A recent decision of the United States District Court for the Western District of New York (Larimer, J.) is an informative analysis of various common fraud principles in the context of a FRCP 12(b)(6) motion to dismiss: Real Bridge LLC v. Dan Wise & Rebecca Holderread, 23-CV-6225-DGL (W.D.N.Y. July 2, 2024). It is good federal authority for the plaintiff’s side of the caption.
Real Bridge Case
After investing $450,000 in a financially-challenged “pre-packaged meal delivery company” (known as “Real Eats”), plaintiff sued the company’s founder and Chief Executive Officer (“CEO”), and Chief Financial Officer (“CFO”), for fraud, claiming they misled plaintiff in connection with the investor presentation.
To stay financially afloat, Real Eats sought to raise $4 million in a bridge round of financing (“Bridge Round”) through the issuance of Convertible Notes at terms particularly favorable to investors, in order to reflect the riskiness of their investment. Real Eats held a virtual information session for potential Bridge Round investors, including plaintiff, where attendees were provided with a written presentation (“Investor Deck”). Plaintiff ultimately purchased a Convertible Note issued by Real Eats, in the amount of $450,000.00. About three months thereafter, the CEO advised plaintiff that Real Eats had ceased operations due to its inability to “weather the current capital climate,” and the abrupt seizure of its bank account by its “senior lender.”
Plaintiff sued the two individual defendants for common law fraud (other claims were withdrawn in an amended complaint) alleging they misrepresented Real Eats’s future financial prospects and growth potential during the Investor Deck presentation, which induced plaintiff to purchase a Convertible Note that it would not otherwise have purchased, and to suffer financial loss.
More specifically, plaintiff alleged that during the virtual information session defendants presented several misleading statements about Real Eats’s past growth percentages and future growth projections, allegedly intended to paint a picture of financial health and a path to profitability, while failing to disclose facts about Real Eats’s structure and financing that would have alerted potential investors that Real Eats was in grave financial distress and on the brink of closure. Plaintiff also alleged that defendants falsely stated that the purpose of the Bridge Round investments was to fund capital expenditures that would allow Real Eats to continue its growth and expansion, when in fact, defendants had no intention of growing the company, and instead were planning to use the invested funds to reduce their own personal liabilities, especially to their senior secure lender, in anticipation of Real Eats’s imminent financial collapse.
In their FRCP 12(b)(6) motion to dismiss, defendants argued that (1) plaintiff failed to allege that the CFO made any particular representations to plaintiff at any time so no fraud claim against her existed; (2) any statements that the CEO made at the investor information session, even if untrue, were merely “nonactionable statements of corporate optimism”; (3) as a “sophisticated investor,” plaintiff could not demonstrate justifiable reliance; and (4) plaintiff failed to plead, with particularity, that either defendant acted with scienter (the intent to defraud) while impermissibly asserting allegations upon “information and belief.”
Misrepresentations Must Come from Defendant
The Court first tackled whether the CFO actually made any misrepresentations to the plaintiff, finding that plaintiff’s allegations against the CFO were “too attenuated to set forth a plausible fraud claim against her.” Simply being the CFO was not enough to satisfy the pleading specificity. The Court noted that plaintiff failed to allege that the CFO actually made or authored any of the allegedly fraudulent statements. The Court therefore dismissed plaintiff’s claims against the CFO, albeit without prejudice to allow for further evidence that may be obtained through discovery in the rest of the case, which the Court did sustain.
“Upon Information & Belief” Allegations
First, the Court found that fraud allegations based on information and belief may be permissible where the alleged facts are “peculiarly within the opposing party’s knowledge,” and if the “complaint . . . adduce[s] specific facts supporting a strong inference of fraud.” It then found that plaintiff’s allegations concerning the CEO’s alleged motive were supported by other factual allegations, including Real Eats’s undisputed financial difficulties, defendants’ clear incentive to lie by omission because “no reasonable potential investor ‘would proceed with a transaction knowing’” that Real Eats’s projections and plans were entirely at the mercy of its senior lender who had the authority to seize its bank account, and the eventual actions by the senior lender to do just that, which Real Eats cited as the reason for its demise.
