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Kruss v. Booth

June 11, 2010


Appeal from a judgment of the Superior Court of Orange County, Stephen J. Sundvold, Judge. Reversed. (Super. Ct. No. 06CC00199).

The opinion of the court was delivered by: Sills, P. J.



As we explain anon, the plaintiff in this difficult shareholder derivative suit must be given leave to amend his second amended complaint so as to allege violations of director fiduciary duty under California law. The plaintiff had alleged violations of California law in his prior, first amended complaint, but the trial court -- erroneously as we show below -- thought the case was governed by Nevada law and required the plaintiff to plead violations of Nevada law in the second amended complaint.

But then, even though the plaintiff had alleged violations of fiduciary duty under Nevada law, the trial court dismissed the suit anyway. The court reasoned that none of the alleged violations of fiduciary duty took place when the plaintiff owned stock in the subject company.

As we explain below, that was error too. The second amended complaint (all the complaints for that matter) alleged self-dealing on the part of the defendant directors that continued into the period when the plaintiff did own stock in the company.

Hence, the judgment of dismissal must be reversed. Plaintiff will have leave to amend to allege violations of fiduciary duty under California law. And, as one might expect, neither California law nor Nevada law permits corporate directors to engage in the complicated scheme of self-dealing alleged to have occurred in this case.


A. Pumps and Dumps and Reverse Mergers

This case involves the arcane world of the capital markets, and there is no avoiding what are alleged to be some very convoluted facts indeed. A little background is therefore helpful.

Two basic ideas must be explained right off the bat. The first idea is that of the "reverse merger." A reverse merger is a kind of cheap alternative to an "initial public offering" (usually abbreviated as an "IPO") as a way to raise capital by selling stock in an existing corporation. (See generally Pavkov, Ghouls and Godsends? A Critique of 'Reverse Merger' Policy (2006) 3 Berkeley Bus. L.J. 475 (hereinafter Ghouls, Godsends and Reverse Mergers).) The basic idea is that you take an existing, nonpublic company and merge it into a public "shell" company whose main asset is the very fact that it is a public company.*fn1 Investors buy stock in the public company that is now the avatar of the old nonpublic company.

The second idea is the securities scam known as a "pump and dump" scheme. A pump and dump scheme is simple in outline: Make claims that artificially inflate ("pump up") the value of stock you own. Gullible investors then buy the stock at inflated prices. You sell high and bug out with the inflated difference in value. (See generally U.S. v. Zolp (9th Cir. 2007) 479 F.3d 715, 717 fn. 1 ["'Pump and dump' schemes 'involve the touting of a company's stock (typically microcap companies) through false and misleading statements to the marketplace. After pumping the stock, fraudsters make huge profits by selling their cheap stock into the market.'"].)

B. Overview

1. The Variation on a Pump and Dump...

The second amended complaint alleges a clever variation on a pump and dump scheme. In this variation, the overinflated stock wasn't, strictly speaking, dumped. Rather, instead of selling the stock, the defendant corporate directors were alleged to have transferred assets out of the company into which the plaintiff investor had bought stock, to their own, privately-held companies, and also transferred liabilities into the company from their own privately-held companies. The effect, of course, was the same as a classic pump and dump: Wealth was transferred from investors in a public company to promoters.

The scheme was made easier because the private companies that were the ultimate recipients of the investors' wealth were in the same business (aluminosilicate products) as the public company. As alleged in the second amended complaint, the new public company was squeezed: It had to buy raw materials from three mining companies (to which the directors allegedly held allegiance) and also had to pay intellectual property royalties to another company (again, one in which the directors allegedly had a beneficial interest).

2.... Using a Reverse Merger

But, complications abound. The company on whose behalf this shareholder derivative suit has been brought (VitroTech) was formed in a reverse merger, yet much of the legwork for the pump and dump scheme antedated that reverse merger, that is, before VitroTech came into being.

