Smith v. Foster: Ne-Yo’s Fraud Claims Dismissed for Lack of Specificity

In Smith. v. Foster, No. 14-Cv-5918 (SHS), 2016 BL 65843 (S.D.N.Y. Mar. 03, 2016), the United States District Court for the Southern District of New York granted David Foster and his firm’s (“Defendants”) motion to dismiss Shaffer Smith’s, the recording artist known professionally as Ne-Yo (“Plaintiff”) third amended complaint (“TAC”). The court held the TAC was not pled properly under Federal Rule of Civil Procedure 9(b) and 15 USC § 78u-4(b)(1).   

According to the allegations, Plaintiff in 2005 contracted Defendants to manage his business affairs. Foster convinced Plaintiff to invest in Imperial Health Research & Development LLC (“Imperial”), which sold a beverage called OXYwater. Plaintiff initially invested $1 million, and another $1 million after learning of sponsorships with NASCAR and the Cleveland Cavaliers. Smith ultimately invested $3.5 million before Imperial’s bankruptcy in 2013. Smith then sued Foster for securities fraud.  

The TAC alleged Foster fraudulently misrepresented Imperial to induce Plaintiff’s investment. Foster never disclosed he was Imperial’s President, CFO, and 66% shareholder. Foster among other things allegedly asserted that Imperial was “on the verge” of taking over Vitamin Water’s market share, “in the process” of going public, and that Plaintiff’s initial investment was “doing great.” Plaintiff also asserted that Foster failed to reveal his relationship with Imperial, including his ownership of a majority of the shares of the company. 

To adequately plead securities fraud under FRCP 9(b) and securities fraud under 15 USC § 78u-4(b)(1), plaintiffs must allege (1) a material misrepresentation or omission; (2) made with scienter; (3) on which the plaintiff relied; (4) which  caused; (5) economic loss; (6) and loss causation. The court addressed only the first two issues in this case.  

First, the court found the TAC failed to plead specific facts providing a basis to conclude that Foster’s statements were false when made. The TAC’s allegations were based on  “information and belief.”  Such a basis was only permissible where “the facts necessary to show falsity ‘are wholly within’ defendants' ‘control,’  or ‘peculiarly within’ defendants' ‘knowledge’” (citations omitted).  The court was not “ersuaded that the purported facts” were “wholly within” Defendants’ control. 

Other statements were considered too vague to establish a claim for fraud.  Allegations that statements about an investment “doing great” while the company was “hemorrhaging money” was not sufficient becuase the “allegation, without any additional facutal support, is too vauge to satisfy the heightened pleading reqruiements of Rule 9(b) and the PSLRA.”  As for the alleged failure to disclose Foster’s status with respect to Imperial, the court determined that the statements did “nothing to cast doubt on anything Foster actually said.”    

Second, the court found that the allegations were insufficient to establish a “strong inference” of scienter.  Scienter in the Second Circuit can be shown through allegations of motiva and opportunity or conscious misbehavior.  The court found that alleged motives to “procure investors” and to “skim the invested funds for his own individual purpose” were insufficient because the behavior was “equally likely” or “consistent” with proper motives.  The court likewise found the allegations of “conscious misbehavior”.    

The court granted Foster’s motion to dismiss Smith’s securities fraud claim with prejudice for failure to plead securities fraud with particularity and specificity.

The primary materials for this case may be found on the DU Corporate Governance website.