Fraud Notes: Fraudulent Inducement and Concealment – Affirmative Misrepresenations, Duplication and Other Issues Relevant to Fraud Claims

• Posted on: Oct 7 2024

By: Jeffrey M. Haber

In today’s Fraud Notes, we examine two cases involving claims of fraudulent inducement and fraudulent concealment.  

In Board of Mgrs. of 570 Broome Condominium v. Soho Broome Condos LLC, 2024 N.Y. Slip Op. 04804 (1st Dept. Oct. 3, 2024) (here), the Court examined a fraudulent inducement claim in connection with the purchase of a condominium unit. As discussed below, the Court held that plaintiff sufficiently alleged that defendant asserted affirmative misrepresentations about the financial condition of the building that induced plaintiff to purchase the unit at issue. The Court also held that the misrepresentations did not duplicate the representations in the offering plan.

In Haart v. Scaglia, 2024 N.Y. Slip Op. 04812 (1st Dept. Oct. 3, 2024) (here), the Court examined a fraudulent inducement and fraudulent concealment complaint in the context of a bitter business and marital breakup. As discussed below, the Court found, among other things, that plaintiff alleged actionable misrepresentations of existing fact, as opposed to inactionable representations of future performance and concealed certain facts from plaintiff in connection with the existence of preferred stock in a business that plaintiff allegedly owned.

Board of Mgrs. of 570 Broome Condominium v. Soho Broome Condos LLC

Plaintiff, a residential condominium, brought suit against, among others, the sponsor of the subject building (“condo” or “building”), alleging that the sponsor/developer of the condo failed to satisfy various promises made in connection with the offering plan related to the sale of the condo’s units. Plaintiff alleged that poor workmanship and faulty construction practices led to numerous deficiencies at the building for which the current board of managers must rectify. Plaintiff maintained that the sponsor and its principals deliberately misrepresented the condo’s budget and intentionally set common charges low to induce purchasers to buy units in the building. Plaintiff maintained that the shoddy construction work and the low common charges resulted in a massive assessment for the unit owners after only two years of operation as a condo. Plaintiff also alleged that the sponsor’s business partners looted the sponsor’s assets.

Defendants moved to dismiss the complaint.

Regarding the fraudulent inducement claim, the sponsor defendants maintained that the claim was nothing more than a breach of the offering plan dressed up as a fraud claim – that is, the fraud in the inducement claim was duplicative of the breach of contract claim. The individual defendants also claimed that they could only be liable for the alleged fraudulent inducement if plaintiff could pierce the corporate veil, which they maintained plaintiff failed to do.

The motion court denied the motion with respect to the fraudulent inducement and breach of fiduciary duty claims.

The motion court found that plaintiff asserted affirmative misrepresentations[1] about the financial condition of the condo that were not made in the offering plan. In this regard, the motion court found that plaintiff detailed when the units were for sale, the fact that the condo’s operating expenses were deliberately low, and that when the units were nearly all sold, the condo’s expenses nearly doubled. In other words, noted the motion court, plaintiff alleged that the sponsor and the individual defendants deliberately misled potential purchasers about the budget until after the units were sold in order to get them to buy the units by, among other things, intentionally setting common charges at a level that did not cover the condo’s expenses. The motion court concluded that these allegations did not duplicate plaintiff’s breach of contract claim:

Plaintiff’s claim is not simply reliant on the fact that the Sponsor breached the contract (the offering plan). It argues that these defendants made misrepresentations about the financial health of the condo in order to induce people to purchase units while (according to the complaint) there were questions about the condo’s ability to continue as a going concern. This is distinct from the failure to construct the building to meet certain parameters in the offering plan, such as the purportedly faulty piping and improper gas room venting.

The motion court also rejected the notion that veil piercing was required to find the individual defendants liable (for pleading purposes) for fraud: “that the individual defendants signed the offering plan, which affirmatively represented that the condo’s budget was acceptable and appropriate to ensure the condo could meet its obligations,” stated a claim for fraudulent inducement.

Finally, the motion court found that the individual defendants breached their fiduciary duty to plaintiff (and the other unitholders). In its complaint, plaintiff alleged that the individual defendants put the interests of the sponsor over those of the condo by keeping common charges low and directing the managing agent not to pay certain bills. Plaintiff argued that the individual defendants did this to make the units more attractive to potential purchasers (by keeping the common charges low) instead of fulfilling their fiduciary duty to the board. In addition, plaintiff detailed how the individual defendants refused to address the obvious construction defects and left plaintiff to fix the issues.

The motion court held that the foregoing actions amounted to self-dealing in favor of the sponsor and constituted bad faith by the individual defendants.

