Imagine devoting years of costly litigation to rescinding a $1 million equity investment in an LLC for fraudulent inducement, prevailing on the merits by clear and convincing evidence after a full trial, but losing anyway because you named the wrong defendant.
That was the painful outcome for an allegedly defrauded restaurant investor in a recent decision by Manhattan Commercial Division Justice Jennifer G. Schecter.
In Han v Kwak (2023 NY Slip Op 33207[U] [Sup Ct, NY County Sept. 14, 2023]), the Court framed the issue as follows:
This case ultimately turns on a purely legal question: whether rescission or rescissory damages are available solely against a defendant who is not a party to the transaction that he fraudulently induced.
As it turns out, the sole defendant named on the fraud claim, Robert Kwak (“Kwak”), was a signatory to the contract the defrauded investor, Janet Han (“Han”), sued to rescind. As the Court noted, Kwak’s signature appeared on the contract, but he signed only in an official capacity, not in his personal capacity. This subtle distinction proved disastrous for Han, who ultimately walked away with nothing after an otherwise successful trial.
The Alleged Fraud
According to the amended complaint, Kwak and two other co-founders formed Sweetcatch KKA LLC (“Sweetcatch KKA”) and certain related entities to finance, develop, own, and operate a chain of five Manhattan Hawaiian poke restaurants named “Sweetcatch.” One of the related entities, NC KKA LLC (“NC KKA”), was Managing Member and majority owner of Sweetcatch KKA.
Leasing and build-out of the Sweetcatch locations took longer, and proved far more expensive, than the founders expected. Only four of the five locations were ever leased. Leasing, development, and operation costs for the four locations exceeded $2.2 million (exceeding by $1 million the initial investors’ capital investment of $1.2 million). Only two of the five Sweetcatch locations finally opened by the time of the amended complaint. In short, Kwak and his co-owners were in deep financial trouble and desperately needed cash to fund existing Sweetcatch operations.
According to Han, she knew none of this when her “long-time friend,” Kwak, approached her to solicit an investment in what she thought was a “successful Sweetcatch business.” Han alleged that Kwak committed a series of fraudulent misrepresentations to induce her investment, including telling her that the existing restaurant locations were fully funded with the initial investors’ $1.2 million, and that Sweetcatch KKA would use her investment only to fund new restaurant locations.
In alleged reliance upon these and other alleged false promises – detailed in paragraphs 39 and 40 of her amended complaint – Han made a $1 million cash investment in exchange for a 20% equity interest in Sweetcatch KKA.
The parties documented the transaction in a Subscription Agreement signed by Kwak as “Manager” of NC KKA, as “Managing Member” of Sweetcatch KKA.
Instead of using Han’s investment to fund new restaurant locations, Sweetcatch KKA used the money to pay down debts upon, develop, and operate, its existing locations, and also, allegedly, to fund “completely independent and unrelated businesses.”
The Amended Complaint
In her amended complaint, Han alleged just one direct claim: her first cause of action for common-law fraud. For reasons that are not entirely clear, Han pled her fraud claim solely against Kwak. The remaining five causes of action Han alleged derivatively on behalf of Sweetcatch KKA for breach of fiduciary duty, unjust enrichment, conversion, money had and received, and accounting.
The Election of Remedies and Dismissal of the Derivative Claims
No side moved for summary judgment, so the case sped toward trial.
At a pre-trial conference, Justice Schecter warned Han’s lawyer of the inherent illogic of suing derivatively on behalf of a limited liability company (which requires equity ownership) while simultaneously suing to rescind equity ownership in the entity.
In response, Han sent the Court a letter electing to proceed at trial on the remedy of rescission on her fraud claim in lieu of suing for fraud damages.
The very next day, Justice Schecter issued an Order dismissing with prejudice all of Han’s derivative claims, holding that Han “herself elected to seek rescission of the equity that she needs to have standing on her derivative claims.”
