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Is an entity providing pre-construction management services in anticipation of a construction project entitled to file a mechanic’s lien if not paid?  While recognizing that there is a dearth of caselaw on this question, the court in Matter of Old Post Road Associates, LLC (Sup. Ct. Westchester Co. May 9, 2018), held that the answer is dependent on the specific nature of the pre-construction services provided. Old Post Road Associates, LLC (“Old Post” or “Petitioner”) owned a piece of property it intended to develop (the “Project”). LRC Construction, LLC (“LRC” or “Respondent”) was “engaged” to perform pre-construction management services in conjunction with the Project including “updating the conceptual budget for the roject and attending meetings with etitioner’s consultants to discuss construction phasing in connection with the site plan approval application.”  According to the opinion, LRC performed its pre-construction services for free with the hope that it would be retained as the construction manager for the Project.  However, LRC was terminated from the Project without being hired in its desired role.  It appears that the parties believed that LRC should have been compensated for its pre-termination work, but an agreement on the amount could not be reached. Thereafter, LRC filed a mechanic’s lien in the amount of $250,000.00 and claimed the amount due was for “pre-construction management services”.  To discharge the lien, Old Post brought a special proceeding pursuant to New York’s Lien Law § 19 , which provides numerous bases for the discharge of a mechanic’s lien.  The provision relied upon by Old Post (§ 19(6)) permits the discharge of a lien “ here it appears from the face of the notice of lien that the claimant has no valid lien by reason of the character of the labor or materials furnished and for which a lien is claimed….”  Old Post argued that, as a firm rule, “pre-construction management services” cannot support a mechanic’s lien. In denying the petition to summarily discharge Old Post’s mechanic’s lien, the Old Post court analyzed the relevant provisions of the Lien Law and the scant caselaw (which was from a “handful of trial-level court rulings” and “has not been addressed by appellate authority” since Goldberger-Raabin, Inc. v. 74 Second Ave. Corp. , 252 N.Y. 336 (1929), was decided almost 90 years ago) on the subject of whether certain work is or is not an “improvement” under the Lien Law. The statutory authorities relied upon by the Old Post court were §§ 3 and 2(4) of New York’s Lien Law.   Section 3 provides that a “contractor…who performs labor or furnishes materials for the improvement of real property with the consent or at the request of the owner…shall have a lien for the principal and interest, of the value, or the agreed price, of such labor….” (Emphasis supplied.) “Improvement” is defined at Lien Law §2(4) to include “demolition, erection, alteration or repair of any structure upon, connected with, or beneath the surface of, any real property and any work done upon such property or materials furnished for its permanent improvement…and shall also include the drawing by any architect or engineer or surveyor, of any plans or specifications or survey, which are prepared for or used in connection with such improvement….” The Old Post court also relied on caselaw.   Goldberger-Raabin involved tearing down an old building and replacing it with a newly constructed building. The lienor in Goldberger-Raabin was the project engineer responsible for “aiding or assisting in procuring subcontracts and subcontractors” and “superintending the construction of the new building and tearing down of the old building”.  The former was held not to be part of the work that “improved” the property and, thus, was not lienable.  As to the latter, the Goldberger-Raabin Court, found that superintending the new construction was lienable as was superintending the demolition of the old building – provided that “the old building was torn down as part of the work necessary for construction and for the improvement of the real property”.  Such a determination, however, was a factual question to be determined “upon a new trial”. The Old Post court also cited Chas. H. Sells, Inc. v. Chance Hills Joint Venture , 163 Misc.2d 814 (Sup. Ct. Westchester Co. 1995) and Henry & John Assoc. v. Demilo Constr. Corp. , 137 Misc.2d 354 (Sup. Ct. Queens Co. 1987) for the proposition that “the procurement of bids or application for building permits and approvals” are not lienable.  The Chas. H. Sells court did hold that architects and engineers that rendered services in conjunction with obtaining permits for a project that was never commenced and, therefore, where “no actual physical permanent improvement has taken place” were entitled to liens for unpaid work, reasoning that because “a landowner fails to take a project to completion, for whatever reason, the claims for work done to improve the property are no less entitled to the benefits of the statute.” Based on the foregoing, the Old Post court found that the mere fact that a lienor may have rendered services on a pre-construction basis does not, in and of itself, resolve the issue of whether an otherwise validly filed lien must be discharged.  Instead, the actual services provided must be analyzed, and a determination must be made, as to whether the services resulted in a permanent improvement to real property.  In Old Post, the court determined that some of the services provided were subject to liens (i.e. “preparing site logistics and access plans for the property and performing a constructability review for the project at the property) and some were not (i.e. procuring permits or bids).  Accordingly, the Old Post court held that “ n the absence of clear case law precluding mechanic’s liens for all the types of work respondent now describes, and construing the Lien Law liberally Lien=">Lien" Law="Law" §23="§23"> , this Court concludes that respondent’s lien is not entirely invalid on its face, and therefore denies the petition for summary discharge.” TAKEAWAY Before performing “pre-construction” services or work on a project to permanently improve real property, consideration should be given to whether such services or work may support the filing of a mechanic’s lien.  This is particularly so if there are any concerns as to the owner’s ability or willingness to pay for such services. As an aside, the Old Post court described the decision in 8 th Ave. Recoveries Corp. v. 111 Stellar 8 Owner, LLC , 42 Misc.3d 1212(A) (NOR) (Sup. Ct. Kings Co. 2104), as “inapposite” and less persuasive than the other authorities cited by it.  In so doing, the Old Post court summarized the 8th Avenue decision as “ invalid a mechanic’s lien for purported supervisory work that occurred after construction work had ceased” (emphasis in original) quoting the 8 th Avenue court’s reasoning that “supervision of construction work may be the basis of a lien, where the property is not being improved, there is nothing to supervise and thus no basis for a lien.” The relevant issue in 8 th Avenue , however, was whether the subject lien was timely filed, which issue necessarily turned on whether the lienor performed supervisory work on the project within the eight-month period preceding the filing of the lien.  (See Lien Law §10(1) .)  The 8 th Avenue court determined that it did not and vacated the lien as having been untimely filed.  It is suggested that had the 8 th Avenue court been called on to answer the identical question posed in Old Post , it would likely have come to the same conclusion as the Old Post court.

Margin abuse occurs when investment professionals take advantage of investors that do not entirely appreciate the risk associated with margin-based investments. In fact, these professionals have a duty to ensure that the investor understands the danger of such an account before entering into an investment agreement. Failure to meet this duty could result in legal liability.  What Does Buying on Margin Mean? When you “buy on margin,” you are purchasing securities with (at least partly) borrowed money. Borrowed money can come from virtually any source, but when you use an investment firm, you must create a “margin account” with that firm. By engaging in this type of investing, you increase your overall purchasing power, which can, in turn, increase your return on your investment. These accounts have minimal risk for the investment firm, and they generate income as well. The advice that you might get from an investment firm or advisory firm is to buy on margin—because they often have commissions or other financial incentives to push you in that direction. Nonetheless, margin investing comes with several risks attached for you, even though it is relatively safe for the investment firm. What is a Margin Call? When you buy on margin, you generally purchase part of the securities with your own money and finance the rest. When you make this type of arrangement, the securities you bought are the collateral for the remaining portion of the investment. If the collateral value dips below a certain amount, the investment firm can take steps to increase their position. This process is generally referred to as a “margin call.” The investment firm will require you to add more money to the margin account. If you do not do this within a specified timeframe, then they can start liquidating your securities to increase the value of the account. There are no extensions for margin calls, making them very risky and potentially very costly. Other Risks Associated with Buying on Margin Investing on margin is not for the faint of heart. It is possible that the entire security could have little to no value, which would require that the investor input more money for an asset that is virtually worthless. While you really take that risk with any investment, buying on margin makes the potential losses a multiple of what you actually invested. You are also charged interest and/or fees for having the margin loan. This means that you could end up paying for the margin loan before you make any money on the securities. Forced sales due to a margin call could also mean that you sell the securities long before you would in a typical investing situation, significantly decreasing your overall return. Margin call abuse does happen. If you have been forced into fronting more money or your securities have been sold because of a margin call, you may have legal options. Investors should consult an attorney to understand whether they have been the victim of margin abuse .

