Court Dismisses Breach of Fiduciary Duty Claim That Should Have Been Brought Derivatively

• Posted on: Jul 31 2019

Distinguishing between direct and derivative claims is not easy. Sometimes, the difficulty arises because of the entity involved. For example, in the LLC context, there are fiduciary relationships (e.g., managing member and non-managing member) that will support a direct action in circumstances that might otherwise require a derivative action. E.g., Pokoik v. Pokoik, 115 A.D.3d 428 (1st Dept. 2014); Salm v. Feldstein, 20 A.D.3d 469, 470 (2d Dept. 2005). Other times, the difficulty rests with the wrong sought to be redressed and the harm incurred (e.g., the diversion of assets by officers or directors of a company for their own benefit and the resulting diminution in the value of the shareholder’s stock).   

Being able to tell the difference between the two types of claims is both procedurally and substantively important. For example, as this Blog has noted in previous posts (e.g., here), in a derivative action, the plaintiff must satisfy the demand requirement, or demonstrate with particularity why demand should be excused, before being permitted to proceed with litigation. There is no comparable pleading requirement in a direct action. 

In today’s post, this Blog looks at Huldisch v. Mermelstein, 2019 N.Y. Slip Op. 32216(U) (Sup. Ct., N.Y. County, July 24, 2019) (here). In Huldisch, the Court dismissed a breach of fiduciary duty counterclaim because the defendants failed to demonstrate that the claim belonged to them and not the company.

A Brief Primer on The Applicable Rules

Where the wrong is directed against a corporation, the claim belongs to the entity. The shareholder does not have an individual claim, even if the shareholder loses the value of his/her shares or incurs personal liability in an attempt to keep the corporation solvent. Abrams v. Donati, 66 N.Y.2d 951, 953 (1985); Serino v.  Lipper, 123 A.D.3d 34, 40 (1st Dept. 2014). “The distinction between derivative and direct claims is grounded upon the principle that a stockholder does not have an individual cause of action that derives from harm done to the corporation but may bring a direct claim when the wrongdoer has breached a duty owed directly to the shareholder which is independent of any duty owing to the corporation.” Accredited Aides Plus, Inc. v. Program Risk Mgmt., Inc., 147 A.D.3d 122, 132 (3d Dept. 2017) (citation and internal quotation marks omitted).

In determining whether a claim is direct or derivative, “a court must look to the nature of the wrong and to whom the relief should go.” Tooley v. Donaldson Lufkin & Jenrette, Inc., 845 A.D.2d 1031, 1038 (Del. 2004). Specifically, the court should consider “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually).” Yudell v. Gilbert, 99 A.D.3d 108, 114 (1st Dept. 2012) (internal quotation marks and citations omitted); Maldonado v. DiBre, 140 A.D.3d 1501, 1503-1504 (3d Dept. 2016).

“The pertinent inquiry is whether the thrust of the plaintiff’s action is to vindicate his [or her] personal rights as an individual and not as a stockholder on behalf of the corporation.” Maldonado, 140 A.D.3d at 1504 (internal quotation marks and citation omitted). The plaintiff must show that the duty allegedly breached was owed to the shareholder, and that he/she can prevail without showing an injury to the corporation. Yudell, 99 A.D.3d at 114. If the individual claim of harm is “confused with or embedded” within the harm to the corporation, then it must be dismissed. Serino, 123 A.D.3d at 40; Patterson v. Calogero, 150 A.D.3d 1131, 1133 (2d Dept. 2017) (even where individual harm is claimed, if it is confused with or embedded in the harm to corporation, it cannot stand separately).

Huldisch v. Mermelstein

Background

[Ed. Note: The factual discussion below is taken from the pleadings.]

Huldisch arose from a dispute over the investment in, and management of, the Jeffrey Stein Salon NYC East 78 Inc. (the “Salon”).

Plaintiffs’ Claims

Plaintiffs invested money in the Salon in 2016. At the time, the Salon was financially struggling, owing tens of thousands of dollars in rent arrears. Defendants purportedly needed Plaintiffs’ investment to pay the back rent. Plaintiffs alleged that to induce them to make the investment, Defendants made numerous misrepresentations and omissions concerning the financial condition of the Salon, actions that Defendants allegedly had taken regarding the renewal of the Salon’s lease, which was set to expire on April 30, 2018, and their commitment to servicing clients at the Salon in the future. Plaintiffs claimed that Defendants concealed material information about the Salon which Plaintiffs had expressly requested as part of their due diligence prior to making their investment including, among other things, that Defendants were taking cash from the company without reporting it on its books and records, purchasing product through the Salon that was used in other Stein salons (“Other Stein Salons”), and improperly running personal expenses through the Salon.

After Plaintiffs made their initial investment in the Salon, Defendants allegedly mismanaged the Salon and wasted its assets. Among other things, Defendants purportedly diverted clients from the Salon to the Other Stein Salons by, inter alia, falsely telling them (and employees) that the Salon was closing.

In May 2018, the Salon closed its doors.

Defendants’ Counterclaims

According to Defendants, Plaintiffs promised that they had the skill, experience and contacts to support the Salon and that they had additional staffing who had significant new clientele that would be brought into the business. Based upon these promises, among others, Defendants sold their shares in the Salon to Plaintiffs rather than to a third party that had made a higher offer for the shares.

Defendants maintained that Plaintiffs knew that those promises were false, and that Defendants were being misled by Plaintiffs.