The Post-Trial Decision
Han proceeded to a bench trial against Kwak on her remaining single cause of action for rescission of the Subscription Agreement based on fraud. In the resulting Decision After Trial, Justice Schecter ruled that Han introduced sufficient trial evidence “clearly and convincingly proving that he defrauded her.”
But, held the Court:
There is a threshold problem with plaintiff’s claim for rescission based on Kwak’s fraud that is fatal to her case. Han cannot obtain rescission or rescissory damages from Kwak because he is not her contractual counterparty. Plaintiff was cautioned about the importance of this issue at trial and was directed to provide authority in her post-trial brief demonstrating that privity is not required to obtain rescissory relief. She did not do so.
The Court quoted a line of Appellate Division and Federal Court cases which the Court wrote “establish that a rescission claim can only be asserted against parties in privity of contract”:
- Jesmer v Retail Magic, Inc., 55 AD3d 171 [2d Dept 2008] [“Auto-Star conclusively established that First Americans’ purchase of the POS system from Magic did not create a contractual relationship between First Americans and Auto-Star. Consequently, the Supreme Court properly granted those branches of Auto-Star’s motion which were to dismiss the first cause of action for rescission”];
- Steinberg v Sherman, 07-cv-1001-WHP, Memorandum and Order [SD NY May 8, 2008] [“A claim for rescission cannot be maintained against a person who was not a party to the contract. This is true even where that individual joined in the false representations that induced the contract”];
- McGarry v Miller, 158 AD2d 327 [1st Dept 1990] [“plaintiff may have a cause of action against Mutual Benefit for rescission” but “as M & M was not a party to the contract, no such cause of action may be alleged against it”]; and
- Alexander City Bank v Equit. Tr. Co. of New York, 223 AD 24 [1st Dept 1928] [“In rescinding a contract and enforcing rights growing out of such rescission, one may only look to the other party to the contract”].
Justice Schecter acknowledged the existence of case law permitting a defrauded plaintiff to sue a nonsignatory to a contract in “an action at law for damages for their fraud” (quoting Mack v Latta, 178 NY 525 ).
But money damages and rescission are very different remedies. “After all,” wrote the Court, “rescission can be effective only by returning or tendering back the consideration received. A nonsignatory who was not the recipient of the consideration cannot restore the status quo” (citation and quotations omitted).
“What is clear,” wrote the Court, “is that the Company was never sued and rescission was never sought against the party that was the recipient of the investment.”
Justice Schecter noted that Han could have proceeded on a damages theory against Kwak, but she did not, and she submitted no evidence of actual financial losses at trial:
While plaintiff could have elected to proceed with her legal claim for damages against Kwak, the ship sailed on that long ago. At the time of the October 4, 2022 order, the court was cognizant that plaintiff had elected to forego her claim for out-of-pocket damages against Kwak, which settled law conceptually would permit. [But] plaintiff had no [damages] expert . . . . Where, as here, a party lacks proper evidence of damages on a fraud claim (i.e., the difference between what the interest in the company was worth at the time of the sale due to the fraud and what she paid for it), the claim must be dismissed as a matter of law.
The Court summed up Han’s predicament as follows:
Of course, plaintiff always really wanted all of her money back because she was fundamentally deceived about the nature of her investment and not merely about its worth. Thus, an equitable rescission claim, rather than a legal claim seeking out-of-pocket damages, had more intuitive appeal. The problem is that, from the outset of the case in her pleading, plaintiff never asserted the fraud claim against anyone other than Kwak (perhaps because the Company does not have the money to pay any judgment), even though she asserted claims against other defendants. So while plaintiff may have prevailed if she pleaded the fraud claim against the Company or hired a damages expert at the discovery stage, those possibilities were foreclosed long ago.
It’s hard not to feel bad for a litigant who wins on the merits of a claim as exceptionally challenging to prove as fraud-based rescission, but loses in the end because of a technical misstep like naming the wrong defendant.
If there is any lesson from Han, it is to always correctly name the actual counterparty to the contract one seeks to rescind.