KLS Diversified Master Fund, L.P. v. McDevitt

• Decision Date: 15 December 2020
• Docket Number: 19-cv-3774 (LJL)
• Citation: 507 F.Supp.3d 508
• Parties: KLS DIVERSIFIED MASTER FUND, L.P., Plaintiff, v. Sean MCDEVITT, Defendant.
• Court: U.S. District Court — Southern District of New York

507 F.Supp.3d 508

KLS DIVERSIFIED MASTER FUND, L.P., Plaintiff,

v.Sean MCDEVITT, Defendant.

19-cv-3774 (LJL)

United States District Court, S.D. New York.

Signed December 15, 2020

David J. Margules, Ballard Spahr, LLP, Wilmington, DE, Heath Khan, Marjorie Joan Peerce, Eugene R. Licker, Ballard Spahr LLP, New York, NY, for Plaintiff.

Christopher John Seusing, Michelle Marie Arbitrio, Wood Smith Henning & Berman LLP, New York, NY, for Defendant.

OPINION & ORDER

LEWIS J. LIMAN, United States District Judge:

Plaintiff KLS Diversified Master Fund, L.P. ("Plaintiff" or "KLS") and Defendant Sean McDevitt ("Defendant" or "McDevitt") each move for summary judgment pursuant to Federal Rule of Civil Procedure 56.

For the following reasons, Plaintiff's motion is granted and Defendant's motion is denied.

BACKGROUND

I. The Relevant Parties

Plaintiff KLS is a Cayman Islands Limited Partnership with a principal place of business in New York. Non-party Sensei, Inc. ("Sensei" or the "Company") is a Delaware corporation that has its principal place of business in Texas. It does business under the name "Kaviva" but its legal name remains Sensei. Defendant McDevitt was an early investor in Sensei, and by 2014, he was the majority owner and Chief Executive Officer ("CEO") of Sensei. At the end of 2016, he was Sensei's CEO, Chairman, and majority stockholder. He was removed as CEO in May 2018. McDevitt resides in Texas.

II. The Transaction

The events that form the basis of this case occur against the backdrop of a company struggling for survival.¹

Sensei marketed itself as "the leading digital entertainment platform and mobile application that enables insurers, health systems, and employers to communicate with their members/employees, engage and educate across various benefits and wellbeing enhancement topics." Dkt. No. 59 ¶ 4. However, as of late 2016, Sensei—then doing business as a limited liability company—was losing money and running out of cash, it had few, if any, clients or revenue sources, and it faced six-figure obligations for accounts payable, payroll, royalty payments, legal fees, and several other categories of payables. Id. ¶¶ 6, 11. From at least 2014 through 2016, Sensei regularly deducted federal income taxes from employee paychecks and, instead of paying them and other payroll taxes to the government, it funneled those funds into its operations and accrued back taxes. Id. ¶ 7.

Faced with those challenges, in 2016, Sensei entered into negotiations with KLS about KLS providing financing to Sensei. Id. ¶ 8. The investment was in the form of a promissory note. In a transaction that closed on January 9, 2017, Sensei issued, and KLS purchased, a $3.33 million convertible promissory note, with a 4% annual coupon and a maturity date of two years from the date of execution (with an option for KLS to extend the maturity date by one year) for a purchase price of $2 million (the "Transaction"). Id. ¶ 10; Dkt. No. 53 ¶¶ 4-5. The Transaction was implemented through three primary integrated documents: the secured convertible promissory note purchase agreement (the "Note Purchase Agreement") between KLS and Sensei, the secured convertible promissory note (the "Note") between KLS and Sensei, and the conditional guaranty by McDevitt (the "Conditional Guaranty"). Dkt. No. 59 ¶ 9; see also Dkt. Nos. 45-1, 45-2, 45-3. All agreements were dated January 9, 2017. McDevitt signed the Note and the Note Purchase Agreement on behalf of Sensei and signed the Conditional Guaranty in his individual capacity. Dkt. No. 59 ¶ 10.

A. Note Purchase Agreement

Under the Note Purchase Agreement, KLS agreed to purchase the Note from Sensei for $2 million for Sensei to use as operating capital. See Dkt. No. 45-2. As reflected by the Note Purchase Agreement, and in connection with it, Sensei agreed to convert from a Florida limited liability company to a Delaware corporation and to form a board of directors of three persons, to be comprised of McDevitt and two KLS representatives. Id. § 4.5; see also Dkt. No. 45-3 § C.

The Note Purchase Agreement contains a series of representations and warranties by both Sensei and KLS as of the date of closing. See Dkt. No. 45-2 § 2 (Sensei representations); id. § 3 (KLS representations). As relevant here, Sensei made representations concerning "Litigation" and "Agreements." The "Litigation" representation stated as follows:

There is no Action² pending or to the Company's knowledge, currently threatened (i) against the Company or any officer, director or Key Employee of the Company; (ii) that questions the validity of the Transaction Agreements or the right of the Company to enter into them, or to consummate the transactions contemplated by the Transaction Agreements, or (iii) that would reasonably be expected to have, either individually or in aggregate, a Material Adverse Effect.

