AJETTIX INCORPORATED and Sue Newhouse, Plaintiffs, v. James D. RAUB, Defendant.
This is a dispute involving former fifty-percent shareholders of a close corporation, Ajettix Incorporated (Ajettix). Plaintiffs commenced this action seeking legal and equitable relief for breach of fiduciary duty and fraud in connection with the agreement of Ajettix to redeem the stock owned by its vice president and secretary, James D. Raub (defendant). Ajettix's agreement to redeem the stock for approximately $500,000 was guaranteed by the other shareholder, Ajettix's president and treasurer Sue E. Newhouse (plaintiff). The action rests upon the allegation that defendant failed to disclose in conjunction with that transaction that he had been negotiating with a competitor (Croop-LaFrance, Inc. [Croop] ) to finance a buy-out of plaintiff and that, during those negotiations, he gave the competitor confidential proprietary information of Ajettix. Plaintiffs have moved for summary judgment on their claim for equitable relief, seeking judgment as a matter of law rescinding the transaction on the ground of breach of fiduciary duty. Defendant has moved simultaneously for summary judgment dismissing the complaint in its entirety and reimbursing him his legal fees in accordance with the terms of the guarantee. The motions are supported by a joint submission of the deposition testimony, as well as separate affidavits.
The court concludes that plaintiffs have established their entitlement to judgment as a matter of law on their claim for rescission and that there are no issues of fact regarding defendant's breach of the fiduciary duty defendant owed to the corporation in connection with this transaction. The court therefore grants plaintiffs' motion and denies that part of defendant's motion seeking summary judgment dismissing the claim for breach of fiduciary duty. Additionally, the court denies that part of defendant's motion seeking summary judgment dismissing the fraud claims. Because the court grants plaintiffs' motion and rescinds the transaction, the court also denies that part of defendant's motion seeking legal fees under the guaranty.
For the purpose of this decision only, the following facts are assumed. Ajettix is a software development company formed by plaintiff and defendant in 1994 and it is in direct competition with Croop. In June 2001, growing animosity between plaintiff and defendant led to discussions between those parties concerning the redemption of plaintiff's stock in Ajettix or the liquidation of the corporation. During those discussions, agreement could not be reached regarding the company's fair market value, so defendant told plaintiff that, “I would investigate selling the business as a going concern to a third party to ascertain its fair market value” (defendant affidavit [12/21/04] at ¶ 23).
Thereafter, without telling plaintiff, defendant arranged a meeting for June 19, 2001 with John Smith, the president of Brite Computers (Brite) and a person with broad experience in acquiring companies, to seek assistance in determining Ajettix's fair market value. In anticipation of that meeting, defendant obtained confidential proprietary information that he felt would be relevant on that issue, including “a list of inventory, a schedule of employees and their customers, the customer's contact information, and a schedule of Ajettix employees, their pay rates and billing rates, Ajettix financial statements and Ajettix marketing material” (Leclair affidavit [6/25/04] at ¶ 13). He obtained that information from Ed Hanchett, Ajettix's director of finance, after telling Hanchett only that he was “going to speak to an investor” (defendant EBT at 256). Also in advance of that meeting, defendant had his personal attorney, not corporate counsel, prepare a non-disclosure agreement.
Before any discussions took place at the meeting, defendant signed the non-disclosure agreement as vice president of Ajettix, and John Smith signed the agreement as president of Brite, thereby binding Brite, as well as, its “employees, consultants and professional advisors ․ [to] hold ․ [Ajettix's proprietary] information confidential” (¶ 2, non-disclosure agreement [6/19/01] ). After the agreement was signed, John Smith invited his son Justin Smith and his brother Jim Smith into the meeting where they, along with John Smith, were given the confidential proprietary information.
During the course of the meeting, defendant became aware that Justin Smith was affiliated with Brite and that Jim Smith was a part-owner of Croop, which is located in the same building as Brite. Unbeknownst to defendant at the time, John Smith also was a principal of Croop.1 Defendant did not require Justin or Jim Smith to sign the non-disclosure agreement because defendant believed that they were bound by the agreement as employees or consultants of Brite.
The focus of the meeting, which had been called to valuate Ajettix, changed when John Smith indicated a desire to become an investor in Ajettix. After extended discussion, the participants in the meeting agreed in principal that Brite would finance defendant's purchase of plaintiff's share of Ajettix and thereafter “the Smiths would acquire majority ownership of Ajettix” (defendant affidavit [12/21/04] at ¶ 28). The plan anticipated, not only defendant's continued employment with Ajettix, but also the continued employment of all the current employees of Ajettix.
Following the meeting, defendant entered into negotiations with plaintiff to purchase plaintiff's share of Ajettix. Although an agreement was reached regarding a selling price, there was continuing disagreement about certain details, and the transaction did not close as scheduled on July 13, 2001. At no time during those negotiations did defendant reveal his dealings with the Smiths.
Shortly thereafter, defendant decided against purchasing plaintiff's shares and determined instead to sell his shares and, no later than July 16, 2001, he informed the Smiths about his change of mind. Upon learning of defendant's decision, the Smiths “either returned to [defendant] or destroyed the Ajettix documents [defendant] had provided to them” (defendant affidavit [12/21/04] at ¶ 35). At a meeting on July 16, 2001, plaintiff on behalf of the corporation accepted the offer of defendant to sell his shares for approximately $500,000.
