United States: Shareholders Can Assert Derivative Fraud Claims Against Corporate Officers And Directors Notwithstanding In Pari Delicto Context

I have written about and explained the so-called in pari delicto defense in fraud actions. See In Pari Delicto Prevents Equal Wrongdoer from Seeking Damages Relating to Its Own Fraudulent Conduct. Basically, in the corporate context, if corporate officers and/or directors are involved in a fraud on behalf of the corporation, the shareholders are barred from asserting derivative claims on behalf of that very same corporation because the wrongdoing of the agents is imputed to the corporation and the corporation is not permitted to benefit from its own wrongdoing.

In Pari Delicto

As explained by a leading Court of Appeals decision: "[W]here conduct falls within the scope of the agents' authority, everything they know or do is imputed to their principals. . all corporate acts-including fraudulent ones-are subject to the presumption of imputation [and], as with in pari delicto, there are strong considerations of public policy underlying this precedent: imputation fosters an incentive for a principal to select honest agents and delegate duties with care." Kirschner v KPMG LLP, 15 N.Y.3d 446 (2010).

There is a well-recognized exception to this defense of in pari delicto-the adverse interest exception-where the fraudulent corporate agents act solely in their own interests and not in the interests of the corporation, then the corporation is permitted to sue them, or in the case of a shareholder, assert a derivative claim against them on behalf of the corporation for harm the fraud caused the corporation.

A new decision of the Appellate Division, First Department, Community Assn. of the E. Harlem Triangle, Inc. v Butts, 2021 NY Slip Op 07503 (1^st Dep't Decided Dec. 28, 2021), involves an interesting factual context for applying the adverse interest exception.

In Butts, the plaintiffs were shareholders of the subject corporation suing derivatively its officers and directors, along with others who joined with them, in connection with the sale of the corporation's real property. Plaintiffs' amended complaint alleged that the individual defendant officers and directors concealed from the Board of Directors an offer to buy the property at issue for $42 million and convinced a majority of the Board to vote to approve the sale of the property to another entity for only $39 million. Plaintiffs alleged that the corporation suffered damages in the amount of the $3 million difference or the difference between the value of the property at the time of the sale and the $39 million purchase price paid by the accepted buyer.

The New York County Commercial Division denied defendants' motion to dismiss the fraud claims and the First Department affirmed in relevant part.

The First Department addressed and rejected a number of arguments defendants asserted in their attempt to dispense with the fraud claims at the pleadings stage.

Out-Of-Pocket Damages

First, the First Department accepted the theory of damages alleged in the amended complaint because there was a specific confirmed alternative offer for more money that defendants squandered:

Plaintiffs adequately pleaded nonspeculative damages, and their claims are not barred by the out-of-pocket rule (see Lama Holding Co. v Smith Barney, 88 NY2d 413, 421 [1996]). Plaintiffs allege 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 (see Bernstein v Kelso & Co., 231 AD2d 314, 322 [1st Dept 1997]; People v Coventry First LLC, 52 AD3d 345, 346 [1st Dept 2008], affd on other grounds 13 NY3d 108 [2009];Connaughton v Chipotle Mexican Grill, Inc., 29 NY3d 137, 141-143 [2017]). 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. The agreement was never memorialized in a contract 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.

For a more detailed discussion of the damages issues as relate to this factual scenario, see my post on the Chipotle decision.

Intent

The First Department then allowed inferences to fill any gaps in alleging the required intent to defraud, citing Court of Appeals case law that recognized more flexible pleadings when facts are particularly within the knowledge of the defendants. (Pludeman v Northern Leasing Sys., Inc., 10 NY3d 486, 491 [2008]; see Bernstein, 231 AD2d at 321-322; Houbigant, Inc. v Deloitte & Touche, 303 AD2d 92, 98 [1st Dept 2003]).). In this regard, the First Department noted the evidence showing even though one of the defendant directors was not in fact at the Board meeting at which the vote was held, he worked directly with the other defendant who was at the meeting and also knew about the other offer, among other things. The First Department also rejected defense arguments that they would have stood to gain from a higher sale so they could not have perpetrated a fraud in orchestrating a lower price. At the pleadings stage, the First Department found this argument unavailing, especially since defendants offered no legitimate reason for rejecting the higher sale.

Adverse Interest Exception to In Pari Delicto

After sustaining claims of aiding and abetting fraud against other defendants, including the corporation's real estate brokers who were involved in the subject sale, and rejecting the business judgment rule defense at this stage, the First Department acknowledged that the in pari delicto defense was also insufficient to dispose of the fraud claims at the pleadings stage:

The court properly concluded that the adverse interest exception to the in pari delicto doctrine applies. Drawing all inferences in plaintiffs' favor, we find that it is sufficiently alleged that defendants totally abandoned EHAT Corp.'s interests and defrauded it out of $3 million on the sale, which harmed EHAT Corp., and that ADC defendants were acting entirely for their own purpose in steering the sale to Extell rather than to Peebles/Integrated (see Kirschner v KPMG LLP, 15 NY3d 446, 464-467 [2010]).

Commentary

Both the Commercial Division and the First Department obviously were concerned enough about the facially-suspicious nature of the sale transaction to let these fraud claims proceed past the pleadings stage. The significant difference in the two offers for the property and concealment of the higher offer laid a firm foundation to allow plaintiffs to explore and pursue their fraud claims, overcoming several well-recognized potential defenses. As many fraud claims turn on how the courts perceive the factual context of the alleged fraud, this scenario served to breathe life into the claims for further litigation.

Originally published Jan 03, 2022

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