Opinion
B186993
10-29-2008
NICHOLAS JENKINS et al., Plaintiffs and Respondents, v. PETER T. McCARTHY, Defendant and Appellant.
Peter T. McCarthy, in pro. per., for Defendant and Appellant. Winston & Strawn, Rebecca Lawlor Calkins and Erin R. Ranahan for Plaintiffs and Respondents.
Not to be Published
Defendant and appellant Peter T. McCarthy (McCarthy) appeals from a judgment entered against him and in favor of plaintiffs and respondents Nicholas Jenkins, Dorothy Eugenia Calkins, John Delos Calkins, Fredericks Family Properties, Chris Jacobson, Debra Jacobson, Jason Jacobson, Irene Jacobson, Ralph Vetsch, and Barbara Vetsch. The trial courts construction of the underlying agreement was correct; the trial court properly interpreted and applied the Internal Revenue Code; and the judgment is supported by substantial evidence. Accordingly, we affirm.
FACTUAL AND PROCEDURAL BACKGROUND
Factual Background
Formation of Natures Wing Fin Design
Natures Wing Fin Design (NWFD) was formed on January 1, 1997, pursuant to an operating agreement and under the Beverly-Killea Limited Liability Company Act (Corp. Code, § 17000 et seq.). It is a small intellectual property limited liability company that licenses the use of its "split-fin" swim and scuba fin design patents to manufacturers of scuba and swim fins (the licensees). The licensees pay NWFD a royalty for each fin they sell using NWFDs patented "split-fin" design.
NWFD obtained its start-up capital from cash investors who contributed monies in exchange for shares in NWFD. The investors cash was used to fund NWFDs operations.
McCarthys Control over NWFD
Since NWFDs inception, McCarthy has been the sole manager, controlling shareholder, and chairman of the board of NWFD.
Unlike the individual investors who contributed cash in exchange for NWFD shares, McCarthy obtained his interest in NWFD by contributing the licensing rights to the "split-fin" patent.
NWFDs Operating Agreement
Because McCarthy was in need of start-up capital for NWFD, he represented to each investor that, except for the payment of his agreed-upon annual salary of $98,000, he would not take money out of NWFD until the cash investors were repaid their investments; in other words, the investors would receive their money back before McCarthy would take any significant money.
Provisions of the operating agreement are consistent with this representation. Specifically, the operating agreement provides that the "business and affairs of [NWFD] shall be overseen by a Board of Directors." Further, as memorialized by provision 7.3 of the operating agreement, one of the primary duties of the board of directors (board) is "to approve certain actions as required under this Agreement."
Significantly, the board retained "exclusive and binding powers over . . . [¶] . . . [¶] (d) approving capital distributions pursuant to Section 11" of the operating agreement. In this regard, the operating agreement provides for two types of distributions: mandatory and discretionary. Mandatory distributions are defined at paragraph 11.2 of the operating agreement: "In order to permit Members to pay taxes on their allocable share of the taxable income of [NWFD], the Manager shall cause [NWFD] to distribute, not later than February 28 of each year, an amount equal to the excess, if any, of (i) the product of the taxable income of [NWFD] determined on a cumulative basis for all years (through and including the immediately preceding tax year) of [NWFD] multiplied by 45% over (ii) all amounts previously distributed pursuant to this Section 11.2. The percentage referred to in clause (i) above shall be increased (or decreased) from time to time by the increase (or decrease) in the maximum rate of tax imposed on individual taxpayers under the Code."
By contrast, discretionary distributions, as defined at paragraph 11.3 of the operating agreement, favor the cash investor. That provision provides: "To the extent [NWFDs] cash on hand exceeds its current and anticipated needs, including, without limitation, needs for operating expenses, debt service, acquisitions, reserves and required distributions under Section 11.2, if any, and subject to Section 11.5 below, the Manager may cause [NWFD] to make distributions. Ninety percent (90%) of all such distributions shall be distributed to repay each Members respective Cash Capital Contribution made to [NWFD] as described in Exhibit A and the remaining ten percent (10%) to be distributed toward Members Capital Contributions consisting of other property and services rendered to [NWFD] as described in Exhibit A. Upon all Cash Capital Contributions being repaid to the Members, all subsequent distributions shall be made in proportion to the Members ownership of shares."
NWFDs Losses
As is common with many small businesses, NWFD suffered significant losses in its early years. According to Louis H. Savett (Savett), a certified public accountant, NWFD had no positive cumulative taxable income through December 31, 2003. Because NWFDs taxable income for 2004 was less than its negative taxable income through 2003, as of 2004, its cumulative taxable income was still in the negative.
