Opinion
SUCV20112307BLS1
06-13-2018
CANNONBALL FUND, LTD. et al. v. DUTCHESS CAPITAL MANAGEMENT, LLC et al.
File Date: June 15, 2018
MEMORANDUM OF DECISION AND ORDER ON DUTCHESS DEFENDANTS’ MOTION FOR SUMMARY JUDGMENT
Mitchell H. Kaplan, Justice of the Superior Court
This case is once again before the court on the Dutchess Defendants’ motion to dismiss the derivative claims asserted against them by the Cannonball Plaintiffs. In this motion, the Dutchess Defendants argue that the seven volumes of evidentiary material submitted to the court in support of their motion establish that there are no material disputed issues of fact and the Dutchess Defendants are entitled to summary judgment dismissing all remaining claims pending against them under Mass.R.Civ.P. 56. The court disagrees. It finds that there are a number of material disputed factual issues and therefore denies the motion.[1]
Dutchess Capital Management, LLC (DCM), Dutchess Advisors, LLC (Dutchess Advisors), Michael Novielli, Douglas Leighton, and Theodore Smith.
Cannonball Fund Ltd. and Cannonball Plus Fund Ltd.
As a result of the numerous dispositive motions filed over the past seven years by these defendants, as well as others-some of whom are no longer parties, there have been numerous previous written opinions issued by this court, as well as an opinion by the Massachusetts Appeals Court (Cannonball Fund, Ltd. v. Duchess Capital Mgmt., 84 Mass.App.Ct. 75 (2013) (Canonball) and an opinion issued by the Grand Court of the Cayman Islands. This court will not repeat the description of the relationships and history among the parties that has been frequently described in those opinions and will assume familiarity with all of them.
For present purposes, it is sufficient to note that the plaintiffs bring this action derivatively on behalf of Dutchess Private Equities Cayman Fund, Ltd. (Dutchess, Ltd.), a Cayman Islands exempt corporation, and Dutchess Private Equities Fund, L.P. (Dutchess, LP), a Delaware limited partnership. Dutchess, Ltd. and Dutchess, LP were two feeder funds (collectively the Feeder Funds) that fed a master fund, Dutchess Private Equities Fund, Ltd. (the Master Fund), also a Cayman Islands exempt corporation, which made all investments. DCM is a Connecticut LLC whose managing members are the individual defendants: Novielli and Leighton. DCM owns all of the voting shares of Dutchess, Ltd., is the general partner of Dutchess, LP, and is the investment manager for Dutchess, Ltd., Dutchess, LP, and the Master Fund. Dutchess Advisors is also a Connecticut LLC managed by Novielli and Leighton. It was paid by some of the Master Fund’s portfolio companies for allegedly providing various consulting services to them and also owns a majority of the equity in one of the portfolio companies. Smith is (or was) the COO of DCM and Vice President of Dutchess Advisors. Novielli, Leighton, and Smith (the Individual Defendants) were on the boards of a number of the Master Fund’s portfolio companies, as well as owning interests in other entities that provided services to DCM or the portfolio companies.[2]
The claims that the Dutchess Defendants are seeking to dismiss are: (i) breach of fiduciary duty asserted derivatively on behalf of Dutchess, Ltd. against the Individual Defendants and DCM; and (ii) unjust enrichment against Dutchess Advisors, asserted derivatively on behalf of both Dutchess, Ltd. and Dutchess, LP.
The court lists below some of the material, disputed issues of fact that preclude the entry of summary judgment dismissing these claims. This list is not intended to be exhaustive, but rather to highlight certain areas in which disputed factual issues exist that must be resolved at trial.
Breach of Fiduciary Duty-the Individual Defendants
Because Dutchess, Ltd. is a Cayman Islands corporation, Cayman Islands law determines the fiduciary duties that the Individual Defendants owe to Dutchess, Ltd. Cannonball, 84 Mass.App.Ct. at 93. Under Cayman Islands law a breach of fiduciary duty arises out of failure of the duty of loyalty. The Dutchess Defendants’ Cayman Island law expert expressed the duty as follows: "The distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not make a profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal."
There are disputed issues of fact regarding whether the Individual Defendants breached their fiduciary duty to Dutchess, Ltd., as defined above.
