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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 circular in April of 2003 that wrongly inflated amounts of vitrolite that were being sold. Thus the defendants allegedly "contrived" the reverse merger to "pump and dump" their equity interests in Hi-Tech.

Post-merger allegations included these:

(1) There was an October 2004 amendment to a mining contract with the mining companies (to whom at least two of the directors, Booth and Kangas, had interests or allegiances) that was "inordinately favorable" to both Hi-Tech and the mining companies. This amendment "validated" an "onerous royalty schedule" previously put in place at the time of the reverse merger, while also diluting the interests of the regular shareholders by giving Hi-Tech some 17 million VitroTech shares.

(2) Also in October 2004, CEO Booth had VitroTech transfer to him personally (or entities controlled by him) certain of VitroTech's (or VitroCo's) assets, including intellectual property interests in the mines and unspecified "real property assets."

(3) Further, in early 2005, Booth received a cash bond securing VitroTech's permit to mine at a certain mine. This permit, however, allegedly limited the amount of vitrolite that could be obtained from that mine.

(4) And in June of 2005 matters reached a "crescendo" when the mining companies controlled by Booth and "his allies" claimed that VitroTech had defaulted on its obligations to them, allowing them to claim ownership of VitroTech's (and VitroCo's) "few remaining valuable assets, such as their rights to obtain minerals from the mines."

The first amended complaint alleged that VitroTech was subject to California internal corporate affairs law. The theory was that Star, the public shell that ostensibly morphed into VitroTech, was incorporated in August 2001, and filed California tax returns for the income year 2002 but did not file any Nevada tax returns for that year. Further, the 2002 tax return recited that Larry Poland, a California resident, owned 67 percent of Star's stock. Besides that, the complaint alleged all of the operations of all the relevant companies (presumably including Hi-Tech) were in California.

The first amended complaint was attacked via a demurrer. In July 2008, the demurrer was sustained with leave to amend. Judge Sundvold, who would later hear the demurrer on the second amended complaint as well, opined, among other things, that: (1) no "double-derivative" suits are allowed in California; (2) Kruss had still not gotten around the business judgment rule because he hadn't alleged "particularized facts" to overcome the rule's burden; and (3) Nevada law still applied because "50% of the shareholders reside outside of California." (For the final of these determinations, the trial court relied on SEC filings of which it took judicial notice.)

The demurrer sent Kruss one more time into the breach. That is, in late August, he filed a second amended complaint. Basically, the second amended complaint was more of the same, except it explicitly pegged its legal theories to Nevada law, including breaches of fiduciary duty (NRS 78.138, the one quoted in the margin above that requires intentional misconduct, fraud or knowing violation of law) and self-dealing (NRS 78.140*fn11 ).

The second amended complaint had also grown in girth, now expanding to more than 70 pages and 296 paragraphs.

This time, the inevitable demurrer had a dispositive effect. In an order made in late December 2008, the trial judge sustained the demurrer, but this time without leave to amend. The court reasoned, among other things:

(1) Nevada law applied;

(2) Kruss could not rely on any facts alleged to have occurred prior to February 3, 2004 (the date of the reverse merger), because Kruss was not a shareholder, and the four directors were not directors, prior to that date;

(3) Kruss had failed to "both plead and prove particularized facts to circumvent the business judgment rule's presumption," (and thus the matter was "proper" to be determined by demurrer);

(4) there were insufficient allegations that the four defendants "were self-dealing or lacked good faith"; and

(5) Kruss had failed to "plead facts showing intentional misconduct, fraud or knowing violation of law."

The formal order sustaining the demurrer was filed on December 23, 2008, but notice of entry of the order was served January 5, 2009. On precisely the sixtieth day thereafter, Kruss filed the notice of appeal that has brought the case to this court.*fn12


A. Issue Waived? No

We first tackle the argument that Kruss waived the right to assert an error as to the choice of law question. The argument goes like this: Kruss did not amend his complaint within 60 days after the trial court commented, in a minute order in connection with the demurrer to the original complaint, that Nevada law applies. Ergo, the matter became final and Kruss has waived the issue in this appeal.