McCarthys Distributions Since NWFDs Inception
Between November 2002 and September 1, 2003, McCarthy made four distributions, which he characterized as "mandatory," totaling approximately $182,648.43. Of those monies distributed, McCarthy personally received over $126,000.
McCarthy did not obtain board approval prior to making these distributions.
McCarthys Personal Purchases at the Same Time as the Distributions
Coincidentally, the distributions were made at the same time as when McCarthy made lavish personal purchases. For example, in February 2003, McCarthy committed to buying a home costing more than $700,000, which ballooned to $858,000 with upgrades before closing escrow in late August 2003. In September 2003, when McCarthy made another distribution, he began breaking ground on a swimming pool, which cost him "somewhere in the [$] 40,000 range."
Procedural Background
Apparently troubled by McCarthys management of NWFD and by his monetary distributions, respondents initiated a derivative action against McCarthy and his wife, Kathy McCarthy, on January 30, 2004. The first amended derivative complaint contains 12 causes of action, including claims for breach of fiduciary duty; breach of the duty of care; breach of the duty of loyalty, violations of Corporations Code sections 17250, 17254, and 17255; and conversion. Respondents also sought a constructive trust, injunctive relief, an accounting, and declaratory relief.
Kathy McCarthy prevailed at trial and is not a party to this appeal.
A bench trial commenced on May 16, 2005. After three weeks of testimony and the presentation of numerous exhibits, the trial court rendered its lengthy, detailed statement of decision. First, the trial court determined that McCarthy violated the operating agreement by making the four purportedly mandatory distributions. After all, NWFD had not had positive cumulative taxable income that would have allowed for mandatory distributions. Thus, the distributions that McCarthy made were discretionary and, as such, violated the terms of the operating agreement regarding discretionary distributions.
Moreover, because NWFDs cumulative taxable income was still in the negative as of 2004, any purportedly mandatory distribution in 2005 was improper as well.
And, regardless of the type of distribution (mandatory or discretionary), McCarthy failed to obtain board approval, as required by the operating agreement.
In any event, the trial court noted, that even if mandatory distributions had been legitimately required, they could only be made once a year in accordance with section 11.2. Thus, the trial court found that McCarthy violated section 11.2 by making multiple "mandatory" distributions in a single year.
Regarding the definition of "taxable income," the trial court found the following: "Although the Internal Revenue Code (`IRC) provisions applicable to partnerships do not permit the consideration of net operating loss carry-forward in the calculation of `taxable income within the reporting requirements of IRC 703, the meaning of `taxable income for purposes of the calculation of mandatory distributions in Section 11.2 mandates the consideration of such losses."
And, as for the tax rate, relying upon the expert testimony from both McCarthys expert and respondents experts, the trial court determined "that McCarthy used an improperly inflated tax rate when calculating the purportedly mandatory distributions in 2002 and 2003."
In making these findings, the trial court was persuaded by evidence that McCarthy made the improper distributions to fund personal expenditures. As the trial court noted in its statement of decision: "McCarthys position that mandatory distributions were required under the Operating Agreement and the IRC is further belied by the coincidence that the distributions frequently coincided with major financial obligations, such as the purchase of new homes. Further, McCarthys credibility in this matter is called into question by evidence that the McCarthys lied to their home lender under penalty of perjury, claiming that they earned a combined income of $278,400 per year, when, in fact, McCarthys salary was $98,000 and K. McCarthys was approximately $25,000. . . . The records indicate that, at the beginning of 2003, McCarthy had $831.00 in his primary bank account. . . . In February 2003, McCarthy committed to buy a house, which with upgrades was priced at $859,000 when escrow closed in August 2003."
Significantly, the trial court expressly commented on the witnesses credibility. "The Courts findings are, in part, based on the fact that the testimony of . . . McCarthy was not credible. McCarthy was caught in a number of inconsistencies with his deposition testimony. Additionally, McCarthy failed to rebut many of [respondents] claims with witnesses or evidence at trial. Most importantly, McCarthy presented no witness who was an investor to rebut [respondents] assertion that the investors were told, believed, and interpreted the Operating agreement to provide that the cash investors would get their money back prior to McCarthys taking money out of the Company." "The Court further finds that McCarthy is not credible as he lied on his home loan application . . . [and] on his personal tax returns." As for McCarthys expert, Steven Carl Gabrielson, his testimony "was similarly not persuasive, as he admitted that he did not personally perform any work, and simply relied on what McCarthy told him."
