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Fraud Notes: Scienter and The Failure to Allege Falsity

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  • Posted on: Mar 5 2020

Many cases involving an alleged fraud typically rise and fall on the reliance element of the cause of action. Sometimes, the issue before the court is the state of mind of the alleged fraudster. While at other times, the issue concerns whether the defendant made a misrepresentation of material fact. In today’s Fraud Notes, we examine Cohen Bros. Realty Corp. v. Mapes, 2020 N.Y. Slip Op. 01440 (1st Dept. Mar. 3, 2020) (here), a case involving the state of mind element of a fraud claim, and Goldberg v. Torim, 2020 N.Y. Slip Op. 01561 (1st Dept. Mar. 5, 2020) (here), a case involving the falsity element of a fraud cause of action.

A Refresher on Fraud

To state a cause of action for fraud, a plaintiff must allege “a material misrepresentation of a fact, knowledge of its falsity, an intent to induce reliance, justifiable reliance by the plaintiff and damages.” Eurycleia Partners, LP v. Seward & Kissel, LLP, 12 N.Y.3d 553, 559 (2009); Braddock v. Braddock, 60 A.D.3d 86 (1st Dept.), appeal withdrawn, 12 N.Y.3d 780 (1st Dept. 2009). The allegations must be stated with particularity to satisfy CPLR 3016(b). Eurycleia, 12 N.Y.3d at 559. Thus, the plaintiff must provide sufficient facts to support a “reasonable inference” that the allegations of fraud are true. Id. at 559-60. Conclusory allegations will not suffice. Id. Neither will allegations based on information and belief. See Facebook, Inc. v. DLA Piper LLP (US), 134 A.D.3d 610, 615 (1st Dept. 2015) (“Statements made in pleadings upon information and belief are not sufficient to establish the necessary quantum of proof to sustain allegations of fraud.”).

Although, CPLR 3016 (b) provides that “the circumstances constituting the [fraud] shall be stated in detail,” the New York Court of Appeals has “cautioned that section 3016 (b) should not be so strictly interpreted as to prevent an otherwise valid cause of action in situations where it may be impossible to state in detail the circumstances constituting a fraud.” Pludeman v. Northern Leasing, Sys., Inc., 10 N.Y.3d 486, 491 (2008) (internal quotation marks and citations omitted). Thus, where the facts “are peculiarly within the knowledge of the party charged with the fraud,” and “it would work a potentially unnecessary injustice to dismiss a case at an early stage where any pleading deficiency might be cured later in the proceedings,” dismissal should be denied. Id. at 491-92 (internal quotation marks and citations omitted). See also CPC Intl. v. McKesson Corp., 70 N.Y.2d 268, 285-286 (1987).

Finally, though a fraud must be pleaded with particularity, where the state of mind of the defendant is concerned, a plaintiff may plead it generally, “particularly at the prediscovery stage,” because the “plaintiff lacks access to the very discovery materials which would illuminate a defendant’s state of mind.” Oster v. Kirschner, 77 A.D.3d 51, 55-56 (1st Dept. 2010). As the Oster court observed, “[p]articipants in a fraud do not affirmatively declare to the world that they are engaged in the perpetration of a fraud”; rather, “intent to commit fraud is to be divined from surrounding circumstances.” Id. at 55-56 (citing Eurycleia, supra).

Cohen Brothers Realty Corp. v. Mapes

Cohen Brothers was brought by eleven limited liability companies, two limited partnerships and one corporation, Cohen Brothers Realty Corp. (“Cohen Brothers”), as their managing agent, to recover damages resulting from, inter alia, the alleged fraudulent activities by the corporation’s former Vice President/Director of Construction, Ryan John Mapes (“Mapes”), and unnamed construction contractors/sub-contractors. In particular, plaintiffs alleged that defendants falsely created and used fraudulent, forged and bogus invoices, purchase orders and/or construction contract forms to falsify liabilities and/or inflate the prices that plaintiffs were charged for work performed – or even charged for work that was never performed.

Cohen Brothers provided management services to plaintiffs including, but not limited to, overseeing construction activities, using independent contractors and sub-contractors, of interior tenant spaces and common areas of the buildings under their management. On most occasions, these construction services were outsourced to certain contractors and sub-contractors (collectively, the “Contractors”), who were required to be selected using a sealed bid process.

Plaintiffs retained Italco Data & Electric Inc. also known as, Italco Data & Electric Co. (“Italco”), R & A Painting, Ltd. (“R & A”), and D & K General Contractor Corp., City Maintenance Corp., and Millennium Star Electric, Inc. (collectively “D & K”) as Contractors and/or as subcontractors for renovations in plaintiffs’ buildings. At some point in 2016, Cohen Brothers’ chief operating officer, Steven M. Cherniak (“Cherniak”), noticed that Mapes had bypassed plaintiffs’ established bid practices in awarding contracts to R & A, D & K, and Italco.

In July 2017, Cherniak decided to investigate. Cherniak found a copy of a purchase order issued to R & A in the amount of $5,000. The signature of Charles S. Cohen (“Cohen”), Cohen Brothers’ president and CEO, was taped over the purchase order’s signature block. Behind the doctored purchase order, Cherniak found eight photocopies of a legitimate purchase order issued to R & A in the amount of $13,500, which Cherniak determined was the original for the copied signature block.

Thereafter, Cherniak located numerous purchase orders issued to D & K, Millennium, R & A, and Italco to which Cohen’s bogus signature had been affixed.

Plaintiffs asserted eight causes of action. The first four were asserted against Mapes, sounding in breach of his employment contract, breach of the duty of good faith and fair dealing, breach of fiduciary duty, and breach of the duty of loyalty. The fifth to eighth causes of action were asserted against all defendants.

