Dawson v. Withycombe, No. 1 CA-CV 06-0043.

• Court: Court of Appeals of Arizona
• Writing for the Court: Kessler
• Citation: 163 P.3d 1034,216 Ariz. 84
• Parties: John DAWSON, an individual, Plaintiff/Appellee/Cross-Appellant, v. F. Keith WITHYCOMBE and Patricia Withycombe, husband and wife; and Roderick Turner and Terry C. Turner, husband and wife, Defendants/Appellants/Cross-Appellees.
• Docket Number: No. 1 CA-CV 06-0043.
• Decision Date: 24 July 2007

163 P.3d 1034 216 Ariz. 84 John DAWSON, an individual, Plaintiff/Appellee/Cross-Appellant,
v.
F. Keith WITHYCOMBE and Patricia Withycombe, husband and wife; and Roderick Turner and Terry C. Turner, husband and wife, Defendants/Appellants/Cross-Appellees. No. 1 CA-CV 06-0043. Court of Appeals of Arizona, Division 1, Department C. July 24, 2007.

[163 P.3d 1041]

Kutak Rock, LLP By E. Scott Dosek, Todd B. Tuggle, Alvin A. Velazquez, Scottsdale, Attorneys for F. Keith Withycombe and Patricia Withycombe.

Shughart Thomson & Kilroy P.C. By Rudolph J. Gerber, Phoenix, Attorneys for Roderick Turner and Terry Turner.

Gallagher & Kennedy, P.A. By Mark C. Dangerfield, Kevin O'Malley, Mark A. Fuller, Phoenix, Attorneys for John Dawson.

OPINION

KESSLER, Judge.

¶ 1 This appeal requires us to clarify when corporate directors may be personally liable to corporate creditors and potential creditors for misrepresentations made by other corporate officers and for constructive fraud. We must also address the scope of the duty of directors to corporate creditors when the corporation enters a zone of insolvency, as well as issues of personal liability for negligent supervision of corporate employees, punitive damages and pre-judgment interest. For the reasons stated below, we vacate the judgment against the appellants and remand for a new trial on the issue of personal liability for fraud committed by an agent.

FACTUAL AND PROCEDURAL HISTORY

¶ 2 Defendants-Appellants-Cross-Appellees F. Keith and Patricia Withycombe ("Withycombe") and Roderick Turner and Terry Turner ("Turner") appeal the superior court's entry of judgment finding them liable for damages to Plaintiff-Appellee-Cross-Appellant John Dawson ("Dawson") resulting from fraud and constructive fraud.¹ Dawson cross-appeals the superior court's orders dismissing

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his claims for punitive damages and negligence, and its calculation of prejudgment interest.

¶ 3 Futech Interactive Products, Inc. ("Futech") was a small corporation founded in the 1990's. Vincent Goett ("Goett") was chief executive officer and chairman of the board of directors ("the Board"). Turner was a member of the Board. Prior to the events culminating in this lawsuit, Turner and Goett had made or guaranteed substantial loans to Futech. Robert Rosepink ("Rosepink") became a member of the Board in early 1998 and remained on the Board throughout 1999.

¶ 4 During the latter part of 1998, Rosepink approached Dawson and Withycombe to present them with an opportunity to invest in Futech.² After meeting with Goett and receiving financial information about Futech, which he forwarded to his chief financial officer for advice, Dawson initially declined to invest in Futech. Withycombe, however, agreed to co-guarantee a $7 million loan in December 1998 and then became a member of the Board.

¶ 5 In January 1999, Turner contacted Withycombe to request a meeting. Turner and Withycombe met in Cabo San Lucas, where Turner spoke with Withycombe about his perception of the financial condition of Futech. Withycombe's notes from the meeting reflect that Turner informed him that Futech lost $20 million in the last three years, Goett had taken between $4 million and $6 million from the company in the form of fees, and had usurped the function of the chief financial officer, the company was "cash poor," and that, if the company went public and was subject to public company requirements, the situation could result in liability for the Board members. Turner also stated, on the other hand, that Futech had excellent team members and had acquired companies that brought in management talent, that it had excellent patent positions and products, and that a public offering could create financing opportunities. Turner acknowledged that he had not paid enough attention to Futech previously. According to Withycombe, Turner wanted Withycombe to act as his "ally" to resolve Futech's financial situation.