Based on an opinion offered by their expert, the defendants assert, as an undisputed fact, that the Master Fund "focused on structured Private Investment in Public Equity ("PIPE") transactions, a form of ‘last resort’ financing pursued by companies with no other financing[3] options." That is what is in the expert report, but that opinion may be rejected by the fact finder. Indeed, the statement does not appear to be reflective of the nature in which many PIPE transactions were employed during the relevant period. See Steinberg, Marc I.; Obi, Emmanuel U. "Examining the Pipeline: A Contemporary Assessment of Private Investments in Public Equity (PIPES)," Univ. of Penn. Journal of Business Law vol. 11, no. 1 (Fall 2008): p. 1-48 (PIPE issuers range in size from small, over-the-counter bulletin board companies to large-cap, NYSE-traded companies. In terms of transaction frequency, PIPES have dramatically increased from the 306 transactions recorded in 1996 to the 1, 454 deals that were closed in 2007. The aggregate PIPE deal value during this same period also has grown from just over $4 billion dollars to a whopping $83 billion dollars-a staggering increase. Although once considered a financing alternative of last resort used mainly by cash-strapped companies or issuers otherwise unable to secure traditional sources of capital, the PIPE market now attracts sophisticated market players"). To the extent that the defendants are using their expert to prove that all investors in Dutchess Ltd. must have known of the Individual Defendants’ and DCM’s high risk investment strategy because of the reference to PIPES in the offering materials, there are disputed factual issues.
Additionally, Cayman Islands law clearly emphasizes that fiduciaries have obligations of undivided loyalty and are not to profit from their trust. Disclosure of conflicts is essential. There is evidence in the summary judgment record from which a fact finder might conclude that the Individual Defendants did not fully disclose all of the financial relationships between them and the Master Fund and its portfolio companies. The court cannot say as a matter of law that all of the payments flowing to the Individual Defendants by way of compensation for board memberships, consulting fees, contractual fees, redemption of stock, or rents were fully disclosed[4] in the financial statements. It may be that all of these services were fairly compensated and necessary, but that will require factual assessment. The existence, if proved, of payments to the Individual Defendants and companies they control from portfolio companies, is some evidence that investment decisions may have been made for purposes other than maximizing returns to Dutchess, Ltd, especially if any such payments are not adequately disclosed.
The Individual Defendants argue that because investment documents permit conflicts, i.e., related party transactions, they cannot be liable for their, or companies that they control, having entered into commercial transactions with the Feeder Funds or portfolio companies. The argument misses the mark. These related party transactions are permitted if they are disclosed, the terms are no more favorable than those that would obtain in arm’s length transactions, and, most importantly, if investment decisions and asset valuations are not undertaken with a view to enabling other sources of income to the defendants rather than maximizing returns to the Feeder Funds and providing accurate information concerning values to investors.
A persistent factual dispute concerns the manner in which the Individual Defendants valued the portfolio companies in the books of account. There is evidence in the summary judgment record that GAAP required the Master and Feeder Funds’ investments in these companies to be reported at "fair value." There is also evidence that these investments were valued at cost in the Funds’ financial statements, until April 1, 2008, when the fair value of investments in several portfolio companies began to be dramatically reduced. While it may be that this was the earliest time that the degradation in value had become apparent, the Individual Defendants were on the boards of these companies and to various extents involved in their management. A finder of fact could conclude that the carrying value of these assets should have been reduced at an earlier time. Additionally, there is evidence that reporting these investments at cost instead of a reduced "fair value" enabled the Individual Defendants to receive increased[5] management fees and to continue to support these companies with additional lending, which had the collateral effect of enabling the portfolio companies to continue to make payments to the Individual Defendants and firms they controlled. There is also evidence for the finder of fact to consider suggesting that the failure properly to value the companies possibly had the effect of camouflaging the defendants’ departure from the investment strategy previously described to investors.
As factual support for the contention that Leighton and Novielli always caused the financial statements to reflect the fair value of the investments, the defendants offer the affidavits of these two individuals in which they state that is what they did. A finder of fact might, however, not fully credit their testimony.
Breach of Fiduciary Duty-DCM
The Dutchess Defendants argue that Dutchess, Ltd.’s claim of breach of fiduciary duty against DCM is governed by New York law because DCM manages Dutchess, Ltd.’s investments pursuant to a contract (the Investment Management Agreement or IMA), that contract states that it is governed by New York law, and under these circumstances Cayman Islands law would look to New York law to define the fiduciary relationship. While the plaintiffs do not actually concede this point, they also do not oppose it. The court will therefore apply New York law.
The Dutchess Defendants next contend that because the IMA states that DCM’s investing activities "on behalf of [Dutchess, Ltd.] shall be subject to the policies and control of [Dutchess, Ltd.’s] Board of Directors," no fiduciary relationship exists between DCM and Dutchess, Ltd. The Dutchess Defendants principally rely on In re MF Glob. Holding Ltd. Inv. Litig., 998 F.Supp.2d 157, 181-82 (S.D.N.Y. 2014) (Global) to support their position. The court finds the citation inapposite. In that case, the Court held that a federal commodities trading merchant (FCM) owed a fiduciary duty to its customers, but the officers and directors of that FCM did not: "the D & O Defendants bore those responsibilities in their capacity as employees of [the FCM], not because of their relationship with the Customers. Put another way, Plaintiffs’ allegations are[6] not sufficient to extend the relationship of trust and confidence between the Customers and [the FCM] into such a relationship between the Customers and the D & O Defendants." Id. In this case, the plaintiffs do not ask that the fiduciary relationship between DCM and its customer Dutchess, Ltd. be extended to include DCM’s directors, who, in any event, already owe fiduciary duties to Dutchess, Ltd., because they control that entity as well.