The transaction was finally consummated on July 20, 2001. As part of that transaction, plaintiff signed a promissory note as president of Ajettix obligating Ajettix to pay defendant the sum of approximately $500,000 to redeem defendant's stock in the company. The note was secured by plaintiff's personal guarantee. Plaintiff also signed general releases on behalf of herself and Ajettix.
Prior to closing the deal, defendant did not tell plaintiff about the previous meeting with the Smiths, the agreement reached at that meeting or the release of confidential proprietary information. Nor did he tell plaintiff about the non-disclosure agreement, even though he signed that agreement on behalf of Ajettix. At best, some time around July 16th, defendant told only Dave Madison, a member of the management committee of Ajettix, that “[he] had turned down an offer to sell the business” (defendant EBT at 281). When asked by Hanchett prior to July 20th 2 “who this offer had come from,” defendant declined to answer, believing that disclosure of that information was unnecessary due to the “NDA” (defendant EBT at 281; see defendant affidavit [12/21/04] at ¶ 38). Plaintiff did not discover Smiths' involvement until sometime after completion of the transaction.
In moving for summary judgment on their claim for rescission, plaintiffs contend that defendant breached a fiduciary duty by failing to disclose, prior to the July 20th transaction, his dealings with the Smiths. Defendant contends that his fiduciary duty encompassed only the obligation to avoid self-dealing and that, in any event, there was no fiduciary relationship with respect to the July 20th transaction because his relationship with plaintiff was hostile and their dealings at arms' length.
The law clearly supports plaintiffs' contention. Defendant's fiduciary obligations to Ajettix arose from the status of defendant as a corporate officer and director (see Alpert v. 28 Williams St. Corp., 63 N.Y.2d 557, 568, 483 N.Y.S.2d 667, 473 N.E.2d 19, rearg. denied 64 N.Y.2d 1041, 489 N.Y.S.2d 1028, 478 N.E.2d 211; Jacobson v. Brooklyn Lumber Co., 184 N.Y. 152, 162, 76 N.E. 1075; Busino v. Meachem, 270 A.D.2d 606, 609, 704 N.Y.S.2d 690) and were not extinguished by his acrimonious relationship with plaintiff so long as defendant did not withdraw from the corporation (see Fender v. Prescott, 101 A.D.2d 418, 423, 476 N.Y.S.2d 128, affd. 64 N.Y.2d 1077, 489 N.Y.S.2d 880, 479 N.E.2d 225; see also Blue Chip Emerald LLC v. Allied Partners, 299 A.D.2d 278, 279, 750 N.Y.S.2d 291). Beyond that, the “relationship between shareholders in a closed corporation, vis-á-vis each other, is akin to that between partners and imposes a high degree of fidelity and good will” (Fender, 101 A.D.2d at 422, 476 N.Y.S.2d 128; see Brunetti v. Musallam, 11 A.D.3d 280, 281, 783 N.Y.S.2d 347). Even on dissolution, partners owe a continuing fiduciary duty to one another with respect to dealings effecting the winding up of the partnership and the preservation of the partnership assets (see generally 15A NY Jur.2d, Business Relationships § 1465; see Matter of Silverberg, 81 A.D.2d 640, 641, 438 N.Y.S.2d 143; Old Harbor Native Corp. v. Afognak Joint Venture, 30 P.3d 101, 106 [Sup. Ct. Alaska]; Ebker v. Tan Jay Intl. Ltd., 741 F.Supp. 448, 469 [U.S. Dist. Ct., S.D.N.Y.], affd. 930 F.2d 909, cert. denied 502 U.S. 853, 112 S.Ct. 161, 116 L.Ed.2d 126, reh. denied 502 U.S. 1000, 112 S.Ct. 625, 116 L.Ed.2d 646). Thus, despite the acrimony here, defendant continued to owe a fiduciary duty to plaintiff with respect to a transaction involving the redemption of his shares of the corporation (cf. Matter of T.J. Ronan Paint Corp., 98 A.D.2d 413, 421, 469 N.Y.S.2d 931). The court therefore concludes that defendant's fiduciary obligations to the corporation and plaintiff personally continued until the July 20th transaction closed (see Blue Chip, 299 A.D.2d at 279, 750 N.Y.S.2d 291; Fender, 101 A.D.2d at 423, 476 N.Y.S.2d 128).
The court rejects the contention of defendant that his fiduciary duty encompassed only an obligation to avoid self-dealing. “[A] fiduciary owes a duty of undivided and undiluted loyalty to those whose interests the fiduciary is to protect. This is a sensitive and ‘inflexible’ rule of fidelity, barring not only blatant self-dealing, but also requiring avoidance of situations in which a fiduciary's personal interest possibly conflicts with the interest of those owed a fiduciary duty” (Birnbaum v. Birnbaum, 73 N.Y.2d 461, 466, 541 N.Y.S.2d 746, 539 N.E.2d 574, rearg. denied 74 N.Y.2d 843, 546 N.Y.S.2d 559, 545 N.E.2d 873). Thus, there is an obligation of utmost candor (see Alpert, 63 N.Y.2d at 569, 483 N.Y.S.2d 667, 473 N.E.2d 19; Kavanaugh v. Kavanaugh Knitting Co., 226 N.Y. 185, 193, 123 N.E. 148), strictly obligating a fiduciary “to make full disclosure of any and all material facts within his or her knowledge relating to a contemplated transaction with the other party to the relationship” (60A NY Jur.2d, Fraud and Deceit § 99). “[W]hen a fiduciary, in furtherance of its individual interests, deals with the beneficiary of the duty in a matter relating to the fiduciary relationship, the fiduciary is strictly obligated to make ‘full disclosure’ of all material facts” (Blue Chip, 299 A.D.2d at 279, 750 N.Y.S.2d 291 quoting Birnbaum, 73 N.Y.2d at 466, 541 N.Y.S.2d 746, 539 N.E.2d 574; see Arlinghaus v. Ritenour, 622 F.2d 629, 636-637 [2d Cir.], cert. denied 449 U.S. 1013, 101 S.Ct. 570, 66 L.Ed.2d 471; 3A Fletcher Cyclopedia of Private Corp. § 1171).