San Francisco-based Credit Karma, Inc. ("Credit Karma" or the "Company"), the rapidly growing financial services tech company, has been penalized by the Securities and Exchange Commission ("SEC") for regulatory violations related to its Employee Stock Ownership Plan ("ESOP"). The SEC alleged that the Company unlawfully offered securities to its employees and failed to provide them with timely financial statements and risk disclosures.  A copy of the press release announcing the settlement can be found here . The Credit Karma Penalty In the tech sector, stock options are used as a perk to attract and retain highly-skilled workers. Between October 1, 2014, and September 30, 2015, the company issued about $13.8 million in employee stock options, above the regulatory threshold of $5 million.  In the SEC’s Order instituting cease-and-desist proceedings ( here ), the SEC found that Credit Karma did not register its offer of stock options.  Instead, the Company sought to rely on Securities Act Rule 701, which allows privately-held companies to compensate their employees with securities without incurring the obligations of public registration and reporting as long as, once the company issues $5 million worth of securities, it provides essential information about the investment to employees. The SEC found that even though financial statements and risk disclosures were available and confidentially provided to potential institutional investors, Credit Karma failed to provide this information to its own employees. “Registration requirements exist to ensure that all investors have access to important information before deciding to invest,” Jina Choi, director of the SEC’s office in San Francisco, said in a prepared statement. “This is equally true for employees who are investors in the companies where they work.” The alleged wrongdoing occurred while Credit Karma was rapidly growing and hiring employees at a dramatic pace. “Between 2014 and 2016, Credit Karma headcount increased by a factor of five to support an additional 20 million new members,” Credit Karma stated in comments emailed to news organizations.  In early 2014, for example, the Company had about 100 employees. By the end of 2016, the number spiked to about 500. Credit Karma presently employs about 750 people, most of whom are located in San Francisco. The SEC also found that Credit Karma executives were aware of the disclosure requirements regarding the stock options as early as April 2015.  Notwithstanding, “ or the next eleven months after August 2015, Credit Karma continued to grant employees stock options and allowed them to exercise their vested stock options granted in the unregistered offering.” The SEC concluded that “ lthough Credit Karma periodically provided certain limited financial information to its employees, it failed to deliver to the employees the complete financial information and disclosures required by Rule 701.”  Credit Karma also allowed employees to exercise vested stock options, but failed to deliver complete financial information and other required disclosures to employees.  After the Company received an inquiry from the SEC regarding its Rule 701 disclosures in July 2016, Credit Karma began providing disclosure packets to its employees.  According to Credit Karma, the violations have ceased. “We have been in full compliance since mid-2016,” the company stated. The SEC concluded that Credit Karma violated the registration requirements of the Securities Act of 1933 because it offered to sell and sold its securities to employees without a valid Rule 701 exemption. As a result, without admitting or denying the allegations in the Order, Credit Karma consented to the civil penalty and the SEC ordered Credit Karma to cease and desist from any further registration violations. The Takeaway The Credit Karma action is the first enforcement proceeding to arise out of the SEC's investigation into Rule 701 option-granting practices.  The settlement reinforces the SEC’s concern that private companies are not providing to employees the disclosures mandated under Rule 701. The Credit Karma action teaches the importance of Rule 701 compliance. Private companies should, therefore, examine their procedures and controls for ensuring that Rule 701 disclosures are made in a reasonable amount of time before options are exercised if the $5 million threshold is met, or if the company anticipates that the threshold will be met. The Credit Karma action also teaches that companies should carefully consider the methods by which Rule 701 disclosures are made to ensure that they permit effective and ongoing access to the disclosure information. Finally, private companies should keep in mind that until the SEC states otherwise, Rule 701 disclosures must be made prior to the grant of the stock options.

When a complaint is served and filed, a defendant can respond to the pleading in many ways. For example, he/she can answer the complaint or file a motion to dismiss. If the defendant files an answer or the court denies the motion, discovery ensues. Sometimes, a party may conclude that the facts and law necessitate the filing of a motion for summary judgment, even before the close of discovery. Regardless of the timing, the moving party must establish their prima facie entitlement to judgment as a matter of law. The failure to do so, as the defendants learned in UB Distributors, LLC v. S.K.I. Wholesale Beer Corp. , 2018 N.Y. Slip Op. 03559 (2d Dept. May 16, 2018) ( here ), will result in denial of the motion. Background The plaintiff, UB Distributors, LLC (“UB”), commenced the action against the defendants, asserting causes of action sounding in fraud, negligent misrepresentation, conversion, and unjust enrichment, among other things. UB alleged that the defendants fraudulently obtained payments from it under the Returnable Container Act by redeeming empty beverage containers that had already been redeemed by a deposit initiator. In particular, UB alleged that sudden and drastic shifts in the defendants’ empty container redemption volume indicated fraudulent activity and corresponded in time with a double-redemption scheme uncovered on Long Island in the summer of 2009. The defendants denied the allegations and asserted counterclaims against UB. The defendants moved for summary judgment dismissing the complaint, arguing, among other things, that UB lacked any direct evidence of their participation in the scheme. UB opposed the motion and cross-moved for summary judgment dismissing the defendants’ counterclaims. The motion court denied the motion and cross motion. The defendants appealed the denial of their motion. The Appellate Division, Second Department, affirmed. The Standard on Summary Judgment A defendant seeking summary judgment bears the initial burden of demonstrating its entitlement to judgment as a matter of law by submitting evidentiary proof in admissible form, even though the ultimate burden of proof at trial falls upon the plaintiff. See Zuckerman v. City of New York , 49 N.Y.2d 557, 562 (1980). For this reason, the ultimate burden of proof after trial plays no part in the assessment of whether there are relevant factual issues presented on a motion for summary judgment. See generally Jacobsen v. New York City Health & Hosps. Corp. , 22 N.Y.3d 824 (2014). On a motion for summary judgment, a moving defendant must affirmatively demonstrate the merit of its claim or defense. The movant cannot satisfy this burden by merely pointing to gaps in the plaintiff’s case. See Marielisa R. v. Wolman Rink Operations, LLC , 94 A.D.3d 963 (2d Dept. 2012). See also Winegrad v. New York Univ. Med. Ctr. , 64 N.Y.2d 851 (1985). The court’s function on a motion for summary judgment is “to determine whether material factual issues exist, not to resolve such issues.” Lopez v. Beltre , 59 A.D.3d 683, 685 (2d Dept. 2009). A motion for summary judgment, therefore, “ ‘should not be granted where the facts are in dispute, where conflicting inferences may be drawn from the evidence, or where there are issues of credibility’ ” Ruiz v. Griffin , 71 A.D.3d 1112, 1115 (2d Dept. 2010), quoting Scott v. Long Is. Power Auth. , 294 A.D.2d 348, 348 (2d Dept. 2002). See also Bykov v. Brody , 150 AD 3d 808, 809 (2d Dept. May 10, 2017) (“Resolving questions of credibility, determining the accuracy of witnesses, and reconciling the testimony of witnesses are for the trier of fact.”) (citation and internal quotation marks omitted). The Court’s Ruling The Court found that denial of summary judgment was appropriate in light of the credibility issues of the witnesses and the conflicting inferences that could be drawn from the evidence submitted. The Court explained: Here, the defendants failed to establish their prima facie entitlement to judgment as a matter of law. While the defendants submitted the deposition transcripts of their two principals and warehouse manager in which those witnesses denied that the defendants engaged in a double-redemption scheme, those witnesses also testified that the defendants kept no records of their container redemption transactions or records of a “cashbox” they used to pay some of their redemption expenses. Those witnesses offered vague and conflicting testimony as to why the defendants’ redemption volume fell so drastically around the time prosecutors acted on the double-redemption scheme on Long Island. Where, as here, conflicting inferences can be drawn from the evidence and issues of credibility exist, summary judgment is inappropriate. “In light of the defendants’ failure to meet their prima facie burden,” the Court “agree with the Supreme Court’s determination to deny their motion for summary judgment, regardless of the sufficiency of the plaintiff’s opposition papers.” Takeaway UB Distributors is a good example of the shifting burdens associated with a summary judgment motion. As a general matter, the courts view the evidence submitted in a light most favorable to the party opposing the motion and give the non-movant the benefit of every favorable inference. Cortale v. Educ. Testing Serv. , 251 AD 2d 528, 531 (2d Dept. 1998).  Notwithstanding, the burden remains on the proponent of the motion to establish entitlement to summary judgment as a matter of law.  Failure by the movant to make the prima facie showing will result in the denial of the motion, regardless of the sufficiency of the opposing paper. See Alvarez v. Prospect Hosp. , 68 N.Y.2d 320, 324 (1986); Winegrad v. New York Univ. Med. Ctr. , 64 N.Y.2d 851, 853 (1985).  However, if the movant makes the requisite showing, the burden shifts to the party opposing the motion for summary judgment to produce evidentiary proof in admissible form sufficient to establish the existence of material issues of fact that require a trial of the action. Zuckerman , 49 N.Y.2d at 562. In UB Distributors , since the defendants could not meet their burden, the burden never shifted to UB to establish the existence of material issues of fact necessary to defeat the motion.

