Out-Of-Pocket Damages, Intent to Deceive and The Business Judgment Rule

• Posted on: Dec 29 2021

By: Jeffrey M. Haber

To allege a cause of action based on fraud, plaintiffs must assert “a misrepresentation or a material omission of fact which was false and known to be false by defendant, made for the purpose of inducing the other party to rely upon it, justifiable reliance of the other party on the misrepresentation or material omission, and injury.¹ To withstand a motion to dismiss, plaintiffs must satisfy each element of the claim.

One of the most difficult elements of the fraud claim to plead and prove is the scienter element. First, a defendant is not likely to declare to the world that he or she intended to commit a fraud. Second, knowledge of the falsity of the representation at issue is “likely to be within the sole knowledge of the defendant and least amenable to direct proof.”² For these reasons, plaintiffs “need only allege specific facts from which it is possible to infer defendant’s knowledge of the falsity of its statements.”³ 

A defendant’s knowledge of a corporate fraud or its concealment may be deduced by his or her position and responsibilities within the organization.⁴ And, while fraudulent intent may “be divined from surrounding circumstances,”⁵ it is generally a question that cannot be resolved on a motion to dismiss.⁶ 

[Ed. Note: this Blog wrote about the scienter element here, here and here.]

The damages element of a fraud claim can also be difficult to satisfy. Generally, plaintiffs are allowed to recover only their out-of-pocket damages – that is, the actual pecuniary loss sustained as the direct result of the wrong. Under the out-of-pocket damages rule, plaintiffs may recover what they lost because of the fraud, not what they might have gained had there been no fraud.⁷ In other words, plaintiffs cannot recover the profits which would have been realized in the absence of the fraud. For that reason, plaintiffs cannot recover damages for fraud based on the loss of a contractual bargain, “the extent, and, indeed the very existence of which is completely undeterminable and speculative.”⁸

To determine whether the plaintiff sustained out-of-pocket losses, courts employ a two-part test.⁹ First, the plaintiff must show the actual value of the consideration it received.¹⁰ Second, the plaintiff must prove that the defendant’s fraudulent inducement directly caused the plaintiff to agree to deliver consideration that was greater than the value of the received consideration.¹¹ The difference between the value of the received consideration and the delivered consideration constitutes the plaintiff’s out-of-pocket damages.¹²

[Ed. Note: this Blog wrote about the out-of-pocket rule here and here.]

With these principles in mind, we look at Community Association of the East Harlem Triangle, Inc. v. Butts, 2021 N.Y. Slip Op. 07503 (1st Dept. Dec. 28, 2021) (here).

The Motion Court Proceedings

[Ed. Note: The discussion below comes from the motion court’s recitation of the facts (here).]

In March 1994, defendant, Abyssinian Development Corporation (“ADC”), and plaintiff, the Community Association of East Harlem Triangle, Inc. (“CAEHT”), formed a joint venture for the purpose of developing property in New York City as a Pathmark supermarket (“Property”). The parties formed East Harlem Abyssinian Triangle Corp. (“EHAT Corp.”) to conduct the business of the joint venture and East Harlem Abyssinian Triangle Limited Partnership (“EHAT LP”) to own and develop the Property. EHAT Corp. was the general managing partner of EHAT LP, and CAEHT and ADC each held 50% of EHAT Corp.’s stock. EHAT Corp. holds a 51% interest in EHAT LP and the New York City Economic Development Corporation holds a 49% interest in EHAT LP. 

At a meeting of the EHAT Corp. board of directors (the “Board”), held in March 2013, defendant James Howard, Senior VP of ADC and a director of EHAT Corp., initiated the first of several discussions with the Board regarding the sale of the Property. Thereafter, defendants Howard and Butts (Chairman of ADC) took a lead role in managing the sale of the Property on behalf of EHAT Corp. According to plaintiff, defendant Victor Sozio of Ariel Property Advisors LLC (“Ariel”), a commercial real estate broker, and defendant Charles Simpson, a partner in the WM law firm, assisted with the sale.