The transaction, here, without question, concerned a matter relating to defendant's fiduciary relationship with plaintiffs. Defendant, therefore, was obligated in negotiating that transaction “to disclose any information that could reasonably bear on plaintiffs' consideration of [his] offer” (Dubbs v. Stribling & Assocs., 96 N.Y.2d 337, 341, 728 N.Y.S.2d 413, 752 N.E.2d 850). Stated another way, defendant was “under a duty to disclose ․ the full facts ․ affecting the value of the stock which [he] was selling” (Saville v. Sweet, 234 App.Div. 236, 238, 254 N.Y.S. 768, affd. 262 N.Y. 567, 188 N.E. 67). “Absent such full disclosure, the transaction is voidable” (Blue Chip, 299 A.D.2d at 279-280, 750 N.Y.S.2d 291; see Birnbaum v. Birnbaum, 117 A.D.2d 409, 416, 503 N.Y.S.2d 451). Indeed, where a fiduciary relationship exists between the parties, there must be clear proof of the integrity and fairness of a transaction between them, “ ‘or any instrument thus obtained will be set aside or held as invalid’ ” (Matter of Gordon v. Bialystoker Center and Bikur Cholim, 45 N.Y.2d 692, 698, 412 N.Y.S.2d 593, 385 N.E.2d 285 quoting Ten Eyck v. Whitbeck, 156 N.Y. 341, 353, 50 N.E. 963).
Defendant contends that full disclosure of his dealings with the Smiths was unnecessary because the release of confidential proprietary information to them was limited to those documents essential and necessary to valuing his stock and the corporation was protected by a non-disclosure agreement. The issue here, however, is not whether defendant breached his fiduciary duty by contacting the Smiths and releasing confidential proprietary information to them (cf. Leviton Mfg. Co. v. Blumberg, 242 A.D.2d 205, 208, 660 N.Y.S.2d 726). The issue is whether defendant's obligation of full disclosure included the obligation to disclose everything about his dealings with the Smiths, including the fact that he released confidential proprietary information to them under a non-disclosure agreement.
Defendant also challenges the materiality of that information in light of the non-disclosure agreement. Again, however, defendant misses the point. The point is that the value of a corporation is effected by the release of its confidential proprietary information to persons associated with a competitor and, while a non-disclosure agreement may diminish that effect, or eliminate it entirely, there is no way for the corporation or a shareholder like plaintiff to make that determination without knowledge of the agreement and an opportunity to review it. Given the fiduciary relationship that existed, it was the obligation of defendant to disclose everything about his dealings with the Smiths, including the fact that he released confidential proprietary information to them under a non-disclosure agreement, because “that information could reasonably bear on plaintiffs' consideration of [defendant's] offer” (Dubbs, 96 N.Y.2d at 341, 728 N.Y.S.2d 413, 752 N.E.2d 850). Additionally, defendant entered into the non-disclosure agreement on behalf of the corporation. That agreement was a corporate document that he had no right to withhold from plaintiffs.
Defendant nevertheless contends that he had no duty to disclose because he had no reason “to believe that the information [was] material and germane to [the] contemplated transaction” (Botti v. Russell, 180 A.D.2d 947, 950, 580 N.Y.S.2d 505). In support of that contention, defendant cites evidence indicating he had no reason to believe that plaintiff harbored any enmity for the Smiths. The relevant question, however, is not whether defendant had any reason to believe that there was any enmity but whether he had any reason to believe that one or more of the persons to whom he released confidential proprietary information were associated with a competitor of Ajettix. Defendant admits such knowledge and thus it is irrelevant whether he had any reason to believe that plaintiff harbored any enmity for the Smiths.
Equally irrelevant to the question at hand is defendant's additional contention that proof of scienter is lacking. Because plaintiffs seek on their motion rescission and not damages, “proof of scienter is not necessary; even an innocent misrepresentation is sufficient for rescission” (Steen v. Bump, 233 A.D.2d 583, 584, 649 N.Y.S.2d 731, lv. denied 89 N.Y.2d 808, 655 N.Y.S.2d 887, 678 N.E.2d 500).
Finally, the court rejects defendant's contention that plaintiffs' claim for rescission is barred by the releases signed in conjunction with the July 20th transaction. “[A] fiduciary cannot by contract relieve itself of the fiduciary obligation of full disclosure by withholding the very information the beneficiary needs in order to make a reasoned judgment whether to agree to the proposed contract” (Blue Chip, 299 A.D.2d at 280, 750 N.Y.S.2d 291; see H.W. Collections v. Kolber, 256 A.D.2d 240, 241, 682 N.Y.S.2d 189). The court therefore concludes that plaintiffs' motion should be granted because, upon all the papers and proof submitted, the claim for rescission based on the defendant's breach of fiduciary duty in connection with the July 20th transaction has been established as a matter of law (see CPLR 3212[b] ).3
The court next examines plaintiffs' fraud claims. The complaint states claims for actual and constructive fraud in connection with the July 20th transaction. The claim of actual fraud rests upon the allegation that defendant intentionally concealed his dealings with the Smiths. The claim of constructive fraud is based on the allegation that defendant breached a fiduciary duty by failing to disclose those dealings.
