Solution Trust v. 2100 Grand LLC (In re AWTR Liquidation Inc.)

• Decision Date: 11 March 2016
• Docket Number: Adv No: 2:15–ap–01095–NB,Case No.: 2:13–bk–13775–NB
• Citation: 548 B.R. 300
• Court: U.S. Bankruptcy Court — Central District of California
• Parties: In re: AWTR Liquidation Inc., Debtor Solution Trust, as Trustee of the AWTR Liquidation Trust, Plaintiff, v. 2100 Grand LLC, Lee Berger, Prashant Buyyala, CCC Diagnostics LLC, Raymond Feeney, Keith Goldfarb, John Patrick Hughes, Rhythm & Hues Sdn. Bhd, Pauline Ts'O, David Weinberg, Defendants.

548 B.R. 300

In re: AWTR Liquidation Inc., Debtor

Solution Trust, as Trustee of the AWTR Liquidation Trust, Plaintiff,

v.2100 Grand LLC, Lee Berger, Prashant Buyyala, CCC Diagnostics LLC, Raymond Feeney, Keith Goldfarb, John Patrick Hughes, Rhythm & Hues Sdn. Bhd, Pauline Ts'O, David Weinberg, Defendants.

Case No.: 2:13–bk–13775–NB

Adv No: 2:15–ap–01095–NB

United States Bankruptcy Court, C.D. California, Los Angeles Division .

Argued: Date: September 1, 2015

Signed March 11, 2016

Todd M. Arnold, Gary E. Klausner, Levene, Neale, Bender, Yoo & Brill L.L.P, Los Angeles, CA, Angela J. Somers, Reid Collins & Tsai LLP, New York, NY, for Plaintiff.

Joshua T. Foust, Mintz Levin, San Francisco, CA, Michael K. Maher, Maher & Maher, Orange, CA, John B. Marcin, Marcin Lambirth LLP, Keith C. Owens, Venable LLP, Los Angeles, CA, for Defendants.

OPINION ON DIRECTORS' AND OFFICERS' DUTIES UPON INSOLVENCY, AND RELATED ISSUES

Neil W. Bason, United States Bankruptcy Judge

I. INTRODUCTION¹

The individual defendants were all directors of the debtor corporation, then known as Rhythm & Hues, Inc. ("Debtor"), before it filed its bankruptcy petition on February 13, 2013 (the "Petition Date"). Some defendants also served as Debtor's officers. The plaintiff, which is the liquidating trustee under Debtor's confirmed chapter 11 plan, alleges that while Debtor was insolvent these defendants (the "Directors") diverted its assets to themselves, or dissipated or unduly risked those assets. The plaintiff seeks to recover damages for the benefit of Debtor's creditors.

The Directors argue that there is no duty to creditors even upon insolvency—that their duties run solely to stockholders—and alternatively that the plaintiff has not adequately alleged insolvency. This opinion rejects those arguments. In so doing this opinion interprets what measures of insolvency apply and what it means for directors (and officers) to "unduly risk" a corporation's assets under the leading California decisions.

Some issues of California law are not settled, so this opinion must predict how the Supreme Court of California would interpret directors' and officers' duties. The prediction is that it would do so consistent with what appears to be the emerging trend in other Federal and State court decisions.

Specifically, the most relevant duty of directors and officers remains the same regardless of insolvency: the duty to exercise their business judgment in an informed, good faith effort to preserve and grow the corporation's value. That duty must be exercised for the benefit of the whole corporate enterprise, encompassing all of its constituent groups, without undue preference to any. What principally changes upon insolvency is who can sue. For acts or omissions occurring outside of insolvency, the creditors cannot sue because they have no cognizable harm. But when the corporation is insolvent or is rendered insolvent by any standard measure—balance sheet, cash flow, or inadequate capitalization—then creditors join stockholders in being able to sue derivatively for breaches of fiduciary duties to the corporation that divert, dissipate, or unduly risk corporate assets.

As a practical matter, the alternative to such essentially unchanging duties would be for directors' and officers' duties to change substantially once the corporation crossed some invisible line that is later determined to constitute insolvency. Such a rule would be unfair to directors and officers, and it would harm all constituent groups by creating conflicting incentives and unclear directions for risk management. This Bankruptcy Court does not anticipate that the California Supreme Court would interpret directors' and officers' duties in that way.

This opinion also rejects most of the other arguments in the defendants' motions to dismiss or for a more definite statement, including most of their assertions that the plaintiff's claims are barred as a matter of law by the business judgment rule. That is not to say that the business judgment rule lacks teeth; to the contrary it is a very powerful defense, but on the facts alleged in the complaint it is not possible to conclude as a matter of law that it applies. In addition, the defendants have established some statute of limitation defenses.

II. BACKGROUND

A. Factual Allegations

Debtor was one of the premiere producers of visual effects and computer-generated animation for the entertainment industry. It blames its financial troubles on a variety of factors, including thin margins, projects that have inherently unpredictable costs, and international competition. See, e.g., Case dkt. 9. The plaintiff, however, places much of the blame on alleged self-dealing, fraudulent transfers, and other asserted acts and omissions by Debtor's Directors.

