Fraud Notes: A Little of This. A Little of That

• Posted on: May 24 2021

As we have discussed in numerous posts, plaintiffs alleging breach of contract and fraud risk having the latter cause of action dismissed because it is duplicative of the former one. Plaintiffs can avoid this fate by alleging: a legal duty owed by the defendant that is separate and apart from the duty to perform under the contract or a duty that is collateral or extraneous to the contract; and damages that are different from the contract damages. In Principia Partners LLC v. Swap Fin. Grp., LLC, 2021 N.Y. Slip Op. 03267 (1st Dept. May 20, 2021) (here), the Appellate Division, First Department affirmed the dismissal of a fraud claim because it duplicated the contract cause of action alleged by plaintiff. 

In addition to the duplication of claims doctrine, we have discussed the particularity requirement under CPLR § 3016(b) and the need to satisfy this requirement with respect to each element of a fraud claim. One element that is often litigated is scienter – that is, an intent to deceive. Plaintiffs run afoul of the pleading requirements for scienter by engaging in group pleading – i.e., the practice of grouping multiple defendants together in a complaint when they are alleged to have collectively committed the wrong complained of. [This Blog wrote about the group pleading doctrine here.] 

In U.S. Tsubaki Holdings, Inc. v. Estes, 2021 N.Y. Slip Op. 03273 (1st Dept. May 20, 2021) (here),although the plaintiffs relied on the group pleading doctrine, the First Department reversed the dismissal of their fraud claims because, among other things, the plaintiffs provided sufficient particularity of the fraud, in addition to the pervasiveness of the alleged misconduct, necessary to infer scienter as to each defendant. The case also concerned the justifiable reliance element of a fraud cause of action and the duplication of claims doctrine, which the Court held did not apply to the claims asserted.

We examine both decisions below.

Principia Partners LLC v. Swap Financial Group, LLC

Principia Partners involved a contract between plaintiff, Principia Partners LLC (“PPP”), and defendant, SWAP Financial Group, LLC (“SFG”), pursuant to which PPP agreed to provide SFG with access to PAS (a program for portfolio analysis and risk management), PPP’s proprietary software for use in valuing swaps. In return for access to PAS, SFG agreed to (i) pay both a minimum quarterly fee, a portion of qualifying revenue from its use of PAS, and interest on late payments, (ii) provide quarterly reports, certified for accuracy, of its qualifying revenue (“Quarterly Reports”), and (iii) allow PPP to audit SFG to verify the accuracy of its reports. 

PPP alleged that it fully performed under the Agreement. Until the end of 2017, PPP believed that SFG was performing too. SFG submitted Quarterly Reports throughout the contractual period that it certified for accuracy, and it made regular payments to PPP. However, in 2017, PPP discovered that SFG had clients that were not being reported to PPP, as SFG’s website referred to customers that SFG had never included in its Quarterly Reports. PPP investigated the discrepancy and found evidence that SFG’s Quarterly Reports were allegedly fraudulent in that certain SFG customers who had used PAS were not included in the Quarterly Reports. PPP asserted a pattern of SFG underreporting revenue since 2005. 

On February 1, 2018, PPP contacted SFG to address the inconsistencies it had found in the Quarterly Reports. In its February 22, 2018 response, SFG admitted to omitting some clients from the Quarterly Reports. However, SFG also allegedly made numerous material misstatements to PPP. For example, according to PPP, SFG falsely stated that it did not provide valuation reports to certain of its customers when, in fact, it did and SFG misrepresented the time frames in which valuation reports were actually provided to certain customers. In addition, SFG allegedly represented to PPP that it exclusively used a non-party valuation and pricing service instead of PAS for many transactions; however, that too was allegedly false. SFG also knowingly misrepresented to PPP that it “always paid its bills,” which PPP alleged was materially false. 

PPP requested an audit, as provided by the Agreement. However, according to PPP, SFG delayed for months and ultimately refused to allow an audit, at which point PPP terminated the Agreement. 