In order to make out a prima facie case of fraud, it must be shown that there was a misrepresentation of a material fact by the defendant, done for a fraudulent intent, and justifiably relied upon by the plaintiffs to their detriment. In other words, there must be proof “of a representation of material fact, falsity, scienter, reliance and injury” (Small v. Lorillard Tobacco Co., 94 N.Y.2d 43, 57, 698 N.Y.S.2d 615, 720 N.E.2d 892). “A fraud cause of action may be predicated upon acts of concealment where the defendant had a duty to disclose material information” (Standish-Parkin v. Lorillard Tobacco Co., 12 A.D.3d 301, 303, 786 N.Y.S.2d 13). “Thus, where a fiduciary relationship exists, ‘the mere failure to disclose facts which one is required to disclose may constitute actual fraud, provided the fiduciary possesses the requisite intent to deceive’ ” (Kaufman v. Cohen, 307 A.D.2d 113, 120, 760 N.Y.S.2d 157 quoting Whitney Holdings, Ltd. v. Givotovsky, 988 F.Supp. 732, 748 [U.S. Dist., S.D.N.Y.] ).
Constructive fraud is similar to fraudulent concealment except that the element of scienter need not be proven (Klembczyk v. DiNardo, 265 A.D.2d 934, 936, 705 N.Y.S.2d 743). “[T]he element of scienter ․ is dropped and is replaced by a requirement that the plaintiff prove the existence of a fiduciary or confidential relationship” (Brown v. Lockwood, 76 A.D.2d 721, 432 N.Y.S.2d 186). Thus, constructive fraud refers to “ ‘an act done or omitted, not with actual design to perpetrate positive fraud or injury upon other persons, but which, nevertheless, amounts to positive fraud, or is construed as fraud by the court because of its detrimental effect upon public interests and public or private confidence’ ” (Bank v. Bd. of Educ. of City of New York, 305 N.Y. 119, 123, 111 N.E.2d 238 quoting Eaton on Equity, § 125).
Here, defendant established in support of his motion that he did not act with fraudulent intent. His evidence indicates that his dealings with the Smiths were for a legitimate purpose and that, although he intentionally refused to disclose those dealings to plaintiffs, his intent was not fraudulent but the product of a mistaken belief that disclosure was unnecessary due to the non-disclosure agreement. In response, plaintiffs cite evidence indicating that defendant was aware of plaintiff's enmity towards the Smiths and her reluctance to deal with them. Although this evidence was of no moment to the breach of fiduciary duty claim, since scienter was not required, it is relevant here. Notwithstanding the fact that defendant refutes plaintiff's proof, the conflicting affidavits on the issue of whether defendant was aware of plaintiff's enmity towards the Smiths creates an issue of fact on the requisite element of scienter, thereby precluding summary judgment in favor of defendant dismissing the actual fraud claim against him.
On the constructive fraud claim, as already indicated, proof of scienter is unnecessary. The same evidence already discussed with reference to the breach of fiduciary claim also establishes the constructive fraud claim as a matter of law. Although defendant contends that requisite proof of injury is lacking, it appears that, if nothing else, the transaction itself is the damage flowing from the fraud. The court rejects defendant's additional contention that the fraud claims are not pled with requisite specificity (see CPLR 3016). The court therefore denies defendant's motion in its entirety.
ON SUBSEQUENT MOTION TO SET THE TERMS OF THE RESCISSION DECREE
Following the court's decision and order granting plaintiff's motion for summary judgment declaring that there are no issues of fact concerning defendant's breach of fiduciary duty in connection with the stock redemption and that plaintiffs are entitled to rescission, plaintiff now moves for summary judgment setting forth the terms of rescission. Plaintiff proposes an equitable decree of rescission which contains the following general terms:
(1) Voiding the stock redemption transaction, including the Ajettix Incorporated Partnership Dissolution Agreement of July 17, 2001, the closing argument, the promissory note dated July 20, 2001, plaintiff's general releases to defendant of July 20th, and the Guarantee Agreement of even date;
(2) Restitution for the full $410,000 paid by plaintiff for defendant's shares in the corporation as follows: $310,000 already paid to defendant under the terms of the promissory note with intent from the date of payment; and $100,000 paid by plaintiff into escrow since the action was commercial pursuant to the escrow order filed June 25, 2004, together with interest earned; and
(3) Restoration to defendant in the form of a declaration that defendant is entitled to our interest in Ajettix Inc. that is the lesser of either (a) the liquidation value of 50% of Ajettix stock as of the date the final judgment is entered, or (b) a value in stock of Ajettix that is no greater than the liquidation value of defendant's shares in Ajettix as of June 30, 2001, when the closing agreement became effective.
Thus, plaintiff seeks, in that part of the equitable decree directing restoration, to insulate herself from any equitable adjustment by reason of depreciation of the stock, if depreciation occurred, and, at the same time, preserve to her the entire benefit of any appreciation of the stock since the redemption.