According to the complaint, here's what happened: There was a private company Hi-Tech. Hi-Tech is technically separate from VitroTech, but easily confused with it because VitroTech would absorb some assets of Hi-Tech.

Anyway, Hi-Tech had substantial assets, including intellectual property rights, in the aluminosilicate products industry.

Then there was another company, Star. Star had the advantage of being an existing public company, though it did not have much in the way of assets.

Now, here's an interesting twist: In the reverse merger, Star did not swallow up Hi-Tech. Hi-Tech would survive as a separate company. But publicly-traded Star did become the owner of some of privately-held Hi-Tech's most valuable assets in a reverse merger. The newly swollen publicly-traded Star then renamed itself as VitroTech.

Despite the infusion of capital, the new public company, Star yclept VitroTech, was doomed from the beginning: In the process of the reverse merger, public Star obligated itself to three privately-held mining companies owned or controlled by its new board members, and also obligated itself to its old privately-held "parent" company Hi-Tech. And guess who privately owned or otherwise had allegiances to the privately-held mining companies and privately-held Hi-Tech? The four defendant directors of the new publicly-held VitroTech.

Hence, the money raised in the reverse merger for the purpose of capitalizing the new publicly-held VitroTech flowed out again to the mining companies or Hi-Tech, all owned or controlled by VitroTech's self-dealing board members.

The trial court looked at this schemata and said, in effect, to the plaintiff: All the bad stuff happened before you owned stock in the new public company, so you can't bring a shareholder derivative suit.

But that was error. Some of the bad stuff -- self-dealing is the more precise legal phrase -- continued on after the new public company was formed. This self-dealing included: not even trying to renegotiate onerous minimum requirement contracts with the three mining companies, assuming $14.5 million of the still privately-held parent company's debt, not making sure all the assets due from the reverse merger were transferred, approving amendments to mining contracts that gave the parent company and the mining companies stock in exchange for allegedly valueless or near valueless royalty concessions, and -- most easily comprehended of all -- paying twice as much as necessary to acquire a milling facility from the parent company. As we also explain below, this self-dealing was a breach of fiduciary duty, regardless of whether California law or Nevada law applied.


We apologize for any repetition of the basic facts stated above in the following recounting of the pleadings, but sometimes it pays to look at shell games in slow motion.

In 2006, plaintiff Alan Kruss filed an original complaint for breach of fiduciary duty and related causes of action against a group of defendants consisting of the corporate officers who assumed positions at VitroTech, the new company that emerged out of a reverse merger that took place in February 2004.

To simplify the history of the corporation: Beginning in 2001 (and continuing to the reverse merger in February 2004), there was a thinly-traded public shell company based in Sunset Beach, California, known as Star Computing (Star), which did not have much in the way of assets or sales. Star was incorporated in Nevada.

During the same period, there was another company, albeit a private one, known as Hi-Tech, also a Nevada company. Hi-Tech was and is a real company in the business of producing the mineral aluminosilicate for sale to real manufacturers, like paint manufacturers, who need it in the production of their own products. At the time of the reverse merger, Hi-Tech spun off from itself another entity, VitroCo*fn2. In this spinoff, Hi-Tech transferred both assets and liabilities to its offspring VitroCo.

The assets included the exclusive rights to purchase, process and sell some 35 billion pounds of "rare amorphous aluminosilicate"*fn3 in Calaveras and Kern Counties. That aluminosilicate could be manufactured into several products, including vitrolite, vitropurge, and vitrocote (italics added to emphasize distinction from VitroTech and VitroCo*fn4 ), which can be used in the painting and plastic molding industries.

The liabilities included a requirement that VitroCo pay its creator, Hi-Tech, royalties based on how much vitrolite was sold. Additionally, VitroCo was also required to pay royalties to three mining companies under a minimum purchase agreement with those companies. (Much of the complaint is a variation on the theme that the liabilities and obligations with which VitroCo was saddled doomed the company from the beginning.)