The motion court rejected the individual defendants’ reliance upon the business judgment rule as a basis to dismiss the complaint.[2] Noting that the business judgment rule prohibits review of decisions within the scope of the authority of the board members, the motion court held that plaintiff alleged more than a mere disagreement with the decisions by the individual defendants. The motion court explained that plaintiff alleged that the individual defendants “made decisions that were anathema to running a functioning building” and “intentionally did not pay bills, did not set common charges at a level sufficient to cover expenses and did not address clear construction defects all to save money for and to benefit the Sponsor despite the fact that their duties were to the board.” “Maximizing the profit to the Sponsor and leaving the subsequent board to deal with financial issues,” concluded the motion court, “states a cause of action for the breach of a fiduciary duty.”

On appeal, the Appellate Division, First Department affirmed the motion’s court order.

The Court held that the “motion court correctly denied dismissal of plaintiff[’s] … fraud in the inducement claim against the individual defendants.”[3] The Court found that “[p]laintiff alleged specific ‘affirmative misrepresentations, not omissions,’ by defendants, ‘who [were] principals of the sponsor, and who signed the certification in the offering plan.”[4] Such allegations concluded the Court, “set forth a scheme independent of the Martin Act disclosure requirements.”[5]

In addition, said the Court, “the allegations do not require piercing the corporate veil, as they are based on the affirmative misrepresentations by the individual defendants concerning the accuracy of the common charges and operating budget, which plaintiff asserts defendants knew to be false at the time.”[6]

The Court also held that the motion court “correctly sustained plaintiff’s breach of fiduciary duty claim against the individual defendants as members of the sponsor-controlled board.”[7] The Court found that the “complaint sufficiently allege[ed] wrongdoing by the individual defendants in the form of self-dealing and willful misconduct, which were not actions ‘taken in good faith and in the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes,’ but rather solely for defendants’ benefit.”[8] The Court explained that the “complaint specifically allege[d] that rather than incrementally raise common charges to meet the condominium’s budget needs, the individual defendants directed the managing agent not to pay Con Edison bills, ignored the independent auditor’s warnings of a budget shortfall, refused to meet the staffing costs, used condominium monies to cover sponsor obligations, and intentionally set the common charges unreasonably low for no business related purpose but for the sponsor’s and the individual defendants’ sole benefit.”[9] The Court also noted that “[p]laintiff’s claims [were] … supported by the allegation that the sponsor-controlled board raised the common charges and imposed a special assessment to pay for past due obligations only after the final sponsor-owned unit was in contract.”[10]

Haart v. Scaglia

Haart was the fourth of five lawsuits filed by plaintiff and defendant during the last few years — one filed in Delaware and four in New York, all of which involved their personal and business divorce.

[Eds. Note: the factual discussion below comes from the parties’ appellate briefs, the motion court’s decision and the First Department’s decision.]

Haart alleged that defendant defrauded her in two ways: fraudulent inducement and fraudulent concealment.

In the former claim, plaintiff alleged that defendant represented that if she worked as CEO of Elite World Group, LLC (“EWG”), a model management company, without an employment agreement or salary, he would transfer to her 50% of the stock of a holding company – Freedom Holding, Inc. (“FHI”) – that owned EWG, in addition to an allegedly valuable apartment. Plaintiff allegedly agreed, and defendant transferred 50 common shares to her. However, according to plaintiff, defendant concealed the existence of 123,665 preferred shares he had issued to himself, thereby giving himself majority control of FHI and making plaintiff’s stock ownership virtually worthless. Consequently, plaintiff claimed that her interest in FHI amounted to a mere 0.0004% (50 of 123,765 total shares).

Plaintiff further maintained that defendant and the accounting defendants repeatedly told her and others in her presence, in writing and orally, that she was a 50% owner of FHI. Plaintiff alleged that she discovered defendant’s misrepresentations about her ownership interest in FHI in March or April 2020. Upon learning the alleged truth, plaintiff maintains that she refused to continue working as CEO of EWG until defendant made her a 50% owner of FHI with equal ownership and control.

In the latter claim, plaintiff alleged that defendant agreed to transfer 50% of the preferred shares to her, but he secretly directed the accounting defendants to draft a binding legal document to give her one less share of FHI and preserve his controlling interest. Defendant signed that document in June 2020 in the presence of both the accounting defendants and plaintiff. According to plaintiff, defendants told her that by doing so, defendant was transferring 50% of the preferred shares to her, knowing that he was, in fact, transferring one share less than 50%. Plaintiff maintained that thereafter, defendant continued to represent to her and others in her presence, both orally and in writing, that she owned 50% of FHI and shared equally in the control of the company with him.

According to plaintiff, the accounting defendants and FHI repeated the foregoing representations, both orally and in writing. Plaintiff maintained that defendant and FHI prepared and submitted written documents to governmental entities, prospective investors, bankers, and auditors representing that he and plaintiff each owned 50% of FHI, while concealing the truth. Plaintiff claimed that she justifiably believed defendants.