Beginning in October 2013, Derek Johnson of Integrated Urban Holdings, LLC (“Integrated”) started working with R. Donahue Peebles, Chairman and CEO of Peebles Corp, (“Peebles Corp.”), to submit an offer to acquire the Property. Peebles Corp. had a real estate portfolio worth approximately $5 billion. At a Board meeting held on or about November 25, 2013, Howard informed the Board that he had identified seven potential buyers of the Property, including Peebles Corp. and Extell Development Company (“Extell”).

On January 15, 2014, Integrated and Peebles Corp. (together “Peebles/Integrated”) jointly submitted a written offer to purchase the Property for $40 million to Butts, and mailed copies of the offer to Sozio and Simpson. Thereafter, Sozio allegedly told Johnson that EHAT Corp. would accept an offer of $42 million, and Johnson allegedly responded that Peebles/Integrated would increase its offer to that amount.

On February 12, 2014, Sozio sent Johnson a term sheet containing the terms that EHAT Corp. would agree to accept the $42 million offer. After Johnson communicated his assent, Sozio told him that the offer had been forwarded to Simpson, who would follow up with Johnson to memorialize the offer in a formal contract. However, Johnson allegedly never heard from Simpson.

On March 24, 2014, the Board held a meeting to consider an offer from Extell to purchase the Property for $39 million. Simpson, Howard and Sozio attended the meeting. During the meeting, a CAEHT representative asked Howard whether there were any other offers to purchase the Property aside from that of Extell. Before Howard could answer, however, Simpson allegedly stated that Extell was the only party to show an interest in purchasing the Property. According to plaintiff, despite knowing this statement was untrue, neither Sozio nor Howard corrected Simpson at or after the meeting, or otherwise disclosed the higher Peebles/Integrated offer.

Plaintiffs alleged that the Peebles/Integrated offer was deliberately concealed from them because Simpson, WM, ADC, Butts, Howard, Sozio and Ariel had previously agreed to steer the Property to Extell. In this connection, at the March 24, 2014 meeting, the Board also discovered that ADC had already received an advance payment from Extell in the amount of $2.5 million at an unspecified date prior to the meeting, which Simpson, Howard, Sozio and Butts had allegedly failed to disclose. Additionally, at that meeting, plaintiffs learned that ADC had never informed Extell of plaintiffs’ interest in the Property.

In view of this new information, the meeting ended without a vote on the sale of the Property. The Board met again on April 3, 2014, to discuss the sale, at which time Howard allegedly denied that there were any other offers besides Extell’s. The Board deadlocked on the vote to approve the sale, with the four ADC-appointed directors voting in favor and the four directors appointed by CAEHT voting against the offer. However, a majority of the Board voted in favor of the sale at an April 10, 2014, meeting, including Butts, who did not attend the meeting but voted by proxy.

Plaintiffs alleged that, as a direct and proximate consequence of the fraudulent concealment of the Peebles/Integrated offer, EHAT Corp. was damaged in the amount of $3 million, or the difference between the amount paid by Extell to purchase the Property and the market value of the Property. Plaintiffs asserted 58 causes of action in various permutations against different combinations of the defendants, sounding in fraud, breach of fiduciary duty, and aiding and abetting, together with a claim pursuant to Business Corporations Law (BCL) § 720 and a demand for punitive damages.

Defendants moved to the dismiss the claims against them.

The Motion Court’s Decision

All defendants challenged the fraud claims on the ground that plaintiffs failed to allege any damages under a recognized tort theory. Specifically, defendants argued that recovery of any loss resulting from the alleged concealment of the Peebles/Integrated $42 million offer was barred by the “out-of-pocket” rule. Defendants claimed that, at most, plaintiffs asserted a claim for lost opportunity or lost profit damages (i.e., damages incurred by the sale of the Property at a deflated price). Under the out-of-pocket rule, defendants argued, such losses were inherently speculative and nonrecoverable as a matter of law.