The complaint defines the "Primary" Directors as John Patrick Hughes (a director, president, treasurer, and, at times, its chief financial officer), his wife Pauline Ts'O (also a director and officer), and Keith Goldfarb (a director). The "Other" Directors are Lee Berger (a director and officer), Prashant Buyyala (same), Raymond Feeney (a director), and David Weinberg (a director and, at relevant times, chief financial officer or "CFO"). Complaint (dkt. 1) ¶¶ 7–15.

The following summary includes some pejorative descriptions of the Directors' alleged acts and omissions because, as always in the context of motions to dismiss, all well pled and plausible allegations are assumed to be true, and all reasonable inferences are drawn in the non-moving party's favor. Ashcroft v. Iqbal, 556 U.S. 662, 678, 129 S.Ct. 1937, 173 L.Ed.2d 868 (2009). The facts might (or might not) turn out to be very different after discovery or after trial.

1. The CCCD Transactions: risky, self-dealing advances, mostly without board approval; and then $1 buyout by Hughes after the gamble paid off

From July 2007 through December 2009 the Primary Directors used $1.89 million of Debtor's scarce capital to fund CCC Diagnostics, LLC ("CCCD"), which was founded by Ts'O's father (Hughes' father-in-law). CCCD had no revenues, was in a business "wholly unrelated" to Debtor's line of business, and "had absolutely no corporate synergies" with Debtor. Complaint (dkt.1) ¶ 30. In exchange for these investments (the "CCCD Transfers") Debtor received five unsecured convertible promissory notes, all of which lacked "performance milestones," "adjustments to the conversion ratio based upon performance," and "other financial requirements" which "would have been typical of an investment in a start-up venture." Id. ¶¶ 30–42.

Hughes was on both sides: he negotiated the notes on behalf of both Debtor and CCCD. Before the fifth investment, 100% of the membership interest in CCCD was transferred to a newly formed entity, CCC Diagnostics, Inc. ("CCCD, Inc."), of which Hughes was President, a board member, and a stockholder. Weinberg (Debtor's CFO and a board member) pointed out Hughes' conflicts of interest in email correspondence. Nevertheless, only the first of the CCCD notes was approved or ratified by Debtor's board. Id.

Eventually the gamble paid off; but not for Debtor. CCCD was able to commercialize its product and, in a private placement memorandum dated August 2012, Hughes and other officers of CCCD valued that company at $10 million. Just a few months later, though, in November 2012, Hughes arranged to purchase the entire $1.89 million series of convertible notes for $1. "Given that these notes were convertible into an 18.9% membership interest, this $1.00 purchase price equated to a $5.29 valuation for CCCD." Id. ¶ 44. This sale (the "CCCD Note Sale") was not approved or ratified by Debtor's board, nor was it accompanied by any fairness opinion or determination.

In addition, the complaint alleges, the Primary Directors caused Debtor to provide services to CCCD at no charge, and Hughes attempted to divert investors from Debtor to CCCD. The remaining Directors allegedly knew or should have known of these things and did nothing to stop them. Id. ¶¶ 46–48.

2. The RHM Software Rights Transfer: giving key software rights to the Primary Directors' overseas corporation for no consideration

On November 1, 2008, the Primary Directors caused Debtor to enter into a Memorandum of Understanding ("MOU") for computer graphic and animation services with a Malaysian business known as Rhythm & Hues Sdn. Bhd (the "RHM"). The Primary Directors owned RHM, and they were on both sides of the transaction. The MOU was executed by Buyyala on behalf of Debtor and Hughes on behalf of RHM. Complaint (dkt.1) ¶¶ 49–50.

RHM filed a proof of claim in the underlying bankruptcy, attaching a copy of the MOU that, unlike the copy in Debtor's files, included an "Addendum B" which purports to transfer to RHM in perpetuity all of Debtor's rights in certain software "which had been developed over decades and used to win multiple awards in the film industry." Id. ¶ 54. Hughes testified that this addendum was created in late 2012, shortly before the Petition Date. RHM now employs many of Debtor's former employees, including Hughes. Id. ¶¶ 51–53.

Debtor received no consideration for this software transfer (the "RHM Software Rights Transfer"). It was not approved or ratified by Debtor's board of directors. Id. ¶ 52.

3. The 2100 Grand Transaction: non-recourse advances to the Primary Directors to buy the business premises, then leasing back the premises at full market rates—leaving Debtor with all of the risks and none of the upside

In early 2009 the Primary Directors caused Debtor to advance millions of dollars to them, on a non-recourse basis, without taking back any of their assets as collateral, and at a 4% interest rate, to buy a six-story office building located at 2100 East Grand Avenue, El Segundo, California, through an entity they created and owned, known as 2100 Grand LLC ("2100 Grand"). Debtor then leased back the property at full market rates, at a cost of $264,000 per month. In December of 2010, due to breaches in the...