PPP filed the action, alleging breach of contract (Counts I and II), fraud and fraudulent inducement (Count III), unjust enrichment (Count IV), and aiding and abetting fraud (Count V).

The motion court dismissed the fraud and aiding and abetting fraud causes of action (here). With regard to one of the defendants, the motion court found that the alleged misrepresentations were “not collateral or extraneous to the Agreement but rather directly flow[ed] from the Agreement.” 

With regard to another defendant, the motion court found that PPP failed to plead scienter. The motion court explained that the inference of scienter was insufficient to support the fraud claim because the facts alleged concerned the participation of one of the defendants in the management of SFG without more: “[a]lthough PPP offers many facts, it fails to offer particularized facts to show that Syncora both completely dominated SFG and did so for the purpose of committing the alleged fraud.”

Finally, the motion court held that the fraud claims duplicated the contract claim. 

First, the motion court found that there was no duty independent of the contract: “The Quarterly Reports were a contractual requirement. It was therefore a breach of the contract for the Quarterly Reports, and thus the Quarterly Revenue Fees, to allegedly be inaccurate.”

Second, the motion court found that the damages sought by the fraud cause of action were speculative and not pleaded with particularity. In that regard, PPP alleged that it “lost key market opportunities”, sustained “reputational harm because customers and competitors [had] become aware that one of PPP’s major clients was stealing millions of dollars of earnings through a scheme” and suffered a “diminution in the esteem in which the PAS system ha[d] been held in the industry.” Under New York law, damages are not pleaded with particularity if the plaintiff fails to allege the causal connection between the tort and the harm. Thus, the plaintiff must plead (i) the precise harm, (ii) the cause, and (iii) specifically connect the two (Morrison v. National Broadcasting Co., 19 N.Y.2d 453, 458 (1967), especially where reputational harm is alleged (Rather v. CBS Corp., 68 A.D.3d 49 (1st Dept. 2009), lv. to appeal denied, 13 N.Y.3d 715 (2010)). The motion court concluded that “PPP fail[ed] to allege one fact to support its assertion of actual damages to its reputation.”

On appeal, the First Department unanimously affirmed the dismissal. The Court held that “[t]he fraud causes of action … were properly dismissed as duplicative of the breach of contract claim.” Slip Op. at *1 (citing Matter of Daesang Corp. v. NutraSweet Co., 167 A.D.3d 1, 18 (1st Dept. 2018)). The Court explained that the “complaint failed to allege a legal duty to plaintiff separate and apart from the duty to perform under the contract or that a fraudulent misrepresentation was collateral or extraneous to the contract,” and that “plaintiff sought only contract damages.” Id. 

U.S. Tsubaki Holdings, Inc. v. Estes

U.S. Tsubaki arose from the sale of Central Conveyor Company, LLC (“Central Conveyor”) to U.S. Tsubaki Holdings, Inc. (“USTH”) by Central Conveyor’s executives and NS CCC Acquisition LLC (“NSCC”), the majority shareholder of Central Conveyor, pursuant to Purchase and Sale Agreement (“PSA”). 

In 2017, NS CCC and two affiliates, New State Capital Partners LLC (“New State Capital”) and New State Management LLC (“New State Management”), began the process of selling Central Conveyor via an auction. USTH participated in this auction process.

In conjunction with the auction process, Defendants provided several sales presentations, and touted Central Conveyor as possessing a large, loyal client base, strong customer relations, talented employees, strong growth and high revenue projections. Plaintiffs claimed that defendants’ presentations affirmatively misrepresented the true nature of Central Conveyor’s customer relations, employees, and sales projections. 

According to Plaintiffs, the presentations did not reveal that Central Conveyor’s “employees and independent contractors were being incentivized through compensation structured in ways that violated tax laws as well as union and pension obligations.” Nor did the presentations allegedly disclose that Central Conveyor’s “strong culture” was “one of corruption, including rampant expense fraud, time card fraud, schemes to avoid union and pension obligations, and other misconduct that depended on dramatically flawed, and arguably nonexistent, internal control systems and unethical leadership,” and that the historical revenue and other information in its financial statements “were predicated on widespread unlawful and unethical business practices.”

