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The Federal District Court for the Southern District of New York recently ruled that a common law fraud claim against the 98% shareholder and officer of a corporation that filed for bankruptcy should not be enjoined because of the corporate bankruptcy nor was that claim part of the debtors’ bankruptcy estate.

The decision was in Armouth International Inc. v. Fallas, No 19-CV-3669 (RA), decided March 1, 2021, Hon. Ronnie Abrams.

The Fraud Claim

Plaintiff sold several million dollars of clothing to a corporation known as National Stores, Inc. (“National”).  Michael Fallas owned 98% of National and was its Board Chairman and Vice President. Soon after Plaintiff began selling to National, the relationship began to expand, with Fallas asking Plaintiff’s CEO to agree to sell $9 million in goods to National on credit.  Plaintiff alleged that when it sought specific assurances about the stability of National and its ability to pay National for the goods, Fallas represented that “National was ‘healthy,’ that its financial status was solid, and that sales were up year after year at the company.”  “‘Relying on [those] representations about National’s finances, [Plaintiff alleged that it] agreed to sell’ nearly all of the [clothing] to National for approximately $9 million.”  After Plaintiff started shipping the goods to National, Fallas allegedly “‘represented on multiple occasions during that time that ‘National was performing well’ and ‘in good financial health.’”

Thereafter, National failed to pay for the goods as promised, and instead, announced that it intended to file for bankruptcy, revealing that it had been in financial distress since before ordering the goods from Plaintiff.  National then refused to return the unsold goods it had in inventory back to Plaintiff, with Fallas asserting that the goods were subject to liens of National’s lenders.  National and its affiliates then filed for bankruptcy in Delaware, with the bankruptcy court thereafter converting the case to a chapter 7 liquidation.

After the bankruptcy filing, Plaintiff filed proofs of claim there against the debtors for the amount of the goods sold.  Plaintiff also filed a new lawsuit against Fallas individually in the state court in New York, alleging common law fraud among other claims.  Fallas removed that action to federal court based upon diversity jurisdiction, and then moved to dismiss, transfer venue to the bankruptcy court or stay the action pending the bankruptcy.  The trustee in bankruptcy then moved for and obtained a temporary injunction enjoining the federal action against Fallas in view of the bankruptcy.  Thereafter, however, the bankruptcy court withdrew the injunction, denied a permanent injunction and ruled that the New York federal action could proceed against Fallas because the claims were personal property of Plaintiff and that any recovery there would reduce any claim in bankruptcy.

Although the District Court in New York initially stay that action while the temporary injunction in bankruptcy was still pending, it withdrew that injunction after the bankruptcy court lifted and denied the injunction there.

Fraud Claim Survives

In response to Fallas’ motion, the District Court soundly denied that aspect of the motion to “change venue” to the bankruptcy court.  The District Court correctly found that Plaintiff’s filing of proofs of claim against the corporate debtors in the bankruptcy were not the same as nor would they provide adequate relief for Plaintiff’s claims against Fallas personally based upon his alleged fraudulent conduct.  Nor would any adjudication of the bankruptcy claim constitute collateral estoppel or bar the fraud claims against Fallas.

The Court also rejected a change of venue for convenience.

The Court similarly rejected Fallas’ argument that the fraud claim arose under the bankruptcy laws or constituted a “core” bankruptcy proceeding.

The District Court also rejected Fallas’ argument that the bankruptcy stay affected the New York action at all. The Court ruled that Fallas was not a debtor in the bankruptcy and Plaintiff’s claims against Fallas individually were personal to the Plaintiff, and not owned by the bankruptcy estate.

Finally, the District Court ruled that the debtors in bankruptcy would not be “irreparably harmed” by continuation of the New York action since any recovery against Fallas would reduce Plaintiff’s claim against the estate in bankruptcy.

Commentary

The District Court’s denial of Fallas’ motion is sound enough.  Clearly, a claim of fraud against the individual shareholder and officer of the corporate debtor in bankruptcy is an independent claim and not barred by nor encompassed within the bankruptcy case or estate.

In terms of the substance of the fraud claim, it does appear that the Plaintiff will have an uphill battle in proving the elements of fraud.  The main obstacle that the Plaintiff faces is establishing that it justifiably relied upon Fallas’ representations that the business was in good financial shape and able to pay for the goods in extending credit and shipping the goods to National. If Plaintiff did nothing more than rely on those representations, without any effort to verify them, such as asking for financials and other documentation, it would be very vulnerable in establishing justifiable reliance.

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