Plaintiff reasons that defendant should suffer losses occasioned by the decrease in value of the stock after the rescinded transaction by reason of his misconduct, citing Spyder Enterprises, Inc. v. Ward, 872 F.Supp. 8 (E.D.N.Y.1995); 2 Robert Haig, Commercial Litigation in New York State Courts, § 9:24, at 539 (2d ed. 2004) (discussing Spyder Enterprises ); 2 Dobbs, Law of Remedies: Damages-Equity-Restitution § 9.3(3) (2d ed. 1993). Furthermore, plaintiff maintains, the court cannot direct restoration to defendant of his previously owned 50% shares if the shares have appreciated since the 2001 redemption, because defendant “should not recover a windfall.” Newhouse insists that any appreciation of the company since the redemption occurred entirely through her efforts as 100% sole shareholder. Under either of plaintiff's proposed scenarios, defendant does not receive Ajettix stock and Newhouse remains sole shareholder; defendant only receives “liquidation value,” as of 2001 in the case of increased value of the shares, or as of the time of final judgment in the case of decreased value.
Not surprisingly, defendant vigorously objects to this formulation. First, defendant contends that true rescission in specie (i.e., money paid in return for 50% of the shares) cannot alone be ordered because that would not restore the parties to the status quo ante. Second, defendant acknowledges that, despite the impossibility of restoring the parties to the pre-contract status quo, rescission is otherwise appropriate and the court may fashion an equitable decree with appropriate adjustments. Third, defendant maintains that an adjustment is necessary because Newhouse “persuasively mismanaged” the corporation after she acquired his shares in the redemption, in that she failed to hire someone after his departure with his skill level to continue profitability. Fourth, the required adjustment cannot be determined until a valuation is had after appropriate discovery of post redemption corporate affairs. Fifth, restoration of the shares is required, even with adjustments, and that once he receives restoration of the shares he has rights under the Business Corporation Law “to vote on whether to pursue liquidation or, in the alternative, pursue its sale as a going concern” instead of “forcing” defendant “to accept a valuation based on a fictitious liquidation.” Defendant thus contends that an equitable decree of rescission entered only after an accounting revealing the valuation in 2001, and now, would deprive him of his rights under the BCL. Finally, defendant objects to an order voiding the releases each plaintiff signed at the July 2001 closing on the ground, which seemingly is at variance with his position on the prior motion, that they concern a Microsoft license upgrade transaction that is entirely separate from the stock redemption transaction.
Is an equitable decree of rescission appropriate?
A plaintiff who sues for rescission and also seeks damages for fraud may plead these inconsistent causes of action, CPLR 3002, but must eventually elect her remedy. Vitale v. Coyne Realty, Inc., 66 A.D.2d 562, 568, 414 N.Y.S.2d 388 (4th Dept.1979) (Callahan, J. for a unanimous court, see id. 66 A.D.2d at 563, 414 N.Y.S.2d 388, and dissenting on other grounds). Plaintiffs impliedly elected their remedy when they moved for summary judgment declaring their entitlement to rescission, and they now confirm their election with this motion, styled as one under CPLR 3002(e) and 3212(e). While ordinarily “[t]he choice of remedy for damages and rescission lies ‘․ within the sound judgment and discretion of the trial court,’ ” and “should be determined by the trial judge in light of the record as it develops,” Vitale, 66 A.D.2d at 568, 414 N.Y.S.2d 388; see also, Ungewitter v. Toch, 31 A.D.2d 583, 584, 294 N.Y.S.2d 1013 (3d Dept.1968), aff'd 26 N.Y.2d 687, 308 N.Y.S.2d 858, 257 N.E.2d 40 (1969), the court must respect the election of equitable rescission even though “we might well find rescission impossible,” when the parties are in agreement as to its propriety, albeit not in the degree of adjustments that may be necessary. Vitale, 66 A.D.2d at 563, 414 N.Y.S.2d 388 (majority opn.); id. 66 A.D.2d at 568, 414 N.Y.S.2d 388 (Callahan, J.). Compare Davenport v. Martin, 294 A.D.2d 891, 891-92, 740 N.Y.S.2d 923 (4th Dept.2002) (where the court held that its discretion concerning the remedy chosen cannot be used to force an unwanted remedy upon the plaintiff), app. after remand, 4 A.D.3d 873, 771 N.Y.S.2d 460 (4th Dept.2004).
Defendant on this motion does not object to rescission, indeed he embraces it, but only upon such conditions as the court, in equity, deems just. This is in accord with the case law, which holds that plaintiffs' tender of the stock certificates may not in the circumstances “exhaust the measure of ․ [their] duty.” Marr v. Tumulty, 256 N.Y. 15, 21, 175 N.E. 356 (1931) (Cardozo, J.). When plaintiff elects equitable rescission, as opposed to “at law upon the basis of a rescission already effectively declared,” plaintiff is only entitled “to procure the declaration of a rescission on whatever terms may be just.” Id., 256 N.Y. at 22, 175 N.E. 356 (“suitable conditions may be imposed by the decree”). See Buffalo Builders Supply Co. v. Reeb, 247 N.Y. 170, 175-76, 159 N.E. 899 (1928); Schank v. Schuchman, 212 N.Y. 352, 360, 106 N.E. 127 (1914) (Cardozo, J.) (“in determining the extent to which changed conditions may relieve from the duty of restoration, [the court] must weigh the equities of each case, and exact such conditions of reimbursement or allowance as just dealing demands”); Vitale, 66 A.D.2d at 568-69, 414 N.Y.S.2d 388. Accordingly, as defendants contend, “[t]he plaintiffs, by seeking to set aside the ․ [stock redemption transaction], have elected to adopt all the consequences of rescission.” Thomas v. Beals, 154 Mass. 51, 55, 27 N.E. 1004 (1891) (Holmes, J.) (cited in Marr v. Tumulty, 256 N.Y. at 22, 175 N.E. 356).