Plaintiff further alleged that the accounting defendants prepared and submitted FHI’s income tax returns in which the ownership of FHI was represented to 50% for each party. Based on defendants’ alleged concealment of the truth, plaintiff alleged that she continued to work as CEO of EWG.

Defendants moved to dismiss. With regard to the fraud claims against defendant, the motion court granted the motion, finding that defendant did not make any actionable promise to make her a 50% partner. With regard to the fraud claims against the accounting defendants, the motion court granted the motion, finding that these parties did not have the capacity to either promise to transfer FHI ownership to plaintiff or appoint anyone as EWG’s CEO.

On appeal, the Appellate Division, First Department unanimously modified the motion court’s order to deny the motions as to the first cause of action up to June 12, 2020 (fraudulent inducement) and the second cause of action (fraudulent concealment) to the extent it was based on the failure to disclose the existence of FHI’s preferred stock.

The Court held that what started as a promise of future performance, which is not actionable,[11] became a misrepresentation of existing fact, which is actionable.[12] In this regard, the Court found that:

when plaintiff agreed to become EWG’s CEO, [defendant’s] promise to give her 50% of FHI was a promise about the future. However, plaintiff does not merely allege that she was induced to become CEO; she also alleges that she was induced to remain CEO without a salary or a contract for a fixed term because [defendants] kept reassuring her that she owned 50% of FHI — which, at that point, would be a misrepresentation of an existing fact.[13]

Speaking to the justifiable reliance element of a fraud claim, the Court held that “it was not unreasonable for plaintiff to rely on [defendant’s] statements that he was giving her 50% of FHI and that she owned 50% of it — he was her fiancé, and then her husband, when he said this.”[14] “As such,” concluded the Court, “they were family members who stood in ‘a fiduciary relationship toward one another in a co-owned business venture,’ making plaintiff’s reliance on [defendant’s] assurances ‘all the more reasonable.’”[15]

The Court held, however, that the claim should be reinstated only up to June 12, 2020.[16] In so holding, the Court explained that, under the circumstances, plaintiff could not have been induced to continue serving as EWG’s CEO because “she executed a stock power which shows, on its face, that she was not getting 50% of the preferred shares”:[17]

Plaintiff discovered the existence of FHI’s preferred shares in April 2020. At that point, she knew that she did not own 50% of FHI; nevertheless, she continued to serve as EWG’s CEO without a regular contract or salary. Since [defendant] promised to give her 50% of FHI’s preferred shares, it may have been reasonable for her to continue working as EWG’s CEO. On June 12, 2020, however, she executed a stock power which shows, on its face, that she was not getting 50% of the preferred shares. Because plaintiff continued serving as EWG’s CEO even after she knew that she was not a 50% owner of FHI, [defendant’s] misrepresentation that she owned 50% of FHI could not have induced her to continue serving as CEO after June 12, 2020.…[18]

The Court also held that the fraudulent inducement claim against the accounting defendants should be reinstated “up to June 12, 2020.”[19] The Court explained that “it [could not] be said, as a matter of law, that it was unreasonable for plaintiff to rely on the [accounting] defendants’ statements about FHI, as they were its accountants. In addition, said the Court, the principal of the accounting defendants “was plaintiff’s accountant before he was FHI’s, and she considered him a friend and trusted advisor.”[20] “While the [accounting] defendants could not have induced plaintiff to accept the position of EWG’s CEO because they had no power to promise to give her 50% of FHI,” said the Court, plaintiff sufficiently alleged “that she was induced to continue being CEO because the [accounting] defendants kept reassuring her that she owned 50% of FHI.”[21] Among other things, plaintiff alleged that “for each tax year following [her] receipt of the [common] shares, [the accounting defendants] prepared … tax returns identifying [plaintiff] and [defendant] as equal owners of FHI, with equal ‘total voting power.’”[22]

The Court also held that the second cause of action (for fraudulent concealment) “should be reinstated insofar as it is based on the concealment of the existence of FHI preferred stock.”[23] “However,” noted the Court, “neither [defendant] nor the [accounting] defendants ‘concealed’ that plaintiff got less than 50% of the preferred shares because the stock power showed this on its face.”[24]

Finally, the Court rejected defendants’ argument that they had no duty to disclose the existence of the preferred shares. A duty to disclose arises when (1) the defendant speaks on the subject, in which case he/she must speak truthfully and completely about the matter;[25] (2) there is a fiduciary relationship between the plaintiff and defendant;[26] or (3) the defendant possesses “special facts” about the matter not known by the plaintiff.[27]

In rejecting the argument, the Court held that defendant “had a duty to disclose the existence of the preferred stock because he had a confidential or fiduciary relationship with plaintiff …,[28]and his superior knowledge of the existence of the preferred stock rendered plaintiff’s agreement to become EWG’s CEO without a regular salary or contract ‘inherently unfair.’”[29]

Regarding the accounting defendants,[30] the Court held that “[w]hile the [accounting] defendants did not have a duty to disclose based on a fiduciary relationship …, they arguably had a duty to disclose based on the ‘special facts’ doctrine.’”[31] The Court found that “it was inherently unfair for plaintiff to work as EWG’s CEO on the assumption that she owned 50% of FHI when she owned only 50 common shares and FHI also had 123,665 preferred shares.”[32]

____________________________

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP. This article is for informational purposes and is not intended to be and should not be taken as legal advice.

