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Fraud Pleading Standard: Specificity Not Required to Plead Scienter of Corporate Defendants in Alleged Corporate Fraud Conspiracy

What facts must a fraud plaintiff plead, pursuant to the heightened pleading standard under CPLR § 3016(b), to cognizably allege scienter among corporate entity defendants in the context of an alleged multi-corporation fraud conspiracy? 

On August 29, 2016, in Ahrenberg et. al. v. Liotard-Vogt et. al., No. 653687, 2016 N.Y. Misc. LEXIS 3151 (Sup. Ct. N.Y. Cnty.), Justice Anil Singh of the Commercial Division held that plaintiffs had sufficiently alleged, through circumstantial allegations of “overlapping entities and schemes,” the scienter element of their fraud claims against corporate co-defendants regarding misrepresentations made to an independent valuation consultant in the context of valuing the plaintiffs’ shares in a corporation.  Justice Singh concluded that a plaintiff need not allege with specify that corporate fraud defendants knew of the falsity of the representations that they made, but instead can point to “surrounding circumstances that may establish that defendants likely knew or knew because of overlapping entities and schemes.”  Ahrenberg, 2016 N.Y. Misc. LEXIS 3151, at *6.   

The plaintiffs in this lawsuit are minority shareholders in “a SmallWorld Holdings Inc.” (“aSW”), a holding company for an invitation-only social network with 850,000 members called ASMALLWORLD.  The defendants were are aSW, ASM Media Consult Corporation (“ASM Media”), and ASW Capital AG (“ASW Capital), as well as two individual corporate officers of the defendant corporations. 

In 2012, defendant ASW Capital obtained a 95% ownership stake in aSW, and then merged with defendant ASM Media.  The merger was structured so that aSW ceased to exist as a legal entity.   At the time of the merger, individual defendant Liotard-Vogt controlled ASW Capital and served on the boards of ASM Media and aSW.  Under the provision of Delaware law, pursuant to which the merger was executed, the plaintiffs, as minority shareholders in aSW, were entitled to cash reimbursement in exchange for their shares in aSW, which valuation was supposed to be based on an independent valuation of their shares.  

Plaintiffs alleged that the defendants retained a consulting firm to provide a valuation of aSW for purpose of establishing the cash value of plaintiffs’ shares.  The consultant provided a valuation of between $3.2 million and $4.6 million.  The defendants thereafter valued aSW halfway between those figures, at $3.9 million. 

In their complaint, plaintiffs alleged that defendants had previously valued the same pool of assets at $43 million when attempting to raise capital.  Plaintiffs argued that Defendants intentionally withheld this $43 million figure from the valuation consultant in order to artificially depress the cash value of plaintiffs’ shares. 

In their motion to dismiss, defendants principally argued that plaintiffs did not properly allege ASM Media’s and ASW Capital’s scienter of the alleged misrepresentations to the independent valuation consultant.  Defendants argued that plaintiffs failed to allege specific facts regarding ASM Media’s and ASW Capital’s awareness of the fact that the valuation information provided to the consultant was allegedly materially incomplete. 

Justice Singh rejected defendants’ argument.  Justice Singh noted that “the standard for particularity of a fraud claim at the motion to dismiss stage is more permissive” than at later stages of a litigation, and that a plaintiff need only allege facts to establish a “rational inference” of scienter.  Id. at *7.  Justice Singh cited the New York Court of Appeals’ decision in Pludeman v. N. Leasing Sys., Inc., 10 N.Y. 3d 486 (2008), which ruled that an allegation of a nationwide scheme that took place over the course of years gave rise to a reasonable inference of the scienter of the corporate defendant.  Justice Singh concluded that plaintiffs’ allegation of a coordinated scheme among the corporate and individual defendants to deprive the plaintiffs of the proper valuation of their shares gave rise to rational inference that the corporate defendants had scienter.  Ahrenberg, 2016 N.Y. Misc. LEXIS 3151 at * 7-8. 

Justice Singh also emphasized that the fact that ASM Media and ASW Capital had overlapping officers and directors provided further reason to infer scienter on the part of those corporate entities.  Id. at *8.  

Finally, the court  rejected the defendants’ argument that even if the plaintiffs had sufficiently pled scienter as to the individual defendants, scienter could not be imputed to the corporate defendants because such imputation would be “too broad” and would “fall[] far short of [giving rise to] a reasonable inference” of corporate scienter.  Id.  The court ruled that the individual defendants’ knowledge could be imputed to the corporate defendants because the individuals controlled ASW Capital and served on the boards of ASM Media and aSW. 

Although Justice Singh’s ruling allows some flexibility in pleading scienter for fraud among corporate defendants, it underscores the need to carefully consider the issue before filing suit.