Although New State allowed potential bidders to access electronic documentation via a “virtual data room” to conduct due diligence on Central Conveyor’s financial status and the nature of its operations, the documents were allegedly doctored and the information misrepresented and concealed. The true nature of Central Conveyor’s operations, Plaintiffs claimed, were peculiarly within defendants’ knowledge. 

USTH extended a $140 million bid to purchase Central Conveyor, which the Sellers accepted in 2018. 

In conjunction with the PSA, the Sellers provided USTH with a Disclosure Schedule “in which they purported to provide an accounting” of Central Conveyor’s material agreements, disclosure of Central Conveyor’s noncompliance with applicable laws and legal disputes or proceedings, audited historical financial statements covering fiscal years 2015 through 2017, and other financial and operational information.

At closing, the Sellers delivered a Closing Certificate, which certified that their representations and warranties in the PSA remained “true and correct”. Plaintiffs claimed that Central Conveyor’s financial and operational conditions at the time of the auction and sale were different than represented by the Seller defendants. According to plaintiffs, since the closing, there was widespread misconduct within Central Conveyor that defendants allegedly concealed during the acquisition process. Such concealed information and false representations allegedly included that: (i) Central Conveyor regularly paid kickbacks to customers and their employees in exchange for customer contracts; (ii) the historical financial statements were materially affected by the widespread unethical and unlawful practices; (iii) the revenue projections provided were grossly overstated; (iv) Work-in-Progress Schedules were doctored to overstate project profitability; and (v) Central Conveyor was subject to an audit by the Canada Revenue Agency. Plaintiffs alleged “on information and belief” that defendants “knew or were reckless with regard to the fact that” Central Conveyor “had this ongoing audit and exposure to tax liability at the time of Closing”.

Additionally, Plaintiffs alleged that (i) defendants caused Central Conveyor to repeatedly underreport its tax liability; (ii) Central Conveyor employees, including Kevin Estes and Jeffrey DeBrabander, regularly used company credit cards for personal use; and (iii) Central Conveyor employees, including Kevin Estes, Jeffrey DeBrabander, and Christopher Estes, engaged in widespread abuses in personal timesheet reporting. 

Plaintiffs further alleged that Central Conveyor “historically engaged in certain unlawful and/or contract-breaching employment practices”, including offering an alternative payment scheme (“Cash Option”) to certain union employees which involved underreporting employee hours and compensation to the labor union to avoid union fees, in violation of collective bargaining agreements. Plaintiffs claimed “[o]n information and belief” that “Defendants had knowledge or else were reckless in failing to learn of the Company’s practice of offering the Cash Option”, and “were directly involved in orchestrating the use of this practice or had a managerial role over the Company that should have necessarily given rise to knowledge of this widespread practice.”

“Given the foregoing activities,” Plaintiffs alleged that the Seller defendants breached various representations and warranties in the PSA. 

In their amended complaint, Plaintiffs asserted 18 causes of action, with USTH asserting 11, Central Conveyor asserting six, and USTH and Central Conveyor jointly asserting one. Defendants moved to dismiss. 

With regard to the fraud causes of action, the motion court granted the motion.

First, said the motion court, “the amended complaint failed to meet the heightened pleading standard of CPLR 3016(b).” The court explained that the “amended complaint ‘did not attribute specific misrepresentations or wrongdoing’ to a particular defendant ‘but, rather, impermissibly lumped’ the defendants together.” (Citations omitted.) Such group pleading doomed the pleading because “[f]raud must be claimed with specificity ‘as to each individual defendant’ which the amended complaint fail[ed] to do.” (Citation omitted.)