[1] The motion court’s finding that plaintiff asserted affirmative misrepresentations, as opposed to omissions, is significant because a fraud claim based on omissions in an offering plan is barred by the Martin Act. See, e.g., Kerusa Co. LLC v. W10Z/515 Real Estate Ltd. P’ship, 12 N.Y.3d 236 (2009); Bd. of Managers of S. Star v. WSA Equities, LLC, 140 A.D.3d 405, 405 (1st Dept. 2016).

[2] “The business judgment rule is a common-law doctrine by which courts exercise restraint and defer to good faith decisions made by boards of directors in business settings.” 40 W. 67th St. Corp. v. Pullman, 100 N.Y.2d 147, 153 (2003) (citation omitted). The rule does not, however, protect directors who “passively rubber-stamp[] the acts of active corporate managers.” Matter of Comverse Tech, Inc. Deriv. Litig., 56 A.D.3d 49, 56 (1st Dept. 2008) (citation omitted). The complaint must “allege facts, such as self-dealing, fraud or bad faith” to show that the subject transaction “could not have been the product of sound business judgment.” Goldstein v. Bass, 138 A.D.3d 556, 557 (1st Dept. 2016). Thus, “[s]o long as the corporation’s directors have not breached their fiduciary obligation to the corporation, the exercise of [their powers] for the common and general interests of the corporation may not be questioned, although the results show that what they did was unwise or inexpedient.” Matter of Levandusky v. One Fifth Ave. Apt. Corp., 75 N.Y.2d 530, 538 (1990) (internal quotation marks and citation omitted).

[3] Bd. of Mgrs., Slip Op. at *1.

[4] Id. (quoting Bd. of Mgrs. of the Walton Condominium v. 264 H2O Borrower, LLC, 180 A.D.3d 622, 622 (1st Dept. 2020)).

[5] Id. (citing Bd. of Mgrs. of the S. Star v WSA Equities, LLC, 140 A.D.3d 405, 405 (1st Dept. 2016)).

[6] Id.

[7] Id.

[8] Id. (quoting Tahari v. 860 Fifth Ave. Corp., 214 A.D.3d 491, 492 (1st Dept. 2023) (internal quotation marks omitted); and citing Bd. of Mgrs. of Fairways at N. Hills Condominium v. Fairway at N. Hills, 193 A.D.2d 322, 325 (2d Dept. 1993)).

[9] Id.

[10] Id.

[11] See Braddock v. Braddock, 60 A.D.3d 84, 89 (1st Dept. 2009).

[12] Haart, Slip Op. at *1.

[13] Id.

[14] Id. at *2.

[15] Id. (quoting Braddock, 60 A.D.3d at 88, 94).

[16] Id.

[17] Id.

[18] Id. (citation omitted).

[19] Id.

[20] Id.

[21] Id.

[22] Id.

[23] Id.

[24] Id.

[25] Bank of Am., N.A. v. Bear Stearns Asset Mgmt., 969 F. Supp. 2d 339, 351 (S.D.N.Y. 2013).

[26] Balanced Return Fund Ltd. v. Royal Bank of Canada, 138 A.D.3d 542, 542 (1st Dept. 2016).

[27] Pramer S.C.A. v. Abaplus Int’l Corp., 76 A.D.3d 89, 99 (1st Dept. 2010). “The ‘special facts’ doctrine holds that ‘absent a fiduciary relationship between parties, there is nonetheless a duty to disclose when one party’s superior knowledge of essential facts renders a transaction without disclosure inherently unfair.’” Greenman-Pedersen, Inc. v. Berryman & Henigar, Inc., 130 A.D.3d 514, 516 (1st Dept. 2015), lv. denied, 29 N.Y.3d 913 (2017) (quoting, Pramer, 76 A.D.3d at 99).

[28] Haart, Slip Op. at *2-*3 (citations omitted).

[29] Id. at *3 (citations omitted).

[30] The Court further held that the third cause of action, against the accounting defendants for aiding and abetting defendant’s fraud, should be reinstated. Id. (citation omitted). The Court found that the accounting defendants provided substantial assistance to defendant by preparing plaintiff’s tax returns, which were “important to the underlying fraud.” Id. (citations omitted).

[31] Id. (citations omitted).

[32] Id.