Motion to Dismiss Granted as to Preferential Transfer Claims, Fraudulent Transfer Claims, Aiding and Abetting Claims Against Individual Director, Disallowance of Claims, and Claims for Recharacterization and Disgorgement
Burtch v. Huston (In re USDigital, Inc.), Case No. 09-10374 (CSS), Adv. Pro. No. 09-50469 (CSS) (January 5, 2011) (J. Sontchi)
On March 26, 2007 (the “Petition Date”), USDigital filed a voluntary Chapter 7 petition, subsequent to which Jeoffrey L. Burtch was appointed as successor interim Chapter 7 Trustee (the “Trustee”). The Trustee filed a complaint on March 18, 2009 seeking to avoid prepetition transfers and alleging breaches of fiduciary duty, aiding and abetting breaches of fiduciary duty, usurping corporate opportunity, corporate waste, unjust enrichment, accounting, disallowance of claims, equitable subordination, and recharacterization against NexGen Telecom, LLC (“NexGen”), Infinidi Media, Inc. (“Infinidi Media”), Stonebridge Marketing, LLC (“Stonebridge”), and directors of USDigital, Inc. (collectively, the “Defendants”).
On November 12, 2009, the Defendants filed a motion to dismiss, to which the Trustee objected on January 14, 2010. The Defendants filed a reply brief on February 12, 2010 and the Court entered its order and issued its opinion on January 5, 2011.
By way of background, USDigital was one of four separate, but interconnected, corporations formed between 2003 and 2006. The corporate quartet consisted of: (1) USDigital; (2) USDigital Television, LLC (“USDTV”); (3) NexGen; and (4) Infinidi Media. Each of these corporations shared the same source of capital, had many of the same directors and officers, and entered into transactions with one another. In relevant part, on June 13, 2006, USDTV executed a promissory note in favor of NexGen in the amount of $104,160.00 secured by set top boxes owned by USDTV, which transaction was documented by a security agreement (the “USDTV Security Agreement”).
Following USDTV’s bankruptcy petition in 2007, USDigital and USDTV entered into an asset purchase agreement (the “APA”) for the sale of substantially all of USDTV’s assets to USDigital, as well as USDigital’s assumption of USDTV’s liabilities to NexGen including the USDTV Security Agreement, which sale was approved on September 12, 2006.
Discussion:
The Court’s ruling and rationale concerning each of the counts of the complaint are set forth below.
Count I: Preferential Transfers to NexGen
Count I of the Complaint alleged that USDigital made two preferential transfers to NexGen: (i) a security interest in the set top boxes, and (ii) a $44,421 payment for expense reimbursement for a payment NexGen made to ESPN on USDTV’s behalf. The issue with respect to both transfers was whether the payment was made “for or on account of an antecedent debt,” as required by 11 U.S.C. § 547(b)(2). The Court determined that neither payment was made on account of an antecedent debt because: (i) the transfer of the security interest occurred on the same day as USDigital incurred the obligation to make such transfer, both of which events either occurred on the date USDigital entered into the APA or on the date the Court approved the asset sale; and (ii) the expense reimbursement payment was made on August 8, 2006, comfortably before the Debtor became obligated to make such payment pursuant to the September 12, 2006 approval of the APA. Accordingly, Count I was dismissed.
Counts II through IV: Constructively Fraudulent Transfers to NexGen
The trustee also pled that the transfer of the security interest and the expense reimbursement constituted constructively fraudulent transfers because the Debtor did not receive reasonably equivalent value for such transfers. Rule 8(a), and not the more restrictive Rule 9, governs constructive fraud claims, which “need only set forth the facts with sufficient particularity to apprise the defendant fairly of the charges made against him[,]” which requires only “an allegation that there was a transfer for less than reasonably equivalent value at a time when the Debtors were insolvent.”
The Court held that the Trustee failed to meet this obligation and, in fact, “fail[ed] to provide any factual allegations supporting the assertion that USDigital did not receive reasonably equivalent value for the secured interest in the set top boxes” because the transfer of the security interest was part and parcel of the purchase of assets, which provided for the assumption of $100,000 in debt. The Court also observed that the Trustee failed to provide factual support for the allegations that USDigital was insolvent or was rendered insolvent at the time it purchased USDTV’s assets.
Similarly with the expense reimbursement, the Court concluded that the Trustee failed to support its allegation that USDigital did not receive reasonably equivalent value where the underlying documentation established that USDigital received a direct, dollar-for-dollar reduction in its liability on the closing date in consideration of the expense reimbursement paid to NexGen.
Because Count IV required a finding that the transfers were avoidable, which finding the Court held could not be made as to either Counts II or III, Counts II through IV were all dismissed.