Based upon the foregoing factual findings, the trial court concluded that McCarthy breached his fiduciary duties of loyalty and care. He did not act in good faith and he could not rely upon the business judgment rule.
McCarthy was ordered to reimburse all monies improperly taken from NWFD and to account for all mandatory distributions.
Judgment was entered, and McCarthys timely appeal ensued.
DISCUSSION
McCarthys lengthy appellate briefs are largely confusing and unintelligible. "Indeed, this document is strongly reminiscent of those magazine puzzles of yesteryear where the reader was challenged to `guess what is wrong with this picture." (People v. Dougherty (1982) 138 Cal.App.3d 278, 280.)
That being said, we have carefully reviewed McCarthys appellate briefs, as well as the record on appeal, and we are able to parse his numerous arguments down to three primary claims. We address, and reject, each in turn.
1. Construction of the operating agreement
First, McCarthy argues that the trial courts construction of the operating agreement was erroneous. "`The fundamental canon of interpreting written instruments is the ascertainment of the intent of the parties. [Citations.] As a rule, the language of an instrument must govern its interpretation if the language is clear and explicit." (Brookwood v. Bank of America (1996) 45 Cal.App.4th 1667, 1670-1671.) We review the interpretation of a contract de novo where the trial court based its interpretation solely upon the words of the unambiguous contract, where the relevant admissible extrinsic evidence is not conflicting, or where there is an issue as to admissibility of extrinsic evidence. (Morey v. Vannucci (1998) 64 Cal.App.4th 904, 912-914.)
After reviewing the operating agreement de novo, we readily conclude that the trial courts interpretation is correct. The operating agreement provides for two types of distributions: mandatory and discretionary. As the trial court aptly found, the distributions made by McCarthy between November 2002 and September 1, 2003, were not mandatory.
According to the terms of the operating agreement, mandatory distributions are: (1) to be made by February 28 of any given year, if at all; (2) calculated using the cumulative taxable income of NWFD through and including the immediately preceding tax year; (3) offset by any prior distributions made to ensure that the aggregate distributions made are on a cumulative basis; and (4) to be determined by the board. That is not what occurred here. Because mandatory distributions are calculated on a cumulative basis for all years since inception, the only occasions upon which a mandatory distribution might be appropriate are those where both the cumulative taxable income for the preceding years of NWFDs operations is positive at the time of calculation and the suggested distribution under that calculation exceeds the total of all amounts previously distributed to shareholders. However, the evidence confirms that at the time McCarthy made the distributions, NWFDs cumulative taxable income was not positive. As such, mandatory distributions have never been required and any alleged mandatory distribution was improper.
Moreover, even if the distributions between 2001 and 2003 were "mandatory," which they were not, McCarthy violated provision 11.2 of the operating agreement by making multiple mandatory distributions in a single year.
And, significantly, McCarthy failed to obtain board approval before making any purportedly mandatory distributions, as required by provision 7.3 of the operating agreement.
For the same reason, the distributions were improper discretionary distributions as well. McCarthy failed to obtain board approval for any type of distribution.
Because the distributions were not mandatory, they were, by default, discretionary. Yet, tracking the express language of the operating agreement establishes that McCarthys discretionary disbursements also violated the terms of the operating agreement. Discretionary disbursements favor cash investors; 90 percent of all discretionary distributions go to the cash investors only, to repay their cash contributions, while the remaining 10 percent is divided among those shareholders who obtained their shares in exchange for property or services other than cash. Quite plainly, the cash distributions were not made according to that agreed-upon schedule of payment. The cash investors, including respondents, were not given 90 percent of the distributions.
The thrust of McCarthys argument lies in his belief that the operating agreement cannot, or should not, be construed to allow for the disbursement of monies to cash investors, such as respondents, before McCarthy, an investor in kind, receives any income from NWFDs proceeds. The problem with this argument, of course, is that the operating agreement clearly differentiates between cash investors and investors of other kinds; regarding discretionary distributions, cash investors are favored. When the language of a contract is plain and unambiguous, "it is not a courts prerogative to alter it, to rewrite its clear terms, or to make a new contract for the parties." (Moss Dev. Co. v. Geary (1974) 41 Cal.App.3d 1, 9; see also Apra v. Aureguy (1961) 55 Cal.2d 827, 830-831.)
McCarthy even sent the board an e-mail in October 2001 expressing this sentiment and his anger. "The forecast indicates investors will be paid back by the end of 2003, but I will not get any significant money until 2004 or 2005. I am pissed off."
