The Distinction Between A Direct and Derivative Claim Proves to Be Elusive for Part Owner of Asset Management and Advisory Services Company

• Posted on: Jun 13 2018

This Blog has previously written about the difficulties plaintiffs often have distinguishing between direct and derivative claims. (Here and here.) In today’s post, this Blog looks at Khan v. Garg, 2018 N.Y. Slip Op. 31061(U) (Sup. Ct. N.Y. County, May 30, 2018) (here). In Khan, the court dismissed a fraud claim because the plaintiff failed to demonstrate whether the claim belonged to the plaintiff or his 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 or 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).

Khan v. Garg

In Khan, the Plaintiff, Raza Khan (“Plaintiff” or “Khan”), alleged that his business partner, Vishal Garg (“Defendant” or “Garg”), misappropriated funds from their business, Education Investment Finance Corporation (“EIFC”).  According to Khan, Garg did so on two occasions.

First, in early 2012, Garg allegedly falsified EIFC’s records to reflect that EIFC owed Garg approximately $1.6 million for capital contributions that Garg had not made. Khan asserted that Garg then misappropriated EIFC funds and transferred those funds into Garg’s personal bank account.

Second, in early May 2013, Garg allegedly withdrew $1,067,000 from EIFC accounts to satisfy his “pro-rata share of [EIFC’s] excess capital.” Khan alleged that Garg’s “pro-rata share of excess capital” was an illusion created by Garg’s manipulation of EIFC records to reflect the absence of capital contributions to EIFC by Khan.

Khan brought suit “individually, in his official capacity as 50% owner of, and on behalf of [EIFC,]” against Garg. Khan alleged: (1) deadlock as to EIFC; (2) breach of fiduciary duty as to Garg; (3) conversion of EIFC assets by Garg; (4) fraud “by Garg” for falsifying EIFC’s financial records/tax returns to benefit Garg and entities owned/controlled by Garg; (5) tortious interference by Garg and Capital; (6) Garg’s failure to execute corporate documents on behalf of a non-party EIFC subsidiary; (7) conversion of EIFC funds by Garg to a MRU Lending (“MRU”), a company owned solely by Garg; (8) unjust enrichment against Garg as a result of EIFC payments to MRU; and (9) accounting.

Garg moved, pursuant to CPLR 3211 (a) (7), to dismiss the fraud cause of action, arguing that Khan failed to plead the elements of intent, reliance, and injury.

The Court granted the motion.

As an initial matter, the Court observed that Khan failed to “specify whether the fraud claim is direct or derivative,” though the allegations in the complaint “indicate[d] that [Khan] intended [the claim] to be direct.”

In analyzing the allegations in the complaint, the Court found that Khan failed to “allege that he sustained any harm separate from that sustained by EIFC.”

Here, the allegations supporting Khan’s fraud claim confuse Khan’s direct and derivative rights; therefore, the claim must be dismissed. Khan alleges that Garg intentionally induced Khan to rely on the EIFC financial records falsified by Garg, and those records made it appear that EIFC owed Garg $1.6 million. Thus, though Khan seeks to plead a direct claim for fraud, there is no individual harm alleged in the amended complaint: Khan does not allege that he sustained any harm separate from that sustained by EIFC.

Derivatively, the Court found that Khan failed to satisfy the elements of a fraud claim:

Construed as a purely derivative fraud claim, dismissal is still required. Khan does not adequately allege that Garg made a misrepresentation of fact (falsified EIFC’s records) with the intent of inducing EIFC’s reliance; instead, the allegations pertaining to Garg’s intent to induce reliance, and the resulting reliance on Garg’s misrepresentations, are assertions pertaining to Khan in his individual capacity. The amended complaint does not adequately plead a derivative fraud claim; indeed, Khan alleges that EIFC was the vehicle by which Garg defrauded Khan, individually, not EIFC in general. [Citations to complaint omitted.]

As a result, the Court dismissed the fraud claim.

Takeaway

The difference between a direct and derivative claim is not always easy to discern. For many practitioners, even those who devote most of their practice litigating derivative claims, the distinction between the two types of claims can be elusive. Nuance and subtlety often rule the day, leading to confusion and uncertainty. As Khan learned, the consequences of such confusion can (and often will) result in dismissal of one’s claims.

Tagged with: and Business Litigation, Business Divorce, Derivative Litigation, Fraud, Shareholder Litigation