Zoo Holdings, LLC v Clinton

[*1] Zoo Holdings, LLC v Clinton 2006 NY Slip Op 50167(U) [11 Misc 3d 1051(A)] Decided on January 24, 2006 Supreme Court, New York County Cahn, J. Published by New York State Law Reporting Bureau pursuant to Judiciary Law § 431. This opinion is uncorrected and will not be published in the printed Official Reports.

Decided on January 24, 2006
Supreme Court, New York County

Zoo Holdings, LLC, individually, and as a shareholder suing derivatively on behalf of Zoologic, Inc., Plaintiff,

against

John B. Clinton, CONNING CAPITAL INVESTMENT PARTNERS VI, LLC, DAVID S. MEYERCORD, IRWIN VENTURES SBIC, LLC, DAVID J. SAMUELS, RICHARD H. BROWN, NORTHAVEN ASSOSIATES, LLC, NORTHAVEN PARTNERS LP, NORTHAVEN PARTNERS II LP, NORTHAVEN PARTNERS III LP, BRUCE R. RUSCH, NOMURA HOLDING AMERICA, INC., PETER MICERA and ZOOLOGIC, INC., Defendants.



107415/04

Herman Cahn, J.

Motion sequence nos. 001 and 002 are consolidated for disposition.

Defendants move (seq. no. 001) to dismiss the complaint based upon documentary evidence and for failure to state a claim upon which relief can be granted, CPLR 3211 (a) (1), (7). Plaintiff moves (seq. no. 002) to disqualify defendants' counsel on grounds of conflict of interest, 22 NYCRR 1200.24 (DR 5-105).

The Alleged Facts:

Zoologic, Inc., is a developer of online-education programs for financial professionals.

Its certificate of incorporation allows it to issue different series of preferred stock A,B,C, etc. carrying different shareholder rights in liquidation and other circumstances. The complaint alleges that after making Series A and Series B preferred stock offerings, Zoologic found itself in need of further capital investment in August 2001. It then made a Series C preferred stock offering to its investors. The Series C offering brought capital to Zoologic in the amount of $2,499,998.00 from investor defendants Conning Capital Partners, VI, LP, Conning Investment Partners VI, LLC, Irwin Ventures SBIC, LLC, and Nomura Holding America, Inc.

The certificate of incorporation provides that, in the event of a liquidation, the Series C preferred stock holders, out of funds available therefor, will receive the greater of "(A) [*2]$3.06 per share, plus an amount that will result in an Internal Rate of Return' of 30% per annum ... and (B) an amount per share equal to each such share's pro rata distribution of the total assets available upon Liquidation" based upon the total amount of capital and common stock (Notice of Motion Ex. 2 at 12).

In April 2003, Zoologic's Board of Directors approved a plan to raise an additional $3,000,000.00 from existing shareholders. Prior to approval, though, plaintiff Zoo Holdings, LLC, a shareholder and director of Zoologic, warned that the infusion of investment capital might cause Zoologic to lose the benefit of its net-operating-loss tax deduction ("NOL"). The Board sought and received advice from its advisors, BDO Seidman LLP, on the implications of the recapitalization.

On June 19, 2003, at a meeting of the Board, plaintiff opposed the contemplated recapitalization, and presented the Board with an alternative proposal which veered away from recapitalization, favoring a bridge loan from plaintiff to the corporation. The Board rejected the alternative, and voted to proceed with recapitalization through the issuance of a Series D preferred stock offering. The Series D offering raised capital for Zoologic in the amount of $2,444,445.00, primarily from investor defendants Conning and Irwin.

The certificate of incorporation provides that, in the event of a liquidation of Zoologic, the Series D preferred stockholders, out of funds available therefor, will receive the greater of "(A) $4.72 per share, (B) $2.36 per share, plus an amount that will result in an Internal Rate of Return' ... of 30% per annum ... and (C) an amount per share equal to each such share's pro rata distribution of the total assets available upon Liquidation" based upon the total amount of capital and common stock.