The argument fails because orders sustaining demurrers with leave are not res judicata, collateral estoppel, law of the case, or any other claim- or issue-precluding disposition. Even now, on appeal, Kruss retains the power to propose an amendment alleging California law applies.*fn13 And, indeed, Kruss's attorney explicitly so requested such an amendment at oral argument.

Cano v. Glover (2006) 143 Cal.App.4th 326, 330, relied on by the four defendant directors, is readily distinguishable.*fn14

B. Section 2115

1. The Problem of Determining the Applicability of Section 2115 on Demurrer

As we show in part III.B.2. (the next part) below, the basic question of whether the internal affairs of an out-of-state corporation should -- under criteria set out in section 2115 of the Corporations Code -- be governed by California corporate internal affairs law depends on several fact-intensive inquiries (such as the amount of sales in this state, the payroll in this state, and the property held in this state). And yet in this case it appears that the four defendant directors of VitroTech have attempted to try the issue of the applicability of section 2115 by judicial notice, mostly by asking the trial court to take judicial notice of filings by VitroTech's own management with the Securities Exchange Commission.

What's wrong with this picture? This case was still in the demurrer stage when the trial court dismissed it. And the basic rule on demurrer is: The court, trial and appellate, accepts all facts alleged in the complaint as true, and draws all reasonable inferences from those facts in favor of the plaintiff.

To be sure, a plaintiff may be stuck with factual admissions made in previous complaints or made by the plaintiff in other documents of which a court could take judicial notice, but here -- what are those admissions by the plaintiff? Plaintiff Kruss has never contradicted his basic allegation, made in the first amended complaint, that in 2002 more than half of Star's voting shareholders lived in California and all of its business was conducted here.*fn15 At most, the second amended complaint merely included Nevada legal authority -- as distinct from California legal authority -- to support the basic set of facts alleged.

We mention the problem for this reason: As we show below, based on the facts alleged and that can still be realleged, section 2115 does indeed apply. That is, for the moment, we must look to California law.

But -- we emphasize: The very attempt, on demurrer, to decide the applicability of section 2115 based on information (SEC filings) outside of the complaint is rife with the potential for anomaly: One jurisdiction's law (here, California's) might readily apply based on facts alleged in a complaint, but another jurisdiction's law (here, Nevada's) might yet apply, based on facts determined later in the litigation, say on a motion for summary adjudication or in a phased or bifurcated trial. The reason: The tests the Legislature articulated in section 2115 are highly fact intensive.

Thus, it may very well be that, in a future motion for summary adjudication, facts will be shown to be undisputed (or in a future bifurcated trial, the trier of fact will find such facts to be true) that will preclude section 2115 from operating, and Nevada law will be the operative body of law to apply to the case.

Hence our conclusion, explained below, that California law applies must be understood as applying only in the context of a case coming to us after a demurrer was sustained without leave to amend. Kruss's case against the four defendant directors could, in theory, ultimately be decided under Nevada law.

That said, we don't perceive the issue to make much difference as to the core allegations of the complaint. Nevada's law is substantially the same as California's in this most important essential: Neither state allows corporate directors to suck money out of a corporation and siphon it on to themselves or entities they control. (For an example of Nevada law on the point, see Medical Device Alliance, Inc. v. Ahr (2000) 116 Nev. 851 [affirming appointment of receiver over Nevada corporation in the wake of director corruption and self-dealing].)

2. Basic Operation of Section 2115

This shareholder derivative suit has been filed ostensibly on behalf of VitroTech, a revoked Nevada corporation. Normally then, under section 2116 of the California Corporations Code,*fn16 Nevada law would apply to the internal dealings of the corporation. (See also Vaughn v. LJ Internat., Inc. (2009) 174 Cal.App.4th 213, 223 ["Corporations Code section 2116 codifies the modern view of the common law doctrine, whereby a court will entertain an action involving the internal affairs of a foreign corporation. With certain exceptions, the law of the state of incorporation applies."].)

