Fraud Notes: Accounting Fraud, Scienter, Justifiable Reliance and the Statute of Limitations – A Potpourri of Fraud Allegations

• Posted on: May 27 2021

In today’s Fraud Notes, we examine Bullen v. CohnReznick, LLP (1st Dept. May 27, 2021) (here), and Sabourin v. Chodos, (1st Dept. May 27, 2021) (here), both decided by the Appellate Division, First Department.

Bullen involved an alleged fraud in which CohnReznick was accused of being a participant through the issuance of audit reports that gave the entities being audited a clean bill of health – i.e., the financial statements presented fairly, in all material respects, the financial position of the entities being audited. The primary issues addressed by the courts in Bullen concerned scienter and justifiable reliance.

Sabourin involved an alleged fraud that took place more than six years ago. The primary issues addressed by the courts concerned the application of the statute of limitations and the continuing wrong doctrine.

We examine both cases below.

[Ed. Note: The background discussion for each case comes from, inter alia, the motion court decision, the appellate court briefing and/or the First Department’s decision.]

Bullen v. CohnReznick, LLP

Bullen was brought by a group of 49 sophisticated investors (comprised of individuals, retirement plans, trusts, limited liability companies, and corporations) who claimed they were defrauded by the managers of a high-risk hedge fund in which they collectively invested $63 million. Plaintiffs sued CohnReznick, LLP, the independent auditor of Platinum Partners Credit Opportunities Fund, L.P. (“PPCO”) and Platinum Partners Value Arbitrage Fund, L.P. (“PPVA”) (collectively, the “Funds”), for its role in the alleged fraud.

CohnReznick audited the Funds’ financials statements in the years immediately preceding the Funds’ collapse and issued unqualified audit reports (the “Audit Reports”) that the Funds’ financial statements presented fairly, in all material respects, the financial position of the Funds.

Plaintiffs claimed that CohnReznick issued the Audit Reports with knowledge of missing material documentation and questionable transactions, which confirmed that PPCO’s assets were grossly overvalued. According to plaintiffs, CohnReznick knew that, for years, Platinum Management (“Platinum”) propped up the Funds with unsupported and fraudulent asset valuations, commingled investor funds, engaged in illicit related-party transactions, and booked improper inter-company loans. Plaintiffs allegedly relied on the Audit Reports to their detriment, investing over $63 million in PPCO.

In their complaint, plaintiffs asserted claims of: (1) fraud; (2) aiding and abetting fraud; and (3) aiding and abetting breach of fiduciary duty. Defendant moved to dismiss. The motion court (Ostrager, J.) denied the motion (here).

First, the motion court held that plaintiffs pleaded fraud with particularity as required under CPLR § 3016(b). The motion court found that CohnReznick disregarded numerous “red flags” that allowed a reasonable inference of the auditor’s “egregious refusal to see the obvious, or to investigate the doubtful”.

Such “red flags” included:

• CohnReznick’s “access to a substantial amount of information.” (“[M]any of the suspect activities noted by plaintiffs and the [r]eceiver directly related to documentation available to CohnReznick.”)
• Information in an affidavit from the court-appointed receiver in which she averred that PPCO’s assets were overvalued “by over 300%”, that there were loans between PPCO and PPVA, and that Platinum engaged in related-party transactions.
• Platinum’s actions to ease PPVA’s liquidity crisis and the commingling of investor funds: (“Indeed, one can reasonably infer scienter from even the single item that Platinum repeatedly effectuated improper cash transfers, booked as loans, between PPCO and PPVA that were used to ease PPVA’s liquidity crisis and were paid back, in part, with distressed debt and private equity of little to no value. These transfers were presumably reflected in PPCO’s financial statements, which CohnReznick improperly certified as presenting ‘fairly, in all material respects, the financial position of [PPCO].’ The commingling of investor funds among the various Platinum Funds was another glaring red flag supporting the inference of scienter.”)

In addition to the “red flag” allegations, the motion court also considered plaintiffs’ allegations that CohnReznick violated Generally Accepted Accounting Principles (“GAAP”) and Generally Accepted Auditing Standards (“GAAS”). When considered together, the motion court held that plaintiffs pleaded enough facts to raise a reasonable inference that CohnReznick acted with scienter.