In the United States, support for legalizing marijuana has been growing. Thirty states and the District of Columbia have enacted legislation that legalize marijuana in some form. Eight states and the District of Columbia allow recreational use of marijuana. According to a 2017 Gallup Poll, 64% of Americans support legalizing marijuana for recreational use. With marijuana becoming more accepted, the cannabis industry has grown. Many of the companies fueling this growth are publicly traded and listed on the MJIC Marijuana Index ( here ) – the Index includes 17 companies, including four that are based in Canada but operate in the United States. As public companies, these entities are required to disclose material information about their business and operations. Legitimate companies do so when newsworthy information, both good and bad, necessitates such dissemination. Companies issuing multiple press releases during a compressed period of time, e.g. , daily or weekly, that only speak glowingly of the entity may be disseminating false information to shareholders and potential investors. Against this background, this Blog will examine the latest SEC enforcement actions against a penny stock cannabis company and its chief executive officer (“CEO”), among others.  The first action involves Bud Genius Inc. (“Bud Genius”), a medical marijuana firm run by Aaron “Angel” Stanz (“Stanz”), that issued false financial statements and claimed to have a licensing agreement with comedian Tommy Chong of Cheech and Chong fame. SEC v. Bud Genius, Inc. , Civil Action No. 18-cv-01005 (S.D. Cal. Filed May 21, 2018). (A copy of the complaint can be found here .) In the complaint, the SEC alleged that Bud Genius, a Wyoming corporation previously known as Rightsmile, Inc., and Stanz, the company’s sole director and CEO, issued false and misleading press releases about a purported licensing agreement with comedian Tommy Chong. In one press release, Stanz allegedly described Chong as a “partner,” and in a subsequent blog post, he described the purported licensing agreement with Chong as a “crowning achievement.” The agreement never materialized, and the defendants allegedly knew at the time that, in light of Bud Genius’s weak financial position, it was extremely unlikely that an agreement would ever be reached. The SEC charged that the defendants’ false and misleading claims about the agreement were picked up by multiple media outlets. The defendants also are alleged to have published fraudulent financial statements and to have facilitated an unregistered offering of Bud Genius securities. The unregistered offering is the subject of a second action filed by the SEC in the Northern District of Iowa against Taylor Moffitt, Carlos Febles, and U.S. CoProducts LLC. SEC v. Moffitt , Civil Action No. 18-cv-03034 (N.D. Iowa Filed May 22, 2018) (A copy of the complaint can be found here .) The SEC alleged that the defendants acquired, offered, and sold billions of shares of unregistered Bud Genius stock for a total profit of more than $540,000, approximately $140,000 of which was paid to Bud Genius and Stanz. Regarding the company’s financial condition, the SEC alleged that between 2012 and 2014, Bud Genius issued materially false and misleading financial reports to the investing public. In 2012, 2013, and the first three quarters of 2014, for example, the defendants allegedly inflated the company’s “total revenue” by adding revenue generated by the company and that of a charter jet business owned by Stanz. In 2012, and the third quarter of 2014, the defendants allegedly inflated the company’s “intangible assets” related to software developed overseas. Under GAAP, while some initial and preliminary development costs are expensed, costs incurred to develop website and computer software during the application development stage are capitalized using their historical ( i.e. , actual) cost. In the case of Bud Genius, the software development work was primarily performed by foreign subcontractors at a significant lower cost than if the work was performed in the U.S. The SEC claimed that Stanz knowingly assigned an inflated and unjustifiable value to the intangible assets by estimating what the cost would have been to perform the development work in the U.S., even though the actual cost was much less. Although the company’s accountant advised that the valuation violated GAAP, “Stanz insisted on going forward with the inflated valuation.” Finally, for 2013 through 2014, Bud Genius and Stanz allegedly reported loan payments owed to Bud Genius by a company owned by consultant Taylor Moffitt as “accounts receivable”. By mischaracterizing the loan as an “account receivable,” the SEC claimed that Bud Genius and Stanz created the false and misleading impression that the company was generating, or had previously generated, more business and operating revenue than was actually the case. Without admitting or denying the SEC’s allegations, Stanz agreed to a judgment enjoining him from violating Sections 5(a), 5(c), 17(a)(1) and 17(a)(3) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, imposing five-year officer-director and penny stock bars, and ordering disgorgement and prejudgment interest of $158,829. Without admitting or denying the SEC’s allegations, Bud Genius agreed to a judgment enjoining it from violating Sections 5(a), 5(c), 17(a)(1) and 17(a)(3) of the Securities Act, and Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder. The settlements are subject to court approval. Without admitting or denying the SEC’s allegations, Moffitt, Febles, and U.S. CoProducts agreed to a judgment enjoining them from violating Sections 5(a) and 5(c) of the Securities Act and all three will be jointly and severally liable for $435,595 in disgorgement and prejudgment interest. In addition, Moffitt and Febles agreed to penny stock bars of three years and one year respectively, and to pay civil penalties of $35,000 and $20,000, respectively. These settlements also are subject to court approval. A copy of the SEC press release announcing the two enforcement actions can be found here .

Litigation of residential mortgage foreclosure actions in New York remains prevalent at the trial and appellate court levels.  Issues related to residential mortgage foreclosure are frequently treated in this Blog. ( Here , here , here , here and here .) It is not uncommon for an individual faced with the prospect of losing a home to foreclosure, to file a bankruptcy petition on the eve of a foreclosure sale in an effort to stop the sale.  Section 362 of the Bankruptcy Code , provides that the filing of a bankruptcy petition “operates as a stay, applicable to all entities, of…the commencement or continuation … of a judicial … or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title….”  (11 U.S.C. 362(a)(1).)  There is no doubt that the filing of a bankruptcy petition, in general, operates to stay mortgage foreclosure actions.  See Lubonty v. U.S. Bank National Association , 159 A.D.3d 962 (2d Dep’t 2018). The stay of a foreclosure sale frequently serves a legitimate purpose consistent with the objectives of the Bankruptcy Code.  Many times, however, the opposite is true and, in such cases, the Bankruptcy Code has some built in protections to prevent abuse.  One such provision of the Bankruptcy Code, known as “Three Strike Rule”, provides that: If a single or joint case is filed by or against a debtor who is an individual under this title, and if 2 or more single or joint cases of the debtor were pending within the previous year but were dismissed, other than a case refiled under a chapter other than Chapter 7 after dismissal under section 707(b), the stay under subsection (a) shall not go into effect upon the filing of the later case. 11 U.S.C. 362(c)(4)(A)(i). In USAA Federal Savings Bank v. Gotsch (Sup. Ct. Suffolk Co. May 10, 2018) ( here ), the Court relied on this provision to deny the mortgagor defendant’s request that the court invalidate the foreclosure sale of residential real property that he owned (the “Property”). The facts in Gotsch are simple. Gotsch borrowed $350,000 from plaintiff and secured the obligation to repay the resulting note with a mortgage on the Property.  When Gotsch defaulted in the repayment of the loan, USAA commenced a residential foreclosure action. Gotsch defaulted in answering the complaint and failed to appear at the scheduled foreclosure settlement conference.  Both of plaintiff’s subsequent motions, for an order of reference and then for a judgment of foreclosure and sale, were granted on default. On the day of the first foreclosure sale, Gotsch filed a petition under Chapter 13 of the Bankruptcy Code that stayed the sale (the “First Bankruptcy”).  The First Bankruptcy was dismissed a few months later.  A second foreclosure sale was scheduled and, on the day that it was to occur, Gotsch filed his second petition under Chapter 13 of the Bankruptcy Code (the “Second Bankruptcy”).  The Second Bankruptcy was dismissed two months later. A third foreclosure sale was scheduled and, on the day it was to occur, Gotsch filed a third petition under Chapter 13 of the Bankruptcy Code (the “Third Bankruptcy”). Despite Gotsch’s “bald” allegation that he notified the lender’s attorney, and that his realtor notified the foreclosure sale referee, of the filing of the Third Bankruptcy, the scheduled sale went forward, and the subject property was sold at public auction.  Within a few weeks of the foreclosure sale, Gotsch moved by Order to Show Cause (the “OSC”) to “invalidate the foreclosure sale” based on, inter alia , violations of the automatic stay provisions of the Bankruptcy Code.  The OSC contained a temporary restraining order prohibiting, inter alia , the transfer of the Property. The several arguments were made in opposition to the motion.  The lender argued that, by virtue of the Three Strike Rule, there was no automatic stay in place upon the filing of the Third Bankruptcy because there were “two or more bankruptcy cases … pending against within the previous year were dismissed….”  It was also argued that because there was ample evidence in the record that Gotsch did not reside at the Property, he would not be prejudiced or irreparably harmed if the sale was sustained. The Third Bankruptcy was dismissed within two months of the filing of the OSC. Relying on the Three Strike Rule and Second Department authority interpreting same, the Gotsch court held that there was no automatic stay in effect on the day of the third foreclosure sale.  The Court also held that there was no evidence to set aside the sale using its “broad equitable powers” that could be invoked in the face of “fraud, collusion, mistake, or misconduct cast doubt on the fairness of the sale.”  The Court further found that “the evidence suggests that three bankruptcy filings, each one initiated on the same day as a scheduled Foreclosure Sale, were brought simply to delay the sale of the subject property and may fairly be characterized as an abuse of the legal system.”  (Citations omitted.)