Counts IX, X & XII: Breach of Fiduciary Duty Against Director Defendants
The Director Defendants consist of Joseph C. Huston (founder of Infinidi Media), Kevin Doman (founder of Infinidi Media and original founder of USDTV), Mark Ziegler (founder of Infinidi Media and vice president of NexGen), Brian Humphrey (founder of Infinidi Media and general counsel for NexGen), Charles S. McNeil (founder of Infinidi Media and chairman of NexGen), Steve Lindsley (founder of Infinidi Media and CEO of USDTV prior to its bankruptcy).
Observing first that, when a corporation becomes insolvent in Delaware, fiduciary duties inure to the benefit of creditors, who generally are not owed such duties beyond the relevant contractual terms prior to the point of insolvency. The Trustee asserted (and the Director Defendants did not contest) that USDigital was insolvent at the time of the Infinidi Media Transfers.
The Court then went on to address the following issues: (1) whether the Trustee had standing to bring such claims against the Director Defendants; (2) whether the Director Defendants breached the duty of care; and (3) whether the Director Defendants breached the duty of loyalty and the related duty of good faith.
Standing
Next, the Court determined that the Trustee had standing to bring claims of corporate misfeasance and malfeasance because, though such claims were generally brought in derivative suits, which were initiated by shareholders who were first required to either make demand on the directors for corrective action or demonstrate that demand would be futile, the Trustee represents the Debtor corporation and is the sole representative of the estate with the authority to sue and be sued and, accordingly, had standing to bring suit without first making demand.
Breach of Duty of Care
As to the allegations of breaches of the duty of care, the Court found that the exculpatory provision in USDigital’s bylaws released the Director Defendants from claims alleging breach of the duty of care and that the Trustee’s failure to allege gross negligence were fatal to the claims and, therefore, dismissed such claims.
Breach of Duty of Loyalty/Good Faith
The Trustee set forth three alleged breaches of the duty of loyalty: (1) that the Director Defendants were enmeshed in conflicts of interests when permitting time and capital to be spent on developing Infinidi Media; (2) that the Director Defendants’ failed to oversee and protect USDigital’s assets by permitting USDigital to invest resources in Infinidi Media and by allowing Infinidi Media to remove intellectual property from USDigital; and (3) that the Director Defendants beached their duty of good faith by approaching the Infinidi Media transfers with a level of indifference and egregiousness.
The Court found that the Trustee failed to explain how Huston, Lindsley, McNeil, Ziegler, and Humphrey lacked independence or were interested in the challenged transfers. Huston, Lindsley, McNeil, Ziegler and Humphrey were not employed by Infinidi Media following its break from USDigital. The Trustee claimed that, after the Infinidi Media spinooff, McNeil, Ziegler, and Humphrey were employed by NexGen, which ceased funding USDigital only to begin funding Infinidi Media. The Trustee also alleged that Doman, who held a 10% equity interest in USDigital, became a director of Infinidi Media after leaving USDigital’s employ. However, without more, the Court did not find these allegations sufficient to plead a facially plausible case for a breach of the duty of loyalty.
The Trustee’s second allegation, that the Director Defendants breached their duty of loyalty and good faith by failing to oversee and protect USDigital’s resources and property, failed to plead facts indicating that USDigital lacked a reporting system or that the Director Defendants failed to adequately monitor the reporting system, and thus also failed.
Moreover, the Trustee’s allegations that the Director Defendants breached their duty of loyalty and good faith by approaching the Infinidi Media Transfers with a level of indifference or egregiousness that amounted to bad faith failed because the Director Defendants did not owe their fiduciary duties to the creditors when it was operating in the “zone of insolvency,” but rather owed these duties to the corporation at its shareholders at that time.
However, the Court found that the Trustee asserted a plausible claim that the Director Defendants approved a transaction that was unfair to USDigital’s creditors when it spent $245,869.25 on operating Infinidi Media without obligating Infinidi Media to repay such contributions. Accordingly, the Court denied the Motion to Dismiss Count IX.
Count X: Claims of Aiding and Abetting Against NexGen and Humphrey
In Count X, the Trustee asserted claims for aiding and abetting the alleged breach of fiduciary duty asserted in Count IX against NexGen and Humphrey. Drawing all reasonable inferences in favor of the Trustee, the Court determined that Count X set out facts sufficiently plausible to sustain Count X with respect to NexGen because the Trustee pled facts that NexGen knowingly participated in the fiduciary duty breaches as the founder, major shareholder, and primary capital provider for USDigital prior to its bankruptcy filing. NexGen’s complete cut-off of funding to USDigital less than one month after it began funding Infinidi Media was sufficiently suspect to support the Trustee’s claims of aiding and abetting.
