The New York Court of Appeals’ recent decision in Pludeman v. Northern Leasing Systems Inc.[FOOTNOTE 1] relaxed the state’s heightened pleading requirements for fraud to the point where, given the right circumstances, a mere recitation of corporate position is sufficient to carry allegations of fraud against individual officers through the pleadings stage.

Historically, the court has long recognized that heightened pleading requirements can be singularly inappropriate when the circumstances constituting the fraud are peculiarly within the knowledge of the party alleged to have committed it.[FOOTNOTE 2] Consequently, it has adopted a relatively permissive stance on pleading requirements for fraud despite the restrictive language of §3016(b) of the New York Civil Practice Law and Rules; the rule mandates that “the circumstances constituting [a fraud] shall be stated in detail.” The court’s stance on fraud pleadings is balanced against New York’s longstanding separation of corporation and officer liability. New York’s demarcation of liability, with respect to corporate fraud, precludes the assertion of liability against an officer except when the officer personally participates in or has actual knowledge of the corporation’s fraud.[FOOTNOTE 3]

Prior to Northern Leasing, the Court of Appeals appeared to have struck a delicate balance between these two poles; the court required only that a plaintiff first allege individualized facts sufficient to associate the officer with the alleged corporation’s fraud, after which the court would not further require that the plaintiff allege the specifics of the officer’s participation in the fraud.[FOOTNOTE 4] Post-Northern Leasing, the distinction between corporation and officer liability is notably more malleable; the court is willing to infer wrongdoing on the part of the officer based on the corporation’s alleged fraud, without any individualized allegation tying the officer to the fraud.

‘PLUDEMAN V. NORTHERN LEASING SYSTEMS’

At issue in Northern Leasing was the sufficiency of the plaintiff’s complaint. The plaintiffs alleged that the defendants, a corporation and four high-ranking officers, all perpetrated a nationwide scheme to defraud customers. Apart from the recitation of the defendant officers’ corporate position, no individualized allegations were made to connect the officers with the fraud. Despite this, the court held that the extensive nature of the corporation’s alleged fraud sufficed to create a rebuttable inference that the individual officers knew of or were involved with the fraud.[FOOTNOTE 5]

In reaching its holding, the Court of Appeals relied heavily on Polonetsky v. Better Homes Depot Inc.,[FOOTNOTE 6] a case where the court allowed an inference of an officer’s “knowledge of or participation in” the corporation’s fraudulent sales scheme to arise from allegations that the officer was actively involved in sales and personally made fraudulent promises to buyers.

One of the key factors supporting the inference was “the degree of [the officer's] personal activities.” The Northern Leasing decision greatly expanded the reach of this Polonetsky inference by applying it to even those officers against whom no individualized allegations were made.[FOOTNOTE 7] In doing so, the court has taken dangerous step away from the procedural protections of 3016(b).

While Northern Leasing is a departure from prior case law insofar as it does away with the requirement of individualized allegations, it is in line with the court’s historical concern about the difficulty in some cases of pleading fraud with the requisite specificity.[FOOTNOTE 8] The Northern Leasing majority sought to justify its decision by asserting that individualized allegations cannot be a strict prerequisite because “[s]imply put, sometimes such facts are unavailable prior to discovery.”[FOOTNOTE 9] To hold otherwise would be to “ignore the obvious — or the strong suspicion of a fraud.”

THE PROBLEM

Although one might empathize with the court’s rejection of “talismanic, unbending allegations” in favor of a keener eye toward substantive justice, the decision places innocent officers[FOOTNOTE 10] in a perilous situation. As the court itself recognized, one of the purposes of the 3016(b) “state in detail” requirement is to inform defendants “with respect to the incidents complained of.”[FOOTNOTE 11] Without an individualized allegation associating the officer with the fraud, the innocent officer is not informed of what she is alleged to have done, is unaware of what role she is alleged to have played, and is put in the unenviable position of having to defend against conclusory allegations of “you must have known.”

Unfortunately, unless curbed by subsequent case law, this decision may open the door to widespread abuse. If this type of wholly conclusory pleading is to pass muster, it will be virtually impossible to dispose of such cases at the pleading stage. The result is that individual defendants will typically be compelled to complete the discovery process before seeking summary judgment. This will create tremendous settlement pressure even in cases which have no merit.

The decision of the Court of Appeals is all the more striking when compared with the parallel jurisprudence in the 2nd U.S. Circuit Court of Appeals of Federal Rule 9(b), which governs federal pleading requirements for fraud. Under Rule 9(b), fraud allegations must fail unless the plaintiff can link the corporation’s alleged fraudulent statements to the individuals.[FOOTNOTE 12] The mere fact that individuals are directors in control of the corporation is insufficient; plaintiffs must allege that the individuals knew of, or participated, in fraud. The gravity of a fraud claim necessitates that the accuser be willing to “put himself on record as to what the alleged fraud consists of specifically.”[FOOTNOTE 13] In addition to providing fair notice, these heightened measures are necessary to “safeguard a defendant’s reputation from improvident charges of wrong-doing.”[FOOTNOTE 14] The perceived need for more specificity to prevent abusive fraud claims is also reflected in Congress’ 1995 enactment of the Private Securities Litigation Reform Act.[FOOTNOTE 15] By moving in the opposite direction, the Court of Appeals creates a safe harbor for poorly supported, but extremely serious, allegations against corporate officers that could not otherwise survive in federal court.