In attacking the trial courts construction of the operating agreement, McCarthy contends that (1) the trial court improperly considered parol evidence, and (2) the operating agreement should be construed against its drafters, who include respondents. As evidenced by the statement of decision, the trial court did not improperly consider parol evidence in its construction of the operating agreement. Regardless, as set forth above, our de novo review of the operating agreement confirms that the trial courts interpretation was correct. And, because the operating agreements language is clear, there is no ambiguous language to construe against the contracts drafters. (Nissel v. Certain Underwriters at Lloyds of London (1998) 62 Cal.App.4th 1103, 1112.)
In any event, McCarthy argues that even if the purportedly mandatory distributions were improper, the trial court erred in ordering him to repay the monies. According to McCarthy, only a credit can be applied against future distributions. No terms of the operating agreement aid this theory. And, McCarthy fails to offer any legal authority in support of his claim.
Finally, McCarthy agues that the trial court erred by ignoring the fact that provision 9.3 of the operating agreement fully protected him. This contention fails both procedurally and substantively.
As a procedural matter, it does not appear that McCarthy raised this argument below. "It is a general rule of appellate review that arguments waived at the trial level will not be considered on appeal." (California State Auto. Assn. Inter-Ins. Bureau v. Antonelli (1979) 94 Cal.App.3d 113, 122.) Having failed to raise this argument with the trial court, McCarthy has forfeited it on appeal.
Setting that aside, this argument provides no basis for reversal. Provision 9.3 of the operating agreement provides: "Any Member or Manager shall be fully protected in relying in good faith upon the records and books of account of [NWFD] and upon such information, opinions, reports or statements presented to [NWFD] by its Manager, or any of its Members or Directors, or by any other person, as to matters the Manager or Members reasonably believes are within such other persons professional or expert competence and who has been selected with reasonable care by or on behalf of [NWFD], including information, opinions, reports or statements as to the value and amount of the assets, liabilities, profits or losses of [NWFD] or any other facts pertinent to the existence and amount of assets from which distributions to members might properly be paid."
Here, there is no evidence that McCarthy relied "in good faith" upon any records, opinions, reports, or statements. Rather, all of the evidence points to McCarthys bad faith. For example, in or around 2004, NWFD retained Stern, Kory, Sreden & Morgan and Douglas A. Ridnor (Ridnor) to conduct a special-purpose audit for a 7-year period and a full audit for 2003. On February 25, 2004, Ridnor submitted what he considered to be his final report, which concluded that mandatory distributions should not have been made. Upon receipt of the final report, McCarthy and his attorney contacted Ridnor and asked that he remove the conclusion that mandatory distributions should not have been made. Ridnor cooperated with McCarthy and removed the conclusion regarding distributions. Yet, there is no evidence that McCarthy ever informed the board that he had Ridnors conclusion removed. This conduct evinces McCarthys bad faith, and confirms that he cannot avail himself of provision 9.3 of the operating agreement.
2. Trial courts interpretation and application of the Internal Revenue Code
In conjunction with his objection to the trial courts construction of the operating agreement, McCarthy repeatedly objects to the trial courts conclusion that Internal Revenue Code section 703 (26 U.S.C. § 703) (section 703) was inapplicable to the operating agreement. McCarthy contends that section 703 controls, and that pursuant to section 703, taxable income can never be negative. If NWFDs taxable income can never be negative, then, according to McCarthy, his purportedly mandatory distributions were proper. As this query calls for us to review the terms of the operating agreement as well as the application and scope of section 703, we review this issue de novo. (Barner v. Leeds (2000) 24 Cal.4th 676, 683.) To the extent our review requires the consideration of evidence, we apply the substantial evidence standard of review. (Milton v. Perceptual Development Corp. (1997) 53 Cal.App.4th 861, 867.)
As the trial court properly determined, section 703 does not apply. While the parties disagree as to whether the Internal Revenue Code definition of "taxable income" even applies, we need not resolve this conflict. If an Internal Revenue Code definition were to apply, we conclude that the definition found at section 63 of title 26 of the United States Code (section 63) governs. That statute, which defines "taxable income" for all of Subtitle A, including section 703, defines "taxable income" as "gross income minus [allowable] deductions." (26 U.S.C. § 63, subd. (a).) It necessarily follows that "taxable income" for purposes of NWFD may be negative.
