Fraud by Omission

• Posted on: Jan 13 2021

When a person claims fraud, he/she typically claims that the alleged wrongdoer made an affirmative misrepresentation of fact. Fraud does not, however, always concern an affirmative statement. Sometimes a person can perpetrate a fraud through the omission of a material fact. For this reason, when alleging fraud, a plaintiff may allege that the defendant made “a misrepresentation or a material omission of fact which was false and known to be false.” Mandarin Trading Ltd. v. Wildenstein, 16 N.Y.3d 173, 178 (2011) (internal quotation marks and citation omitted); Lama Holding Co. v Smith Barney, 88 N.Y.2d 413, 421 (1996).

Where fraud by omission is claimed, the plaintiff must allege that the defendant “had special knowledge or information regarding” the transaction “that [was] not ascertainable by the plaintiff[].”Williams v. Sidley Austin Brown & Wood, L.L.P., 38 A.D.3d 219, 220 (1st Dept. 2007); Selechnik v. Law Off. of Howard R. Birnbach, 82 A.D.3d 1077, 1078-1079 (2d Dept. 2011). A fraud by omission claim is not sustainable where information allegedly withheld is ascertainable through publicly available sources. Northern Group Inc. v. Merrill Lynch, Pierce, Fenner & Smith Inc., 135 A.D.3d 414 (1st Dept. 2016). Moreover, as in a fraud by misrepresentation case, the plaintiff must satisfy the other elements of the claim – namely, intent to defraud, justifiable reliance and injury. 

[Ed. Note: we previously wrote about fraud by omission, or fraudulent concealment, here.]

In Johnson v. Asberry, 2021 N.Y. Slip Op. 00120 (1st Dept. Jan. 12, 2021), the Appellate Division, First Department affirmed the denial of a motion to dismiss a fraud by omission claim, holding that the plaintiff adequately alleged the cause of action with the requisite specificity.

Johnson v. Asberry

Background

Johnson involved a dispute between a minority shareholder, Melissa Johnson (“Johnson”), and Tiffany Asberry, the majority shareholder of Johnson & Asberry Communications, LLC (“J&A”). Johnson alleged that Asberry mismanaged and wasted company assets and executed a freeze-out merger with defendant, Asberry Holding Company, LLC (“AHC”), a limited liability company that Asberry solely owned, to eliminate Johnson’s minority interest.

In 2011, Johnson and Asberry formed J&A to provide public relations services for government-related projects as a subcontractor to prime contractors working for city agencies. Johnson and Asberry initially made equal capital contributions to J&A and intended to jointly and co-equally manage and own the entity. However, Johnson and Asberry subsequently decided to split their membership shares, 51% to Asberry and 49% to Johnson, for the purpose of obtaining certifications from New York City as a “Minority Owned Business Enterprise”.

In connection with the formation of J&A, Johnson and Asberry entered into an operating agreement (“Original Operating Agreement”) and were elected under the agreement to operate the company “as co-equal Managers.” Notwithstanding their co-equal ownership, Johnson maintained that she performed most of the client and administrative work for J&A and that Asberry failed to maintain timesheets and to devote any substantial time to J&A. 

In or around July 2017, Johnson sought to buyout Asberry’s interest in J&A due to, inter alia, Asberry’s alleged use of J&A funds for personal expenses, the alleged failure to perform services, and the alleged failure to maintain timesheets. Asberry rejected the offer.

On May 31, 2018, Asberry emailed Johnson a “written consent in lieu of meeting,” which Asberry signed in her sole capacity appointing herself as sole manager of J&A and substituting a New Operating Agreement, bearing the same date, which Asberry signed in her sole capacity as “Co-Founder” and “Majority in Interest Member”. The New Operating Agreement did not reference the original agreement.

Johnson alleged that she did not consent to amending the Original Operating Agreement and that the New Operating Agreement altered the method of calculating J&A’s income and distributions in a manner that adversely affected her, in violation of Section 417(b) of the Limited Liability Company Law. Section 417(b) of the Limited Liability Company Law prohibits the amendment of an operating agreement that changes the manner of computing distributions of any member without the written consent of each member adversely affected. Additionally, Johnson alleged that on May 31, 2018, Asberry improperly withdrew money from J&A’s bank account without authorization and opened a new J&A account naming herself as the sole signatory.