¶ 6 Withycombe's notes reflect he responded that he thought he had been misled, apparently by Goett, as to Futech's prospects and the security of his loan guaranty, but that his nature was to solve problems rather than tear things down. Following the meeting, Turner was to meet with Goett to develop a compensation plan for Goett and have Goett return excess compensation as well as make other changes at Futech. Withycombe's notes reflected that any plan developed should be supported by Goett, that the Board should be redirected toward looking after shareholder interests, that a new CEO with appropriate authority and compensation was needed, that Futech needed to start moving toward becoming a public company, and that there should be an operating plan for 1999 that included additional financing.

¶ 7 The following month, Withycombe, Goett, Turner, and Rosepink met. Goett told Withycombe that the Board had previously approved a compensation package in which he took a 10 per cent fee on all financing he brought into the company in lieu of a salary. Withycombe's notes reflect that he was told that all accounts payable were current and on track.

¶ 8 Meanwhile, Rosepink again approached Dawson and informed him that Withycombe had become involved in the company. Rosepink testified that this piqued Dawson's interest, and Rosepink provided financial information to Dawson's CFO over the following months.

¶ 9 On May 12, 1999, Goett met with Withycombe to request that Withycombe lend additional funds to Futech. Withycombe agreed to loan $2 million to Futech in exchange for warrants to purchase stock in Futech and on the condition that on December 1, 1999, he would be released from the guaranty on the $7 million December 1998 loan. Withycombe further testified that, as

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of this meeting, he was aware that Rosepink and Goett were negotiating with Dawson, for what he thought was a $5 million investment.

¶ 10 The following week, Withycombe met with Dawson at Dawson's invitation. According to Dawson, they barely talked about Futech at lunch, but Dawson did ask Withycombe what he thought about the future of Futech. Withycombe responded that it was very definitely a venture capital deal and that there were good people involved with it. According to Withycombe, Dawson did most of the talking during lunch. Dawson did ask Withycombe what he thought about Rosepink. Withycombe responded that they were friends, and Dawson said that Dawson was feeling pressure from Rosepink to get involved with Futech.

¶ 11 On May 27, 1999, the Board convened for a meeting. The final minutes of the meeting, signed by Futech's CFO, Fred Gretsch ("Gretsch"), state that "the Corporation plans to borrow $5,000,000 from John Dawson and all actions taken by the officers of the Corporation for and on behalf of the Corporation in entering into such loan, are hereby in all respects ratified, approved, and affirmed."³ According to Gretsch, there was no discussion of the loan terms, but that it would have been nothing new for the Board to authorize Goett to "do what he needed to do" because there had never been constraints or restrictions placed upon Goett to obtain funds. Turner testified that the Board did not in fact approve the Dawson loan, but that there was a general intent to do something. As of January 2000, the Board had not approved the minutes.

¶ 12 Key to our decision was an alleged misrepresentation concerning the priority of security between Dawson and other prior lenders. As the loan negotiations with Dawson continued, Dawson informed Rosepink that he wanted the same arrangement as Withycombe, but with a security interest priority immediately behind that of Withycombe. When Dawson met with the bank that was to loan the money, the bank informed him that it had reached the limit of its lending for Futech, but that it would consider making a direct loan to Dawson that Dawson could in turn make available to Futech. Dawson received a summary of a proposal for interim financing that provided that Dawson borrow $5 million from the bank on an unsecured revolving credit basis, which Dawson would in turn make available to Futech. It further stated that the loan agreement and security interest would be identical in form and substance to those used in Withycombe's loans, and that Dawson would retain a security interest in all of Futech's assets. While the summary of the proposal stated that Dawson's security interest would be junior only to the rights of "Futech's asset-based lenders" and Withycombe's loans, those "lenders" were not defined. More importantly, the loan agreement provided that all loans made to Futech "by anyone (including loans made by shareholders . . .) other than Bank of America . . . and . . . Withycombe are expressly made subordinate" to the line of credit.

¶ 13 The proposal also stated in part that

Because until recently Futech has been a research and development company, its revenues have been insufficient to finance its growth, including creation of the new Internet site. Futech has an immediate need for capital to help finance the acquisition of the merged companies and to meet short-term operational needs. However, Futech has secured an underwriter which has committed to helping Futech raise by private placement some of its stock sufficient capital to meet all of its short and immediate term needs. Proceeds from such private placement, as well as increased revenues from sales of additional products, will allow Futech to repay the financing being sought from Dawson.

Dawson also testified that Goett told him that because it was expected that Futech

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would receive public financing as well as a private placement shortly, the line of credit might not be drawn at all, and that it would function merely as a bridge or gap loan.

¶ 14 Dawson ultimately provided a line of credit to Futech. According to the loan agreement, signed on August 4, 1999 by Goett and Dawson, the line of credit would expire on December 1,...