The No-Fault Regulations, 11 NYCRR 65-3.16(12), provide:

A provider of health care services is not eligible for reimbursement under section 5102(a)(1) of the Insurance Law if the provider fails to meet any applicable New York State or local licensing requirement necessary to perform such service in New York or meet any applicable licensing requirement necessary to perform such service in any other state in which such service is performed.

This provision, arguably buried in a section of the Regulations devoted to and entitled “Measurement of No-Fault Benefits,” has been the subject of several landmark decisions and has been cited as the basis for numerous investigations of, and demands for additional verification from, medical professional corporations who submit claims for no-fault insurance reimbursement.

In State Farm. Mut. Auto Ins. Co. v. Robert Mallela, 4 N.Y.3d 313 (2005), the New York Court of Appeals, answering a question certified from the U.S. Court of Appeals for the Second Circuit, held: “under our “no-fault” insurance laws (see Insurance Law §5101 et seq. and implementing regulations), insurance carriers may withhold payment for medical services provided by fraudulently incorporated enterprises to which patients have assigned their claims.” The statutory authority for its decision was the above-cited regulatory provision, together with Business Corporation Law (BCL) §1507 and §1508, which provide, inter alia:

1507: A professional service corporation may issue shares only to individuals who are authorized by law to practice in this state a profession which such corporation is authorized to practice and who are or have been engaged in the practice of such profession in such corporation or a predecessor entity, or who will engage in the practice of such profession in such corporation within thirty days of the date such shares are issued.

1508: No individual may be a director or officer of a professional service corporation unless he is authorized by law to practice in this state a profession which such corporation is authorized to practice and is either a shareholder of such corporation or engaged in the practice of his profession in such corporation.

In that case, the insurer argued that the defendant medical corporations violated BCL §1507 and §1508. Specifically, the insurer alleged that unlicensed lay people paid a licensed physician for use of his name to incorporate the facility. Moreover, the insurer alleged, the unlicensed individuals actually operated the companies and set up a scheme whereby the actual profits went, not to the nominal licensed owner, but to the non-physician de facto owners. In essence, the insurer alleged, the medical corporations were fraudulently incorporated. The court determined: “If State Farm’s allegations are true, as we must construe them to be at this stage, the defendant companies undisputedly fail to meet the applicable state licensing requirements, which prohibit nonphysicians from owning or controlling medical service corporations.”

The court further held, “that on the strength of this regulation [65-3.16(12)], carriers may look beyond the face of licensing documents to identify willful and material failure to abide by state and local law.” Insurers often cited the Mallela decision, and particularly this clause, to justify their investigations of claimant medical corporations and their corporate structure. The Mallela court cautioned insurers, however, that, “The regulatory scheme … does not permit abuse of the truth-seeking opportunity that 11 NYCRR 65-3.16 (a) (12) authorizes. Indeed, the Superintendent’s regulations themselves provide for agency oversight of carriers, and demand that carriers delay the payment of claims to pursue investigations solely for good cause (see 11 NYCRR 65-3.2 [c]). In the licensing context, carriers will be unable to show ‘good cause’ unless they can demonstrate behavior tantamount to fraud. Technical violations will not do.”

Approximately four years later, the fraudulent incorporation “Mallela” defense was the subject of a consolidated jury trial in the New York City Civil Court, Richmond County in the matter of Andrew Carothers v. Insurance Companies Represented by Bruno Gerbino & Soriano, et al., 26 Misc.3d 448 (NY City Civ. Ct., Richmond Cty. 2009). In that case, the defendant insurers alleged that the plaintiff medical corporation, like the medical provider in Mallela, was fraudulently incorporated and therefore not entitled to reimbursement of no-fault benefits pursuant to 11 NYCRR 65-3.16(12) because it was actually owned and controlled by two lay people. The insurers also asserted an alternative defense that the listed owner of the corporation was not “engaged in the practice of such profession in such corporation” as required in BCL §1507. The jury found in favor of the defendants on both defenses. The plaintiff moved to set aside the verdict, arguing, inter alia, that certain evidentiary rulings and jury instructions were incorrect as a matter of law. As to the fraudulent incorporation defense, the plaintiff argued that under Mallela, to sustain its defense, the defendants were required to prove the traditional elements of fraud, which include intent to defraud. The trial court disagreed, focusing instead on whether the lay people were de facto owners of the corporation or exercised substantial control over the corporation. The trial court also denied the plaintiff’s request to set aside the jury’s determination as to the defense that the listed owner was not “engaged in the practice of such profession in such corporation.”