Relying on Bernstein v. Kelso & Co., 231 AD2d 314 (1st Dept. 1997), the motion court rejected defendants’ contention. In Bernstein, the plaintiff alleged that the management employees of a company schemed with a potential buyer to sell the company at the lowest price that the principal and other shareholders would accept, furnishing confidential information to aid the buyer in obtaining the most favorable offer for itself. The Court found it irrelevant that the plaintiff ultimately made an overall “profit” from the transaction, noting that the plaintiff was not seeking the undeterminable future profits that might generated by the company after the sale. Rather, the plaintiff “sought to recover the difference between the price he received in the sale of the company and the price he would have received had his employees and [the buyer] not deceived him.”

The motion court held that plaintiffs could submit nonspeculative proof demonstrating that they were induced “to deliver consideration [the Property] that was greater than the value of the received consideration [$39 million]” by proffering evidence of the market value of the Property at the time of the sale.¹³ 

The ADC defendants argued that plaintiffs failed to allege that defendants possessed the requisite intent to defraud. In particular, they contended that there were no allegations indicating their motive for steering the sale to Extell or suggesting how they benefitted in any way from doing so. They also pointed out that the broker defendants would be working against their own interest in a commission by procuring a sale at a lower price.

The motion court rejected the ADC defendants’ contention. The motion court noted that plaintiffs alleged that both Butts and Howard were aware of the Peebles/Integrated offer through their interactions with each other, their counsel and the brokers, and either falsely denied or concealed its existence. At this stage of the proceeding, noted the motion court, such allegations were sufficient to demonstrate their knowledge for the purpose of the fraud claim. 

Regarding the argument that the individuals did not personally profit from the alleged fraud, the motion court observed, quoting Polonetsky v Better Homes Depot, 97 N.Y.2d 46, 55 (2001), that “corporate officers and directors may be held individually liable if they participated in or had knowledge of the fraud, even if they did not stand to gain personally.” 

Finally, the motion court declined to rule on defendants’ argument that the business judgment rule protected them from liability for the alleged breaches of fiduciary duty. The motion court said that it was premature to rule on the applicability of the business judgment rule, especially given its ruling on plaintiffs’ allegation concerning the ADC defendants’ state of mind at the time of the sale.

It is premature to rule on the applicability of the business judgment rule as to the ADC defendants’ conduct. Although the rule would ordinarily shield them from liability in such a routine decision concerning the sale of a corporate asset, defendants are entitled “adduce evidence of self-dealing, fraud, or other acts constituting a breach of fiduciary duty sufficient to overcome the business judgment rule” Accordingly, resolution of the issue is not appropriate at the pleading stage, as questions of fact exist “involving the condition or state of the defendants’ minds, which can be proved or judged only through evidence.” [Citations omitted.]

[Ed. Note: “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.”¹⁴ The rule does not, however, protect directors who “passively rubber-stamp[] the acts of active corporate managers.”¹⁵ 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.”¹⁶ 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.”¹⁷] 

On appeal, the Appellate Division, First Department affirmed.

The First Department’s Decision

The Court held that plaintiffs “adequately pleaded nonspeculative damages,” such that their claims were “not barred by the out-of-pocket rule.”¹⁸ The Court found that “Plaintiffs allege[d] that a specific alternative offer for the property for $3 million more was made at around the same time as the Extell offer, that the higher offer was concealed from them, and that they had unknowingly passed on that offer in approving the $39 million sale.”¹⁹ The Court explained that the “alternative Integrated/Peebles offer of $42 million and the term sheet conditions had been agreed to, and thus did not amount to mere speculative damages.”²⁰ “The agreement was never memorialized in a contract,” observed the Court, “because defendant Charles Simpson, EHAT Corp.’s lawyer, allegedly colluded with the other defendants to steer the sale to Extell, and never drafted and delivered a contract to Peebles’s principal.”²¹

The Court also held that the motion court “correctly concluded that the amended complaint sufficiently pleaded intent to defraud by the ADC defendants.” The Court noted that the “amended complaint allege[d] that Butts and Howard, as officers and board members of EHAT Corp. and ADC, worked together on the sale of the property; that Howard personally heard Simpson mispresent at the March 24, 2014 board meeting that there were no offers other than Extell’s; that Butts was sent the Integrated/Peebles offer; and that they communicated with one another concerning the Integrated/Peebles offer.”²² 

