Andrew Carothers, M.D., P.C. v. Progressive Insurance Co.

OPINION OF THE COURT

New York State law mandates that professional service corporations be owned and controlled only by licensed professionals. In State Farm Mut. Auto. Ins. Co. v Mallela ( 4 NY3d 313 [2005]), the Court of Appeals held that under the no-fault insurance law (Insurance Law § 5101 et seq.), an insurance carrier may withhold payment for medical services provided by a professional corporation which has been “fraudulently incorporated” to allow nonphysicians to share in its ownership and control. The primary issue we are called upon to determine, for the first time, is what elements are necessary to establish the defense of fraudulent incorporation recognized by Mallela. For the reasons which follow, we find that the jury in this case was properly instructed on the elements of a fraudulent incorporation defense.

Background of the Action

In July 2004, Andrew Carothers, a radiologist, formed a professional service corporation, the plaintiff, Andrew Caroth-ers, M.D., P.C., to perform MRI scans at three existing MRI facilities in Brooklyn, Queens, and the Bronx. The plaintiff leased the three MRI facilities, and all of the medical and office equipment used at the facilities, from companies owned and controlled by nonparty Hillel Sher. In 2005 and 2006, approximately 38,000 MRI scans were performed at the three facilities. The majority of the scans performed were for patients allegedly injured in motor vehicle accidents. These patients assigned their right to receive first-party no-fault insurance benefits to the plaintiff, and the plaintiff billed insurance companies to recover payment on the assigned claims. Because payment was not made in many instances, the plaintiff commenced thousands of actions against insurers, including this action against the defendant, Progressive Insurance Company, to recover unpaid claims of assigned first-party no-fault insurance benefits.

Sher and Vayman were both deposed prior to trial. However, both invoked their Fifth Amendment (US Const Fifth Amend) privilege against self-incrimination in response to virtually all the questions posed to them during their respective depositions.

A joint trial was held on actions pending in Kings County and Richmond County between the plaintiff and 53 insurers and self-insurers, including this action. During the course of the lengthy trial, the defendant insurers called several expert witnesses, who provided testimony in support of their claims that the plaintiff’s profits were funneled to Sher and Vayman through grossly inflated equipment lease payments made to a company owned and controlled by Sher, and through Vayman’s transfers of funds to her own personal accounts. For example, while the plaintiff paid $547,000 per month for two years to lease old MRI equipment, an expert in the field of selling and leasing of MRI equipment testified that the plaintiff could have purchased the same equipment for a onetime payment of $600,000. In addition, the defendants’ expert forensic accountant noted that Sher, through one of his companies, leased one of the machines in 2001 for approximately $9,800 per month and then charged the plaintiff $75,000 per month for the same machine. In the forensic accountant’s view, the lease agreements between the plaintiff and Sher’s companies were not made at arm’s length because the terms of those agreements were not mutually beneficial to both parties. To illustrate this point, the forensic accountant noted that the equipment lease permitted Sher to terminate the lease without cause and made

The evidence presented by the defendant insurers further showed that Carothers had no real involvement with the management of the plaintiff. Vayman hired all of the personnel and signed all of the checks of the plaintiffs operating account. The only checks that Carothers signed on behalf of the plaintiff were from a new account that was set up around the time that the plaintiff ceased its operation. With respect to that account, Carothers received $52,000 and Vayman and her company received $75,000. The forensic accountant also testified that he found a web of eight different accounts associated with the plaintiff and that he could ascertain no business purpose for that number of accounts. He testified that the plaintiffs money went to Sher’s companies each month, leaving no money in the accounts, that no tax returns were filed on behalf of the plaintiff, and that no books or records were maintained on behalf of the plaintiff. According to this expert, $8.7 million from one of the accounts, the plaintiffs operating account, went to one of Sher’s companies, Forum Medical Group, and Vayman received $882,600 of those funds, which were immediately transferred from that company’s account into Vay-man’s personal account.

In the two-year period during which the plaintiff operated the practices, Sher and Vayman received a total of $12.2 million, while Carothers earned $133,000.

In contrast, when called to testify, Carothers was unable to account for such transactions. He asserted that the payments to Vayman’s personal account were for back wages and payment of corporate expenses and that the only payments for Sher’s benefit were to repay a $400,000 bridge loan, for which he presented no proof. Although Carothers testified that a general ledger compiled by an accounting firm in 2007 accounted for all transactions, no general ledger was admitted into evidence. Carothers’ testimony also revealed that he did not recognize the names of employees, some of whom were Sher’s relatives, and that he lacked knowledge about the operation and finances of the plaintiff.

Although the parties agreed that neither Sher nor Vayman was available to testify at the trial within the meaning of CPLR 3117 (a) (3), the Civil Court, over the plaintiff’s objection,

Before the Civil Court delivered its jury charge, the plaintiff requested that the jury be instructed that in order to prove fraudulent incorporation, the defendants were required to prove, by clear and convincing evidence, the traditional elements of common-law fraud, including the element of fraudulent intent. The plaintiff further requested that the jury be charged that the defendants were required to prove that such fraudulent intent was present at the time it was incorporated in July 2004. In addition, the plaintiff requested that the jury be charged on the business judgment rule and instructed to consider the rule in evaluating whether Carothers’ decisions were reasonable and whether he engaged in sham transactions as that term is defined under federal tax law. The court denied these requests.