The plaintiff appealed the trial court’s decision. The Appellate Term reversed and set aside the verdict as to the “engaged in the practice” defense, but otherwise affirmed the lower court decision, including the jury’s determination that the plaintiff was not eligible for reimbursement based on the “fraudulent incorporation” or “Mallela” defense. The Appellate Term agreed with the trial court that “the essence of the [Mallela] defense … was the provider’s ‘lack of eligibility,’ which does not require a finding of fraud or fraudulent intent, but rather, addresses the actual operation and control of a medical professional corporation by unlicensed individuals.” Andrew Carothers, M.D., P.C. v. Progressive Ins. Co., 42 Misc.3d 30 (App. Term 2d, 11th & 13th Jud. Dists. 2013). On appeal to the Appellate Division, the Second Department affirmed, holding, inter alia, that “the jury charge, read as a whole, adequately conveyed the correct legal principles on ‘fraudulent incorporation’ as established by Mallela” and properly instructed the jury to determine “whether … the plaintiff was organized under the facially valid cover of [the licensed physician] but was, in actuality, operated and controlled by [the unlicensed alleged de facto owners] to funnel profits to themselves.” Andrew Carothers, M.D., P.C. v. Progressive Ins. Co., 150 A.D.3d 192 (2d Dept. 2017).

The plaintiff appealed to the Court of Appeals, which recently issued its decision affirming the lower courts’ decisions. Andrew Carothers, M.D., P.C. v. Progressive Insurance Company, 2019 N.Y. Slip Op. 04643 (2019). In its review, the court addressed the apparent contrariety from the lower courts’ decisions that an insurer asserting a “fraudulent incorporation” defense need not prove fraud.

Plaintiff, citing our language in Mallela contends that the trial court erred in denying its request to instruct the jury that it had to find fraudulent intent or, at least, conduct “tantamount to fraud.” We conclude that there was no error. Neither 11 NYCRR 65-3.16(a)(12) nor our interpretation of that regulation in Mallela requires that an insurance carrier, seeking to demonstrate that a professional service corporation engaged in corporate practices that violate Business Corporation Law §1507, Business Corporation Law §1508 or Education Law §6507(4)(c), show that the professional service corporation or its managers engaged in common-law fraud. We drew the term “fraudulently incorporated” from the Second Circuit’s certified question, but the term may be misleading. A corporate practice that shows “willful and material failure to abide by” licensing and incorporation statutes … may support a finding that the provider is not an eligible recipient of reimbursement under 11 NYCRR 65-3.16(a)(12) without meeting the traditional elements of common-law fraud.

The court also addressed plaintiff’s alternative argument on appeal; that the trial court committed error by admitting deposition testimony of non-parties wherein they repeatedly invoked their Fifth Amendment right against self-incrimination, and in giving the jury an adverse inference instruction based on their invoking that right:

In a civil trial, “an unfavorable inference may be drawn against a party from the exercise of the privilege against self-incrimination” (Prince, Richardson on Evidence §5-710). We have not previously decided whether a nonparty’s invocation of the Fifth Amendment may trigger an adverse inference instruction against a party in a civil case, and we have no occasion to do so here because any error by the trial court was harmless … There is no reasonable view of the evidence under which plaintiff could have prevailed.

Id. Thus, as to a “Mallela”-type defense, the court has clarified that the relevant inquiry by the court is not necessarily whether the corporation was fraudulently incorporated, but whether it willfully and materially fails to abide by licensing and incorporation statutes, such BCL §1507 and §1508. Therefore, while a fraudulently incorporated medical corporation would certainly be ineligible for reimbursement of no-fault benefits, if a medical corporation was properly incorporated at the outset, but later willfully and materially violates such licensing statutes, it may also be ineligible for reimbursement. One question not answered by the decisions in either Carothers or Mallela is, assuming a medical corporation is in willful and material violation of licensing statutes at the present time, can it ever fix itself and reorganize so that it becomes eligible for reimbursement in the future? Logic would dictate that it could, but that will need to be addressed, and will remain an issue for, another day.

David M. Barshay is a member of Sanders Barshay Grossman, in Garden City. Steven J. Neuwirth, a member of the firm, assisted in the preparation of this article.