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.”¹ The allegations must be stated with particularity to satisfy CPLR 3016(b).² Thus, the plaintiff must provide sufficient facts to support a “reasonable inference” that the allegations of fraud are true.³ Conclusory allegations will not suffice.⁴ Neither will allegations based on information and belief.⁵ 

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.”⁶ 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.⁷ 

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.”⁸ As the First Department 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.”⁹ 

In today’s Fraud Notes, we examine the foregoing, in particular the scienter element of the claim.

Cimen v. HQ Capital Real Estate L.P., 2024 N.Y. Slip Op. 02888 (1st Dept. May 28, 2024)¹⁰

Cimen arose from defendants’ solicitation of plaintiffs to invest in a limited partnership in certain properties located in Brooklyn, New York. Defendants moved to dismiss, arguing that plaintiffs failed to plead viable claims based on fraud, gross negligence, and breach of fiduciary duty. The motion court granted the motion and the Appellate Division, First Department affirmed.

Plaintiffs’ principal allegations of fraud concerned alleged projections and estimates contained in defendants’ Investment Memorandum with respect to (a) renovation rates of apartments in the properties; (b) market rental rates of three-bedroom apartments in the vicinity; and (c) the projected annual vacancy losses. 

The motion court held that plaintiffs failed to adequately allege that the foregoing projections were based on actionable factual misrepresentations, or that they did not reflect the views of defendants, with the requisite particularity to sustain a claim for fraud or misrepresentation.

Turning to plaintiffs’ claims based on the projected renovation rates, plaintiffs alleged that the Investment Memorandum “falsely stated that an annual turnover rate of 23 apartments per year was in line with the ‘portfolio’s historical natural turnover rate.’” The allegation was based on the fact that “a maximum of only 65 apartments would be available from 2015 through 2018 to effectuate the contemplated” renovations. This was due, in part, to certain apartments being subject to the Home Written Agreement. Plaintiffs noted that “the Investment Memorandum … projected that 92% of the available apartments would be vacated and renovated during such period.” Plaintiffs alleged that, based on the foregoing, defendants “had no reasonable reason to believe that such number would be vacated and renovated.”

In rejecting the allegation, the motion court noted that the Investment Memorandum disclosed that the 52 apartment units subject to the Home Written Agreement would not be “candidates for the upgrade strategies” until the program’s expiration in 2018. The motion court held that plaintiffs failed to allege why defendants’ projections, with that disclosure, constituted a misstatement of present fact or lacked a reasonable basis. The motion court concluded that the “challenged statements were ‘not actionable because such projections [were] merely statements of prediction or expectation.’”¹¹ 

The motion court also found that “the only support for Plaintiffs’ allegations based on the vacancy loss projections [was] the fact that the actual vacancy losses were higher than those projected.” “This, too,” concluded the motion court, was “insufficient to sustain [plaintiffs’] claims as neither the Amended Complaint nor Plaintiffs’ opposition contain[ed] allegations that Defendants knowingly made factual misstatements at the time they were made.”

Regarding market rental rates, the motion court found that the allegation was “not based on any alleged arithmetical error but on the fact that the Investment Memorandum utilized apartments which were not representative of the true state of the market.” Such allegations, concluded the motion court, “amount[ed] to a disagreement with Defendants’ business judgment and [were] insufficient to sustain a claim based on fraud or misrepresentation.”¹² 

Further, the motion court held that plaintiffs failed to adequately allege scienter. The motion court found that plaintiffs’ scienter allegations were based on information and belief without any “statement of facts upon which [their] belief [was] based.”¹³ 

As noted, the First Department affirmed.

The Court found that the statements concerning vacancy losses were nothing more than “expressions of hope for the future,” which, it held, “do not constitute actionable representations of fact.”¹⁴ The Court explained that a “party does not make an actionable representation of fact when predicting a future event with no knowledge of whether or not the event may occur.”¹⁵ “Thus,” concluded the Court, “to the extent the first and second causes of action (fraud and negligent misrepresentation) were based on the investment memoranda’s understatement of the expected vacancy losses, they were properly dismissed.”

The Court also held that plaintiffs failed to adequately allege scienter.¹⁶ The Court noted that “[a]lthough scienter is the element of fraud that is ‘most likely to be within the sole knowledge of the defendant and least amenable to direct proof, plaintiff is still required to allege facts from which it is possible to infer defendants’ knowledge of the falsity of their statements when they were made.’”¹⁷ The Court found that “[p]laintiffs allege[d] no such facts; instead, they merely allege[d], ‘Upon information and belief, HQ either knew that [the] statements [about turnover rate and average rent] . . . were false or made such statements with reckless disregard for determining the truth thereof.’”¹⁸ “An allegation made ‘on information and belief … is insufficient to state [a fraud] claim,’” said the Court.¹⁹ 

The Court also found plaintiffs’ motive allegations to be insufficient to support their scienter allegations: “an allegation of ‘pecuniary incentive is insufficient to plead scienter.’”²⁰ 

The Court rejected plaintiffs’ fraud-by-hindsight allegations as a basis to support their claim of scienter: “To the extent that plaintiffs rely on the fact that the portfolio performed much worse than expected, that is insufficient.”²¹ 

The Court also rejected plaintiffs’ attempt to use gross negligence or recklessness as a basis to support the scienter requirement:

Relying on DaPuzzo v Reznick Fedder & Silverman (14 AD3d 302 [1st Dept 2005]), plaintiffs contend that it is sufficient to plead gross negligence or recklessness. However, DaPuzzo said, “In a fraud case against an auditor, a showing of gross negligence or recklessness will permit the trier of fact to draw the inference that a fraud was perpetrated” (id.). HQ is not an auditor. None of the cases in which we have cited DaPuzzo have extended its statement about gross negligence/recklessness to non-auditors. Furthermore, the allegations in DaPuzzo were more indicative of fraud than the ones in the instant action.²²

Chongqing Huansong Indus. (Group) Co. Ltd. v. Kinderhook Indus. LLC, 2024 N.Y. Slip Op. 02887 (1st Dept. May 28, 2024)²³

In Chongqing, plaintiffs, sued Defendant Kinderhook Industries, LLC and its affiliates (collectively, “Kinderhook”) and Defendant Richard Godfrey (“Godfrey”) to recover approximately $60 million allegedly owed to them by non-party Performance Powersports Group, LLC (“PPG”), which Kinderhook acquired from Godfrey in a leveraged buyout of Godfrey’s PPG shares in October of 2021.

Plaintiffs sued Kinderhook and PPG in federal court for breach of contract. PPG filed for bankruptcy protection and obtained a discharge of its debts to plaintiffs. Thereafter, plaintiffs sued Kinderhook and Godfrey in New York state court for, inter alia, fraud. 

Plaintiffs alleged that Godfrey falsely assured them that Kinderhook would ensure that PPG would honor its debts to plaintiffs. Plaintiffs maintained that the statements were false because PPG was cash poor due to the capital requirements of the leveraged buyout through which Kinderhook acquired control over PPG. Plaintiffs argued that defendants knew that the buyout had depleted PPG’s resources, such that the company could never pay back plaintiffs. They also alleged that defendants knew that Kinderhook had no intention of covering PPG’s contractual obligations. 

Defendants moved to dismiss. The motion court granted the motion, holding that plaintiffs failed to plead scienter. The First Department affirmed.

The Court held that “the complaint [did] not plead facts sufficient to permit a reasonable inference that the alleged misrepresentations by defendants were made with knowing falsity.”²⁴ The Court explained that “[t]he allegations of defendants’ attempts to perform on their assurances that all past and future debts of the distributor would be paid by offering payment proposals and making substantial partial payments, including approximately $18 million between October 20, 2021, and November 23, 2021, and $22 million between December 1, 2021, and January 12, 2022, [did] not permit a reasonable inference that defendants knowingly made false representations.”²⁵ “Given the failure to adequately plead scienter,” concluded the Court, “[the] claims were properly dismissed.”²⁶

Footnotes

1. 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).
2. Id. at 559.
3. Id. at 559-60.
4. Id.
5. 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.”).
6. Pludeman v. Northern Leasing, Sys., Inc., 10 N.Y.3d 486, 491 (2008) (internal quotation marks and citations omitted).
7. 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).
8. Oster v. Kirschner, 77 A.D.3d 51, 55-56 (1st Dept. 2010).
9. Id. at 55-56 (citing Eurycleia, supra).
10. Cimen can be found here.
11. Citing ESBE Holdings, Inc. v. Vanquish Acquisition Partners, LLC, 50 A.D.3d 397, 398 (1st Dept. 2008) (internal citation omitted).
12. Citing Olkey v. Hyperion 1999 Term Tr. Inc., 98 F.3d 2, 7-8 (2d Cir. 1996).
13. Quoting Bd. of Managers of Beacon Tower Condominium v. 85 Adams St., LLC, 136 A.D.3d 680, 686 (2d Dept. 2016).
14. Slip Op. at *1.
15. Id. (quoting Albert Apt. Corp. v. Corbo Co., 182 A.D.2d 500, 501 (1st Dept. 1992), lv. dismissed, 80 N.Y.2d 924 (1992)).
16. Id.
17. Id. (quoting MP Cool Invs. Ltd. v. Forkosh, 142 A.D.3d 286, 292 (1st Dept. 2016) (brackets and internal quotation marks omitted), lv. denied, 28 N.Y.3d 911 (2016)).
18. Id.
19. Id. (quoting Elmrock Opportunity Master Fund I, L.P. v. Citicorp N. Am., Inc., 155 A.D.3d 411, 412 (1st Dept. 2017)).
20. Id. (quoting Jonas v. National Life Ins. Co., 147 A.D.3d 610, 612 (1st Dept. 2017) (internal quotation marks omitted)).
21. Id. (citing MP Cool, 142 A.D.3d at 292 (“Although the company may not have performed as plaintiff expected, this does not support a reasonable inference that defendants knew that (the company) would fall short of its business projections.”)).
22. Id. at *1-*2.
23. Chongqing can be found here.
24. Slip Op. at *1 (citing Cronos Group Ltd. v. XComIP, LLC, 156 A.D.3d 54, 72 (1st Dept. 2017); FNF Touring LLC v. Transform Am. Corp., 111 A.D.3d 401, 402 (1st Dept. 2013)).
25. Id. The Court agreed with Godrey, who argued that scienter could not be inferred after substantial partial performance.
26. Id.