Securities fraud claims fail but plaintiff succeeds with related corporate transaction claims

In AJZN, Inc v. Yu, et al (2015 U.S. Dist. LEXIS 8407) the plaintiff brought various claims relating to corporate transactions after he transferred intellectual property rights to the defendants who subsequently failed to honor the terms of their agreements. AJZN held numerous patents, trademarks, and copyrights relating to wireless audio and internet radio technology.  In 2007, AJZN entered into a senior secured note purchase agreement with defendant Great American Life Insurance Company (“GALIC”) securing AJZN’s assets for a debt obligation.  When AJZN received a $1.5 million settlement of a patent lawsuit, GALIC demanded to be paid the proceeds, and insisted that AJZN appoint defendant Yu as CEO of AJZN.  In 2009, GALIC formed Aerielle with Yu acting as CEO.  In the following year, AJZN entered into an asset purchase agreement with Aerielle and sold all of its assets and its ownership of Aerielle subsidiary ATI for the assumption of certain debt and a warrant.  The warrant gave AJZN an option to acquire membership units of Aerielle and was to further compensate AJZN for its assets.  As part of the agreement, AJZN also entered into a confidential mutual release and settlement agreement. Problems began when AJZN attempted to exercise its rights under the warrant.  Aerielle initially failed to respond to AJZN’s request, but subsequently offered to terminate the warrant in exchange for an earnout agreement.  The earnout agreement would provide AJZN a percentage of the gross revenues generated by ATI if ATI merged with Aerielle.  AJZN rejected the offer, which went through, but ultimately failed to generate any revenue for AJZN. The plaintiff then brought suit for violations of the Securities Exchange Act, Cal. Corp. Code §25401 and §25501, breach of warranty, promissory fraud, recission of release, breach of fiduciary duty, civil conspiracy, tortious interference with contractual relations, fraudulent transfers, unjust enrichment, and successor liability. For the securities fraud, AJZN alleged that the defendants knew the warrant was worthless, would never be honored, and was used to induce AJZN to transfer its assets and eliminate its interest in Aerielle.  The Court however, held that AJZN failed to allege any misrepresentation or omission by the defendants, and dismissed the securities fraud, state corporate fraud claims under §§25401 and 25501, promissory fraud, and recission of release claims.  The Court also dismissed the civil conspiracy claim, finding the violation alleged only by one defendant, and dismissed the claims for unjust enrichment in part against Aerielle. The Court sustained the claims for breach of fiduciary duty, tortious interference with contractual relations, fraudulent transfers, and successor liability.  Breach of fiduciary duty was upheld against Yu for compensation increases and personal expenses he approved to himself.  Yu argued that the release removed any liability from him, but the release specifically excluded intentional fraud.  AJZN alleged tortious interference sufficiently, claiming that GALIC instructed Yu to withhold payments to Aerielle to prevent earned payments to AJZN.  The Court also accepted AJZN’s claim for fraudulent transfers, as it was purported that the transfer rendered Aerielle insolvent, Aerielle received no value for the transfer, and the subsequent company was controlled by GALIC and Yu.  Finally, the Court upheld successor liability because AJZN alleged that Aerielle’s transfer of assets resulted in the successor conducting the same business as Aerielle, using the same assets, and being controlled by the same defendants. The Court granted and denied the motion as described above.

Plethora of Evidence Reverses Alter-Ego Employer's Summary Judgment

After reading through the opinion of the California Court of Appeals it is surprising to find that the trial court granted summary judgment for Ensign in Castaneda v. The Ensign Group, Inc. (229 Cal.App.4th 1015). Castaneda filed a class action suit against Ensign, alleging violations of California Labor Code for unpaid minimum and overtime wages.  He claimed Ensign was the alter ego of Cabrillo Rehabilitation and Care center, the nursing facility where he worked, and that the corporate veil should be pierced.  The trial court accepted Ensigns’ argument that Cabrillo was an independent company and granted summary judgment.

The Court of Appeals opinion first explained the situation hypothetically.  The Court stated that a corporation with no employees, who owns a corporation with employees, could be the employer of the owned corporation’s employees.  Under California law, the broad definition of an employer includes “any person...who directly or indirectly, or through an agent or any other person, employs or exercises control over the wages, hours, or working condition of [an employee].”