Second, explained the motion court, “the allegations [were] impermissibly made on information and belief.” Such statements said the court, were “‘not sufficient to establish the necessary quantum of proof to sustain allegations of fraud.’” (Quoting Facebook, Inc. v. DLA Piper LLP (US), 134 A.D.3d 610, 615 (1st Dept. 2015)). 

Third, noted the motion court, “the amended complaint fail[ed] to satisfy the pleading requirements of CPLR 3016(b) as to the elements of scienter and knowledge.” The court held that the scienter allegations were “conclusory and factually insufficient.” (Quoting Facebook Inc., 134 A.D.3d at 615). 

The motion court also found the justifiable reliance allegations to be lacking. The court rejected Plaintiffs’ argument that they satisfied this element by pleading “special facts” that were within Defendants’ knowledge. The motion court said that the “mere disparity of knowledge between sophisticated business entities [did] not trigger a duty to disclose.” (Citations omitted.) Also, the motion court noted that Plaintiffs had “acknowledge[d] [that] they had access to Central Conveyors books, records and personnel and the opportunity to conduct due diligence prior to the closing.” Such access negated the “special facts” exception, ruled the motion court.

The motion court also found the fraud claim against the Seller Defendants to be duplicative of the breach of contract claim. The court explained that Plaintiffs failed to allege any misrepresentation that was extraneous to the terms of the parties’ contract. (Citing HSH Norbank AG v. UBS AG, 95 A.D.3d 185 (1st Dept. 2012). 

Finally, the motion court held that Plaintiffs failed to state a cause of action against New State Capital and New State Management “neither of which was a party to the alleged fraudulent representations.” “Other than generalized and conclusory allegations, alleged by category of lumped together defendants”, the motion court found that “USTH fail[ed] to allege the requisite facts so as to state causes of action in fraud against these two defendants.” The motion court explained that “there [were] no particularized factual allegation as to a misrepresentation made by these two non-signatories of the PSA at any stage of the transaction.” Similarly, noted the motion court, “[t]he amended complaint … lack[ed] a particularized factual allegation as to the elements of scienter, knowledge of the alleged misconduct by other defendants, and the existence of a duty.” Further, noted the motion court, Plaintiffs failed to allege the “circumstances under which these elements [could] be inferred.”

On appeal, the First Department unanimously reversed the dismissal.

As an initial matter, the Court held that Plaintiffs satisfied the particularity requirement of CPLR § 3016(b), notwithstanding the use of group pleading. Slip Op. at *1. The Court explained that the degree of detail alleged, and the pervasiveness of the alleged fraud, permitted a reasonable inference that each of the defendants named actually knew of defendants’ alleged fraud. Id. (“given the complaint’s concrete allegations, plaintiffs’ grouped allegations are largely superfluous, since knowledge of the fraud can be inferred from the detailed allegations of its pervasiveness.” (citing AIG Fin. Prods. Corp. v. ICP Asset Mgt., LLC, 108 A.D.3d 444, 446 (1st Dept. 2013)).

The Court also held that “Plaintiffs’ fraud claims [were] not duplicative of their contract claim.” Slip Op. at *2. The Court explained that “Plaintiffs allege[d] misrepresentation[s] of numerous present facts, in the form of defendants’ alleged breaches of [the PSA’s] representations and warranties.” Id. These included that: the Company’s accounting was accurate; the Company was in compliance with employment laws; and the Company had disclosed all audits and material contracts. Id. 

“Moreover,” noted the Court, “the fraud claims [were] asserted against a distinct set of defendants from the contract claims.” Id. In this regard, the Court was referring to the Non-Seller Defendants, who were not parties to the PSA. Because they were not signatories to the PSA, Plaintiffs did not sue them for breach of contract. Accordingly, the Court concluded that the fraud claim against them could not be duplicative of the contract claim against the other defendants.

Finally, the Court noted that because “the PSA specifically gave plaintiff U.S. Tsubaki Holdings, Inc., the right to sue for fraud”, the “PSA [could not] be said to bar (as duplicative) a cause of action which the PSA itself guarantees.” Id.