This Blog has previously examined the different aspects of a shareholder’s derivative action, such as the standing requirements and the distinction between direct and derivative claims. ( Here , here and here .) Today’s article revisits these issues. The Demand Futility Requirement Under Delaware law, to have standing to bring a derivative claim on behalf of a corporation, a plaintiff “must make a pre-suit demand that the board pursue the contemplated action.” Asbestos Workers Phila. Pension Fund Asbestos Workers v. Bell , 137 A.D.3d 680, 682 (1st Dept. 2016). “A pre-suit demand upon a board may be excused, however, if such a demand would have been ‘futile.’” Id .  Either allegation must be pled with particularity in order for a derivative claim to survive a motion to dismiss. See , e.g. , Brehm v. Eisner , 746 A.2d 244, 254 (Del. 2000). Where the “subject of the derivative suit is not a business decision of the board” but, instead, is a wrong committed against the company by a third party, or the board’s inaction, demand is only excused when the plaintiff alleges facts “rais a reasonable doubt that … the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” Rales v. Blasband , 634 A.2d 927, 934 (Del. 1993). “ o rebut the presumption of disinterestedness under the Rales test, the plaintiff must plead particularized facts that, if proved, would establish that a majority of the directors face a ‘substantial likelihood’ of personal liability for the wrongdoing alleged in the complaint.” Wandel v. Dimon , 135 A.D.3d 515, 517 (1st Dept. 2016). Demand futility is examined with respect to the board’s membership at the time the complaint is filed. Braddock v. Zimmerman , 906 A.2d 776, 785 (Del. 2006). The Distinction Between Direct and Derivative Claims Where the wrong is against a corporation, the shareholder does not have an individual claim, even if the shareholder loses the value of his/her shares or incurs personal liability in an attempt to keep the corporation solvent. Abrams v. Donati , 66 N.Y.2d 951, 953 (1985); Serino v.  Lipper , 123 A.D.3d 34, 40 (1st Dept. 2014). “The distinction between derivative and direct claims is grounded upon the principle that a stockholder does not have an individual cause of action that derives from harm done to the corporation but may bring a direct claim when the wrongdoer has breached a duty owed directly to the shareholder which is independent of any duty owing to the corporation.” Accredited Aides Plus, Inc. v. Program Risk Mgmt., Inc. , 147 A.D.3d 122, 132 (3d Dept. (2017) (citation and internal quotation marks omitted). In determining whether a claim is direct or derivative, “a court must look to the nature or the wrong and to whom the relief should go.” Tooley v. Donaldson Lufkin & Jenrette, Inc. , 845 A.D.2d 1031, 1038 (Del. 2004). Specifically, the 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).” Yudell v. Gilbert , 99 A.D.3d 108, 114 (1st Dept. 2012) (internal quotation marks and citations omitted); Maldonado v. DiBre , 140 A.D.3d 1501, 1503-1504 (3d Dept. 2016). “The pertinent inquiry is whether the thrust of the plaintiff’s action is to vindicate his personal rights as an individual and not as a stockholder on behalf of the corporation.” Maldonado , 140 A.D.3d at 1504 (internal quotation marks and citation omitted). The plaintiff must show that the duty allegedly breached was owed to the shareholder, and that he/she can prevail without showing an injury to the corporation. Yudell , 99 A.D.3d at 114. If the individual claim of harm is “confused with or embedded” within the harm to the corporation, then it must be dismissed. Serino , 123 A.D.3d at 40; Patterson v. Calogero , 150 A.D.3d 1131, 1133 (2d Dept. 2017) (even where individual harm is claimed, if it is confused with or embedded in the harm to corporation, it cannot stand separately). Glaubach v. PricewaterhouseCoopers, LLP In Glaubach v. PricewaterhouseCoopers, LLP , 2018 N.Y. Slip Op. 30875(U) (Sup. Ct., N.Y. County, May 9, 2018) ( here ), Justice O. Peter Sherwood of the Supreme Court, New York County, considered the foregoing principles in dismissing an action brought against, among others, PricewaterhouseCoopers, LLP (“PwC”) for accounting malpractice. Background In 2010, Plaintiff, Felix Glaubach (“Glaubach”), the founder, former president, and a minority shareholder of Personal Touch Holding Corp. (“Personal Touch”), a home health services company, took a medical leave of absence from Personal Touch. From 2010 through 2011, several Personal Touch executives, particularly chief executive officer David Slifkin (“Slifkin”), executive vice-president and general counsel Robert Marx (“Marx”), and vice-president Gertrude Balk (“Balk”), caused Personal Touch to pay themselves undeclared and undisclosed income that was improperly classified as reimbursement of education expenses that they never incurred. When Glaubach recovered from his illness and returned to Personal Touch, he blew the whistle on the fraud and improprieties. In 2013, the Internal Revenue Service (“IRS”) audited the company. Personal Touch hired counsel to represent it in the audit. The firm discovered the fraud and advised Glaubach of it. Glaubach personally paid $827,759 to the IRS and the New York State Treasury to address the wrongdoing perpretrated by the company’s executives. On July 2, 2013, Slifkin resigned from the board of directors. Notwithstanding Slifkin’s resignation, Glaubach claimed that the board, which added four new directors, was beholden to him. In July 2014, Glaubach demanded that the board take action with regard to the financial improprieties previously identified. That demand was followed up with a demand letter in October 2014 letter, and again in January 2015. In February 2015, the board appointed a committee consisting of newly appointed board members to investigate the allegations. During this time, PwC performed independent audits of Personal Touch’s consolidated financial statements and issued opinion letters with respect thereto. In March 2015, Glaubach commenced a derivative action in Supreme Court, Queens County, in which he asserted claims against all of the members of the board and company officers. Glaubach claimed that he incurred $5 million in legal expenses in that action. In 2016, Glaubach commenced the action in New York Supreme Court against PwC, asserting one derivative claim for accounting malpractice (first cause of action), and the remaining claims as direct claims arising from the fraudulent misconduct by the executives at the company (second through seventh causes of action). Glaubach asserted that for years he had a “direct relationship of trust” with PwC, and that each year PwC discussed the financial health of the company with Glaubach at Personal Touch’s offices. He also asserted that he discussed with PwC his role as a 27% shareholder, as a lender of $10 million, and the importance of the audits to his own financial decisions. PwC was told of the fraud and improper activities and reexamined and reevaluated the previous years’ financial statements to address those issues. Glaubach claimed that due to the fraudulent activities at the company and the alleged accounting malpractice, the value of the company had severely declined, and the value of his shares had plummeted. Glaubach stated that he loaned millions of dollars to the company, and that he had spent millions of dollars in legal fees to try to repair the damage to the company and to his reputation. PwC moved to dismiss, contending that Glaubach’s direct claims against it were derivative, and that it did not owe any duty to Glaubach independent of any duty it owed to Personal Touch. It also contended that the nature of the damages Glaubach sought demonstrated that the claims were derivative. As to the derivative claim, PwC contended that Glaubach failed to plead demand futility. The Court agreed and dismissed the complaint in its entirety. The Court’s Ruling The Court found that Glaubach failed to make a pre-suit demand on the board to pursue a  malpractice claim against PwC, or allege that such a demand would have been futile. The Court rejected Glaubach’s reliance on his letter demands because they were not directed at the claimed auditor malpractice: First, while Glaubach alleges “demands” that he made on the board of directors, his demands were for the Board to investigate alleged wrong doing of certain company executives, not to investigate and commence an action against PwC for auditing malpractice. Specifically, he demanded that the Board take “‘action against all parties who received monies fraudulently characterized as ‘educational expenses.’” This fails to satisfy Delaware’s presuit demand requirement for the derivative accounting malpractice claim. Moreover, the Court held that “the complaint fail to sufficiently allege demand futility.” The Court found that Glaubach failed to allege “particular facts establishing that a majority of the board at the time plaintiffs commenced this action was interested or lacked independence,” as required under Delaware law. The Court went on to note that “Plaintiffs fail to allege that any, much less a majority, of the directors faced a substantial likelihood of liability for PwC’s alleged malpractice.” The complaint failed to allege that “there were direct ties between PwC and Personal Touch’s board members, or any allegations that the board was dominated by a director or officer who condoned PwC’s alleged improper conduct.” (Citations omitted.) The Court further noted that the complaint did “not even detail the size of the board or its current composition, or that a majority of them were involved in, or even stood to gain by any alleged fraudulent conduct, or other improper conduct by PwC.” As such, Glaubach failed “to meet the heightened pleading standard set forth in Delaware Chancery Court Rule 23.1, as it failed to plead in a ‘director-by-director’ fashion, instead, asserting conclusory and speculative statements about the board.” (Citations omitted.) The Personal Touch executives Glaubach asserts were looting the company for their personal benefit, Slitkin, Balk, and Marx, were not a majority. In fact, Slifkin resigned from the Board in July 2013, and these executives were not alleged to have control over the board. Glaubach’s conclusory allegations that the board is populated by persons with “ties to” one of the alleged wrongdoers, falls far short of the requirement of particularized allegations that a majority of the board would face a substantial likelihood of personal liability. Accordingly, the Court dismissed the accounting malpractice claim against PwC. The Court also dismissed the remaining claims against PwC, holding that they were derivative, rather than direct, claims. As such, they “should have been pleaded as derivative claims, and were required to meet the demand requirements” discussed above. Here, Glaubach’s claim for damages based on the lost value of his shares is derivative. “The lost value of an investment in a corporation is quintessentially a derivative claim by a shareholder.” Because Glaubach’s alleged damage for lost share value is not any different from the losses suffered by any other shareholder, and his claim is supported by the identical proof, it is not viable as a direct claim, as a matter of law. All of the shareholders of Personal Touch are harmed by PwC’s alleged auditing failures and would recover pro rata in proportion with their ownership of the company’s stock because they are stockholders. In addition, his claim for damages in the amount of $2.2 million for the allegedly false continuing education reimbursements clearly alleges injuries suffered by the company, which would receive the benefit of any recovery, not the individual shareholders. The Court rejected Glaubach’s attempt to convert the action into a direct one by alleging that PwC made misrepresentations to him personally, or that PwC knew that he had a financial interest in the company. Such allegations, held the Court, were “unsubstantiated.” Similarly, the Court rejected Glaubach’s attempt to convert the action into a direct one because of the damage to his reputation “as a pioneer in the health services industry” and for lost earnings, “because they are inextricably intertwined within the derivative claim.” The Court noted that while Personal Touch did “not have any right to recover for damage to Glaubach’s reputation in the health services community, it is the financial difficulties that the company suffered as a result of the financial mismanagement and purported looting that could have negatively impacted his reputation.” The Court held that this claim was “indistinguishable from the embedded claims.” Finally, the Court rejected the argument that Glaubach had a relationship with PwC that converted the claim to a direct one. Contrary to Glaubach’s contentions, the amended complaint fails to allege and seek recovery for any personal damages for an individual, personal contractual relationship with PwC. Glaubach does not allege that he ever hired or paid PwC to perform any services for him individually. The annual engagement letters demonstrate that PwC was retained by Personal Touch, not Glaubach, and that it was for services for the company, not for him personally. Glaubach was not a party to a commercial contract with PwC that he was seeking to enforce in his own right. His allegations that he made personal financial decisions in reliance upon PwC’s audits of Personal Touch do not convert these derivative claims into direct claims. Takeaway Glaubach demonstrates that a board’s failure to act is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” Asbestos Workers , 137 A.D.3d at 684. One reason for such difficulty is the demand requirement. The cases show that the demand requirement is rigorous. Factual particularity is necessary. As Justice Sherwood found, Glaubach could not meet those requirements.

