Fraud Claim Dismissed; Claim Was Derivative, Not Direct

On May 30, 2018, Justice Masley of the New York County Commercial Division issued a decision in Khan v. Garg, 2018 NY Slip Op. 31061(U), dismissing a fraud claim because it did not plead a direct claim for fraud, explaining:

With respect to Garg, defendants contend that the fraud claim inadequately pleads the elements of intent, reliance, and injury. A fraud claim must allege a misrepresentation or a material omission of fact which was false and known to be false by the 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.

. . .

Preliminarily, the court notes that Khan does not specify whether the fraud claim is direct or derivative; however, the allegations supporting the fraud claim indicate that it is intended to be direct.

A stockholder has no individual cause of action against a person or entity that has injured the corporation, even if the alleged wrongful acts diminished the value of the shares of the corporation or where a shareholder incurred personal liability. A shareholder may not obtain a recovery that otherwise duplicates or belongs to the corporation, except under the narrow exception applicable where the wrongdoer has breached a duty owed directly to the shareholder which is independent of any duty owing to the corporation.

As directed by the First Department in Yudell v Gilber, to determine whether a claim is direct or derivative, a court should consider (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually). Direct claims fail as as matter of law where the harm alleged is anything other than harm to the corporation alone: if the allegations confuse the complaining shareholder's derivative and individual rights, even if some of the claims are direct in nature, the claims cannot stand.

Here, the allegations supporting Khan's fraud claim confuse Khan's direct and derivative rights; therefore, the claim must be dismissed. Khan alleges that Garg intentionally induced Khan to rely on the EIFC financial records falsified by Garg, and those records made it appear that EIFC owed Garg $1.6 million. Thus, though Khan seeks to plead a direct claim for fraud, there is no individual harm alleged in the amended complaint: Khan does not allege that he sustained any harm separate from that sustained by EIFC.

(Internal quotations and citations omitted).

This decision relates to something common in complex commercial litigation--the question of whether a claim can be brought by an individual on his or her own behalf or must be brought on behalf of a corporation or other entity in which the plaintiff has an ownership stake (that is, derivatively). Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client have questions regarding bringing an action on behalf of a corporation or other business entity.