There is an exception, however, found in section 2115 of the Corporations Code.*fn17 While section 2115 is a mass of text,*fn18 it has been conveniently distilled into this one sentence by the court in State Farm Mutual Automobile Ins. Co. v. Superior Court (2003) 114 Cal.App.4th 434, 448 (State Farm): "California law governs certain internal affairs of a foreign corporation if more than half of the corporation's voting stock is held by California residents, and the corporation conducts a majority of its business in the state (as measured by assets, payroll, and sales)."*fn19

We would add only this introductory clause to that sentence from State Farm: "After a certain amount of time has passed, California law governs certain internal affairs of a foreign corporation if...." Pinpointing that amount of time, however, is necessary to figure out which law applies here. And that is going to require us to penetrate the thicket of section 2115's text.

The structure of section 2115 is somewhat convoluted, reflecting, alas, a devotion to cross-referencing worthy of the Internal Revenue Code. The statute begins, in subdivision (a), with the thought that on a certain date, as defined in subdivision (d), and until a certain date, as defined in subdivision (e), an out-of-state corporation "is subject to" certain requirements, which are spelled out in subdivision (b), if two tests, enumerated in subdivisions (a)(1) and (a)(2), are met.

So we begin with the question, what exactly are "the requirements of section 2115, subdivision (b)?" Answer: Those requirements are the need to conform to certain kinds of internal corporate behavior as delineated in specified sections of the Corporations Code,*fn20 including, of course, a standard of care imposed on corporate directors, requiring them to act in good faith in the best interests of the corporation as an ordinary prudent person would under similar circumstances.*fn21

We have already met, in the State Farm court's encapsulation, the tests enumerated in subdivisions (a)(1) -- which is, roughly speaking, half or more of the corporation' business*fn22 -- and subdivision (a)(2) -- which is, exactly speaking, more than half the voting stock.*fn23 For convenience we will call these tests the "business-voting stock" standard.

We say "roughly speaking" for the business element in subdivision (a)(1) because, in order to determine whether half or more of the corporation's business is being done in California, you have to look at the corporation's tax returns. Yet another cross-reference in subdivision (a)(1) are to those provisions in California's Revenue and Taxation Code that subdivide "business" into the factors of property, payroll and sales.*fn24

The need to look at tax returns (or, more exactly, the data that goes into the tax returns), plus common sense, dictates that the applicability of California law to a given action by the board of an out-of-state corporation can only kick in after a certain time lag.*fn25 In a close case, for example, a corporation wouldn't know whether its property, payroll and sales added up to doing more than half its business in California until its tax returns were finalized.

Additionally, there is the fact that stock may change hands instantly, but records may not instantaneously reflect that change. Thus subdivision (a)(2) of section 2115 refers the reader to address records of stockholders on either the record date for the last shareholders' meeting or the last day of the "latest full income year," which, of course, may be yet in the future.*fn26

The precise point at which California internal-governance law applies if the business-voting stock standard is met is itself the subject of yet more intricacy. Subdivision (a) cross-references to subdivision (d) on this point. Subdivision (d) says -- we'll take a stab at a plain English paraphrase -- that if there is a year in which "the tests referred to in subdivision (a) have been met" (i.e., business-voting stock standard), you wait 135 days into the next income year, and the very first day of the income year after that one is the one in which the directors are now subject to California law.*fn27 In short, the lag time can be around three years.

Fortunately, there is a plain English case from the United States Bankruptcy Court, In re Flashcom, Inc. (2004) 308 B.R. 485 (Flashcom) that illustrates the operation (and length) of this time lag. The core issue in Flashcom was whether California or Delaware law applied to an act of alleged director malfeasance -- an improper $9 million stock redemption -- that took place on February 23, 2000. While the corporation began life in Nevada in May 1998, it had been reincorporated in Delaware in January 1999. So, under the normal operation of section 2116 (sometimes called the "internal affairs doctrine") Delaware law would apply to the internal affairs of the corporation. Even so, from the beginning half its business was in California. (Id. at p. 487.*fn28 ) Thankfully (for future readers of the Flashcom opinion), the corporation used the standard calendar year as its fiscal year.