In Global, the Court quotes In re Refco, Inc. Securities Litigation, 826 F.Supp.2d 478, 502-03 (S.D.N.Y. 2011) (Refco) for a definition of the general standard that determines when a fiduciary relationship exists between two parties under New York law: "Broadly stated, a fiduciary relationship is one founded upon trust or confidence reposed by one person in the integrity and fidelity of another." Id. at 181. In Refco, investment funds organized under Cayman Islands law sued, among other defendants, the entity that administered the funds pursuant to a Service Agreement, i.e., a contract. Applying New York law, the court found that a claim was stated for breach of fiduciary duty against the administrator, although their relationship was based on contract. The court observed that the administrator performed a number of discretionary functions for the funds. The question of whether the funds reposed trust and confidence in the administrator was a fact specific inquiry.
The court does not find support in the cases cited by the Dutchess Defendants for the proposition that because DCM’s investing activities are subject to control and supervision by the directors of the Dutchess, Ltd., the court must conclude, as a matter of law, that Dutchess, Ltd. did not place trust and confidence in DCM to faithfully execute its investment decisions in a manner[7] focused on maximizing Dutchess, Ltd.’s returns on its investments, rather than the fees generated by DCM, or other third parties such as Dutchess Advisors, or the Individual Defendants.
Of course, while as a matter of law Dutchess, Ltd. and DCM are distinct entities, Leighton, Novielli and, arguably, Smith were making the investment decisions as the managers of DCM and overseeing DCM as the directors of Dutchess, Ltd. It is hard to imagine that the facts will develop in such a way that either the Individual Defendants or DCM will be found liable to Dutchess, Ltd. for breach of fiduciary duty while the other is found not liable, or, conversely, that the Individual Defendants could be found not liable, but DCM legally responsible for Dutchess, Ltd. losses.
Smith’s Motion for Summary Judgment
Smith also moves for summary judgment on the ground that "Smith was not a director of Dutchess, Ltd. and played no role in its management." However, in Cannonball, the Appeals Court held that the allegations in the complaint "concerning Smith’s involvement, taken in their totality, are sufficient to show his de facto control of Dutchess, Ltd." 84 Mass.App.Ct. at 95. The summary judgment record contains sufficient evidence of Smith’s involvement in the investment, valuation, and other decisions regarding the affairs of Dutchess, Ltd., as well as his access to critical information relevant to these decisions by virtue of his board seats on several portfolio companies, to potentially support the allegations that the Appeals Court found sufficient to state a claim. Additionally Smith’s compensation was directly tied to the same valuation decisions and related party transactions that impacted Leighton’s and Noviello’s compensation. While the question is a close one, the fact that Smith was not specifically named as a director of Dutchess, Ltd. is not determinative, and disputed questions of fact concerning his control over Dutchess, Ltd. exist.[8]
The Unjust Enrichment Claims
"Unjust enrichment is defined as retention of money or property of another against the fundamental principles of justice or equity and good conscience ... Restitution is an equitable remedy by which a person who has been unjustly enriched at the expense of another is required to repay the injured party ... It is appropriate only if the circumstances of its receipt or retention are such that, as between the two persons, it is unjust for one of them to retain it." Santagate v. Tower, 64 Mass.App.Ct. 324, 329-30 (2005) (internal citations and quotations omitted). It is not entirely clear how this claim applies to the evidence presented in this case. Evidence that Dutchess Advisers was paid fees by the portfolio companies, even if those fees were in excess of fair value for the services provided, would not necessarily establish a claim for unjust enrichment in favor of the Feeder Funds. However, additional evidence that the fees were excessive and paid by the portfolio companies with moneys invested by the Funds might. That issue has not been adequately addressed in the summary judgment materials.
In any event, the defendants have moved to dismiss principally on the grounds of statute of limitations. While the period of limitations that applies to these claims is three years (Cannonball, 84 Mass.App.Ct. at 83 n.21), there is evidence that the defendants had an obligation to disclose that the portfolio companies were making payments for services to entities controlled by the Individual Defendants. If that is so, failure to disclose these transactions would toll the running of the period of limitations. See Demoulas v. Demoulas Super Markets, Inc., 424 Mass. 501, 519 (1997). Questions of fact remain on the question of tolling. Questions of fact also remain concerning whether the payments to Dutchess Advisors were made at fair value for necessary services and whether the Feeder Funds were the source of cash used to pay Dutchess Advisors. Accordingly, summary judgment is denied as to the unjust enrichment claims.[9]
ORDER
For the foregoing reasons, the Dutchess Defendants’ motion for summary judgment is DENIED.