Opinion
No. C 03-3657 CW (Related Case) C 03-5023.
November 5, 2004
ORDER GRANTING DEFENDANTS' MOTION TO DISMISS FIRST AMENDED AND SUPPLEMENTAL COMPLAINT
Defendants William M. Hawkins III, William A. Hall, H. William Jesse, Jr. and Richard Lehrberg move to dismiss Plaintiffs Gaia Offshore Master Fund, Ltd. and HFTP Investments, LLC's first amended and supplemental complaint pursuant to Federal Rule of Civil Procedure 12(b)(6). Plaintiffs oppose the motion. This matter was heard on October 1, 2004. Having considered all of the papers filed by the parties and oral argument on the motion, the Court GRANTS Defendants' motion to dismiss.
BACKGROUND
Plaintiffs' first amended and supplemental complaint alleges as follows. Plaintiffs Gaia Offshore Master Fund, Ltd. and HFTP Investments, LLC are shareholders in The 3DO Company, a computer software and game company incorporated in Delaware. Most of the assets of The 3DO Company are held in a wholly-owned California subsidiary also called The 3DO Company; the companies are alter-egos of one another (and will hereinafter collectively be referred to as "3DO"). Defendants comprise 3DO's board of directors, and Defendant Hawkins is also the founder, chief executive officer and controlling shareholder of 3DO.
In December, 2001, Plaintiffs purchased 12,500 shares of 3DO Convertible Series A Preferred Stock pursuant to a securities purchase agreement (SPA). Plaintiffs' rights as preferred shareholders are outlined in the SPA and in a certificate of designations, preferences and rights (Certificate) that 3DO filed with the Secretary of State of Delaware. The SPA prohibits 3DO from entering into transactions or arrangements with company affiliates unless certain exceptions apply, one of which is approval by a majority of disinterested directors. The Certificate provides that, in the event of liquidation, preferred shareholders shall receive asset distribution prior to holders of 3DO common stock. The Certificate further states that 3DO may not enter into any agreement that would adversely effect or impair the relative priority of the preferred shareholders absent two-thirds written consent of outstanding preferred shares. Violation of this provision results in Plaintiffs' ability immediately to redeem their preferred stock shares.
3DO's financial stability began to erode shortly after Plaintiffs' investment, and by the summer of 2002 the company was insolvent and unable to borrow money from any arms-length lender. From October, 2003 to January, 2004, 3DO and Hawkins undertook a series of transactions whereby Hawkins transferred $12 million to 3DO in the form of a secured loan, guaranteed by 3DO assets that included the company's intellectual property. Directors Hall, Jesse and Lehrberg approved these transactions.
Given 3DO's deteriorated financial situation, Defendants knew or should have known that further infusions of debt were not in the company's best interests. For this reason, Plaintiffs contend that Hawkins' $12 million advance should have been characterized as an equity investment rather than a loan (thereby not requiring repayment). However, because Defendants characterized the $12 million as a secured loan, Hawkins as a secured creditor gained rights in liquidation superior to those of Plaintiffs as preferred shareholders. If Hawkins' $12 million advance had been characterized as a contribution of equity, it would have stood no higher in the capital structure than common stock and therefore would have been of lower priority than the rights of Plaintiffs.
The Hawkins loan was a substantial part of an irresponsible business strategy that ultimately led to 3DO's bankruptcy. The $12 million loan both deepened 3DO's insolvency and diluted the company's assets. 3DO filed for Chapter 11 bankruptcy on March 28, 2003, and the case was converted to Chapter 7 on November 7, 2003. In a related case, the trustee of 3DO's bankruptcy estate has filed a lawsuit against Defendants that includes sixteen claims for relief, several of which arise from allegations surrounding the $12 million Hawkins loan. The 3DO Company v. Hawkins, et al., C 03-5023.
Plaintiffs filed their first amended and supplemental complaint on June 16, 2004, alleging causes of action for (1) tortious interference with contract and (2) breach of fiduciary duty. Both claims arise from Defendants' alleged mischaracterization of Hawkins' $12 million loan to 3DO.