To decide the case, however, the Bankruptcy Court had to ascertain the nature of reference to the phrase "full income year" as used in subdivision (d). (See Flashcom, supra, 308 B.R. at p. 488.) The defendants argued that the term "full income year" meant a full calendar or fiscal year. Thus, under their theory, the first year in which the two tests of business-voting stock were met was 1999 (not the partial year 1998), so "the 135-day count" began January 1, 2000, and the first day of the next full income year after the year in which the 135 day count expired -- 2001 -- was the date of first applicability of California law. According to the defendants, then, California law did not apply to the stock redemption in February 2000.

The bankruptcy trustee, by contrast, wanted the partial year 1998 to be the first year in which the two tests were met, hence the 135 days began running on January 1, 1999, and the beginning of the next year following the year in which the 135 days expired -- 2000 -- would be the year of first applicability of California law.

The Flashcom court reasoned that "the only workable definition of 'full income year' as used" in section 2115 "is a full calendar or fiscal year." (Flashcom, supra, 308 B.R. at p. 489.) Besides which, said the court, an out-of state corporation couldn't tell if it was doing half its business in California "without data from a full fiscal or calendar year." (Ibid.) Thus:

(a) the corporation's "first full fiscal year," which was its "'full income year,'" was 1999;

(b) 1999 was the first year of satisfaction of the more-than-half-the- business-in-California test;

(c) therefore the 135 days began running the next full year, or on January 1, 2000;

(d) the 135 days expired in May 2000; so

(e) 2001 was the "'first income year'" after the 135 days expired; meaning

(f) January 1, 2001 was the first day on which California law became applicable to the affairs of the corporation. (Flashcom, supra, 308 B.R. at p. 489.)

And the January 1, 2001 date-of-first-applicability was after the dubious February 2000 stock redemption. Hence Delaware law applied to the redemption, and defendants were entitled to judgment in their favor on the various claims brought against them under the California Corporations Code statutes. (Flashcom, supra, 308 B.R. at p. 490.)

To recap the operation of section 2115: Take the first full year in which the business-voting stock standard for an out-of-state corporation is met -- year 1; then, in the next full year -- year 2 -- count 135 days; and then finally, the very first day of the next full year, year 3, is the very first day which California internal affairs law applies to that out-of-state corporation.

3. As Applied to the Case Before Us

Star -- the public shell that swallowed Hi-Tech's spinoff in the form of VitroCo (which was itself eaten by VitroTech) was alleged to have been incorporated in Nevada on July 16, 2001. There is no dispute about that, nor is there any dispute that, like the corporation in Flashcom, Star used the standard calendar year as its fiscal year.*fn29 As shown above, the first amended complaint (itself supported by a request for judicial notice of Star's tax return for 2002) alleged that in 2002 more than half of Star Computing voting shareholders and all of its business were in California. That is, under the facts alleged, in 2002 the business-voting stock tests were met.*fn30

Under the section 2115 formula, then: 2002 was year 1; the 135 days expired in May of 2003 (year 2); and therefore January 1, 2004 (first day of year 3) was the date of first applicability of California law to the internal affairs of the corporation. The date of the reverse merger was February 3, 2004. Therefore, for purposes of a demurrer to the complaint, California law applied to the reverse merger.

But this case presents anything but a straight path, and we're not quite out of the dark woods yet. As noted above, there may come a time when California law ceases to apply to an out-of-state corporation's internal affairs. That time is delineated in subdivision (e), which provides: "(e) For purposes of subdivision (a), the requirements of subdivision (b) shall cease to be applicable to a foreign corporation (1) at the end of the first income year of the corporation immediately following the latest income year with respect to which at least one of the tests referred to in subdivision (a) is not met or (2) at the end of the income year of the corporation during which a final order has been entered by a court of competent jurisdiction declaring that one of those tests is not met, provided that a contrary order has not been entered before the end of the income year." (Italics added.)

Subdivision (e) thus creates yet one more beastly problem, and unfortunately one in which we do not have a solid bankruptcy decision to guide us, Virgil-like, down through its multiple rungs of analysis: The respondent defendant directors argue on appeal that, regardless of the situation in 2002,*fn31 in 2003 -- as shown by SEC filings of which the trial court took notice (a form 10KSB) -- Poland sold off about half his 67 percent interest to various investors outside of California. For what it's worth, in his own briefing plaintiff Kruss implicitly concedes that by 2003 at least the voting-stock part of the business-voting stock standard could not be satisfied.