In charging the jury on the fraudulent incorporation defense, the Civil Court instructed the jury that the defendants had to establish that Sher and/or Vayman were de facto owners of the plaintiff or that they exercised substantial control over the plaintiff. To find de facto ownership, the jury was told that it must find that Sher and/or Vayman exercised dominion and control over the plaintiff and its assets, and that they shared risks, expenses, and interests in the profits and losses of the plaintiff. However, the court advised the jury that salary and other compensation and rents should not be considered as profits if it found such salary and leases were negotiated in good faith and were not in actuality a means to channel profits to Sher and/or Vayman. To find control, the jury was instructed that it must find that Sher and/or Vayman had a significant role in the guidance, management, and direction of the plaintiff. In determining the issue of whether Sher and/or Vay-man were de facto owners or exercised substantial control over the plaintiff, the jury was instructed to consider the totality of the circumstances and any relevant factor. The court also gave the jury a list of 13 factors it might want to consider, including whether Sher’s dealings with the plaintiff were arm’s length or were instead designed to give Sher and his companies substantial control over the plaintiff and channel profits to him; whether Sher and Vayman exercised dominion and control over the plaintiff’s assets, including the plaintiff’s bank accounts;

The jury returned a verdict finding, inter alia, that the defendants proved their defense by clear and convincing evidence, i.e., that the plaintiff was fraudulently incorporated. The jury further found that Carothers was not engaged in the practice of medicine during the time the plaintiff was in business as required by Business Corporation Law § 1507 (a).

The Civil Court denied the plaintiff’s motion pursuant to CPLR 4404 (a) to set aside the verdict and for judgment as a matter of law, or, in the alternative, to set aside the verdict as contrary to the weight of the evidence or in the interest of justice and for a new trial, and a judgment was entered in favor of the defendant and against the plaintiff in this action, dismissing the complaint. Upon the plaintiff’s appeal, the Appellate Term set aside as contrary to the weight of the evidence so much of the verdict as determined that Carothers failed to practice medicine, but upheld so much of the verdict as found that the plaintiff was fraudulently incorporated, affirming the judgment on that basis (see Andrew Carothers, M.D., PC. v Progressive Ins. Co., 42 Misc 3d 30 [2013]). The Appellate Term rejected the plaintiff’s contention that the Civil Court erroneously instructed the jury on the essential elements of a fraudulent incorporation defense as set forth in Mallela, and determined that it was not error for the Civil Court to set forth a list of factors to assist the jury in determining the issue of whether Sher and Vayman were de facto owners or exercised substantial control over the plaintiff. This Court granted the plaintiff leave to appeal. We affirm the Appellate Term’s order insofar as appealed from.

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];

The parties agree that the plaintiff is a professional corporation in the business of providing MRI scanning services at three locations and is subject to the Business Corporation Law.

Governing Provisions of Insurance Law

Pursuant to New York State’s Comprehensive Motor Vehicle Insurance Reparations 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 AD3d 407 , 409 [2006]).

The Court of Appeals has interpreted 11 NYCRR 65-3.16 (a) (12) to allow insurance carriers to withhold reimbursement for

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 ). 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 ; United States v Gabinskaya, 829 F3d 127 , 133 [2d Cir 2016]). 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. Co. v Mallela, 4 NY3d at 322 ; see 11 NYCRR 65-3.2 [c]; Dynamic Med. Imaging, P.C. v State Farm Mut. Auto. Ins. Co., 29 Misc 3d 278 , 285 [Nassau Dist Ct 2010]) 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 NY3d at 322 ). The Court further cautioned that “[technical 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.).

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

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 NY2d 393 , 401 [2002]; Hatzis v Buchbinder, 112 AD3d 890 , 890 [2013]; Winderman v Brooklyn/McDonald Ave. Shoprite Assoc., Inc., 85 AD3d 1018 , 1019 [2011]). 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 tunneled 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 arm’s 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,

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). 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 ). 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

Finally, the Civil Court properly denied the plaintiffs 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 Commissioner of Internal Revenue, 862 F2d 400 , 406 [2d Cir 1988]). 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.

Harmless Error

While a party’s invocation of the privilege against self-incrimination can generally be used to draw an adverse inference against that party in a civil action (see Marine Midland

In evaluating whether the error in permitting the deposition testimony to be read into evidence affected the outcome of the trial, we note as an initial matter that the jury determined that the defendant established fraudulent incorporation by clear and convincing evidence (see Tahir v Progressive Cas. Ins. Co., 12 Misc 3d 657 , 662-663 [Civ Ct, NY County 2006]; cf. Gaidon v Guardian Life Ins. Co. of Am., 94 NY2d 330 , 350 [1999]). In light of the jury’s determination that the evidence at trial met this more stringent standard of proof than required by the preponderance of the evidence standard, we do not reach the issue of which is the appropriate standard of proof in establishing the defense of fraudulent incorporation (see e.g. Matter of State of New York v Dennis K., 27 NY3d 718 , 742 [2016]). Nonetheless, the evidence clearly favored a verdict in the defendant’s favor. The evidence demonstrated that Carothers was merely the nominal owner of the plaintiff and that the plaintiff was actually owned and controlled by nonphysicians Sher and Vayman, who tunneled the plaintiff’s profits to themselves, and that the outcome of the trial would have been the same absent the error arising from the charge relating to the invocation by Sher and Vayman of the right against self-incrimination pursuant to the Fifth Amendment.

In light of the overwhelming evidence establishing fraudulent incorporation, the error arising from the charge pertaining to the invocation by Sher and Vayman of the right against self-

The plaintiffs remaining contention is without merit.

Accordingly, the order is affirmed insofar as appealed from.

Leventhal, J.P., Miller and Maltese, JJ., concur.

Ordered that the order is affirmed insofar as appealed from, with costs.