The above concerns are further exacerbated by the uncertain bounds of the court’s inference. As Judge Robert S. Smith noted in dissent in Northern Leasing, one of the defendants was the corporation’s vice president and chief information officer; no allegations besides his title were made connecting him to the sales fraud.[FOOTNOTE 16] In upholding the complaint against the CIO, the court left unclear what relationship, if any, is required to exist between the corporate title and the alleged fraud.

These problems were avoidable. Granted, plaintiffs alleging fraud are in a difficult position; sometimes the facts necessary to connect participants to a fraud are available only through divine intervention or discovery. The court feared that requiring a plaintiff to allege individualized facts could force courts to turn a blind eye to obvious or strongly suspected frauds. This fear seems unwarranted. In a proper case, a plaintiff is permitted under CPLR §3102 to seek discovery even before a complaint is filed.[FOOTNOTE 17] Alternatively, the plaintiff could initially proceed solely against the corporation, begin document or other discovery, and then add additional defendants only if and when it became clear there exists a credible basis to do so.[FOOTNOTE 18] In that way, the rights of all concerned parties are balanced.

CONCLUSION

The Court of Appeals has taken a pronounced step towards further relaxation of the heightened pleading requirements for fraud. Careful attention should be paid to future cases following Northern Leasing that circumscribe the boundaries of the court’s decision: how extensive does the alleged corporate fraud need to be in order support an inference of officer participation, how deep in the corporate structure does this inference reach, and is there any way for an officer to successfully attack the “you must have known” inference at the pleadings stage?

Joe DiBenedetto is a partner of the firm of Winston & Strawn. The views expressed are the author’s and do not necessarily represent the views of the firm. Mark Chen, summer associate, assisted in the preparation of this article.

:::::FOOTNOTES:::::

FN1 2008 NY Slip Op 4183; 2008 N.Y. LEXIS 1182, 2008 WL 1944567 (N.Y. 2008).

FN2 Jered v. New York City Transit Authority, 22 NY2d 187 (N.Y. 1968).

FN3 Marine Midland v. Russo, 40 NY2d 31, 44 (N.Y. 1980) Cf. Olszewski v. Waters of Orchard Park, 758 NYS2d 716 (4th Dept. 2003) (holding that an officer is not liable for negligence of the corporation merely because of his official relationship to it).

FN4 CPC International Inc. v. McKesson Corp., 70 NY2d 268 (N.Y. 1987) (after finding sufficient allegations to support a claim that the multiple defendants, both corporate and individual, took part in a fraudulent scheme, the court held that uncertainty regarding each defendant’s contribution to the fraud was not fatal at the pleadings stage).

FN5 2008 NY Slip Op 4183; 2008 N.Y. LEXIS 1182 (N.Y. 2008).

FN6 97 NY2d 46 (N.Y. 2001).

FN7 2008 NY Slip Op 4183 *5, 2008 N.Y. LEXIS **10, 2008 WL 1944567.

FN8 See, e.g., Jered, 22 NY2d 187; Lanzi v. Brooks, 43 NY2d 778 (N.Y. 1977).

FN9 2008 NY Slip Op 4183 *5, 2008 N.Y. LEXIS **10, 2008 WL 1944567.

FN10 Defining an innocent officer as one who has neither knowledge of, nor has participated in the corporate fraud.

FN11 2008 NY Slip Op 4183 *3, 2008 N.Y. LEXIS **6, 2008 WL 1944567.

FN12 Mills v. Polar Molecular Corp., 12 F.3d 1170, 1175 (2nd Cir. 1993).

FN13 Segal v. Gordon, 467 F.2d 602, 607 (2d Cir. 1972) quoting 1A W. Barron & A. Holtzoff, “Federal Practice and Procedure” §302, at 215-16 (Wright rev. 1960).

FN14 Rombach v. Chang, 355 F.3d 164, 171 (2d Cir. 2004) quoting O’Brian v. Nat’l Property Analysts Partners, 936 F.2d 674, 676 (2d Cir. 1991).

FN15 15 U.S.C.S. §78u-4(b)(1)(B).

FN16 2008 NY Slip Op 4183 *7, 2008 N.Y. LEXIS **14, 2008 WL 1944567.

FN17 See e.g. Weinstein-Korn-Miller, 2nd Edition, par 3102.07, 3102.11, 3102.12; In re Kevin Toal, 300 AD2d 592 (2d Dept. 2002); Stewart v. New York City Transit Auth., 112 AD2d 939 (2d Dept. 1985).

FN18 Making use of New York’s liberal amendment and joinder rules, see CPLR §1003, CPLR §3025(b); see e.g. Berger v. Water Comm’rs, 296 AD2d 649, 649 (3d Dept. 2002), Weinstein-Korn-Miller 2nd Edition, par 3025.14.