Subdivision (3) says that California internal affairs law ceases to be applicable "at the end of the first income year of the corporation immediately following the latest income year with respect to which at least one of the tests referred to in subdivision (a) is not met." That is, you have "the latest income year with respect to which at least one of the tests referred to in subdivision (a) is not met" -- here, that would be 2003 (year 1) -- and then applicability ceases "at the end of the first income year" -- year 2 -- "of the corporation immediately following" that income year. So, here, on the assumption that 2003 was year 1, then the end of year 2, 2004, that is, December 31, 2004, was the date of the end of the applicability of California internal affairs law.

Conclusion: for the year 2004 -- which includes the February 2004 reverse merger and the next 11 months or so -- and again, for purposes of review on demurrer -- California law applied to the internal workings of the corporation formerly known as Star Computing, and which, for purposes of this appeal, we treat as the correct entity on which to test the applicability of section 2115 to VitroTech, on behalf of which this shareholder derivative action has been filed.*fn32

Consequently, there is no doubt but that Kruss must be given leave to amend his complaint to allege (or, precisely speaking, reallege) the applicability of California law.


But our deliberations cannot stop here. There are a few more rungs to be explored. If the trial court was correct that Kruss had alleged no postreverse merger self-dealing conduct, allowing an amendment to allege applicability of California law wouldn't make any difference. We would still be required to affirm the judgment, as it would be correct under California law in any event.

A. The Pre- and Post- Reverse Merger Problem

The trial court's rationale was that Kruss could not "rely" on any facts alleged to have occurred prior to February 3, 2004, i.e., the date of reverse merger, because Kruss was not a shareholder, and the four defendant directors were not directors, prior to that date.

The answer to the trial court's rationale is: yes and no. Yes, in the strict sense that no corporate action taken by directors of Hi-Tech or the mining companies truly prior to the reverse merger of February 2004 can, by itself, establish liability to Kruss (or like investors) for a breach of fiduciary duty. In a word, Kruss never owned any part of Hi-Tech or the mining companies.

Section 800 embodies what is often called the contemporaneous ownership rule, which can be reduced to this sentence: A plaintiff must be a shareholder in the corporation on whose behalf the plaintiff has brought the derivative suit, and have been a shareholder at the time the corporation's claim arose. Here, Kruss did not own any stock until VitroTech was created in the reverse merger. And under the contemporaneous ownership rule the derivative suit cannot be based on premerger events. (See Daly v. Yessne (2005) 131 Cal.App.4th 52, 61-62 [plaintiff had no standing because the events of which she complained "all took place before plaintiff acquired her shares"].)

However, section 800 is also home to an exception to the contemporaneous ownership rule, which allows a plaintiff to bring a derivative action where the previous misconduct and its bad effects continue over into the period after the plaintiff acquired the stock. (See generally Wells, Maintaining Standing in a Shareholder Derivative Action (2004) 38 U.C. Davis L. Rev. 343, 346 (hereinafter, "Wells, Maintaining Standing") ["This doctrine allows standing if plaintiffs can show that the previous misconduct and its negative effects continued after the acquisition of the stock."].)

Though the question of whether section 800 embodies the continuing wrong doctrine appears to be one of first impression in our state's case law, commentators have taken the position that section 800 does indeed do so. (Wells, Maintaining Standing, supra, 38 U.C. Davis L. Rev. at p. 351 [grouping California, Pennsylvania and Ohio as states that "have explicitly or implicitly adopted the continuing wrong doctrine"].)

The basis of the assertion that California has explicitly adopted the continuing wrong doctrine is this language taken from subdivision (b)(1) of section 800, which, after an iteration of the contemporaneous ownership rule, states: "provided, that any shareholder who does not meet these [contemporaneous ownership] requirements may nevertheless be allowed in the discretion of the court to maintain the action on a preliminary showing to and determination by the court, by motion and after a hearing, at which the court shall consider such evidence, by affidavit or testimony, as it deems material, that... (iii) the plaintiff acquired the shares before there was disclosure to the public or to the plaintiff of the wrongdoing of which plaintiff complains." (Italics added.)