At the same time (February 2004), yet another company was created in the reverse merger, VitroTech. In the reverse merger, VitroTech ostensibly purchased VitroCo from Hi-Tech. Thus VitroTech effectively took on the assets and liabilities of VitroCo. The reverse merger was completed when VitroTech, pregnant with VitroCo, was in turn swallowed up by publicly-traded Star, and, lest the movement of the shells be any easier to spot than absolutely necessary, Star then promptly changed its name to VitroTech. VitroTech was now a publicly-traded company in which investors like plaintiff Kruss could purchase shares.*fn5

And promptly lose their money. In September 2006, Kruss, on behalf of himself and other similarly-situated investors, filed his original complaint, styled as both a derivative and double-derivative suit. The "double-derivative" part was because the only real value of VitroTech was the kernel inside it, VitroCo.

Three of the defendants had ties either to Hi-Tech -- to which, remember, the freshly born VitroTech was obligated by way of royalties -- or to one of the three mining companies, to which VitroTech was also obligated by way of a minimum purchase agreement.

Things went downhill for VitroTech from the beginning, given its obligations. Its demise was hastened by sweetheart deals made thereafter with Hi-Tech and the three mining companies (that is, sweet for Hi-Tech and the mining companies, rather bitter for VitroTech).

The original complaint did not specify which jurisdiction's law should apply. The choice of law issue was soon tested in a demurrer to the original complaint brought by defendant James Roth.*fn6 The trial court sustained the demurrer, albeit with leave to amend. The trial court also observed that the plaintiff had neither pled nor "established" the "requirements" of section 2115 of the Corporations Code.*fn7 (To interject a thought and get ahead of ourselves for a moment: Section 2115 is the California statute which specifies when, if ever, California law should apply to the internal affairs of an out-of-state corporation. We will explain it in more detail in part III.A. of this opinion. Precisely how one would go about "establishing" the "requirements" of section 2115 on demurrer is, as it turns out, highly problematic. The trial court appears to have been under the impression that Kruss had to prove the elements of section 2115 on demurrer. While that's possible in theory (tax returns might make the issue beyond peradventure), section 2115 is fact intensive, and therefore sometimes not readily susceptible to being "established" on demurrer.)

The trial court's observation prompted a motion for judgment on the pleadings from a group of four different defendants. These are the defendants who remain in the case in this appeal. We will refer to them as the "four defendant directors."*fn8

The motion for judgment on the pleadings was based on the theory that Nevada law requires "intentional misconduct, fraud or knowing violation of law" to hold directors liable to shareholders.*fn9 Thus -- as the motion argued -- even if dumb business decisions might arguably have been made by the directors of VitroTech after its emergence from the reverse merger, there were no allegations of actual intentional misconduct, fraud or knowing violation of law lodged against those directors. In word, at least according to the motion, everything was covered by the business judgment rule.

In early 2008 the trial court granted the motion for judgment on the pleadings. The trial court noted that there had been no amendment to the complaint since the demurrer and in the context of the hearing on that demurrer the court had made its comment about the applicability of Nevada law. Thus, the trial court considered Kruss to have "admitted that Nevada law applies." The trial court then agreed that "intentional misconduct, fraud, or a knowing violation of law" was required, and went on to opine that Kruss, as plaintiff, had the "burden to both plead and prove facts" to get around the business judgment rule, which burden he hadn't carried. The court then noted there were no "allegations that Defendants were self-dealing or lacked good faith."

The trial court's order, however, did not explicitly preclude leave to amend. So, two months later, Kruss debuted his first amended complaint. The first amended complaint made these points: The four defendant directors who had filed the motion for judgment on the pleadings*fn10 paid themselves disproportionate salaries in relation to the company's sales; in the period 1999 through 2004, the four defendants misrepresented facts about Hi-Tech to make it appear more profitable than it was. And during that period the defendants disseminated brochures, newsletters, updates and staff reports all to that effect. In particular, defendant Easterbrook was alleged to have made a number of outright false statements about Hi-Tech's prospects and sales at a meeting at a Newport Beach hotel in 2001. There was also a ...

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