Carothers, a radiologist, formed Andrew Carothers, M .D., P.C., to perform MRI scans at three existing MRI facilities in Brooklyn, Queens, and the Bronx.  In sum, the carrier alleged “doc in the box”.  The Court’s dicta is as follows:

Business Corporation Law

New York State permits licensed professionals to incorporate if they are the sole organizers, owners, and operators of the corporation (see Business Corporation Law §§ 1503[a], [b]; 1508). To incorporate, the licensed individual must obtain a “certificate … issued by the [New York State Department of Education (DOE) ] certifying that each of the proposed shareholders, directors and officers is authorized by law to practice a profession which the corporation is being organized to practice” (Business Corporation Law § 1503[b] ). The DOE may not issue a certificate of authority to a professional service corporation that does not meet these qualifications (see Education Law § 6507[4][c][i] ). Once the professional corporation is formed, shareholders may not transfer their voting power to any person who is not a licensed professional in the field (see Business Corporation Law § 1507[a] ); only shareholders or the licensed professionals engaged in the practice may be directors and officers (see Business Corporation Law § 1508 [a] ). Any agreement by a shareholder transferring the voting power of his/her share to individuals who are not authorized by law to practice the profession is void (see Business Corporation Law § 1507[a] ). Thus, New York State law mandates that professional service corporations be owned and controlled only by licensed professionals (see Business Corporation Law §§ 1503[a]; 1507[a]; 1508[a] ) and that licensed professionals render the services provided by such corporations (see Business Corporation Law § 1504[a] ). In short, New York State law prohibits unlicensed individuals from organizing a professional service corporation for profit or exercising control over such corporations.


Governing Provisions of Insurance Law

Pursuant to New York State’s Comprehensive Motor Vehicle Insurance Reparation Act (no-fault law), insurers such as the defendant are required to indemnify all covered persons for reasonable and necessary medical services (see Insurance Law §§ 5102, 5104). Insureds or their medical provider assignee are entitled to reimbursement for “basic economic loss” (Insurance Law § 5102[a][1] ). A provider of healthcare services, however, is not eligible for reimbursement if the provider “fails to meet any applicable New York State or local licensing requirement necessary to perform such service” (11 NYCRR 65–3.16[a][12] ). The purpose of the regulations is to “combat fraud” (Allstate Ins. Co. v. Belt Parkway Imaging, P.C., 33 A.D.3d 407, 409, 823 N.Y.S.2d 9).

The Court of Appeals has interpreted 11 NYCRR 65–3.16(a)(12) to allow insurance carriers to withhold reimbursement for no-fault claims “provided by fraudulently incorporated enterprises to which patients have assigned their claims” (State Farm Mut. Auto. Ins. Co. v. Mallela, 4 N.Y.3d at 319, 794 N.Y.S.2d 700, 827 N.E.2d 758) and to “look beyond the face of licensing documents to identify willful and material failure to abide by state and local law” (id. at 321, 794 N.Y.S.2d 700, 827 N.E.2d 758).

In Mallela, the Court of Appeals answered a certified question from the United States Court of Appeals for the Second Circuit as to whether a medical corporation that was fraudulently incorporated under Business Corporation Law §§ 1507 and 1508 and Education Law § 6507(4)(c) was entitled to be reimbursed for assigned no-fault claims (see id. at 320, 794 N.Y.S.2d 700, 827 N.E.2d 758). The Court of Appeals answered the question in the negative, determining that a provider which was not solely owned and controlled by physicians, as required by Business Corporation Law §§ 1507(a) and 1508(a), was ineligible for no-fault reimbursements, and that insurers may look at the actual ownership and operation of the practice, to wit, whether the practice was actually controlled or owned by an unlicensed individual in violation of state and local law (see id. at 321, 794 N.Y.S.2d 700, 827 N.E.2d 758; United States v. Gabinskaya, 829 F.3d 127, 133 [2d Cir] ). In this context, however, the Court of Appeals cautioned that insurance carriers could not delay payments of reimbursement claims to pursue investigations unless they had “good cause” (State Farm Mut. Auto. Ins. Con v. Mallela, 4 N.Y.3d at 322, 794 N.Y.S.2d 700, 827 N.E.2d 758; see 11 NYCRR 65–3.2[c]; Dynamic Med. Imaging, P.C. v. State Farm Mut. Auto. Ins. Co., 29 Misc.3d 278, 285, 905 N.Y.S.2d 880 [Nassau Dist Ct] ) and that, in the licensing context, “carriers will be unable to show ‘good cause’ unless they can demonstrate behavior tantamount to fraud” (State Farm Mut. Auto. Ins. Co. v. Mallela, 4 N.Y.3d at 322, 794 N.Y.S.2d 700, 827 N.E.2d 758). The Court further cautioned that “[t]echnical violations will not do. For example, a failure to hold an annual meeting, pay corporate filing fees or submit otherwise acceptable paperwork on time will not rise to the level of fraud” (id.).