The Court rejected the ADC defendants’ argument that any fraudulent intent on their part was “nonsensical because they too stood to gain from the sale of the property”.²³ The Court stated that “at this juncture in the absence of any explanation as to why they would accept the lower offer without disclosing the Integrated/Peebles offer to the board,” the complaint stated a claim.²⁴ 

Finally, the Court held that “the motion court correctly concluded that dismissal based on the business judgment rule would be premature.”

Takeaway

The Court of Appeals has explained that under the out-of-pocket damages rule, damages should compensate the plaintiff “for what [he/she] lost because of the fraud,” not “what [he/she] might have gained.”²⁵ Consequently, “there can be no recovery of profits which would have been realized in the absence of fraud.”²⁶ The Court underscored this point by noting that it had “consistent[ly] refus[ed] to allow damages for fraud based on the loss of a contractual bargain, the extent, and, indeed, … the very existence of which is completely undeterminable and speculative.”²⁷ 

In Community Association, the Court made it clear that a plaintiff alleging fraud can recover lost opportunity damages, where such damages are not speculative and can be quantified. As discussed, the alleged damages were quantifiable at $3 million. 

Aside from the damages issue, Community Association is notable for its analysis of the scienter element of a fraud claim. There, the Court found that plaintiffs alleged sufficient facts from which state of mind could be inferred – namely, that “Butts and Howard, as officers and board members of EHAT Corp. and ADC, worked together on the sale of the property; that Howard personally heard Simpson mispresent at the March 24, 2014 board meeting that there were no offers other than Extell’s; that Butts was sent the Integrated/Peebles offer; and that they communicated with one another concerning the Integrated/Peebles offer.”²⁸ While these defendants raised an interesting argument about the absence of motive to deceive, the Court held that such arguments are left for later proceedings.

Contact our business lawyer to get started on your claim.

Footnotes

1. Lama Holding Co. v. Smith Barney, 88 N.Y.2d 413, 421 (1996) (citations omitted).
2. Houbigant, Inc. v. Deloitte & Touche, 303 A.D.2d 92, 98 (1st Dept. 2003).
3. Id. at 99.
4. Pludeman v. N. Leasing Sys., Inc., 10 N.Y.3d 486, 493 (2008).
5. Oster v. Kirschner, 77 A.D.3d 51, 56 (1st Dept. 2010).
6. ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 131 A.D.3d 427, 428 (1st Dept. 2015).
7. Connaughton v. Chipotle Mexican Grill, Inc., 29 N.Y.3d 137, 142-43 (2017) (quoting, Lama, supra) (internal quotations omitted)).
8. Id.
9. Kumiva Grp., LLC v. Garda USA Inc., 146 A.D.3d 504, 506 (1st Dept. 2017).
10. Id.
11. Id.
12. Id.
13. Citing Kumiva, 146 A.D.3d at 506.
14. 40 W. 67th St. Corp. v. Pullman, 100 N.Y.2d 147, 153 (2003) (citation omitted).
15. Matter of Comverse Tech, Inc. Deriv. Litig., 56 A.D.3d 49, 56 (1st Dept. 2008) (citation omitted).
16. Goldstein v. Bass, 138 A.D.3d 556, 557 (1st Dept. 2016).
17. Matter of Levandusky v. One Fifth Ave. Apt. Corp., 75 N.Y.2d 530, 538 (1990) (internal quotation marks and citation omitted).
18. Slip Op. at *1 (citation omitted).
19. Id.
20. Id.
21. Id.
22. Id. at *1-*2.
23. Id.
24. Id. (citations omitted).
25. Connaughton, 29 N.Y.3d at 142.
26. Id. (citations omitted).
27. Id. at 142-143 (quoting, Dress Shirt Sales v. Hotel Martinique Assoc., 12 N.Y.2d 339, 344 (1963)).
28. Slip Op. at *1-*2.