether a cause of action exists and is only available where a petitioner demonstrates that he or she has a meritorious cause of action and that the information sought is material and necessary to the actionable wrong.”[6]

The burden is on the petitioner to present “facts fairly indicating a cause of action against the adverse party.”[7]

Recently, this Blog examined Khorassani v. FINRA, No. 153819/2023, 2023 WL 4029701 (Sup. Ct., N.Y. County June 15, 2023), aff’d, 223 A.D.3d 589 (1st Dept. 2024) (here), a case in which the Appellate Division, First Department affirmed the denial of a request for pre-action discovery.[8]

Khorassani involved alleged fraud in connection with the merger of Torchlight Energy Resources (“Torchlight”) and Meta Materials, Inc. (“Meta Materials” or “MMAT”). After the merger, Meta Materials traded on the NASDAQ under the ticker symbol “MMAT”.

In connection with the merger, Meta Materials issued a special dividend in the form of Series A Preferred shares (“MMTLP”) to Torchlight stockholders before the merger. MMLTP shares were not intended to be traded on any public exchange and were only intended to be a dividend placeholder for shareholders who owned Torchlight shares prior to the merger.

In October 2021, the MMTLP shares were listed on the Over-The-Counter Market (“OTC Market”) with the assistance of an unidentified securities broker. Thereafter, unidentified brokers and market makers began trading shares of MMTLP on the open market.

In July 2022, the company’s board of directors voted to spin off Torchlight’s assets into a new company called Next Bridge Hydrocarbons, Inc. (“Next Bridge”). In connection with the transaction, MMAT filed a Form S-1 Registration Statement (the “Registration Statement”) with the Securities and Exchange Commission (“SEC”) to register the issuance of stock in Next Bridge.

Shortly after the Registration Statement became effective, short interest in MMTLP shares grew. By early December 2022, the volume of short sales exceeded the volume of stock that was not shorted by traders. As a result, on December 9, 2022, FINRA halted trading of MMTLP shares.

FINRA’s halt in trading resulted in the failure of unknown and unidentified brokers to settle their short positions. As a result, the petitioner claimed that he was harmed, in addition to the Company’s other retail investors.

The petitioner sought the “Blue Sheets” maintained by FINRA to allow him to ascertain the names, addresses, and basis of liability of the unknown brokers and market makers to frame his claims, which the petitioner said he intended to bring against the unknown and unidentified brokers and market makers for spoofing, naked short selling, market manipulation, and fraud.

The motion court denied the petition, holding that the petitioner (a) was using CPLR § 3102 for purposes other than ascertaining the identity of the defendants, and (b) failed to assert a meritorious cause of action for fraud. The motion court found that the allegations and arguments in the petition were speculative and conclusory and, as a result, concluded that the petition was an improper fishing expedition.

On appeal, the First Department affirmed, holding that the petitioner’s allegations were “conclusory” and fell “far short of the showing necessary to obtain pre-action disclosure.” In other words, the Court found that the petitioner failed to state a meritorious cause of action for fraud.

In Steamroller, LLC v. OTC Mkts. Group, Inc., 2024 N.Y. Slip Op. 32891(U) (Sup. Ct., N.Y. County Aug. 20, 2024 (here), the court was faced with “virtually” the same request for “relief as [the] petitioner” in Khorassani (i.e., “the pre-action disclosure of the identities of the brokers who traded in MMTLP shares”).[9] Relying on Khorassani and finding the case to be dispositive, the motion court denied the motion.[10]

Steamroller was brought by an MMTLP shareholder. Petitioner sought the disclosure of the identities of the individuals who or the entities that submitted a Form 211 to FINRA for the MMTLP shares to be listed for trading on the OTC Market.[11] Petitioner claimed that the relief requested was necessary so that he could name the brokers and marker makers responsible for the fraudulent information allegedly used to list MMTLP on the OTC Markets.

The motion court held that the petition “suffer[ed] from the same infirmities as the petition in Khorassani.”[12] The motion court found that “[p]etitioner failed to identify any material misrepresentation by the broker or brokers who listed MMTLP for trading on which petitioner justifiably relied in purchasing shares of the security.”[13] The motion court explained that “petitioner specifically claim[ed] that it relied on [Torchlight’s] public disclosures…, the shareholders of which were to receive MMTLP shares upon Torchlight’s merger with Meta Materials, Inc.”[14] “That disclosure,” said the motion court, “stated that MMTLP ‘will not be listed or traded on any exchange’ and ‘[n]o market is expected to develop for [MMTLP] in the foreseeable future and holders of [MMTLP] may not be able to find a buyer and sell their shares if they desired to do so.’”[15] Thus, “based on petitioner’s own allegations,” concluded the motion court, “not only did petitioner not rely on any misrepresentation by the unidentified brokers, but it could also not have justifiably relied on Torchlight’s public disclosure because it does not state that MMTLP would or could not be traded on an unsolicited basis in the over-the-counter market.”[16] “Indeed,” noted the motion court, “by stating that it might be difficult for holders of MMTLP to find buyers for their shares should they desire to sell them, it implicitly recognized that the shares might be bought and sold.”[17]

The motion court also held that petitioner failed to plead fraud with particularity, finding that petitioner failed to provide the “how” and “why” of the claimed fraud, and failed to allege any damages resulting from a misrepresentation by the broker or brokers and petitioner’s reliance thereon.[18]

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Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

[1] CPLR 3102(c) (“Before an action is commenced, disclosure to aid in bringing an action, to preserve information or to aid in arbitration, may be obtained, but only by court order.”).

[2] Id.

[3] Uddin v. New York City Tr. Auth., 27 A.D.3d 265, 266 (1st Dept. 2006).

[4] Matter of Stewart v. New York City Transit Auth., 12 A.D.2d 939, 940 (2d Dept. 1985) (citation omitted).

[5] Id. (citation and internal quotation marks omitted).

[6] Bishop v. Stevenson Commons Assocs., L.P., 74 A.D.3d 640, 641 (1st Dept. 2010) (citations omitted).

[7] Matter of Schenley Indus. v. Allen, 25 A.D.2d 742, 743 (1st Dept. 1966).

[8] In addition Khorassani, this Blog examined applications for pre-action discovery under CPLR 3102, here and here.

[9] Slip Op. at *1.

[10] Id.

[11] Form 211 is an application to initiate or resume quotations on an exchange of a non-exchange listed security. Rule 15c2-11(b) of the Securities Exchange Act of 1934 and FINRA Rule 6432 govern the information that must included in the Form 211.

[12] Slip Op. at *2.

[13] Id.

[14] Id.

[15] Id. (citation to court record omitted).

[16] Id. at *2-*3.

[17] Id. at *3.

[18] Id.