Contract provisions containing deadlines for giving notice of an event or occurrence, such as a claimed default, are key parts of commercial transactions. These provisions vary from contract to contract, often requiring different forms of notice and different timing requirements for notice to be given on different issues. Not surprisingly, notice provisions, and compliance with these provisions, are often a basis for disputes. Recently, the Delaware Court of Chancery underscored the importance of the foregoing. In PR Acquisitions, LLC v. Midland Funding LLC , C.A. No 2017-0465-TMR (Del. Ch. April 30, 2018) ( here ), the court barred a claim made for funds held in escrow because the subject agreements required notice to be sent to the seller, but instead notice was sent to the escrow agent. Although the buyer gave actual notice by phone to the seller prior to the deadline, the Court rejected such notice as violative of the agreements. Background PR Acquisitions involved the sale of consumer debt accounts by Plaintiff PR Acquisitions, LLC (“PRA”) to Defendant Midland Funding LLC (“Midland”) pursuant to a purchase and escrow agreement. The agreements required that claims for funds held in escrow based, for example, on alleged breaches of the parties’ representations and warranties, be sent to an address provided in the agreement. Midland drafted a letter identifying legal claims against the escrow in relation to the purchase agreement. Midland sent the letter by facsimile and FedEx to the escrow agent rather than PRA as required under the agreements. Midland never sent a copy of the letter or any other form of notice to PRA. A few days later, the escrow agent informed PRA of the letter containing Midland’s claims. Midland conceded that the sole reason for its failure to provide notice pursuant to the purchase agreement and escrow agreement was “ uman error” on its side. PRA asked Midland to release the escrow funds and disputed the claims set forth in the letter. Midland refused to release the escrow funds. PRA filed suit seeking the release of the escrow funds. Midland asserted counterclaims against PRA and third-party claims against Operating Partners Co., LLC, an affiliate of PRA that serviced the purchased accounts, alleging contractual breaches, fraud, aiding and abetting fraud, negligent misrepresentation, indemnification claims, and unjust enrichment arising from the sale of the accounts. A couple of months later, PRA moved for summary judgment on its request to release the escrow funds. Amendments to the counterclaims followed, along with motions to dismiss the counterclaims. On December 8, 2017, Midland moved for partial summary judgment, seeking declaratory judgment that the escrow funds should not be released until Midland’s counterclaims and third-party claims were adjudicated. The Court granted PRA’s motion and denied Midland’s motion. The Court’s Analysis Noting that “ he applicable provisions in the Purchase Agreement and Escrow Agreement express and clear,” the Court rejected Midland’s argument that notice by means other than those set forth in the agreement ( e.g. , by telephone) should suffice. To establish a timely claim, the Escrow Agreement requires that notice be sent either by a nationally recognized courier service or by certified mail to a specified PRA address, or by facsimile to a specified PRA location followed by a telephone call to confirm receipt thereof. If Midland fails to provide notice by these methods by the expiration date, then the terms of the transaction documents negotiated by the parties dictate that the escrow funds should be released. Midland acknowledges that it did not comply with these requirements. But Midland notes that the escrow agent made PRA aware of Midland’s escrow claims before the expiration date. Midland argues that because PRA received actual notice, case law allows the Court to ignore the terms of the notice requirements in the Escrow Agreement. Midland further argues that the actual text of the Purchase Agreement and Escrow Agreement do not require strict compliance with the notice provision. These arguments fail. Strict Compliance with The Terms of The Contract is Required The Court rejected Midland’s argument that actual notice to PRA by phone should suffice as substantial compliance with the agreements. It did so by distinguishing several cases that Midland relied on.  None of the cases, however, allowed for substantial compliance when the agreement specified a particular method of delivery to a specific party by a fixed deadline as a condition for claims to an escrow fund. PRA and Midland are sophisticated parties who negotiated the Purchase Agreement and Escrow Agreement at arm’s length. Further, in each case to which Midland points, the party actually transmitted notice to whom it was due. Here, Midland sent notice to a third party (the escrow agent) who then informed PRA of Midland’s escrow claims. Thus, I reject Midland’s argument that Midland substantially complied with the notice provision in the Escrow Agreement. The Court also rejected Midland’s argument that the agreements did not require “strict compliance” with the notice provision. The Court noted that the Escrow Agreement specified “what constitute notice and require the release of the escrow funds if such notice not provided by” the specified date. Midland failed to satisfy the provision and offered “no reason other than its own error for its failure to comply with the notice provision in the escrow agreement.” Consequently, the Court granted PRA’s motion for summary judgment and denied Midland’s motion for partial summary judgment. Takeaway While the result in PR Acquisition may seem a bit harsh, especially since Midland gave PRA actual notice, the analysis employed to get there reflects traditional contract interpretation. As the Court noted, “ he terms of the contract control when they establish the parties’ common meaning so that a reasonable person in the position of either party would have no expectations inconsistent with the contract language.” Slip op. at 16 (citations and internal quotation marks omitted). In PR Acquisition , “ he applicable provisions in the Purchase Agreement and Escrow Agreement express and clear.” Id . at 17.  As such, “the terms of the transaction documents negotiated by the parties dictate ” how and when notice was to be provided and the circumstances under which the escrow funds should be released. Therefore, as a matter of law, the failure to comply with the express terms of the notice provision compelled the result reached by the Court. Given the foregoing, PR Acquisition provides a cautionary tale about the importance of complying with contractual provisions.