Johnson further alleged that on June 11, 2018, Asberry sent her: (1) an exchange agreement between AHC and Asberry in which Asberry transferred her interest in J&A for a 100% membership interest in AHC (without prior notice to Johnson and without offering Johnson the right to purchase such interest in violation of the Original Operating Agreement); (2) an agreement and plan of merger between defendant AHC and J&A; (3) a “notice of action in lieu of meeting,” a “notice of merger,” and a “notice of dissenters’ rights”; (4) a “written consent of the majority in interest” of J&A, authorizing the merger of AHC and J&A; and (5) an “agreement and plan of merger” between AHC and J&A.

On June 27, 2018, Johnson commenced the action, asserting causes of action for: (1) injunctive relief for breach of the Original Operating Agreement and the Limited Liability Company Law; (2) declaratory judgment that the Original Operating Agreement remained in full force and effect, and the purported merger was of no effect; (3) specific performance of the Original Operating Agreement; (4) imposition of a constructive trust upon the membership interests of J&A; (5) an accounting; (6) breach of fiduciary duty, waste, mismanagement, and self-dealing; (7) fraud; and (8) conversion.

Defendants moved to dismiss, claiming, inter alia, that the complaint failed to plead a cause of action for fraud. 

The motion court denied the motion, holding that although plaintiff did not identify any affirmative misrepresentation, she did allege a fraud by omission. The motion court explained that, as alleged, “Asberry did not inform Johnson that she intended to appoint herself the sole manager of J&A; that she intended to and purportedly adopted a new operating agreement for J&A in violation of the law; that she transferred her entire interest in J&A to AHC; and that she executed a merger between J&A and AHC, which effectively froze Johnson out of J & A.” “These allegations,” said the motion court, “constitute[d] material omissions by Asberry, who worked independently of Johnson and sought to conceal her activities.” Thus, concluded the motion court, plaintiff “sufficiently state[d] a fraud cause of action through allegations which give rise to permissible inferences that Asberry had certain knowledge or information regarding the management of J&A and her activities thereunder, as co-manager, which Johnson was unable to ascertain.” 

The motion court noted that the fraud claim was not based on breaches of the Operating Agreement, nor was it based on a fraudulent inducement to enter into the Operating Agreement: “Contrary to Asberry’s contentions, the fraud alleged is not that Asberry failed to perform under the Original Operating Agreement. Rather, it is based on Asberry’s material omissions as to her intent and actions to amend the operating agreement to cause a merger of J&A with her own company, and then freeze Johnson out of the business.” 

Defendant appealed.

The Court’s Decision

The First Department affirmed the motion court’s order, holding that “plaintiff ha[d] adequately pleaded a claim for fraud by omission”: 

Asberry conceived of and executed a scheme to eliminate plaintiff’s interest in J&A. Asberry failed to disclose this scheme to plaintiff despite her fiduciary duty, as LLC manager and majority member, to inform plaintiff of her intentions. Plaintiff justifiably relied on Asberry’s silence to her detriment (in losing all of her interest in the company). 

Slip Op. at *1 (citations omitted).

Takeaway

Where a party alleges fraud (or fraudulent inducement) based on an omission of information, rather than an affirmative misrepresentation, a special relationship (e.g., a fiduciary relationship) is required to state a claim. However, in the absence of a special relationship, a party may still properly allege fraud where there are special facts such that one party had superior knowledge of certain information, not readily available to the other party. See P.T. Bank Central Asia v. ABN AMRO Bank N.V., 301 A.D.2d 373 (1st Dept. 2003) (citing cases). 

In Johnson, a fiduciary relationship existed between Johnson and Asberry such that the latter “had special knowledge or information regarding” the alleged scheme to eliminate the former’s interest in J&A, which was “not ascertainable by the plaintiff[].” Williams, 38 A.D.3d at 220.