Seeking to nullify the Board's approval of the recapitalization, the complaint alleges that the Series C and D offerings were not bona fide recapitalizations; but rather, usurious loans, due to their 30% Internal Rates of Return,[FN1] implicating Penal Law 190.40, which provides that: A person is guilty of criminal usury in the second degree when, not being authorized or permitted by law to do so, he knowingly charges, takes or receives any money ... as interest on the loan ... at a rate exceeding twenty-five per centum per annum or the equivalent rate for a longer or shorter period.[*3]

(Penal Law 190.40.)[FN2]

The first two causes of action seek, derivatively, on behalf of Zoologic, a declaration that the Series D offering is a usurious loan in violation of the Penal Law and, thus, void; rescission of the Series D offering; a permanent injunction against extraordinary transactions by Zoologic; and punitive damages for breaches of fiduciary duty by director defendants David S. Meyercord, John B. Clinton, David J. Samuels, Richard H. Brown, and Bruce R. Rusch, who voted in favor of the Series C and D offerings. The third cause of action seeks, on plaintiff's individual behalf, punitive damages for breach of fiduciary duty by the director defendants.

Motion to Disqualify:

"[T]he party seeking the disqualification[] bears the burden of establishing that such a drastic remedy is warranted" (O'Donnell, Fox & Gartner, P.C. v R-2000 Corp., 198 AD2d 154 [1st Dept 1993]).

Plaintiff argues that defendants' counsel, the firm of Morgan, Lewis & Bockius, LLP, is conflicted because it represented Zoologic in connection with the stock offerings. This representation is characterized by plaintiff's counsel as drafting the transactional documents, implementing the offering, participating in Board meetings, and issuing opinion letters (Chinitz Affirm. ¶ 9). Such actions do not constitute an inappropriate conflict. A firm's prior representation of a litigant in connection with the transaction that is the subject of the litigation does not disqualify the firm (U.S. Risk Mgrs., Inc. v Gershuny, 141 AD2d 389 [1st Dept 1988]). Nor is the particular lawyer who negotiated the transaction automatically disqualified from representing the party in the litigation relating to the transaction (Kaplan v Maytex Mills, Inc., 187 AD2d 565 [2d Dept 1992]).

Plaintiff further argues that a conflict exists vis-a-vis the firm's representation of the various defendants. Specifically, it is argued that the firm is currently representing both sides of the disputed transaction Zoologic and the director defendants, on the one hand; and the investor defendants, on the other. Plaintiff maintains that this invokes a prohibition under the rule against "simultaneous representation," in certain circumstances, DR-105.

The rule prohibiting simultaneous representation of multiple clients in certain circumstances contains the following qualification: ... [A] lawyer may represent multiple clients if a disinterested lawyer would believe that the lawyer can competently represent the interest of each and if each consents to the representation after full disclosure of the implications of the simultaneous representation [*4]and the advantages and risks involved.

(22 NYCRR 1200.24 [c], DR-105 [C].) The foregoing criteria are satisfied here. As confirmed by defendants' affidavits, Zoologic, the director defendants, and the investor defendants are all naturally aligned in their support of the Series C and D offerings. In addition, defendants have all consented to the firm's representation (Rusch Aff. ¶ 11; Brown Aff. ¶ 9; Clinton Aff. ¶ 11). No sufficient showing has been made to warrant disqualification on grounds of simultaneous representation of multiple clients (see also, In re Metropolitan Transp. Auth., 222 AD2d 340 [1st Dept 1995]).

Finally, plaintiff argues that the firm runs the risk of having one of its members testify in the case, implicating DR-102 (22 NYCRR 1200.21). Morgan-Lewis attorney Ira White, Esq., represented Zoologic during the course of the offerings (see, White Affirm., passim). He affirms that he, and attorneys from another law firm, LeBoeuf, Lamb, Greene & MacRae, LLP, on behalf of the investor defendants, negotiated the transactional documents (id., ¶ 2).

DR-102 (A) provides that: A lawyer shall not act, or accept employment that contemplates the lawyer's acting, as an advocate on issues of fact before any tribunal if the lawyer knows or it is obvious that the lawyer ought to be called as a witness on a significant issue on behalf of the client ....