This is really the first time an Appellate Court upheld the principle set forth in Dynamic Med. Imaging, P.C. v. State Farm Mut. Auto. Ins. Co., 29 Misc.3d 278, 285, 905 N.Y.S.2d 880 [Nassau Dist Ct]

Jury Charge At Issue

On appeal to this Court, the plaintiff maintains that the Civil Court’s jury charge on fraudulent incorporation was improper because it permitted the jury to make a finding of fraudulent incorporation without a showing that Carothers possessed fraudulent intent at the time he incorporated the plaintiff, or engaged in criminal or fraudulent behavior. The plaintiff also contends that the Civil Court erred in setting forth a list of 13 factors the jury could consider in determining whether Sher and Vayman were de facto owners of the plaintiff or exercised substantial control over it. The plaintiff asserts that the list of factors impermissibly allowed the jury to consider “technical violations” of corporate formalities such as the failure to hold annual meetings, and administrative activities routinely performed by office managers, such as paying personnel. The plaintiff additionally argues that the Civil Court erred in denying its requests for charges on the business judgment rule and sham transactions.

Contrary to the plaintiff’s contention, the jury charge on fraudulent incorporation, read as a whole, adequately conveyed the correct legal principles articulated by the Court of Appeals in Mallela (see Nestorowich v. Ricotta, 97 N.Y.2d 393, 401, 740 N.Y.S.2d 668, 767 N.E.2d 125; Hatzis v. Buchbinder, 112 A.D.3d 890, 890, 978 N.Y.S.2d 298; Winderman v. Brooklyn/McDonald Ave. Shoprite Assoc., Inc., 85 A.D.3d 1018, 1019, 925 N.Y.S.2d 637). As the Appellate Term correctly determined, the charge properly focused the jury on the question of whether Carothers was a mere nominal owner of the plaintiff, and if, in actuality, nonphysicians Sher and Vayman owned or controlled the plaintiff such that the profits were funneled to them. The Civil Court properly instructed the jury to consider whether Sher and/or Vayman shared in the profits of the plaintiff, and that the jury could consider whether the leases entered into between the plaintiff and Sher’s companies were arms’ length or meant to funnel profits to Sher. The Civil Court charged the jury that, in order to succeed on its defense, the defendant was required to establish, by clear and convincing evidence, that Sher and/or Vayman, two nonphysicians, were “de facto owners” of the plaintiff or exercised “substantial control” over the plaintiff; and that to find de facto ownership, the jury must find that either Sher and/or Vayman exercised “dominion and control over” the plaintiff and its assets and that they “shared the risks, expenses, and interest in the profits and losses” of the plaintiff. To find control, the jury was instructed that they must find that Sher and/or Vayman had a “significant role in the guidance, management, and direction of the business.” The court also sufficiently explained the relevant definitions of these terms.