Second, the motion court held that plaintiffs alleged that CohnReznick had actual knowledge of Platinum’s fraud and breaches of fiduciary duty. According to plaintiffs, CohnReznick knew by early 2015 – before CohnReznick issued the 2014 Audit Reports for both PPCO and PPVA – that PPVA’s then-auditor had discovered a “material weakness” in the way Platinum valued its Level 3 assets (which comprised nearly all the Funds’ holdings). Despite such knowledge, CohnReznick implemented no additional auditing procedures for PPCO and issued a clean Audit Report for the fund. The motion court found that these allegations sufficed to allege actual knowledge of the alleged fraud.

Third, the motion court held that plaintiffs sufficiently pleaded that CohnReznick substantially assisted Platinum’s fraud and breaches of fiduciary duty with the required specificity.

Fourth, the motion court held that plaintiffs justifiably relied on the Audit Reports in deciding to invest in PPCO. According to the motion court, plaintiffs “were entitled to rely on the information in the [Audit] Reports as being factually correct and to use those facts to make their own investment decisions.” The motion court noted that “many investors spoke with CohnReznick’s managing partner about their investments” in an effort to make informed decisions about whether to invest in the Funds.

Finally, the motion court rejected CohnReznick’s argument that plaintiffs merely claimed that they were induced “to continue to hold securities”, which, under New York law, is not actionable. The motion court explained that plaintiffs invested in PPCO “in the first instance in reliance on the Audit Reports, and not merely to maintain or ‘hold’ the investment.”

On appeal, the First Department unanimously affirmed.

First, the Court held that the motion court correctly found that plaintiffs pleaded scienter with the requisite particularity. The Court found that “the ‘[a]llegations of “red flags,” when coupled with allegations of GAAP and GAAS violations, [were] sufficient to support a strong inference of scienter.’” Slip Op. at *1 (quoting In re Bear Stearns Cos., Inc. Securities, Derivative & ERISA Litig., 763 F. Supp. 2d 423, 511 (S.D.N.Y. 2011)). See also State St. Trust Co. v. Ernst, 278 N.Y. 104, 112 (1938).

Second, the Court held that plaintiffs adequately pleaded justifiable reliance. The Court explained that plaintiffs “‘took reasonable steps to protect [themselves] against deception by’ having their advisor ‘examin[e] available financial information to ascertain the true nature of’ the investment fund’s asset valuation, including contacting defendant about the results of its audits, which were ‘matters peculiarly within the [defendant’s] knowledge.’” Slip Op. at *2 (quoting IKB Intl. S.A. v. Morgan Stanley, 142 A.D.3d 447, 448-49 (1st Dept. 2016)). In any event, the Court noted that “‘reasonable reliance is not generally a question to be resolved as a matter of law on a motion to dismiss.’” Id. (quoting ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1045 (2015)). The Court said that the “same [was] true for the aiding and abetting fraud claim, to the extent that it may require a showing of reasonable reliance.” Id. (citing Bankers Conseco Life Ins. Co. v. KPMG LLP, 189 A.D.3d 402, 403 (1st Dept. 2020)).

Third, as to the aiding and abetting fraud claim, the Court held that the “complaint sufficiently alleged ‘actual knowledge’ of the investment fund manager’s fraud, which ‘need only be pleaded generally.’” Slip Op. at *2 (quoting Oster v. Kirschner, 77 A.D.3d 51, 55 (1st Dept. 2010)).

[Ed. Note: to plead aiding and abetting, a plaintiff must allege the existence of the underlying fraud, actual knowledge, and substantial assistance. Oster, 77 A.D.3d at 55.]

The Court explained that the “timing of defendant’s alleged receipt of information from the prior auditor of a related fund indicating a material weakness in the process of asset valuation, as well as defendant’s multiple years of auditing the fund’s financial statements, allow[ed] for the inference that defendant ‘willingly turned a blind eye to evidence’ that the fund’s asset valuations were fraudulent with no documentation supporting them.” Slip Op. at *2 (quoting AIG Fin. Prods. Corp. v. ICP Asset Mgt., LLC, 108 A.D.3d 444, 446 (1st Dept. 2013)); see also Weinberg v. Mendelow, 113 A.D.3d 485, 488 (1st Dept. 2014).