In Mitsubishi Motors North America Inc. v. Grand Automotive, Inc. d/b/a Planet Mitsubishi , the United States District Court for the Eastern District of New York granted Mitsubishi Motors North America’s (“Mitsubishi”) request for a preliminary injunction pursuant to Rule 65 of the Federal Rules of Civil Procedure. Mitsubishi distributes its vehicles through a network of authorized dealerships that are authorized to “sell and provide services relating to…Mitsubishi motor vehicles, parts, and accessories pursuant to Dealer Sales and Service Agreements <“dssa”> .”  Entering into the DSSA, entitled dealers to the limited use of Mitsubishi’s trademarks and related intellectual property (“IP”) in connection with the sale of Mitsubishi vehicles.  Significantly, the license is strictly “limited to the authorized location of the dealership from which the dealer operates.” In 2016, Planet and Mitsubishi entered into a new three-year DSSA (the “Planet DSSA”), that, inter alia , authorized Planet to operate its dealership, and granted to Planet a non-exclusive license to use the IP (absent contrary prior written authority), exclusively at 265 North Franklin Street, Hempstead, New York (the “Location”). The Location was leased from the fee owner (“Landlord”).  Planet failed to timely notify the Landlord that it intended to exercise a renewal option under the lease and, accordingly, the Landlord sent notice to Planet that its lease was terminated.  At the time, Mitsubishi was not notified of this development.  Thereafter, Planet advised Mitsubishi that it was considering a new location, which, for a variety of seemingly appropriate reasons, was not approved by Mitsubishi.  Mitsubishi denied Planet’s subsequent request to relocate to a different alternative location (the “Unauthorized Location”) – again for seemingly appropriate reasons. Undaunted, despite Mitsubishi’s failure to approve same, Planet nonetheless relocated to the Unauthorized Location.  This move prompted Mitsubishi to serve a “cease and desist” letter to Planet demanding that it stop using the IP and otherwise comply with the Planet DSSA.  A “Notice of Termination” of the Planet DSSA was served as a result of Planet’s alleged failure to resolve the issues presented by the “cease and desist” letter. Mitsubishi commenced action and moved by Order to Show Cause for a Temporary Restraining Order (“TRO”) prohibiting Planet from using the IP and from operating a Mitsubishi dealership at the Unauthorized Location.  The requested TRO was granted and the Court directed briefing on whether to issue a preliminary injunction.  Upon review and analysis of the parties’ submissions, the Court issued a preliminary injunction. In order to establish entitlement to a preliminary injunction, the movant must demonstrate: 1. the likelihood of success on the merits; 2. irreparable harm absent preliminary relief; 3. that the balancing of equities tips in movant’s favor; and, 4. that injunctive relief is in the public’s interest.  The Court also noted that when “a preliminary injunction requires an affirmative act or mandates a specific course of conduct (as opposed to maintaining the status quo ), the injunctive relief is understood to be mandatory requiring the application of a ‘clear’ and ‘substantial’ likelihood of success on the merits.”  (Citations and some internal quotation marks omitted.) Irreparable Harm The Court described irreparable harm as the “single most important prerequisite” for preliminary injunctive relief, and stated that to prove same, the movant must demonstrate that “absent a preliminary injunction they will suffer an injury that is neither remote nor speculative, but actual and imminent, and one that cannot be remedied if a court waits until the end of trial to resolve the harm.  (Citations and some internal quotation marks omitted.)  The factors to consider in determining whether irreparable harm exists are: 1. the likelihood of irreparable injury absent the requested injunctive relief; 2. remedies at law – such as monetary damages – are inadequate to compensate movant; 3. the balancing of hardships favors the movant; and, 4. the public interest would not be “disserved” if the injunctive relief is granted.     (Citations and some internal quotation marks omitted.) The Court also recognized recent Second Circuit authority holding that courts “must not adopt a categorical or general rule or presume that the plaintiff will suffer irreparable harm” and, accordingly, must actually consider the consequences to the movant if the preliminary injunction is denied, but the movant prevails on the merits.  (Emphasis in original; citations and some internal quotation marks omitted.) Based on the evidence, the Court determined that irreparable injury was likely absent the requested relief based on Mitsubishi’s “loss of control over its reputation and goodwill caused by Defendant’s continued use of at the Unauthorized Location pending a final” merits determination.   Much of the Court’s analysis in this regard related to the contractual requirement that Mitsubishi approve the dealer’s location and the unsuitability of the Unauthorized Location for a Mitsubishi dealership. Mitsubishi had no adequate remedy at law because “the losses of reputation and goodwill and resulting loss of customers are not precisely quantifiable.”  As to the balancing of the equities, the Court found, among other things, that “Planet has only itself to blame for its present predicament by failing to timely exercise the lease extension option at .”  In addition, the Court presumably agreed with Mitsubishi’s position that, among other things, Planet will not be burdened because the injunction would simply prevent Planet from engaging in conduct to which it has no right to engage and its performance was so poor it consistently lost money on the sale of new Mitsubishi vehicles.  Finally, the public interest would be served by the granting of the requested injunctive relief because such would alleviate the potential for the “consuming public” to be confused as to whether Planet is an authorized Mitsubishi dealer. Likelihood of Success As previously discussed, the Court determined that a heightened standard of proof because “the relief sought here requires Planet to engage in an affirmative act or specific course of conduct ( i.e., removal of all from the Unauthorized Premises as well as Planet’s website) which would alter the status quo ante .” Applying the heightened standard, the Court found that Mitsubishi would likely succeed on its unfair competition claims because the Planet DSSA was properly terminated and, therefore, Planet’s continued use of Mitsubishi’s protectable IP is improper, unauthorized and would likely lead to confusion.  Even if the Planet DSSA was not properly terminated, the Court found that Mitsubishi would likely succeed on the merits of its unfair competition claims because the license to use the IP was contractually limited to the Location and, therefore, use of the IP at the Unauthorized Location was prohibited and might confuse the public into thinking such use was indeed permitted. Similarly, the Court found that Mitsubishi would likely succeed on the merits of its contract claims because “Planet’s unauthorized relocation and subsequent continued use of the constituted the initial breach of the parties’ agreement giving rise to damages.”

The Securities and Exchange Commission (“SEC”) has been busy so far this month. In the latest roundup, this Blog looks at three enforcement actions taken by the SEC against hedge funds and advisers involving fraud and insider trading. Hedge Fund Advisory Firm Settles Charges Related to Asset Mismarking and Insider Trading On May 8, 2018, the SEC announced ( here ) that New York-based Visium Asset Management LP (“Visium”), a hedge fund advisory firm, agreed to settle charges related to asset mismarking and insider trading by its privately managed hedge funds and portfolio managers.  Visium’s CFO also agreed to settle charges that he failed to respond appropriately to red flags that should have alerted him to the asset mismarking. According to the SEC’s cease-and-desist order (the “Order”) ( here ), Christopher Plaford (“Plaford”) and Stefan Lumiere (“Lumiere”), portfolio managers employed by Visium, falsely inflated the value of securities held by hedge funds Visium advised, causing the funds to falsely inflate returns, overstate their aggregate net asset value, and pay approximately $3.15 million in excess fees to Visium. The SEC also found that certain Visium portfolio managers traded in the securities of pharmaceutical companies in advance of two generic drug approvals by the U.S. Food and Drug Administration (“FDA”).  The trades were based on confidential information received from a former FDA official working as a paid consultant to Visium.  Trades were also made in the securities of home healthcare providers in advance of a proposed cut to certain Medicare reimbursement rates by the Centers for Medicare and Medicaid Services (“CMS”), based on confidential information received from a former CMS employee working as a paid consultant to Visium. In a separate order ( here ), the SEC found that Visium’s CFO, Steven Ku (“Ku”), failed to supervise Plaford and Lumiere by not responding appropriately to red flags that should have alerted Ku to their misconduct. The SEC previously charged Plaford and Lumiere, and the former FDA official, among others, for their misconduct, in an enforcement action filed in June 2016.  The former CMS employee was charged for other misconduct in May 2017.  Earlier this year, the SEC barred Lumiere from the securities industry based on a final judgment entered against him in the SEC’s case as well as his conviction in a parallel criminal case.  The SEC’s case against Plaford had been stayed pending the completion of a parallel criminal case. “Advisory firms must create a culture of zero tolerance when it comes to unlawful conduct, and supervisors at those firms must take reasonable measures necessary to detect and prevent securities law-related violations by their personnel,” said Marc P. Berger, Director of the SEC’s New York Regional Office.  “Here Visium’s portfolio managers engaged in illegal asset mismarking and insider trading, and Ku failed to act in the face of red flags that should have exposed the asset mismarking scheme.” In the settlement, Visium agreed to disgorge illicit profits totaling more than $4.7 million, plus interest of $720,711, and pay a penalty of more than $4.7 million.  Ku agreed to pay a $100,000 penalty and to be suspended from the securities industry for twelve months.  Visium and Ku each consented to the applicable SEC order without admitting or denying the findings. Registered Municipal Advisor and Its Owner Settle Charges Relating to Alleged Fraud in Connection with Multiple Municipal Bond Offerings On May 9, 2018, the SEC announced ( here ) that it charged a registered municipal advisor and its owner with defrauding a south Texas school district in connection with multiple municipal bond offerings. In the order instituting proceedings ( here ), the SEC found that in connection with three municipal bond offerings for a local school district in South Texas, Mario Hinojosa (“Hinojosa”) and his wholly-owned municipal advisor, Barcelona Strategies LLC (“Barcelona Strategies”), misrepresented their municipal advisory experience and failed to disclose conflicts of interests to their client.  According to the SEC, while working as a paralegal, Hinojosa set up Barcelona Strategies, registered it as an SEC municipal advisor, drafted a marketing brochure about the firm, and circulated the brochure to the school district and other municipalities.  The brochure created the misleading impression that Hinojosa and Barcelona Strategies had served as a municipal advisor on numerous municipal bond issuances and failed to disclose that Hinojosa had a financial interest in the school district’s offerings.  By virtue of their misrepresentations and omissions, Barcelona Strategies and Hinojosa improperly earned hundreds of thousands of dollars in municipal advisory fees. “Municipal advisors owe a fiduciary duty to their municipal clients, who rely on advisors to make important financial decisions,” said Shamoil T. Shipchandler, Director of the SEC’s Fort Worth Regional Office.  “Undisclosed conflicts of interest can lead to significant investment losses, and prevent municipal entities from making informed decisions in their selection of municipal advisors.  As described in today’s order, Barcelona fell well short of its obligations to this school district client.” Without admitting or denying the allegations, Barcelona Strategies and Hinojosa consented to a cease-and-desist order and agreed to jointly and severally pay $362,606 in disgorgement and $19,514 in prejudgment interest.  Barcelona Strategies was also assessed a civil penalty of $160,000, while Hinojosa was assessed a civil penalty of $20,000.  Finally, Hinojosa was barred from association with various regulated entities, including municipal advisors. Investment Adviser, Portfolio Manager, and Trader Charged with Mismarking Securities By Hundreds Of Millions of Dollars On May 9, 2018, the SEC announced ( here ) that it charged New York-based investment adviser Premium Point Investments LP (“Premium Point”) with inflating the value of private funds it advised by hundreds of millions of dollars.  The SEC also charged Premium Point’s CEO and chief investment officer Anilesh Ahuja (“Ahuja”), as well as Amin Majidi (“Majidi”), a former partner and portfolio manager at the firm, and former trader Jeremy Shor (“Shor”). According to the SEC’s complaint ( here ), the scheme ran from at least September 2015 through March 2016 and relied on a secret deal where in exchange for sending trades to a broker-dealer, Premium Point received inflated broker quotes for mortgage-backed securities (“MBS”).  In addition, the defendants allegedly used “imputed” mid-point valuations, which were applied in a manner that further inflated the value of securities. This practice allegedly boosted the value of many of Premium Point’s MBS holdings and further exaggerated returns.  The SEC alleged that the defendants overstated the funds’ value in order to conceal poor fund performance, attract and retain investors, and stave off redemptions. “Investors rely on their investment advisers to fairly and accurately value securities, and that is especially true when the securities trade in opaque markets,” said Daniel Michael, Chief of the Enforcement Division’s Complex Financial Instruments Unit.  “As we allege, Premium Point masked its true performance, which denied investors the opportunity to make informed investment decisions.” The SEC’s complaint, filed in U.S. District Court for the Southern District of New York, charged the defendants with fraud, with aiding and abetting fraud, or both.  The SEC seeks permanent injunctions, return of allegedly ill-gotten gains with interest, and civil penalties. The U.S. Attorney’s Office for the Southern District of New York, which conducted a parallel investigation of this matter, also announced charges against Ahuja, Majidi, and Shor ( here ).  Commenting on the charges, Audrey Strauss, the Attorney for the United States on the case, said: “Investors rely on a hedge fund’s performance numbers when deciding whom to trust with their capital.  To compete with other peer funds, Neil Ahuja, founder of an investment firm, allegedly manipulated the firm’s performance numbers, using fraudulently inflated values for the firm’s securities holdings and lying to investors about how the firm would mark its positions.  By allegedly cooking the books, Ahuja and his co-defendants made the fund appear more attractive to would-be investors and dissuaded current investors from withdrawing their investments.  We will continue to work with our law enforcement and regulatory partners to ensure that investors are provided accurate information when making important investment decisions.”