In fact, the experts who testified at trial so agree. Savett stated that taxable income can be negative. So too did Ridnor, who testified that "taxable income, by definition . . . is taxable income or loss." As did Randy Henningfield, a certified public accountant whose firm was engaged to audit NWFD for the year ending 2004; he explained that a partnership can have negative taxable income. McCarthy, who does not have a tax background or a law school background or an accounting background, is apparently the only one who believes otherwise. In fact, Ridnor testified that he researched the issue and could not find any support for McCarthys novel definition of the phrase "taxable income."
Moreover, as Savett testified, section 703 is a reporting requirement. (See, e.g., Burke v. C.I.R. (1st Cir. 2007) 485 F.3d 171, 175.) Nothing in that statute or the legal authority supplied by McCarthy suggests that it was intended to replace the general definition of "taxable income" found at section 63.
In light of this interpretation of the operating agreement and Internal Revenue Code sections 63 and 703, as well as the overwhelming expert testimony regarding the definition of the phrase "taxable income," we easily reject McCarthys claim that the trial court erred in finding that he applied an improper method of accounting in computing NWFDs taxable income.
3. McCarthys challenges to the evidence
The remainder of McCarthys arguments consists of evidentiary objections and challenges to the trial courts findings based on that evidence. In so arguing, McCarthy focuses on his testimony and his evidence, urging us to ignore contrary evidence. These arguments do not allow for reversal.
In reviewing a challenge to the sufficiency of evidence, our inquiry is limited to whether, on the entire record, substantial evidence supports the judgment. (Kuhn v. Department of General Services (1994) 22 Cal.App.4th 1627, 1633.) We must view the record in the light most favorable to the prevailing party and resolve all inferences in support of the judgment. (Milton v. Perceptual Development Corp., supra, 53 Cal.App.4th at p. 867.) We are also precluded from second-guessing the trial courts credibility determinations. (Sav-On Drug Stores, Inc. v. Superior Court (2004) 34 Cal.4th 319, 334 ["`questions as to the weight and sufficiency of the evidence, the construction to be put upon it, the inferences to be drawn therefrom, the credibility of witnesses . . . and the determination of [any] conflicts and inconsistencies in their testimony are matters for the trial court to resolve"]; Beck Development Co. v. Southern Pacific Transportation Co. (1996) 44 Cal.App.4th 1160, 1204 ["testimony of a witness offered in support of a judgment may not be rejected on appeal unless it is physically impossible or inherently improbable and such inherent improbability plainly appears"].)
"Substantial evidence" in this regard does not mean "any evidence." Rather, to be "substantial," the evidence must be "`of ponderable legal significance, . . . reasonable in nature, credible, and of solid value." (Bowers v. Bernards (1984) 150 Cal.App.3d 870, 873, italics omitted.) If there is substantial evidence, contradicted or uncontradicted, that will support the finding, it must be upheld regardless of whether the evidence is subject to more than one interpretation. (Western States Petroleum Assn. v. Superior Court (1995) 9 Cal.4th 559, 571 ["`[w]hen two or more inferences can be reasonably deduced from the facts, the reviewing court is without power to substitute its deductions for those of the trial court"]; Von Beltz v. Stuntman, Inc. (1989) 207 Cal.App.3d 1467, 1481 [reviewing court may not reweigh the evidence].)
Here, the trial courts findings are supported by ample evidence. At a minimum, the evidence establishes that McCarthy made improper "mandatory" distributions, which benefitted him to the detriment of the cash investors who were promised that they would receive back their investment before McCarthy took money other than his salary. And, his interpretations of the operating agreement and the Internal Revenue Code were unreasonable and unsupported by any expert testimony. Under these circumstances, we readily conclude that the trial courts findings are supported by the evidence.
Along with his other challenges to the evidence and judgment, McCarthy asserts that respondents never established that he violated Corporations Code sections 17254 and 17255; as such, the trial courts conclusion must be reversed. More than sufficient evidence supports the trial courts finding that McCarthy violated Corporations Code sections 17254 and 17255. At the risk of sounding redundant, respondents proved that McCarthy made improper distributions, claiming that they were "mandatory," when, pursuant to the terms of the operating agreement, they were anything but. Respondents also established that McCarthy interfered with and manipulated the forensic audit performed by Ridnor, in an attempt to hide the improper distributions.
We also conclude that, based upon this same evidence, the trial court did not err in denying McCarthy indemnification.
Finally, McCarthy claims that the trial courts judgment is inequitable. We are not convinced. A judgment that is supported by substantial evidence and a proper construction of the controlling contract is not inequitable.
DISPOSITION
The judgment of the trial court is affirmed. Respondents are entitled to their costs on appeal.
We concur:
BOREN, P. J.
DOI TODD, J.