Failure to Disclose – Fraud by Omission
I have written often about the circumstances under which a fraud claim can be based upon the failure to disclose material information rather than affirmative misrepresentations. See,e.g., Omissions Can Amount to Fraud: Duty to Disclose to Avoid Misleading Impressions. As I have explained, one ground to impose a duty to disclose is where a false impression is made that requires clarification. The Court therefore observed that a duty to disclose may arise where the company simultaneously makes “positive assurances . . . that would necessitate additional disclosures,” or that would otherwise “significantly alter[] the ‘total mix’ of information available.” The Court found that plaintiff plausibly alleged that the CEO “engaged in fraud, via a series of ‘optimistic’ statements and ‘positive assurances’ in describing Real Eats’s financial options and future, at the same time deliberately omitting and concealing facts that reflected the unlikelihood that any of those optimistic projections could ever come to fruition.” The Court characterized these as “lies-by-omission,” including “the failure to disclose the very real risk that Real Eats’s senior investor would seize control of the company’s bank account and wipe out every Bridge Round investor’s interests in an instant – a possibility which swiftly came to fruition.”
Justifiable Reliance
In addressing defendants’ argument that justifiable reliance was not adequately alleged, the Court first observed: “It is well settled that ‘[a]n investor may not justifiably rely on a misrepresentation if, through minimal diligence, the investor should have discovered the truth’” citing Ashland, Inc. v. Morgan Stanley & Co., 652 F.3d 333, 337-38 (2d Cir. 2011).
Specifically, defendants argued that plaintiff was a “sophisticated investor,” and was given unfettered access to all of Real Eats’s financial information, which correctly and truthfully reflected the company’s deteriorating financial condition, as did the Investor Deck, which showed the company’s past and future projected losses, and demonstrated the need for the Bridge Round funding to keep the company afloat while it searched for a strategic buyer or Series B investor. As a result, defendants argued it was implausible for plaintiff to not have realized that some or all of the proceeds of the Bridge Round were intended by the CEO to make payments and reduce his liability to Real Eats’s senior lender, since the agreement plaintiff signed stated that the proceeds would be used for “general corporate expenses.” Finally, defendants argued that plaintiff had the ability and opportunity to ask additional questions at the information session or contact defendants or their consultant, but chose not to do so.
On the other hand, plaintiff argued that it exercised its due diligence, engaging a consultant to give advice on Real Eats’s profitability and efficiency, but that defendants’ affirmative deceptions and material omissions prevented it from making a well-informed choice to invest.
The Court concluded that at the pleadings stage of the case, it was “not convinced” that plaintiff failed to plausibly allege justifiable reliance on the completeness and accuracy of the information session materials, or that the “unrestricted access” to Real Eats’s financials that defendants claim to have provided is apparent on the face of the complaint or can reasonably be inferred from plaintiff’s allegations.
Scienter (Fraudulent Intent)
In addressing the element of fraudulent intent, the Court observed: “In order to plausibly set forth a fraud claim, plaintiffs must ‘allege facts which give rise to a strong inference that the defendants possessed the requisite fraudulent intent’” citing Cosmas v. Hassett, 886 F.2d 8, 12-13 (2d Cir. 1989). The Court continued: “The requisite inference may be drawn where a plaintiff alleges: ‘(a) facts showing that defendants had both motive and opportunity to commit fraud, or (b) facts constituting strong circumstantial evidence of conscious misbehavior or recklessness.’ ATSI Communs., Inc. v. Shaar Fund Ltd., 493 F.3d 87, 99 (2d Cir. 2007). ‘Motives that are generally possessed by corporate directors and officers do not suffice; instead, plaintiffs must assert a concrete and personal benefit to the individual defendants resulting from the fraud.’ Sawabeh Info.Servs. [v. Brody], 832 F. Supp. 2d 280, 296 [S.D.N.Y. 2011] (quoting Laknit v. Eichler, 264 F.3d 131, 139 (2d Cir. 2001)).”
Assessing the allegations against these legal principles, the Court sustained the amended complaint, finding:
Here, plaintiff has sufficiently alleged that [the CEO] acted with scienter, plausibly alleging his motive and opportunity to commit fraud by recklessly failing to disclose Real Eats’s true and complete financial condition to potential investors, including Real Eats’s complete susceptibility to its senior investor, and the truth about how invested funds would be used. Plaintiff has also plausibly alleged that by virtue of his statements and omissions, [the CEO] stood to receive direct financial benefits, including the ability to use invested funds to reduce his personal liability to Real Eats’s senior lender, rather than assist the company to achieve the growth and expansion and/or strategic sale plans that were pitched to potential investors.
Commentary
The Court’s decision in Real Bridge is a good source of authority for a plaintiff seeking to support a common law fraud claim in the federal court in New York. While federal courts in New York must apply the substantive law of New York as to the elements of fraud, Federal Rule of Civil Procedure 9(b) (requiring specificity in alleging fraud) and the “plausibility” standard for pleadings apply in federal courts. And federal courts look primarily to other federal decisions interpreting state law, so it is always helpful to have federal case law even on the substantive principles.