Although the plaintiff is correct that certain of the factors enumerated in the non-exhaustive list of factors with which the jury was charged that it might wish to consider, could not, standing alone, support a finding of fraudulent incorporation, these factors were relevant for the jury to consider in determining the ultimate issues of de facto ownership and substantial control, and the jury was properly instructed to consider the totality of the circumstances (see United States v. Gabinskaya, 829 F.3d at 132). For example, the fact that Vayman controlled the plaintiff’s bank accounts and was responsible for hiring and paying employees could not, on its own, support a finding that she owned and controlled the plaintiff. However, since the jury was instructed to look to the totality of the circumstances to determine whether Sher and/or Vayman were de facto owners or exercised substantial control over the plaintiff, factors such as Vayman’s control of the bank accounts and Carothers’ limited day-to-day management were relevant to that issue. Likewise, although Malella instructed that “[t]echnical violations” such as a failure to hold an annual meeting, pay corporate filing fees, or submit paperwork on time would not establish the defense of fraudulent incorporation (State Farm Mut. Auto. Ins. Co. v. Mallela, 4 N.Y.3d at 322, 794 N.Y.S.2d 700, 827 N.E.2d 758), a failure to follow corporate formalities is a relevant factor for the jury to consider, in conjunction with other factors, in determining the ultimate issue of ownership and control and whether the plaintiff was a proper professional corporation or merely a vehicle operated by nonphysicians to funnel profits to themselves.

 Further, the Civil Court did not err in declining to instruct the jury as to common-law fraud, fraudulent intent at the time of incorporation, and the business judgment rule. Mallela involved fraud “in the corporate form” rather than the more traditional forms of common-law fraud (id. at 320, 794 N.Y.S.2d 700, 827 N.E.2d 758). With respect to fraudulent intent at the time of incorporation, Mallela instructs that even if a professional corporation did not intend to yield control to unlicensed parties at the time of incorporation, it nonetheless would be ineligible for no-fault reimbursement if the nominal physician owner yielded control of the corporation at some later date (see id. at 322, 794 N.Y.S.2d 700, 827 N.E.2d 758). Good faith compliance with the requirements of a professional corporation at the time of incorporation does not end when the certificate of incorporation is filed and does not defeat a claim of fraudulent incorporation if the evidence demonstrates that at some point after the initial incorporation, the nominal physician owner turned over control of the business to nonphysicians in contravention of state regulations (see id.). Similarly, with respect to the plaintiff’s requested charge as to the business judgment rule, which is typically charged in actions alleging a breach of fiduciary duty and bars inquiry into actions of corporate directors taken in good faith in the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes (see Auerbach v. Bennett, 47 N.Y.2d 619, 629, 419 N.Y.S.2d 920, 393 N.E.2d 994; Mobarak v. Mowad, 117 A.D.3d 998, 999–1000, 986 N.Y.S.2d 539), the evidence presented at the trial did not support such a charge. Carothers failed to account for the vast majority of funds transferred by Vayman from the plaintiff to her personal account and to Sher’s companies. Further, Carothers provided no proof in support of his testimony that payments made to Sher were for the purpose of repaying a $400,000 bridge loan. Moreover, Carothers’ testimony displayed his almost complete lack of knowledge about the operation and finances of the plaintiff. In short, there was no evidentiary basis for a business judgment rule charge under the facts elicited at trial (see generally Dotson v. City of New York, 296 A.D.2d 372, 372–373, 745 N.Y.S.2d 434; Mejia v. Coleman, 168 A.D.2d 245, 246, 562 N.Y.S.2d 482). Accordingly, the Civil Court properly declined to give the plaintiff’s requested charges on common-law fraud, fraudulent intent, and the business judgment rule.

Finally, the Civil Court properly denied the plaintiff’s request to charge the jury, in accordance with federal tax law, that a “sham transaction” is one that has no business purpose or economic substance (see DeMartino v. C.I.R., 862 F.2d 400, 406 [2d Cir] ). Nonetheless, the jury was properly instructed that salary and lease payments should not be considered as profits if it found that they were negotiated in good faith and were not in actuality a means to funnel profits to nonphysicians.

In sum, the jury charge, read as a whole, adequately conveyed the correct legal principles on “fraudulent incorporation” as established by Mallela. The instructions asked the jury to consider whether, under the totality of the circumstances, the plaintiff was operating as a proper professional medical corporation in compliance with state regulations or whether, in order to obtain money that insurers were otherwise entitled to deny, the plaintiff was organized under the facially valid cover of Carothers but was, in actuality, operated and controlled by Sher and Vayman to funnel profits to themselves.





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