However, the Court held that Humphrey could not both have breached his fiduciary duties (as set forth in Count IX) and aided and abetted the same breach of fiduciary duties. Accordingly, the Court dismissed Count X as to Humphrey.
Count XII: Claims of Corporate Waste and Mismanagement Against the Director Defendants
In Count XII, the Trustee alleged that the Director Defendants wasted the Debtor’s resources by permitting the use of operating funds on the development of Infinidi Media without fair consideration. The Court held that the Trustee pled facially plausible claims for corporate waste because, though investing operating funds to develop an internal sales division such as Infinidi Media made sense, doing so without an accompanying arrangement for reimbursement after the Director Defendants decided to spin-off Infinidi Media may constitute corporate waste. Accordingly, the motion to dismiss Count XII was denied.
Count XIII: Claims of Unjust Enrichment Against McNeil, Ziegler, Humphrey, NexGen, Doman, and Infinidi Media
In Count XIII, the Trustee set forth claims of unjust enrichment against McNeil, Ziegler, Humphrey, NexGen, Doman, and Infinidi Media (the “NexGen Defendants”), alleging that the NexGen Defendants were unjustly enriched to the detriment of the creditors of USDigital by using assets of the Debtor to start a new company owned and operated by the NexGen Defendants to the detriment of USDigital and its creditors. The Court found that the allegations, which demonstrated that the NexGen Defendants held ownership interests in NexGen, worked for NexGen, or worked for Infinidi Media following the spin-off, that they were enriched because they held interests in Infinidi Media after the divestiture, and that USDigital was impoverished because USDigital spun off Infinidi Media, depriving it of assets in which it held legitimate claims, were sufficient to state a plausible claim of unjust enrichment.
Count XIV: Disallowance of Claims Against NexGen and Stonebridge
In Count XIV, the Trustee seeks the disallowance of claims filed by NexGen and Stonebridge under § 502(d). However, because the Trustee’s claims for disallowance under sections 544, 547, 548 and 550 failed as a matter of law, the Court dismissed Count XIV.
Count XV: Claims for Equitable Subordination of Security Interest and Claims
The Trustee seeks equitable subordination of NexGen’s security interest and the claims filed in the bankruptcy case by Huston, Lindsley, McNeil, Ziegler, Humphrey, NexGen and Stonebridge. Because the complaint fails to refer to claims other than those filed by NexGen and Stonebridge, the Court addressed only the claims filed by NexGen and Stonebridge. The Trustee alleged that NexGen and Stonebridge, both insiders, engaged in inequitable conduct that preferred themselves to the harm and detriment of other creditors.
Specifically, the Trustee alleged that NexGen, through its dominion and control over the Debtor, compelled the Debtor to invest money in Infinidi Media to grant the lien in the set top boxes. Similarly, the Trustee contends that Stonebridge, through its dominion and control over the Debtor, compelled the Debtor to transfer $20,000 to itself over the course of five months. The court found the facts alleged were sufficient to state a plausible claim for equitable subordination against both NexGen and Stonebridge due to their insider access to USDigital and allegations which, if true, would result in creditors of the estate receiving less than they would have otherwise received. Accordingly, the Motion to Dismiss Count XV was denied.
Count XVI: Claims for an Accounting
In Count XVI, the Trustee demanded an accounting with supporting documentation of all the transactions relating to the Infinidi Media Transfers. Having determined that a fiduciary duty to the creditors existed, the Court found that it would be inappropriate to dismiss the Trustee’s accounting claim and, accordingly, denied the Motion to Dismiss Count XVI.
Count XVII: Claims for Recharacterization and Disgorgement of Secured and Unsecured Promissory Notes from Debt to Equity
In Count XVII, the Trustee sought recharacterization and disgorgement of the NexGen $100,000 Secured Promissory Note and the NexGen $100,000 Unsecured Promissory Note (which was executed contemporaneously with the NexGen Secured Promissory Note), contending that these notes were capital contributions and should be recharacterized as equity because NexGen contributed the money when the Debtor was insolvent and when repayment was unlikely.
In essence, the Court reviewed the transaction to determine whether the “parties called an instrument one thing when in fact they intended it as something else.” The Court found it difficult to understand how NexGen could have intended its assumption of USDTV’s debt to NexGen as a capital contribution to USDigital if the debt was assumed out of a sale in an altogether different bankruptcy case. Moreover, the Court determined that the Trustee did not set forth any facts indicating an intention of the parties that the NexGen Promissory Notes were to be capital contributions and not, in fact, promissory notes. Accordingly, the Court dismissed Count XVII.
Motion for More Definite Statement
Although the Court agreed with the Defendants that the Complaint was unclear at times, the Court was not convinced that this lack of clarity approached the level of unintelligibility required to grant a motion for a more definite statement and, accordingly, denied the motion.
