I have observed that the more reprehensible the alleged underlying fraud, the more likely it is that courts will accept even less than artfully-pleaded elements of the fraud. A review of the cases upon which I comment in this blog certainly shows a pattern of courts accepting fraud claims that really do not contain all of the required elements of fraud, where the fraudster has acted particularly egregiously.
Last month, I wrote about a decision in which the Appellate Division sustained a claim of “aiding and abetting fraud” against a bank that was asked for a credit reference about a customer who was admittedly involved in criminally-fraudulent conduct. The majority decision in the case (William Doyle Galleries, Inc. v Stettner, 2018 NY Slip Op 08743 (1st Dep’t Decided December 20, 2018) drew a strong and persuasive dissent by Justice Peter Tom. The First Department continued this pattern in the recent decision of Epiphany Community Nursery Sch. v Levey, 2019 NY Slip Op 00842 (1st Dep’t Decided February 5, 2019), in which the majority opinion also prompted a dissent written by Justice David Friedman and joined by Justice Peter Tom.
Reprehensible Fraudster
In his dissent, Justice Friedman acknowledged the “reprehensible” nature of the fraud rather concisely:
The complaint alleges that plaintiff, a not-for-profit corporation operating a preschool, was fleeced of millions of dollars by defendant Hugh W. Levey (Hugh), a financial professional who was, during the relevant period, the husband of nonparty Wendy Levey (Wendy), plaintiff’s founder and (at the time) principal officer and director. Wendy allegedly entrusted plaintiff’s financial management to Hugh from some point in the 1990s until 2013, when Hugh filed for divorce. Assuming the truth of the allegations of the complaint, as a court is required to do upon a CPLR 3211 motion to dismiss, Hugh’s conduct with respect to plaintiff was reprehensible.
The court below granted defendants’ motion to dismiss the complaint with prejudice. The motion court held that the first set of fraud claims were time-barred, while the second set of fraudulent acts constituted conversion and were also time-barred. On appeal, the majority of the First Department affirmed the dismissal on the first set, but reinstated the second set. The dissent opined that all fraud claims were correctly dismissed.
The plaintiff not-for-profit school called Epiphany alleged, in what the court described as the “first set” of fraud claims, that defendant Hugh induced it to sell a part of its business to a company he owned and controlled at an unreasonably low price. The complaint alleged that the $300,000 purchase price was based on a fraudulent valuation commissioned by Hugh, which was “substantially inaccurate.” By applying false figures, Hugh allegedly reduced the purchase price by $1.5 million. The complaint further alleged that if the valuation had been properly calculated the purchase price would have exceeded $1.8 million.
Both the lower court and the First Department found this fraud claim was barred by the statute of limitations. The action was commenced more than six years after this cause of action accrued, so to be timely, the action must have been brought within two years from the time that Epiphany discovered the alleged fraud, or from when it could have discovered it in the exercise of reasonable diligence. The First Department found that Epiphany could have discovered the alleged fraud when Wendy, as Epiphany’s Executive Director, signed the asset purchase agreement on Epiphany’s behalf in 2003. Among other things, the First Department noted that she signed it without obtaining her own appraisal and did not question the disproportionally high rent, which was the basis for the undervaluation of the asset. Thus, these fraud claims were time-barred because plaintiff could have discovered the alleged fraud within the two-year period. There was no dissent on that determination.
First Department Debates the Reasonable Reliance Element
The ”second set” of the fraud claims alleged that Hugh made unauthorized transfers of over $5.9 million from Epiphany’s bank accounts to himself and some of the collateral defendants by linking the bank accounts to his private banking portfolio. Hugh, with the assistance of other defendants, falsely recorded these transfers in Epiphany’s general ledgers as “loans.” However, there were no documents to memorialize these “loans.” Nor were any loan payments ever made. The “loans” were subsequently characterized as “other receivables.” At the end of each year, the other receivables were offset by fake charges Epiphany purportedly owed to companies affiliated with Hugh for “consulting fees” and “lease commissions.”
The majority of the First Department reinstated these fraud claims, first ruling that they were not time-barred because plaintiff was not on notice of anything fraudulent here. The main dispute with the dissent was about the element of reasonable reliance. The majority was content to infer that Wendy relied on her husband Hugh to act in good faith and not defraud her. According to the dissent, however, nothing in the complaint actually identified who on behalf of the plaintiff entity actually relied upon the misrepresentations of Hugh and the other defendants. The dissent makes some cogent points:
… True, the complaint alleges that plaintiff relied on Hugh personally to manage its financial affairs honestly and competently. But there is no allegation that any agent of plaintiff actually relied on Hugh’s written misrepresentations — because no such agent is alleged ever to have read those misrepresentations.
Particularly noteworthy is the complaint’s failure to allege that Wendy — plaintiff’s founder and the director of its school — read or relied upon the alleged misrepresentations in plaintiff’s books and records and financial statements. Presumably, the complaint does not allege reliance on Wendy’s part because Wendy admits, in the affidavit she submitted in opposition to the motion to dismiss, that she did not become aware of Hugh’s scheme until 2016, when it was uncovered by forensic accountants retained by plaintiff’s counsel [footnote omitted]. In the affidavit, Wendy does not say that she was misled about the transfers; she says that she was unaware of them. In addition, the record shows that Wendy testified at her deposition in the divorce case that it was not her practice even to review plaintiff’s audit reports.
To be clear, while the false accounting entries and financial statements alleged in the complaint certainly constitute misrepresentations that could support a fraud cause of action, the complaint fails to identify any particular individual acting as plaintiff’s agent who, at any point in time, read and relied on these misrepresentations. In the 36 pages and 172 paragraphs of the complaint, all that is alleged concerning the reception of the falsehoods in plaintiff’s accounting records and financial statements is the unsubstantiated conclusion that plaintiff itself — a legal entity capable of acting only through real-world human agents — “justifiably relied” on the statements of Hugh.
There were a number of other points of contention between the majority and the dissent, including as to whether the plaintiff could have easily uncovered the alleged fraud – since plaintiff asserted that the defendant auditor should have discovered and disclosed the alleged fraud because it was so obvious.
Commentary
The First Department’s decision in Epiphany Community Nursery Sch. v Levey, is an important example of what I have observed to be the courts’ effort to sustain fraud claims where the underlying fraudulent conduct is particularly evil, manipulative and/or reprehensible. Courts often show leniency in such circumstances. The dissent takes issue with this approach, seeking instead to rely on the well-established elements of the cause of action.