Defendants claimed that despite the promises, and their reliance on those promises, Plaintiffs never hired any stylists with clients.

Moreover, Plaintiffs allegedly failed and refused to pay the full amount of the purchase price for the shares of stock in the business. Plaintiffs were supposed to pay an additional $70,000, which was needed for renovations and upgrades. Defendants alleged that Plaintiffs failed to pay the $70,000 balance due.

Finally, Defendants argued that Plaintiffs mismanaged the business for Plaintiffs’ benefit.

On September 7, 2018, Plaintiffs filed their complaint. On April 18, 2019, Defendants filed an answer and counterclaims. In their answer, Defendants sought relief for: (l) breach of contract (first counterclaim), (2) indemnification (second counterclaim),  (3) contribution (third counterclaim), (4) breach of contract (fourth counterclaim), (5) breach of fiduciary duty (fifth counterclaim), fraud (sixth counterclaim), and an accounting and judicial dissolution (seventh counterclaim).

Plaintiffs moved to dismiss all but the seventh counterclaim. The Court granted Plaintiff’s motion.

[Ed. Note: This Blog looks at the Court’s rulings concerning the breach of fiduciary duty and fraud counterclaims.]

The Court’s Decision

In dismissing the breach of fiduciary duty counterclaim, the Court held that the counterclaim asserted derivative, not direct, claims.

Defendants alleged that Plaintiffs mismanaged the Salon by, among other things, changing bank accounts, failing to pay Salon staff, failing to pay contractors, refusing to communicate with Defendants, causing checks to bounce, and hiring relatives that were incompetent. Without reaching the issue whether Plaintiffs breached their fiduciary duties, the Court held that the counterclaim should be dismissed because Defendants did not assert the claims derivatively. Slip Op. at *6.

In dismissing the fraud counterclaim, the Court held that Defendants failed to plead fraud with particularity under CPLR § 3016(b) and a misrepresentation of present fact that did not relate to future performance.

Defendants alleged that Plaintiffs made two misrepresentations: that Plaintiffs had the “skill, experience, and contacts to support the Salon”; and that Plaintiffs would bring in new staff with clients in the future.

To plead a cause of action for fraud, the plaintiff must allege that (1) the defendant made a material false representation, (2) which the defendant knew was false (3) the defendant intended to defraud the plaintiff thereby, (4) the plaintiff reasonably relied upon the representation, and (5) the plaintiff suffered damage as a result of such reliance. See Lama Holding Co. v. Smith Barney Inc., 88 N.Y.2d 413, 421 (1996).

A fraud claim cannot be based on statements that are promissory in nature and that relate to future performance. Elghanian v. Harvey, 249 A.D.2d 206, 206-07 (1st Dept. 1998). To be actionable, a fraud claim based upon a statement of future intention must allege facts that show the defendant, at the time the promise was made, never intended to honor or act on his/her statement. Lanzi v. Brooks, 54 A.D.2d 1057, 1058 (3d Dept. 1976). If the plaintiff can show that the promise was actually made with a preconceived and undisclosed intention of not performing it, the promise constitutes a misrepresentation of a material existing fact upon which an action for rescission may be predicated. White v. Davidson, 150 A.D.3d 610, 611 (1st Dept. 2017); see also Sabo v. Delman, 3 N.Y.2d 155, 160 (1957); Laduzinski v. Alvarez & Marsal Tax and LLC, 132 A.D.3d 164, 168-169 (1st Dept. 2015). Such misrepresentations are collateral to the agreement and can form the basis of a fraudulent inducement claim. White, 150 A.D.3d at 612; Laduzinski, 132 A.D.3d at 169.

With these principles in mind, the Court held that “Defendants fail[ed] to identify any statements made by the Plaintiffs that would constitute a material misrepresentation.” Slip Op. at * 7. In particular, the Court found the representation that Plaintiff had the “skill, experience, and contacts to support the Salon” to be insufficiently vague “to meet the heightened pleading standard for fraud.” Id.  The Court also found the representation that Plaintiffs would bring new staff and clientele to the Salon to be promissory in nature and, therefore, an insufficient basis for alleging fraud. Id. citing Tribune Print Co. v. 263 Ninth Ave. Realty, Inc., 88 A.D.2d 877, 879 (1st Dept. 1982).

Takeaway

Mismanagement or diversion of corporate assets is a wrong to the corporation. Abrams, 66 N.Y.2d at 952. As such, a lawsuit seeking to redress such harm must be brought derivatively. This is so even if the plaintiff has a direct claim that is embedded in the derivative claim. Yudell, 99 A.D.3d at 115. In Huldisch, the Court found that the wrongs complained of – mismanagement and diversion of assets – impacted the Salon, not Defendants in their individual capacities. Consequently, the Court dismissed the fiduciary duty counterclaim because it should have been asserted derivatively, not directly.

Huldisch also serves as a reminder that fraud must be pleaded with particularity and that a promise alleged to be false must be shown to have been made with a preconceived and undisclosed intention of not performing it. In the absence of such a showing, the promise will be deemed to be an inactionable promise of future performance, instead of a misrepresentation of a material existing fact upon which an action for fraud may be predicated.

Tagged with: Breach of Fiduciary Duty, Commercial Litigation And Business Litigation, Derivative Action, Fraud, Mismanagement, Misrepresentation Of Existing Fact, Promise Of Future Intention, Shareholder Litigation, Waste Of Corporate Assets