(DR-102 [A], 22 NYCRR 1200.21 [a].) First, White's possible testimony regarding the decisions of the director defendants is not necessary, as such testimony may be elicited from said defendants (S&S Hotel Ventures Ltd. Partnership v 777 S.H. Corp., 69 NY2d 437 [1987]; Metropolitan Transp. Auth. v 2 Broadway LLC, 279 AD2d 315 [1st Dept 2001]).[FN3]

Second, Attorney White served as Zoologic's corporate counsel. He does not serve as Zoologic's litigation counsel herein (White Affirm. ¶ 7). Even if his testimony were necessary and no showing has been made that it is the Morgan-Lewis litigators are not automatically disqualified thereby (Talvy v American Red Cross, 205 AD2d 143 [1st Dept 1994], affd 87 NY2d 826 [1995]; Owen & Mandolfo, Inc. v Davidoff of Geneva, Inc., 197 AD2d 370 [1st Dept 1993], lv denied 83 NY2d 751 [1994]).

Consequently, the motion to disqualify defendants' counsel is denied.

Motion to Dismiss:

The test to be applied on a motion to dismiss for failure to state a claim is whether, upon examination of the four corners of the pleading, plaintiff has made any factual allegations that indicate the existence of any cause of action cognizable at law (Guggenheimer v Ginzburg, 43 NY2d 268 [1977]).

Plaintiff alleges that the Series C and D offerings are not really securities transactions; but, in reality, are usurious [*5]loans. Plaintiff's theory is that the majority shareholders of Zoologic, i.e., Conning and Irwin, have the power to trigger, at any time, a minimum return of 30% per annum, which exceeds the applicable loan-interest limitation of 25%. Plaintiff requests, therefore, a declaration that the offerings are void.

The Series C and D offerings are not loans. "The rudimentary element of usury is the existence of a loan or forbearance of money.... [W]here there is no loan, there can be no usury .... Significantly, there is a strong presumption against a finding of usury ...." (Feinberg v Old Vestal Rd. Assocs., Inc., 157 AD2d 1002, 1003-04 [3d Dept 1990] [citations omitted].) "For a true loan it is essential to provide for repayment absolutely and at all events or that the principal in some way be secured as distinguished from being put in hazard" (Rubenstein v Small, 273 AD 102, 104 [1st Dept 1947]). Here, there is no certainty that the Series C and D preferred stock will ever be redeemed. That which was "loaned," in plaintiff's view, may never be returned. The fact that a stock might yield a return above the 25%-return limitation on loans, does not transform a stock purchase into a loan.

Moreover, the certificate of incorporation states that payment would be made "out of funds available therefor," i.e., out of corporate funds on hand at the time of a liquidation not that payment would be made absolutely (Notice of Motion Ex. 2 at 12). Thus, the "principal" of the alleged loan is exposed to the hazard of market fluctuations as well as other uncertainties affecting the corporation's own profitability and retained earnings. As such, the transactions are, quite basically, not loans.

In addition, insofar as the complaint seeks affirmative monetary relief (Complaint ¶¶ 100, 108), plaintiff improperly attempts to use a shield created by the Legislature as a sword (Hammelburger v Foursome Inn Corp., 54 NY2d 580, 588-89 [1981]). GOL 5-521 (1) specifically provides that no corporation shall interpose a defense of usury (see also, Intima-Eighteen, Inc. v A.H. Schreiber Co., Inc., 172 AD2d 456, 457-58 [1st Dept], lv denied 78 NY2d 856 [1991]). Plaintiff purports to rely on the exception contained in GOL 5-521 (3), for criminal usury ("The provisions of subdivision one of this section shall not apply to any action in which a corporation interposes a defense of criminal usury as described in section 190.40 of the penal law"). But "[t]he statutory exception for interest exceeding 25 percent per annum is strictly an affirmative defense to an action seeking repayment of a loan and may not, as attempted here, be employed as a means to effect recovery by the corporate borrower" (Intima-Eighteen, Inc., supra, at 457-58 [citation omitted]; see also, Schneider v Phelps, 41 NY2d 238, 242-43 [1977]).

Consequently, the motion to dismiss the causes of action seeking a declaration of usury, rescission of the Series D offering on that basis, and a permanent injunction on that basis, is granted.