The Duty of Plaintiff to Restore Upon Rescission
“At common law and equity, rescission entails the undoing of the original transaction and restitution involves the restoration of each party to his precontract position.” Randall v. Loftsgaarden, 478 U.S. 647, 671, 106 S.Ct. 3143, 3157, 92 L.Ed.2d 525 (1986) (Brennan, J., dissenting). “In practice, where the defendant has sold something to the plaintiff for money, the steps leading to return to the status quo are streamlined: generally the plaintiff must tender the subject of the sale to the defendant and the defendant must tender to the plaintiff the sale price plus interest, minus whatever direct value the plaintiff has received from the transaction.” Id. 478 U.S. at 671-72, 106 S.Ct. at 3157. See E.T.C. Corp. v. Title Guarantee & Trust Co., 271 N.Y. 124, 127-28, 2 N.E.2d 284 (1936) (“plain distinction between the equitable remedy of rescission or cancellation (where, as in all equity decrees, complete relief is awarded to the defendant as well as to the plaintiff), and the legal remedies”) (quoting 5 Pomeroy on Equity Jurisprudence, p. 4765); Vitale, 66 A.D.2d at 564, 414 N.Y.S.2d 388 (same); 5A Corbin on Contracts § 1114 (Rev. ed.); A.L.I., Restatement (Second) of Contracts § 376 (1981) (restitution to party avoiding contract); id. § 384 (restoration to culpable party by party avoiding contract). “He who seeks equity must do equity, ․” Holdeen v. Rinaldo, 28 A.D.2d 947, 949, 281 N.Y.S.2d 657 (3d Dept.1967). Accordingly, the one sidedness of the remedy proposed by plaintiffs, whether or not appropriate in a rescission at law case, Sim v. Edenborn, 242 U.S. 131, 135, 37 S.Ct. 36, 37, 61 L.Ed. 199 (1916); Neblett v. Macfarland, 92 U.S. 101, 103-05, 23 L.Ed. 471 (1875); cf., Heckscher v. Edenborn, 203 N.Y. 210, 96 N.E. 441 (1911), cannot form the basis of an equitable decree of rescission.4
Adjustment by Reason of Depreciated or Appreciated Shares
Taking defendant's claim that the shares have depreciated first, plaintiffs rely on the above cited Spyder Enterprises case as authority for the proposition that defendant, as the wrongdoer must absorb the loss occasioned by the asserted decrease in value of the shares since 2001. This rule, however, is confined to the situation in which the wrongdoer was in control of the enterprise before rescission was ordered, and because of his own conduct could not be put into the position he was in before the contract was entered into. In such cases, it is said: “If the wrongdoer has, by his own act, complicated the case so that full restoration cannot be made, he has but himself to blame.” Hammond v. Pennock, 61 N.Y. 145, 152 (1874). See Butler v. Prentiss, 158 N.Y. 49, 63-64, 52 N.E. 652 (1899); Masson v. Bovet, 1 Denio 69 (1845).
But in this case, the plaintiffs were in control of the enterprise, the money having been paid to the defendant, who retained no interest in the corporation, and the allegation is that Newhouse so mismanaged the business that, in fairness, defendant should not have to, even as the culpable party, bear the entire loss by mere restitution to him of the depreciated shares without adjustment. As defendant contends, the depreciation in Spyder Enterprises was occasioned wholly by market conditions, not the party in possession of the vehicle. In this case, defense counsel conceded at oral argument that any loss caused by mere market conditions or economic decline quite out of plaintiff's control was his client's to bear. In a case of a plaintiff seeking rescission who is without fault or blame with respect to the value of property in her possession which must be restored to the party against whom rescission is sought, this concession is in accord with applicable law. Butler v. Prentiss, 158 N.Y. at 64, 52 N.E. 652 (requirement of restoration to “the one guilty of the fraud” is not, in cases where the party defrauded is “without fault” in the management of the property to be restored, “strictly applied, because it would become a loophole for the escape of fraud”); Sokolow, Dunaud, Mercadier & Carreras LLP v. Lacher, 299 A.D.2d 64, 72, 747 N.Y.S.2d 441 (1st Dept.2002) (“rule that rescission is unavailable where a party cannot be returned to the status quo ante will not be strictly enforced where the party against whom rescission is sought is a wrongdoer who is exploiting its change of position to shield its wrongdoing”). See also, Snow v. Alley, 144 Mass. 546, 551, 11 N.E. 764 (1887) (“If that which he returns is diminished in value by natural causes, or in the ordinary and proper use of it, he may still return it, as in such case, the contract being rescinded, and loss is the loss of the original owner.”); A.L.I., Restatement (First) of Restitution § 66 Comment b (1937) (“The fact that the subject matter suffered a severe depreciation in market value does not prevent restitution upon its retransfer in specie, provided the other party to the transaction was at fault.”); A.L.I., Restatement (Second) of Contracts § 384 Comment a (1981) (“Mere depreciation in market value, however, is not such a change as will preclude restitution.”); 27 Williston on Contracts § 69:51 (4th ed. 2003) (rescission not precluded by “diminution in value of the consideration by lapse of time or by reasonable use before discovery of the fraud”).