The Court noted that the complaint also “sufficiently alleged, inter alia, that defendant ‘ignored irregularities’ in the fund’s ‘books and records,’ which, if reviewed, would have uncovered the fraud.” Slip Op. at *2-*3 (quoting Weinberg, 113 A.D.3d at 488).

As to the claim for aiding and abetting breach of fiduciary duties, the Court found that the complaint “sufficiently alleged defendant’s actual knowledge of the fund manager’s improper related-party transactions and unauthorized loans to the related fund, given defendant’s access to the fund’s financial information, as well as defendant’s ‘strong financial motive’ to aid the fund manager, given its allegedly inflated fees.” Slip Op. at *3 (citations omitted).

The Court rejected defendant’s argument that it owed no duty to plaintiffs: “‘There are allegations not only that defendant fail[ed] to act when required to do so,’ but also that defendant ‘affirmatively assist[ed]’ the fund manager to convince one investor plaintiff to invest additional capital, which obviates any need for plaintiffs to allege that ‘defendant owe[d] a fiduciary duty directly to’ them.” Id. (quoting Kaufman v. Cohen, 307 AD2d 113, 126 (1st Dept. 2003) (citation omitted).

Finally, the Court agreed with the motion court that plaintiffs did not merely allege inactionable holder claims. The Court explained that plaintiffs did “not seek ‘recovery for the loss of the value that might have been realized in a hypothetical market exchange that never took place,’ but instead assert[ed] ‘an out-of-pocket loss, specifically, the loss of their investment.’” Slip Op. at *3 (citations omitted).

Sabourin v. Chodos

Sabourin involved an intricate and complex fraud perpetrated by defendant Adam Chodos, an attorney, in concert with his client, William Frost, to divest plaintiffs of their media company and its value.

After an arbitration held in 2013-2014, plaintiffs were awarded $56.4 million against Frost. According to plaintiffs, it was only as a result of the documents presented and testimony adduced during the arbitration that they came to learn that defendant was not merely Frost’s lawyer, but also a knowing and indispensable participant in the fraud.

Consequently, in February 2015, plaintiffs commenced the action against defendant Chodos, alleging fraud, aiding and abetting fraud, unjust enrichment, aiding and abetting breach of fiduciary duty, civil conspiracy to commit conversion, and tortious interference with economic advantage.

Defendant moved for summary judgment, arguing, among other things, that the claims were time-barred because the conduct complained of took place in 2008, well beyond the six-year statute of limitations applicable to the fraud claims and the three-year statute of limitations applicable to the remaining tort claims.

The motion court denied defendant’s motion as to the fraud claims (here).

On appeal, the First Department affirmed.

In New York, the limitations period for fraud is the greater of six years from the date of the fraud or two years from the time when, with reasonable diligence, the plaintiff could have uncovered the fraud. CPLR § 213(8). See also Cusimano v. Schnurr, 137 A.D.3d 527, 531 (1st Dept. 2016).

To prevail on a motion to dismiss on statute of limitations grounds, the defendant must show that there is no issue of fact under either of the foregoing prongs.

Against these principles, the Court found that defendant “failed to show dispositively that plaintiffs were in possession of facts that would have triggered inquiry notice under CPLR § 213(8) more than two years before the action was commenced.” Slip Op. at *1 (citing Sargiss v. Magarelli, 12 N.Y.3d 527, 532 (2009)).

The Court rejected defendant’s reference to inconsistent deposition testimony given by plaintiff and an affidavit he submitted in opposition to the motion to dismiss. “Such inconsistencies may be fodder for cross-examination,” said the Court, “but they do not support a finding, as a matter of law, that plaintiffs were on inquiry notice more than two years before this action was commenced.”

The Court also found that plaintiffs had “raised issues of fact as to whether defendant committed independent and distinct fraudulent acts in 2009 in furtherance of the fraudulent scheme” to toll the statute of limitations “pursuant to the continuous wrong doctrine.” Slip Op. at *3 (citing Henry v. Bank of Am., 147 A.D.3d 599, 601 (1st Dept. 2017)). The Court noted that “plaintiffs submitted documents showing that in 2009 defendant forged Ishak’s signature on a resignation letter and then used the forged letter to freeze the bank account of plaintiffs’ corporation.” Id. In addition, noted the Court, plaintiff showed that defendant prepared fraudulent K-1s and tax filings, and created a series of fake, back-dated notes purporting to evidence debt by one of the plaintiff entities to entities controlled by Frost. Id.