Relevant to the appeal and this article, plaintiffs alleged in the fifth cause of action that defendants committed fraud by generating false, forged, or inflated purchase orders. Plaintiffs claimed that defendants misrepresented the work that plaintiffs actually needed, the work that defendants actually performed, and how much such work would cost. It was alleged that the Contractors shared with Mapes the monies that plaintiffs paid them. Plaintiffs alleged that they reasonably relied on the purchase orders so generated because of the trust they vested in Mapes as their director of construction.

In its answer, Italco asserted four counterclaims, sounding in breach of contract, account stated, unjust enrichment, and quantum meruit, alleging, in sum, that Italco had performed valid work for plaintiffs, had issued invoices to which plaintiffs never objected, and had not been fully paid. R & A served an answer, generally denying plaintiffs’ allegations and asserting numerous affirmative defenses, including accord and satisfaction and lack of particularity.

Italco moved to dismiss the complaint for lack of particularity. Italco also moved for summary judgment on its counterclaims, including account stated. R & A moved to dismiss the complaint for failure to state a claim and lack of specificity.

On July 20, 2018, the motion court (Lebovits, J.) granted R & A’s motion to dismiss the complaint as against it. On September 26, 2018, the motion court granted Italco’s motion as against all plaintiffs except Cohen Brothers. The First Department unanimously reversed the decision and order dismissing the claims against R &A, and unanimously reversed the decision and order entered in favor of Italco on the causes of action for fraud and unjust enrichment.

The Court held that, at the pre-discovery phase of the proceedings, plaintiffs had alleged circumstantial evidence of the alleged fraud. Slip Op. at *3. In particular, the Court found that “plaintiffs sufficiently pleaded fraud causes of action with the information available to them in a pre-discovery posture.” Id. (citing Houbigant, Inc. v Deloitte & Touche, 303 A.D.2d 92, 98-100 (1st Dept. 2003). “They alleged,” among other things, that defendants “create[ed] and present[ed] for payment to plaintiffs of false, forged or inflated purchase orders; [and] that defendants ‘knew that the work described on the bogus purchase orders or invoices and other contract forms was either falsely stated, overcharged or not provided.…’” Id. Such allegations sufficed, concluded the Court, especially since plaintiffs could “amplify their pleadings” after discovery, at which time “defendants [could] renew their motions.” Id. “But at this stage,” said the Court, “plaintiffs should be allowed to probe defendants’ knowledge of the alleged fraudulent scheme.” Id.

Goldberg v. Torim

[Ed. Note: the facts discussed below come from the motion court’s (Bluth, J.) decision and order, dated January 3, 2019 (here).]

Goldberg arose from a purported real estate transaction between plaintiff, David Goldberg (“Goldberg”), and defendant, Shloime Torim (“Torim”).

In February 2017, Torim allegedly called Goldberg about a property the latter should buy for $500,000 to resell at a later date. According to Goldberg, Torim assured him that he would be able to flip the property for a ten percent return within a year.

Goldberg alleged that Torim called him in early August 2017 and told him that the property sold for $700,000 and that he was going to send Goldberg a check. Goldberg complained that he only received a check for $525,000 instead of the full $700,000. Goldberg insisted that Torim send him the remaining $175,000 from the sale of the property.

Goldberg sued Torim for breach of fiduciary duty, conversion and fraud. Torim moved to dismiss the complaint. Relevant to the appeal and this article, the motion court dismissed the fraud claim.

The motion court dismissed the fraud cause of action because Goldberg failed to allege a material misrepresentation of fact. The motion court found that “the complaint contends that defendant did what he said he would do. Defendant took plaintiff’s money to buy the property, sold the property and sent plaintiff a portion of the proceeds.” The motion court explained that “[t]his is not a case where plaintiff was lured into sending defendant $500,000 and then the money disappeared.” Instead, plaintiff received $525,000 from the sale – a profit of $25,000 within 6 months. “The complaint simply does not establish a fraudulent scheme to steal plaintiff’s money,” concluded the motion court. Rather, “[i]t suggests a disagreement about how much of the proceeds plaintiff is owed.”

In fact, the complaint alleges that defendant suggested that plaintiff might make a return of ten percent in a year; plaintiff did not say that defendant guaranteed the return. Simply put, defendant predicted the property would make plaintiff some money and that induced plaintiff to invest. That prediction (which was not a representation of a fact) turned out to be true – plaintiff made five percent in six months. This Court is unable to find that there was any misrepresentations or justifiable reliance by plaintiff based on his complaint.

The First Department affirmed.

Like the motion court, the First Department found that Goldberg alleged, “essentially, that defendant did precisely what he represented he would do, specifically that he would be purchasing real estate that would turn a 10% profit to plaintiff within a year.” Slip Op. at *1. The Court noted that the “complaint [was] devoid of any allegation that defendant represented how much, in addition to the 10%, if any, defendant agreed to remit to plaintiff after the sale.” Id.  “As such,” concluded the Court, “plaintiff has alleged no material misrepresentation, justifiable reliance or damages.” Id. (citing Connaughton v. Chipotle Mexican Grill, Inc., 29 N.Y.3d 137, 142-143 (2017); Eurycleia Partners, 12 N.Y.3d at 559).

Takeaway

Cohen Bros. serves as an important reminder that demonstrating actual knowledge is not necessary to satisfy the scienter element of a fraud claim. It can be done circumstantially. As the Oster court observed, no one admits that they knowingly perpetrated a fraud. For this reason, the courts look at the surrounding circumstances to divine a defendant’s intent to deceive.

Goldberg also serves as a reminder that to withstand dismissal, a plaintiff pleading fraud must allege falsity. Though such a lesson should not require reinforcement, cases like Goldberg show otherwise. After all, without falsity, there can be no cause of action for fraud.

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