Defendant maintains, however, that he has sufficiently established, albeit by hearsay affidavit, that discovery will lead to admissible evidence of Newhouse's very real mismanagement of the company. The court agrees that defendant's proffer in this regard should not be rejected as conclusory or speculative, and that (for the reasons stated below) a defendant such as Raub properly restored to his 50% share of the corporation upon even a conditional rescission will have rights to explore the issue through discovery in a statutory action under the Business Corporation Law.5
An Interlocutory or Conditional Decree is Appropriate
Defendant contends that Newhouse should account for the depreciation of the corporate stock due to her mismanagement since the stock redemption in 2001. This contention is only partially correct. The timing of plaintiffs' discovery of the defendant's breach of fiduciary duty was not considered important enough for defendant to plead laches in defense of plaintiffs' prior motion for partial summary judgment. That timing, however, is critical to the particulars of the equitable rescission decree to be issued by the court, because the cases hold that plaintiff need only account for depreciation of the stock due to mismanagement that has occurred since her discovery of defendant's breach of fiduciary duty. Sipola v. Winship, 74 N.H. 240, 66 A. 962 (1907). See Gannett Co., Inc. v. The Register Publishing Co., 428 F.Supp. 818, 831-32 & esp. n. 32 (D. Conn. 1977) (Newman, J.) (“Neblett rule makes sense only where the decline took place before knowledge of the fraud or after notification to the opposing party”). The Sipola case is often cited for the proposition that rescission is unavailable and should be denied when “the property received by the plaintiff as a result of fraud becomes less valuable because of the plaintiff's own fault or mismanagement.” 2 Dan B. Dobbs, Law of Remedies § 9.3(3), at 588 (2d ed. 1993) (“In such cases restitution should be denied.”) See also, 1 George Palmer, The Law of Restitution § 3.12, at 308 (1978) (“restitution was denied”); Dobbs, Pressing Problems for the Plaintiff's Lawyer in Rescission: Election of Remedies and Restoration of Consideration, 26 Ark. L. Rev. 322, 351 (1972) (“he can't get rescission”). But that is not what the court held in Sipola. Rather, the court acknowledged the force of cases decreeing restitution notwithstanding that the property in specie was depreciated or damaged, because “in such cases it was practicable to shape a decree so as to do equity between the parties.” Sipola v. Winship, 66 A. at 964. The court's holding was, however, that in the particular case before it, “shap[ing] the decree so as to do equity between the parties” was impossible, because it was “inequitable to require the defendant to take the farm back, greatly deteriorated in value, even in connection with the payment of a sum of money to compensate him for the deterioration, or to take it back after so long a delay.” Id. (emphasis supplied). Thus, if it is possible to shape an equitable decree, restitution may be appropriate notwithstanding damage or depreciation at plaintiff's hands while she was in possession and after her discovery of the fraud. In this aspect, Sipola is consonant with New York law: “The terms upon which rescission may be granted where complete restoration of the parties to their former position is impossible rests in the sound discretion of the courts.” Buffalo Builders Supply Co. v. Reeb, 247 N.Y. 170, 176, 159 N.E. 899 (1928).
The case of Duggan v. Platz, 263 N.Y. 505, 189 N.E. 566 (1934) points the way. In that case, plaintiff sued to rescind a corporate stock sale on the ground of fraud, and for an accounting. The referee found for the plaintiff and “directed a judgment not only rescinding the transfer of stock but unqualifiedly ordering its retransfer to the plaintiff.” Id., 263 N.Y. at 508, 189 N.E. 566. The referee deferred the accounting to a “future determination,” ostensibly on the theory that “the accounting was to be the means by which the equities, if any, were to be determined and the terms of the retransfer fixed.” Id. A final judgment was entered directing an “unqualified retransfer of the stock ․ ‘without prejudice, however, to any rights which appellants may have to an accounting from defendant company.’ ” Id. 263 N.Y. at 508, 189 N.E. 566 (quoting id. 238 App.Div. 197, 202, 264 N.Y.S. 403 (3d Dept.1933)).
On appeal, the Court of Appeals modified the judgment on the ground that the defendants, having been found “trustees, ex maleficio,-are hardly in a position to bring an action for an accounting.” Id. 263 N.Y. at 508-09, 189 N.E. 566. Accordingly, the Court of Appeals made the judgment “interlocutory in form; by striking the provisions directing an unqualified retransfer of the stock ․; by directing an accounting to be had between the parties; and by providing for a delivery of the stock in question upon such terms as may be fixed by the final judgment.” Id. 263 N.Y. at 509, 189 N.E. 566.