A client contacts you about a potential fraud claim. The client tells you that because of alleged false statements, she decided to hold her securities rather than sell them. She says that as result of the false statements she was deprived of the opportunity to sell at a higher price and, therefore, suffered damages when the securities declined upon the disclosure of the truth. Does she have a case? Recently, Justice Shirley Werner Kornreich of the Supreme Court, New County, Commercial Division, held, in an analogous situation ( i.e. , forbearance from taking action because of the defendant’s misrepresentations and omissions) that she does not. Q Chiuna Holdings, Ltd. v. TZG Capital Ltd. , 2018 N.Y. Slip Op. 30797 (Sup. Ct., N.Y. County, Apr. 23, 2018) ( here ) The Problems with Holder Claims In a holder claim, the plaintiff alleges that he/she had taken no action because of information provided by the defendant that was materially false or misleading. When the truth is disclosed, the plaintiff claims damages because he/she was deprived of the opportunity to secure the benefit of the transaction or event for which he/she took no action. As the above hypothetical indicates, a holder claim is often alleged as a fraud or a negligent misrepresentation cause of action. In New York, to plead and prove a cause of action for fraud, a plaintiff must demonstrate the following: a material misrepresentation of a fact, knowledge of its falsity, an intent to induce reliance, justifiable reliance by the plaintiff, and damages. E.g., Eurycleia Partners, LP v. Seward & Kissel, LLP , 12 N.Y.3d 553, 559 (2009). To plead and prove a claim for negligent misrepresentation, the plaintiff must demonstrate: (1) the existence of a special or privity-like relationship imposing a duty on the defendant to impart correct information to the plaintiff; (2) that the information was incorrect; and (3) reasonable reliance on the information. Mandarin Trading Ltd. v. Wildenstein , 16 N.Y.3d 173, 180 (2011) (citations omitted). In holder claims cases, the plaintiff is often unable to demonstrate justifiable reliance and damages. Courts that have recognized holder claims have held that the holder’s forbearance from taking action ( e.g. , selling his/her securities) because of the defendant’s misrepresentations or omissions satisfies the reliance element of a common law fraud and negligent misrepresentation cause of action. They have found that the holder’s inaction ( e.g. , his/her retention of the security) is the equivalent of an action ( e.g. , the sale of a security) and, therefore, amounts to reliance on another’s misstatement or omission. In 1927, the Appellate Division, First Department, recognized the viability of a holder claim under circumstances in which the plaintiff could claim out-of-pocket damages. Continental Insurance Co. v. Mercadante , 222 A.D. 181, 183 (1st Dept. 1927). The plaintiffs in Continental Insurance alleged that, as a result of being fraudulently induced to refrain from selling their bonds, they were ultimately left with instruments that were “substantially worthless.” Id. at 182. Thus, because the bonds had virtually no value, Continental Insurance suffered an out-of-pocket loss, specifically, the loss of its investment in the bonds. More than 80 years later, the First Department called into question “the continued viability of such claims.…” Starr Found. v. Am. Int’l Grp. , 76 A.D.3d 25, (1st Dept. 2010). In Starr, the plaintiff alleged that the defendants’ misrepresentations regarding its exposure to losses in its CDS portfolio caused the plaintiff to hold its stock rather than sell it. Id. at 26-27. The plaintiff sought to recover the value it would have realized for its shares if the defendants had accurately reported the risk. Id. The court rejected the plaintiff’s fraud claim and held that the “plaintiff did not suffer any out-of-pocket loss as a result of retaining its [] stock.” Id . at 28. Since Starr , New York courts have reinforced the rule that holder claims in which only hypothetical lost profit damages are pled, with no supporting factual allegations concerning actual, out-of-pocket damages, are insufficient as a matter of law. See, e.g., Tradex Global Master Fund SPC v. Titan Capital Group III LP , 95 A.D.3d 586, 587 (1st Dept. 2012) (citing Starr, the First Department held that a holder claim based solely upon hypothetical lost profit was barred “under the out-of-pocket rule by which the true measure of damages for fraud is indemnity for the actual pecuniary loss sustained as a direct result of the wrong”); Universal Inv. Advisory SA v. Bakrie Telecom Pte, Ltd., 2016 N.Y. Slip Op. 50631 (Sup. Ct. New York County, Apr. 18, 2016). The courts reason that such claims are impermissibly speculative because it is impossible to know what the plaintiff would have received for his/her forbearance had he/she not been induced to do so. Connaughton v. Chipotle Mexican Grill, Inc ., 135 A.D,3d 535, 538 (1st Dept. 2016), aff’d, 29 NY3d 137, 142-43 (2017) 142-43 (“ his Court has consistent refus to allow damages for fraud based on the loss of a contractual bargain, the extent, and, indeed, . . . the very existence of which is completely undeterminable and speculative.”) (internal citations and quotation marks omitted). Thus, where the damages sought are based on what the plaintiff might have received had it taken action but for the fraud, the fraud claim must be dismissed because there can be no recovery for such a hypothetical injury. See Varga v. McGraw Hill Fin., Inc. , 147 A.D.3d 480, 481 (1st Dept. 2017). The other problem with holder claims cited by New York courts is the inability of the plaintiff to satisfy the justifiable reliance element of the fraud cause of action. In New York, to plead justifiable reliance, the plaintiff must demonstrate “with the required detail . . . how changed position or otherwise relied upon any purported misrepresentations or omissions to detriment.” Waggoner v. Caruso, 68 A.D.3d 1, 6 (1st Dept. 2009), aff’d, 14 N.Y.3d 874 (1st Dept. 2010). Merely alleging that forbearance is the equivalent of action does not satisfy the reliance element for a fraudulent misrepresentation claim. Q Chiuna Holdings, Ltd. v. TZG Capital Ltd. Background The Plaintiff, Q Chiuna Holdings, Ltd. (“QCH”), brought action to recover millions of dollars arising from the Defendants’ alleged unauthorized sale of a business venture in China and $5 million arising from the Defendants’ alleged fraudulent conduct to hide and misappropriate the proceeds of that sale. QCH alleged that the Defendants covertly sold 70% of Q-TZG Leasing Financial (China) Company Limited (“Leasing”) – a company the parties jointly owned, but in which the Defendant, TZG Capital Limited (“TZG Capital”), held the controlling share – to Shanghai Yu’an Investment Group Company, Limited, a Chinese state-owned enterprise (“Shanghai Yu’an”), on December 31, 2015 for the equivalent of $18,396,794, or approximately $1.10 per share (the “Sale”). QCH claimed that the sale agreement prohibited execution of the transaction without its prior written approval, and that the Defendants neither sought nor received QCH’s authorization to sell Leasing and did not report to QCH the $18 million sale price. QCH maintained that after carrying out the Sale, the Defendants hid all of the proceeds in a bank account that the Defendants opened for the sole purpose of concealing the sale proceeds from QCH. QCH alleged that, following the Sale, the Defendants began a fraudulent cover-up. On January 22, 2016, less than one month after the Defendants sold Leasing at $1.10 per share, the Defendants allegedly offered to “purchase” QCH’s stake at approximately $0.77 per share (a 30% discount to the price Shanghai Yu’an had paid the Defendants), which would have allowed the Defendants to defraud QCH of over $5 million. QCH claimed that it spent weeks attempting to negotiate better terms with the Defendants but could not convince them to pay QCH a higher price. Thereafter, according to QCH, Defendants falsely claimed that Shanghai Yu’an was an interested buyer (even though Shanghai Yu’an had already purchased Leasing months earlier). On May 13, 2016, despite explicit instructions from QCH not to sell unless a certain price was achieved, the Defendants represented that Shanghai Yu’an closed the purchase of 70% of Leasing for the equivalent of $11,276,879, on May 13, 2016 – almost 40% lower than the actual price at which Defendants had sold Leasing to Shanghai Yu’an on December 31, 2015. QCH eventually discovered that the Sale had occurred in December 2015 (through “documents filed with the Chinese government”). QCH never sold its stake in Leasing to TZG Capital. On December 7, 2016, QCH commenced the action by filing a complaint in which it asserted claims against TZG Capital, Hsiang I Ben Tsen (“Tsen”), and other individuals. On August 31, 2017, QCH filed a third amended complaint, in which it asserted causes of action for: (1) fraud; (2) breach of contract; (3) breach of fiduciary duty; and (4) fraudulent concealment. On October 2, 2017, the