Id. § 2.9. The "Agreements" representation stated as follows:

Except for the Transaction Agreements, there are no agreements, understandings, instruments or proposed transactions to which the Company is a party or by which it is bound that involve (i) obligations (contingent or otherwise) of, or payments to, the Company in excess of $50,000 ...

Id. § 2.12(a).

Sensei's representations and warranties were qualified by an attached disclosure schedule (the "Disclosure Schedule"). Dkt. No. 45-5. Under "Litigation," the Disclosure Schedule listed litigation threatened against Sensei for the failure to pay for software development services (and a $155,257.19 confession of judgment in connection with that dispute) and three collection efforts threatened against Sensei in amounts of $25,000, $8,700, and $1,500. Id. § 2.9. Under "Agreements," the Disclosure Schedule reflected, among other items, that Sensei owed debts to McDevitt in the amount of $480,824. Id. § 2.12(a)(3).

The Disclosure Schedule also noted that Sensei had not paid its employees since the pay period ending September 15, 2016 and that the amounts owed had been accrued as liabilities on Sensei's financial statements. Id. § 2.18(c)(1). It further reflected, under Section 2.19, that Sensei owed back taxes for payroll in a number of states and federally and had not yet completed and filed its 2015 tax return. Id. § 2.19(1)-(2). Finally, the Disclosure Schedule reflected that, in addition for use as working capital, Sensei proposed to use $1,036,835 of the $2 million proceeds paid by KLS to pay pre-existing debt obligations and accrued payroll obligations. Id. § 2.33.

B. The Note

Under the Note, Sensei agreed to pay KLS interest on the principal sum of $3.33 million at a 4% annual interest rate compounded quarterly and to repay the entire outstanding principal balance and all unpaid accrued interest on the earliest of: (1) the two year anniversary of the issue date (January 9, 2017), (2) upon a company sale, or (3) upon the automatic acceleration of the Note as a result of an "Insolvency Event." Dkt. No. 45-1 § 2. The Note states that it is issued pursuant to the Note Purchase Agreement. Id.

Under the Note, Sensei covenanted, among other things:

To provide weekly updates from CEO McDevitt via conference call or email, as requested by KLS, and to provide a quarterly business and financial update, id. § 5(b)(iv);

To make to KLS a "prompt report of any legal actions pending or threatened in writing against the Company," id. § 5(b)(vi); and

To "[t]imely file all required tax returns and reports and timely pay all foreign, federal, state, and local taxes, assessments, deposits and contributions owed by the Company," id. § 5(c).

Sensei also agreed to a series of negative covenants, including with respect to dispositions, indebtedness, and investments. Id. § 6.

Importantly, the Note provided that if one or more of a series of "Events of Default" occurred, the Note would accelerate and all principal and unpaid accrued interest would become due and payable. Id. § 7. The Events of Default included:

(a) Company fails to pay timely any of the principal amount due under this Note on the date and the same becomes due and payable or any accrued interest or other amounts due under this Note on the date the same becomes due and payable;

(b) Company shall default in the performance of any covenant under this Note;

(c) a Material Adverse Change occurs;

....

(e) ... (ii) a notice of lien or levy is filed against any of Company's assets by any governmental authority ...;

(f) There is, under any agreement to which Company is a party with a third party or parties, (a) any default resulting in a right by such third party or parties, whether or not exercised, to accelerate the maturity of any Indebtedness in an amount individually or in the aggregate in excess of Fifty Thousand Dollars ($50,000); or (b) any breach or default by Company, the result of which could result in a Material Adverse Change;

(g) one or more fines, penalties or final judgments, orders or decrees for the payment of money in an amount, individually or in the aggregate, of at least Fifty Thousand Dollars ($50,000) shall be rendered against Company by any governmental authority;

(h) Company or any Person acting for Company makes any representation, warranty, or other statement now or later in this Note, any Note Transaction Document or in any writing delivered to [KLS] or to induce [KLS] to enter this Note or any Note Transaction Document, and such representation, warranty, or other statement is incorrect or misleading in any material respect when made;

....

(j) (i) Any guaranty of this Note terminates or ceases for any reason to be in full force and effect; (ii) any guarantor of this Note does not perform any obligation or covenant under any guaranty of this Note; (iii) any circumstance described in clause (c), (d), (e), (f) or (g) occurs with respect to any such guarantor; (iv) the occurrence of a "Recourse Event" as set forth in the Guaranty, dated as of January 9, by Sean McDevitt.

Id.

Finally, the Note granted a security interest to KLS in collateral to secure the payment and...