[Ed. Note: this Blog examined the statute of limitations for fraud claims and the continuous wrong doctrine here.]

Takeaway

It is generally understood that “scienter . . . is … the element most likely to be within the sole knowledge of the defendant and least amenable to direct proof.” Houbigant, Inc. v. Deloitte & Touche, 303 A.D.2d 92, 98 (1st Dept. 2003). For this reason, to plead scienter, a plaintiff need only allege “some rational basis for inferring that the alleged misrepresentation was knowingly made,” or that the defendant acted with reckless disregard of the truth. Id. “[R]ecklessness … involve[s] conduct that is highly unreasonable, and must ‘in fact, approximate an actual intent to aid in the fraud being perpetrated by the audited company.’” CRT Investments, Ltd. v. Merkin, 29 Misc. 3d 1218(A) (Sup. Ct., N.Y. County 2010), aff’d sub nom., CRT Investments, Ltd. v. BDO Seidman, LLP, 85 A.D.3d 470 (1st Dept. 2011) (internal citation omitted).

When alleging fraud against an auditor, a plaintiff must “allege that the auditor’s practices were so deficient as to amount to no audit at all, that there was a refusal to see the obvious, a failure to investigate the doubtful, or the auditor’s judgments were such that no reasonable accountant would have made the same decisions if confronted with the same facts.” Id. (internal quotations omitted). The failure to do so will result in the dismissal of the claim for the failure to plead scienter with particularity.

In Bullen, the courts concluded that plaintiffs satisfied the foregoing standard by providing allegations that CohnReznick disregarded numerous “red flags” and other detailed facts, such as the violation of GAAP and GAAS, related-party transfers and commingling of investor funds, which supported the strong inference that CohnReznick’s audits amounted to “no audit at all”.

With regard to justifiable reliance, Bullen highlights how sophisticated parties can satisfy this element. A sophisticated party must allege that it exercised due diligence and took affirmative steps “to protect itself against deception.” DDJ Mgt., LLC v. Rhone Grp. L.L.C., 15 N.Y.3d 147, 154 (2010). This means, for example, that a sophisticated party must employ whatever “means of verification were available at the time” of the alleged misrepresentations. VisionChina Media, Inc. v. Shareholder Representative Servs., LLC, 109 A.D.3d 49, 57 (1st Dept. 2013) (citation omitted). One way to do so is to make an additional inquiry into the truth of the representation (ACA Fin., 25 N.Y.3d at 1045), as the plaintiffs had done in Bullen. As noted by the First Department, plaintiffs had their advisor “examin[e] available financial information to ascertain the true nature of the investment fund’s asset valuation” and, as noted by both courts, they asked questions of CohnReznick’s managing partner about their investments in order to make informed decisions about whether to invest in the Funds.

More fundamentally, as both courts indicated, plaintiffs could not have discovered the alleged fraud because the information was peculiarly within CohnReznick’s knowledge. Basis Yield Alpha Fund Master v. Stanley, 136 A.D.3d 136, 143 (1st Dept. 2015).

Sabourin concerns the situation most often found in fraud claims – the plaintiff does not know it was the victim of a fraud until years later. Consequently, as is often the case, the plaintiff brings suit well after the statute of limitations has expired. In such situations, the plaintiff can escape dismissal by finding a basis to toll the statute of limitations. In Sabourin, plaintiffs were able to rely on the continuing wrong doctrine. Under the continuing wrong doctrine, “where there is a series of continuing wrongs,” the statute of limitations will be tolled to the last date on which a wrongful act is committed. Henry v. Bank of Am., 147 A.D.3d 599, 601 (1st Dept. 2017).  The wrongs, however, must be separate and independent (id.), not “continuing consequential damages” that arise from a single tortious act. Town of Oyster Bay v. Lizza Indus., Inc., 22 N.Y.3d 1024, 1032 (2013). As discussed, in Sabourin, plaintiffs were able to withstand summary judgment by demonstrating that defendant committed independent and distinct fraudulent acts in  in furtherance of the alleged fraudulent scheme.

The motion court denied defendant’s motion as to the fraud claims (here).