Defendants filed a motion to dismiss the first, third, and fourth causes of action. With regard to the fraud claims, the Defendants argued that QCH failed to plead justifiable reliance, noting that QCH did not identify any act QCH had taken, or refrained from taking, in reliance on the Defendants’ statements regarding the Sale or the alleged May 2016 buy-out of the Plaintiff’s remaining shares in Leasing. The Defendants claimed that QCH was unable to allege with particularity, how its reliance on Tsen’s communications about the timing and sale price of the Leasing transaction, or the proposed buy-out transaction, actually manifested in any of QCH’s actions, or inactions. Justice Kornreich granted the Defendants’ motion. The Court’s Ruling In granting dismissal of the fraud claim, the Court found that QCH failed to plead justifiable reliance with the requisite particularity: he alleged fraud consisted of the misrepresentations about the status of the Sale, which had actually occurred in December 2015 but which was represented to not have closed until May 2016. QCH does not allege it engaged in any action to its detriment in reliance on these untruths. To be sure, had QCH actually sold its stake in the Company based on the understanding that the Sale had not yet occurred, perhaps it might have a claim for being induced to sell based on a material misrepresentation about the value of the Company. However, QCH never sold its stake. Footnote omitted. The Court also found that QCH did not allege that it suffered any out-of-pocket damages, noting that QCH conceded at oral argument that the damages it suffered as a result of the alleged fraud was forbearance. Justice Kornreich held that such damages were “impermissibly speculative” because it was “impossible to know what” QCH “would have received” for its stake in Leasing “had it not been induced to hold onto it.” Citing, Connaughton , 29 N.Y.3d at 142-43. Given the foregoing, the Court described Q’s claim as “a quintessential ‘holder’ claim that is not permitted under New York law,” and dismissed the claims. Citing, Bank Hapoalim B.M. v. WestLB AG , 121 A.D.3d 531, 535 (1st Dept. 2014). Takeaway While the First Department has called into question the continued viability of a holder claim, cases like Q Chiuna demonstrate the difficulty in pleading and proving such a claim. Indeed, Q Chiuna shows that pleading such a fraud-based claim, can be almost insurmountable. Perhaps, then, the lesson of Starr and its progeny (such as, Q Chiuna ) is that holder claims should be viewed as typical common law fraud cases dependent upon the facts and circumstances of the matter before the court. See Universal Inv. Advisory SA (holding that “ Starr stands for the proposition that holder claims in which only hypothetical lost profit damages are pled, with no supporting factual allegations concerning actual, out-of-pocket damages, are insufficient as a matter of law,” and finding that the plaintiffs alleged “a definite, measurable, out-of-pocket loss … due to the alleged false post-offering representations.”). Viewed in that way, rather than as an ironclad rejection of such claims, the courts can examine holder claims as fraud-based causes of action dependent upon satisfaction of the elements of such a claim.

On several occasions, this Blog has treated issues related to problems faced by mortgagees foreclosing on certain residential loans.  “ Appellate Division Second Department Tells Foreclosing Residential Lender to ‘SHOW ME THE EVIDENCE’ ” addressed the sufficiency of evidence necessary for a foreclosing lender to demonstrate compliance with the requirement under RPAPL §1304 that ninety days prior to the commencement of an action to foreclose a home loan, a lender must send a letter to the borrower that, among other things, the loan is in default.  “ The Second Department Denies Summary Judgment To Another Foreclosing Mortgagee Due To The Insufficiency Of Evidence Presented On The Motion ” addressed the sufficiency of evidence necessary for a lender to demonstrate that it is the holder of the underlying note and mortgage and, thus, has standing to prosecute the foreclosure action.  Finally, “ The Second Department Reverses Another Grant Of Summary Judgment To A Foreclosing Lender On A Home Loan Due To The Insufficiency Of Proof Of Mailing Statutorily Required Notices To The Borrower ” addressed the sufficiency of evidence required by a lender to prove that the “ninety-day” default notice required by RPAPL §1304 was properly mailed. Many of the onerous residential foreclosure rules apply only to “lenders” and, therefore, mortgagees that are not deemed “lenders” under the applicable rules need not comply with such rules.  For example, the requirements of RPAPL 1304 are applicable to “lenders”.  “Lender“ is defined in RPAPL §1304 as a “mortgage banker” as defined in Banking Law §590(1)(f) or an “exempt organization” as defined in Banking Law §590(1)(e) .  Section 590(1)(f) of the Banking Law defines “mortgage banker” as “a person or entity who or which is licensed pursuant to section five hundred ninety-one of to engage in the business of making mortgage loans in ” and §590(1)(e) of the Banking Law defines “exempt organization” as “any insurance company, banking organization, foreign banking corporation licensed by the superintendent or the comptroller of the currency to transact business in this state, national bank, federal savings bank, federal savings and loan association, federal credit union, or any bank, trust company, savings bank, savings and loan association, or credit union organized under the laws of any other state, or any instrumentality created by the United States or any state with the power to make mortgage loans .” Moreover, Banking Law §590(2)(a) provides that “ o individual, person, partnership, association, corporation or other entity shall engage in the business of making mortgage loans without first obtaining a license from the superintendent in accordance with the licensing procedure provided in this article and such regulations as may be promulgated by the superintendent.  Exempted from the licensure requirement of §590(2)(a), are, among others, “exempt organizations” and, in general, individuals, persons, partnerships, associations, corporations or other entities that do not make “more than three such loans in a calendar year, nor more than five in a two year period.” (See Banking Law §590(2)(a)(i) and (iii) .) Not all mortgagees are “lenders” as defined in the Banking Law.  Sometimes, for example, a seller of residential property will take a mortgage as part of the sale transaction if the purchaser is a relative, cannot obtain financing from a bank and/or if the seller treats the sale as a business deal and is motivated by a favorable rate of return that might be obtained as part of the transaction.  Similarly, private lenders may make mortgage loans, but not a sufficient number to require licensure under Banking Law §590(2)(a)(iii). Frequently, defendants in mortgage foreclosure actions assert defenses based on requirements imposed on “lenders” despite the fact that the foreclosing mortgagee is not a deemed “lender” under the RPAPL/Banking Law.  Such was the case in NIC Holding Corp. v. Eiseneggert (Sup. Ct. Suffolk Co. April 25, 2018) .  The plaintiff in NIC was a member of the New York Mercantile Exchange and one of its traders was relocating to Oklahoma.  In order to facilitate the sale of the trader’s home in conjunction with the move, plaintiff agreed to fund the defendant’s purchase of the home and, as security for the repayment of the loan, took back a $1,050,000 mortgage on the property. The NIC defendant defaulted and plaintiff commenced a mortgage foreclosure action.  In opposition to plaintiff’s motion for summary judgment and an order of reference to compute, defendant argued that the action should be dismissed because plaintiff failed to serve the ninety-day notice required by RPAPL §1304.  In response, plaintiff argued that it was not a “lender” and, therefore, was not required to serve such a notice. The NIC court agreed with the plaintiff and granted its motion.  The court determined that plaintiff, although it was a private lender, it was not a “lender” under RPAPL §1304 and did not have to send a ninety-day notice.  In this regard, the court credited the affidavit of plaintiff’s controller in which it was averred that “plaintiff is in the petroleum business and is not in the business of giving loans collateralized by mortgages for the purchase of residential homes.” TAKEAWAY The NIC court does not address the question of the number of mortgage loans that plaintiff may have made in the one or two-year period around the time that the subject loan was made.  ( See Banking Law §590(2)(a)(iii).)  Perhaps this issue may be argued if an appeal is filed. Individuals and entities that make a number of mortgage loans for business reasons, as accommodations to employees (as was the case in NIC ) or otherwise, should take note of Banking Law §590(2)(a)(iii) and determine whether licensure under the Banking Law is necessary.