Duggan had some important differences with this case, but it provides valuable guidance here. First, in Duggan it was the plaintiff who sold the stock and would be having it returned to her whereas in this case the plaintiff purchased the stock and will be returning it to the defendant. Second, in Duggan the plaintiff, upon return of the stock, became “owner of the entire capital stock outstanding ․ [and therefore] [u]nder the circumstances, the corporation may be disregarded.” Id. 263 N.Y. at 508, 189 N.E. 566. Here, on the other hand, upon restoration of the stock to defendants, the parties will each be 50% stockholders, and therefore observance of the corporate form will be required. Two choices present themselves. The court could, prior to restoration of the shares to defendant, direct an accounting and thereafter provide for delivery of the stock upon such terms as may be just. Or the court could direct an exchange in specie, each to be held in escrow pending a dissolution action under the BCL in which defendant's claims of adjustment by reason of mismanagement may be adjudicated. Plaintiff announced at oral argument her intention to dissolve the corporation upon any retransfer, and the statute also gives defendant, as holder of stock in escrow, rights to litigate the mismanagement issue. BCL § 1104-a. A final judgment of rescission may then be decreed in this action. As Duggan emphasized, “plaintiff was equitably bound to do equity as a condition precedent to obtaining equitable relief” and “the court has power and it is its duty to protect the equities of all parties.” Id. 263 N.Y. at 507, 189 N.E. 566 (adding that “defendants, even though guilty of the fraud charged, were not outlaws”) nearly quoting Holmes, J. in Stoffela v. Nugent, 217 U.S. 499, 501, 30 S.Ct. 600, 54 L.Ed. 856 (1910) 6
Plaintiff is Entitled to Rescission of the Releases
On the prior motion, defendant maintained that plaintiffs' action was barred by the releases executed by plaintiffs in favor of defendant on July 20, 2001, in connection with the Stock Redemption Agreement. The releases covered any claims arising out of a dispute between the parties concerning the payment by Ajettix of some $87,000 to Microsoft to obtain upgradable Microsoft licenses ultimately for the benefit of PAETEC, defendant's current employer. Defendant contends that, because plaintiffs “knew of the underlying events regarding the Microsoft licenses when they were discovered in 1999,” the releases are not subject to rescission by reason of defendant's breach of fiduciary duty not then known to plaintiff.
This argument misses the mark. Before the releases were signed, plaintiffs maintain that they had a cause of action against defendant in connection with the acquisition by his current employer of upgradable licenses virtually free of charge. Whether or not such a cause of action existed and whatever its merits, plaintiffs released any such claim as part of the consideration for the stock redemption. This court held in the prior decision granting plaintiffs summary judgment that they were entitled to rescission of the stock redemption transaction by reason of defendant's breach of fiduciary duty that the release did not bar plaintiffs' rescission claim. Now the court holds that if the stock redemption is to be rescinded, as defendant now concedes for purposes if this motion it may be (upon whatever adjustment is deemed equitable), the releases must be rescinded also. As in Sher v. Sandler, 325 Mass. 348, 90 N.E.2d 536 (1950), a case on its facts similar to this one, the “release [wa]s obtained without a full disclosure of the relevant facts by one who is under a duty to reveal them.” Id. 325 Mass. at 354, 90 N.E.2d at 540. It was held that “the release ․ was inextricably linked to the sale[;][i]t would be strange indeed if we should hold that the plaintiff was entitled to rescind the sale of stock because of defendant's nondisclosure but that the release which was given in conjunction with such sale was immune from attack and extinguished the right to rescind.” Id. See also, Pacelli Brothers Transportation, Inc. v. Pacelli, 189 Conn. 401, 409, 456 A.2d 325, 329 (1983). The fact that plaintiffs knew of the particulars concerning the upgradable license acquisition by PAETEC is not important except insofar as their knowledge gave them reason to believe that they had a viable claim against defendant worthy of being covered by the releases they executed. One can validly release collateral claims as part of an overall transaction settling the dispute between the parties. It was probably the case, from all the papers on these two motions reveal, that Newhouse believed when she executed the releases that she (or more properly the corporation) had a right to recover from defendant for the manner in which PAETEC acquired the Microsoft licenses that Ajettix paid for. Whatever the merits of her belief, she released defendant in connection with that transaction when she agreed to pay defendant to redeem his stock in Ajettix. Having recovered his share of the corporation in exchange inter alia for relinquishing her legal claims, her rescission of the transaction puts her back to the status quo ante, in which she will have her perceived legal claims against defendant for the PAETEC license acquisition paid for by Ajettix, but no part of defendant's 50% share of the stock she received in the redemption agreement. At the same time, defendant will not have the money paid for his interest in the corporation, but he will have his stock “but no release.” Fleming v. United States Postal Service AMF O'Hare, 27 F.3d 259, 262 (7th Cir.1994) (Posner, J.). Defendant cannot “take the position” that he is entitled to the stock and to have the releases also, “ for the surrender of her claim ․ [against defendant in connection with the PAETEC acquisition] was part of the consideration for ․ [defendant's offer to relinquish his stake in the company].” Id. (on quite different facts using the quoted formulation). Therefore, plaintiff is entitled to a conditional judgment rescinding the releases also, albeit with the adjustments to be computed after this interlocutory judgment is entered pursuant to Duggan v. Platz, supra.
Submit conditional judgment for interlocutory decree accordingly.
1. Defendant has indicated that he did not become aware of John Smith's affiliation with Croop until John Smith's EBT (defendant affidavit [12/21/04] at ¶ 26).
2. Apparently after talking to Madison.
3. The court does not consider that plaintiffs' motion for summary judgment concerns the Third Cause of Action, which is separately denominated “rescission.” Nor does the court consider that plaintiffs' motion concerns the Fourth or Fifth Causes of Action.
4. Even in actions at law, the plaintiff must “mak[e] allowance for benefits received.” Schank v. Schuchman, 212 N.Y. 352, 359-60, 106 N.E. 127 (1914).
5. By the same token, contrary to plaintiffs' position, if the corporation has appreciated, plaintiff “may be ordered to account for any profits which [s]he may have received up to this date.” Thomas v. Beals, 154 Mass. at 54, 27 N.E. at 1005.
6. In so holding, the Court of Appeals specifically rejected the notion that an inability to restore defendants to their original position requires no adjustment because “[t]he law cares very little what a fraudulent party's loss may be, and expects nothing for his sake.” Id. 238 App.Div. at 201, 264 N.Y.S. 403.
KENNETH R. FISHER, J.