The remaining causes of action, for breach of fiduciary duty, also fail as a matter of law. Zoologic is a Delaware corporation, and the law of Delaware governs any claims herein related to corporate governance (Diamond v Oreamuno, 24 NY2d 494 [1969]; Hart v General Motors Corp., 129 AD2d 179 [1st Dept], lv denied 70 NY2d 608 [1987]). Under Delaware law, "the right to a fair allocation of proceeds is one shared by the common and preferred stockholders and is a right that implicates the fiduciary duty of loyalty" (Jackson Natl. Life Ins. Co. v Kennedy, 741 A2d 377, 387 [Del Ch 1999]). Plaintiff's claims of breach of fiduciary duty are based upon the election of the Board to: (1) engage in "usurious" preferred stock transactions; and (2) forego [*6]the potential benefit of its NOL tax deduction. The first basis has been rendered moot hereinabove.

With reference to the NOL tax deduction, Zoologic has submitted evidence that the question was considered by the Board, and the Board then made a business decision to go forward with the Series D offering, in consultation with its advisors, BDO Seidman LLP (Notice of Motion Ex. 7). This flatly refutes the allegation that Zoologic "failed to secure expert advice regarding the effect the transaction would have on the Company's net operating loss benefit" (Complaint ¶ 55 [o]).

Further, plaintiff does not allege that Zoologic actually incurred any tax-related loss as a result of the offering. Rather, it alleges that the Board approved the Series D offering "without considering" whether Zoologic "stood to lose its ability to make use of its valuable NOL" (id., ¶ 96). Thus, by plaintiff's own assessment, the Board's action only implicates an alleged potential loss. Allegations of hypothetical loss cannot sustain a cause of action to invalidate a corporate board's decision (Stroud v Grace, 606 A2d 75 [Del 1992]).

"[W]here a claim for breach of fiduciary duty fails to contain allegations of fact that, if true, would rebut the presumption of the business judgment rule, that claim should ordinarily be dismissed ...." (In re BHC Communications Shareholder Litig., Inc., 789 A2d 1, 4 [Del Ch 2001].) Similar to Stroud v Grace, supra, the Board in the present case rejected plaintiff's offer of a bridge loan, and instead pursued other offerings, after consulting its advisors. "That is not an injury. It is a reality flowing from a proper turning of the wheels of corporate democracy ...." (Stroud, supra, 606 A2d at 96).

Consequently, the motion to dismiss the causes of action for breach of fiduciary duty, is granted.

Accordingly, it is

ORDERED that plaintiff's motion to disqualify defendants' counsel is denied; and it is further

ORDERED that defendants' motion to dismiss the complaint is granted, and the same is hereby dismissed; and it is further

ORDERED that the clerk is directed to enter judgment accordingly.

Dated:January 24, 2006

ENTER:

/s/

J.S.C. Footnotes

Footnote 1:The complaint (¶ 91) casts its theory thus: "Notwithstanding their labels as Preferred Stock, the Series C and Series D shares, in fact, carry the attributes of a loan. There is a stated interest rate (here, at least 30% per annum) and Conning Capital and Irwin Ventures have the power to trigger repayment at any time, because, as a result of the Series D Offering[,] they have control of the Company and can liquidate the Company at any time and force a redemption of their shares at these usurious rates."

Footnote 2:GOL 5-511 provides that "[n]o law regulating the maximum rate of interest which may be charged, taken or received, including section 190.40 and section 190.42 of the penal law, shall apply to any loan or forbearance in the amount of two million five hundred thousand dollars or more." Thus, had the Series C offering included an additional $2.00, above the $2,499,998 actually raised, or if the Series D offering included an additional $55,555.00, above the $2,444,445 actually raised, neither transaction could be challenged under Penal Law 190.40. While the complaint attacks the validity of both Series C and D offerings, the causes of action focus only on Series D; perhaps due to the preceding observation that Series C was only two dollars short of the threshold amount for non-usury.

Footnote 3:The value of any witness's testimony in this case is somewhat tenuous, given the plaintiff's cornerstone theory of its case usury. The complaint assails the offerings as usurious on their face, seemingly, without resort to any extrinsic showing (see, supra, note 1). Whether or not the transaction is criminally usurious in these circumstances, is an issue of law.