LEGAL STANDARD
Dismissal of a complaint can be based on either the lack of a cognizable legal theory or the lack of sufficient facts alleged under a cognizable legal theory. Balistreri v. Pacifica Police Dep't, 901 F.2d 696, 699 (9th Cir. 1988). A motion to dismiss for failure to state a claim will be denied unless it appears that the plaintiff can prove no set of facts which would entitle it to relief. Conley v. Gibson, 355 U.S. 41, 45-46 (1957);Fidelity Fin. Corp. v. Fed. Home Loan Bank of S.F., 792 F.2d 1432, 1435 (9th Cir. 1986). All material allegations in the complaint will be taken as true and construed in the light most favorable to the plaintiff. NL Indus., Inc. v. Kaplan, 792 F.2d 896, 898 (9th Cir. 1986).
When granting a motion to dismiss, a court is generally required to grant a plaintiff leave to amend, even if no request to amend the pleading was made, unless amendment would be futile.Cook, Perkiss Liehe, Inc. v. N. Cal. Collection Serv. Inc., 911 F.2d 242, 246-47 (9th Cir. 1990). In determining whether amendment would be futile, a court examines whether the complaint could be amended to cure the defect requiring dismissal "without contradicting any of the allegations of [the] original complaint." Reddy v. Litton Indus., Inc., 912 F.2d 291, 296 (9th Cir. 1990).
DISCUSSION
A. Standing
Defendants move to dismiss Plaintiffs' first amended and supplemental complaint, arguing that Plaintiffs, as shareholders, lack standing to assert their claims. When a company declares bankruptcy, a bankruptcy "estate" is created that is comprised of "all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case." 11 U.S.C. § 541(a)(1). The named trustee of the estate holds the exclusive right to assert the debtor's claims. In re Real Marketing Servs., LLC, 309 B.R. 783, 788 (S.D. Cal. 2004). An action is "derivative" of the estate's rights, and thus not actionable as an independent or "direct" claim by shareholders, if "the gravamen of the complaint is injury to the corporation . . . or it seeks to recover assets for the corporation or to prevent the dissipation of its assets." Id. (internal citations omitted). The converse is also true: a claim that "does not explicitly or implicitly allege harm to the debtor" is a "direct" claim that is personal to shareholders or creditors and may be asserted only by those persons or entities. In re Van Dresser Corp., 128 F.3d 945, 947 (6th Cir. 1997) (cited with approval by Real Marketing, 309 B.R. at 788 n. 1).
Whether a claim properly belongs to the estate of a bankrupt corporation (i.e. is "derivative") or to a shareholder individually (i.e. is "direct") is a matter to be determined by State law. Van Dresser, 128 F.3d at 947. The parties agree that the relevant test is stated in Tooley v. Donaldson, Lufkin Jenrette, Inc., 845 A.2d 1031 (Del. 2004). The issue of "whether a stockholder's claim is derivative or direct must turnsolely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?"Id. at 1033.
(1) Who Suffered the Alleged Harm
Defendants argue that the harms alleged by Plaintiffs are principally harms suffered by the debtor corporation; the alleged harm to debtor 3DO led to the nullification of Plaintiffs' preference rights. According to the Tooley court, the inquiry regarding who suffered harm should determine whether "the plaintiff demonstrated that he or she can prevail without showing an injury to the corporation." Tooley, 845 A.2d at 1036.
Plaintiffs allege direct injury as a result of Hawkins' $12 million loan in (1) their resulting inability to redeem their preferred shares and (2) their loss of priority in 3DO's ensuing bankruptcy. In neither case can Plaintiffs demonstrate injury that is independent of injury to 3DO. In their first amended and supplemental complaint, Plaintiffs allege that 3DO's acceptance of $12 million in the form of a loan instead of equity "was made at plaintiffs' direct expense and resulted in the dissipation of [3DO's] assets, the deepening of [3DO's] insolvency, and the loss of plaintiffs' contractual rights." Fir. Am. Sup. Compl. ¶ 78. Plaintiffs allege that they "will recover less from the depleted bankruptcy estate than they would have recovered" if Defendants had not accepted the $12 million in the form of a loan. Id. ¶ 79. Plainly, Plaintiffs could not allege injury resulting from nullification of preference rights and reduced recovery from the bankruptcy estate if 3DO had not first declared bankruptcy. In other words, Plaintiffs' injury is wholly dependent upon injury to the debtor company resulting from the very transactions of which Plaintiffs are complaining. Accepting $12 million in the form of a loan cannot be "at Plaintiffs' direct expense" if the loan's result was 3DO's bankruptcy, a necessary predicate of Plaintiffs' alleged injury.