The facts against Ensign were many.  Castaneda introduced evidence that Ensign: owned Cabrillo, exercised control over its operations and employees, acknowledge control over Cabrillo, transferred officers between Ensign and Cabrillo, supervised and controlled employee job functions, and provided policy and training videos for Cabrillo employees.  At summary judgment, Ensign claimed it had no employees, but a brochure it distributed stated otherwise.  Castaneda and other witnesses also testified that they were hired and paid by both Ensign and Cabrillo.  Finally, Cabrillo employees were given Ensign email addresses, the Ensign VP set their rate of pay, they received their employee benefits through Ensign, and they had to file complaints with Ensign’s HR department.

The Court reversed summary judgment.

Intervening for Alter-Ego Liability

In Perez v. E-Smart Technologies, Inc. (U.S. District Court, N.D. California, Case No. C 14-00835 RS), Richard Barrett, a former COO of E-Smart, motioned the court to intervene and impose alter-ego liability on another officer. Prior to the motion, the plaintiff Secretary of Labor had issued final orders under the whistleblower protection provisions of the Sarbanes-Oxley Act (18 U.S.C. §1514) holding that E-Smart constructively discharged Barrett for raising complaints concerning the accuracy of E-Smart's public filings. Barrett sought to intervene to recover damages and costs against E-Smart’s control person, Mary Grace, who he claimed diverted E-smart funds for personal use. The court found that Barrett’s intervention motion satisfied the four-part test under Fed. R. Civ. P. 24 but did not determine the issue of alter-ego liability.

The court laid out three factors to determine whether to apply alter-ego liability: (1) the amount of respect given to the corporate identity by shareholders; (2) the degree of injustice in recognizing the corporate identity; and (3) the fraudulent intent of incorporators. Alter ego liability is imposed if the former and at least one of the two latter factors are present.

Although the record raised sufficient questions to grant the motion to intervene, the court did not rule on the substantive issue and continued the case.

California Court of Appeal Clarifies Rights of Dissenting Shareholders in "Common Control" Merger

Corporations Code Section 1312 addresses the rights of minority dissenting shareholders in a short form merger context.  The statute in subsection (a) states, and the California Supreme Court has long held, that minority shareholders who dissent from a merger vote have no right to rescind the merger or sue for damages; however, the shareholders may institute an appraisal proceeding and obtain the fair value of their shares. Until the recent decision in Busse v. United Panam Financial Corp. (, no reported decision dealt with subsection (b) of Section 1312 which addresses circumstances where merger partners are under common control.  The case first addressed whether in fact an individual with 40% voting control of the entity being acquired who also held the position of Chairman of the Board held common control.  The Court concluded that those facts coupled with some allegations of control over other directors and admissions from public statements about the individual's ability to control the corporation's activities were enough to allege control.  The Court then reached the critical question:  what rights did the minority dissenting shareholders have?   The Court held that they (1) could seek rescission, or (2) could sell their shares through an appraisal proceeding.  They could not, however, sue for damages under breach of fiduciary duty and other similar claims.  Thus, in common control situations, dissenters have more expansive rights but they are still substantially limited by Section 1312.

Proliferation of Books and Records Litigation

It has been recently noted by other commentators such as Boris Feldman at Wilson Sonsini ( noted a dramatic increase in lawsuits seeking corporate "books and records" under Del. Corp. Code section 220.  Mr. Feldman noted that plaintiff's firms essentially just keep asking for more and more documents until they force an impasse when the corporation finally draws the line.  Mr. Feldman suggested that the suits are becoming so common and disruptive that the Delaware legislature may eventually need to step in to curtail the litigation. The phenomenon of "books and records" litigation appears to be catching on to an extent in California as well.  We have noted an increasing advent of lawsuits under Cal. Corp. Code sections 1600-1605.  The California code sections purport to apply broadly to corporations incorporated outside the state in some instances and lack some of the procedural protections of the Delaware laws (the statement of purpose for the inspection need not be under oath in California).  The case law in California is also less developed, providing corporations with less certainty as to their obligations to comply with broad requests, under the threat of having to pay the plaintiff-shareholders' fees and costs if it errs in the breadth of documents it allows for production.

Like Delaware, California should perhaps look again at its shareholder inspection laws.