Plaintiffs further argue that they were directly injured as a result of Hawkins' $12 million loan because that loan artificially kept 3DO afloat, thereby not allowing Plaintiffs to redeem their shares. Plaintiffs argue that, at the time of the Hawkins loan, 3DO "had sufficient assets such that, upon liquidation, plaintiffs would have been able to have their Series A Preferred Stock redeemed for the full amount." Fir. Am. Sup. Compl. ¶ 64. Again, Plaintiffs do not allege an injury independent of injury to 3DO. Agostino v. Hicks, 845 A.2d 1110 (Del.Ch. 2004), cited favorably in Tooley as correctly applying the first prong of Tooley's analysis, is instructive on this point. In Agostino, a controlling shareholder loaned $100 million to a company in exchange for promissory notes and warrants to purchase stock. Despite the loan, the company continued to struggle and eventually declared bankruptcy. In its confirmation order, the bankruptcy court eliminated the company's stock for no consideration. Id. at 1114-15. The plaintiff, a shareholder until his shares were eliminated by the confirmation order, sued both the investor and the company's directors. The Agostino court ruled that the plaintiff lacked standing because the nature of his claim remained "nothing more than a claim of mismanagement" and his injury "was a natural and expected consequence of the injury initially borne by the Company." Id. at 1123-24.
Similarly, Plaintiffs here cannot allege injury in the form of inability to redeem preferred stock without first alleging that 3DO suffered from mismanagement. The harm Plaintiffs allege was an expected consequence and therefore derivative of Defendants' alleged mismanagement. Plaintiffs argue unconvincingly that their injury does not require a showing of injury to the company because if 3DO had "thrived" as a result of the $12 million loan, Plaintiffs still would have been injured by "delays in receiving their cash." Opp'n at 14. This argument is self-defeating. If 3DO had thrived as a result of the Hawkins loan there necessarily would have been no breach of fiduciary duty, nor a tort to complain of. Furthermore, if the Hawkins payment had been an equity investment, it would not have been secured by a lien on 3DO's intellectual property and thus would not have given Hawkins secured creditor status. Plaintiffs therefore would not have been delayed in receiving their cash; they would not have been entitled to redeem their preferred shares at all because their relative priority for purposes of asset distribution would not have been disturbed. Plaintiffs cannot satisfy the first prong of the Tooley standing test because they cannot claim injury independent of injury to 3DO.
(2) Who Would Receive the Benefit of Recovery or Remedy
Defendants argue that Plaintiffs do not satisfy the second prong of the Tooley standing test because any recovery obtained by Plaintiffs would principally benefit the debtor company 3DO.
Plaintiffs argue that this prong is satisfied because they seek damages from Defendants rather than a restoration of 3DO assets. However, Plaintiffs concede that "proving the proper characterization of Hawkins' infusions may be a necessary predicate to relief." Opp'n at 15. Plaintiffs further acknowledge that "proper characterization of Hawkins' `loans' could have collateral estoppel effects in the 3DO bankruptcy cases. In that respect, creditors of 3DO might benefit indirectly from Hawkins' loss of secured creditor status." Id. n. 13. These concessions are telling. While recharacterizing the Hawkins loan would indeed lower Hawkins' priority in the recovery line, as Plaintiffs assert, it would also undeniably make restorations to the 3DO bankruptcy estate — recharacterization of the loan as equity would cause legal rights to the intellectual property encumbered by the loan to be restored to the estate. Thus, benefit to the 3DO estate (and its creditors) comes before, and is a necessary predicate of, any benefit to Plaintiffs.
Plaintiffs cannot satisfy the second prong of the Tooley standing analysis. While Plaintiffs seek damages from Directors, they admit that their claim depends on restorations, and therefore direct benefit, to the 3DO estate.
B. Amending the Complaint
Plaintiffs are granted leave to amend to plead facts sufficient to satisfy the requirements of the Tooley test for standing, if they can do so without contradicting allegations in their first amended and supplemental complaint.
CONCLUSION
Because the claims asserted in the first amended and supplemental complaint are derivative rather than direct, Plaintiffs lack standing to bring them. The Court GRANTS Defendants' motion to dismiss the first amended and supplemental complaint (Docket No. 40). Plaintiffs are granted leave to amend. Plaintiffs' second amended complaint shall be filed within twenty days of the date of this order.
IT IS SO ORDERED.