But this language in section 800 brings us to yet another rung of complication: As the quoted language shows, the continuing wrong exception of section 800 requires a hearing, with evidence, and the actual application of the exception is left to the court's discretion.

However, plaintiff Kruss sought no such hearing under section 800. We therefore cannot, bound by the procedural posture of this case, simply declare that all the premerger malfeasance engaged in by the defendants alleged in this complaint is enough to overturn the trial court's judgment. As the case comes to us, the contemporaneous ownership rule remains the operative one, without the application of the discretionary exception in section 800 for continuing but undisclosed wrongs. Any discretionary application of the continuing wrong doctrine by the trial court and its review on appeal is a problem that must await another day.

Even so, the contemporaneous ownership rule does not make facts alleged to have taken place prior to the reverse merger ipso facto irrelevant as to facts alleged to have taken place after the reverse merger. Those premerger facts simply cannot, by themselves, support claims of breaches of fiduciary duty in a shareholder derivative suit based on stock acquired only in the reverse merger or thereafter.

Complaints, as our Supreme Court explained in Blank v. Kirwan (1985) 39 Cal.3d 311, 318, must be given "a reasonable interpretation." They must be read "as a whole" with their "parts in their context."

Here, we can understand the nature of board malfeasance after the merger by recognizing a context shaped by premerger events. Read as a whole and in context, the second complaint tells the story of a remarkable twist on pump and dump schemes:

You take a real company with real assets (here, Hi-Tech) which is part of a group of companies, including raw materials suppliers (the mining companies). From this real company (Hi-Tech), you spin off an entity which is supposed to embody certain profitable operations (VitroCo). But then, in the course of a reverse merger, you put a shell (VitroTech as the incarnation of the public Star) on top of the newly born spin-off (VitroCo), and simultaneously -- shell games require sleight of hand, remember -- lard up the shell (VitroTech) and the supposedly profitable pea under it (VitroCo) with obligations to the original mother company (Hi-Tech) as well as to the raw materials suppliers that you conveniently control. Then you take money from investors who think they are buying into the profitable pea (VitroCo), and arrange for that money to be dissipated in a series of sweetheart deals with yourself, i.e., the companies (Hi-Tech and the mining companies) you control. It's a clever scheme, but it should be clear to any outsider (like a court) that all the actions taken to implement the plan after the reverse merger are still self-evidently a breach of fiduciary duty to the investors who were led to believe that the spin off was itself supposed to be profitable and not just a conduit for their money to go to your entities.

The upshot is (again, for the time being and independent of any hypothetical future attempt by Kruss to seek the court's discretionary imprimatur to allow him and his like investors to be excused from the contemporaneous ownership rule): Actions taken by the four defendant directors after the reverse merger can still support the derivative suit, particularly as those actions are understood as part of a larger scheme to use VitroTech to siphon money to entities controlled by the four defendant directors.

Allegations of postreverse merger hanky-panky on the part of the board, as spelled out in paragraph 270 of the second amended complaint, include:

-- agreeing to an "onerous" royalty structure and minimum requirement contracts with Hi-Tech and the mining companies, also allegedly controlled by the four defendant directors, and then failing to even try to renegotiate those contracts (paragraph 270f);

-- having VitroTech assume $14.5 million of Hi-Tech's debt (paragraph 270h);

-- failing to assure that assets that were supposed to be transferred from Hi-Tech to VitroCo (and thus effectively VitroTech) actually were transferred (paragraph 270i);

-- approving amendments to the mining contracts that resulted in VitroTech shares being transferred to Hi-Tech and the mining companies in exchange for valueless or near valueless royalty concession (paragraph 270m);

-- having VitroTech buy a milling facility from Hi-Tech at double the price Hi-Tech paid for it just two months before (paragraph 270q).*fn33

The four defendant directors' responses to these postmerger instances of alleged self-dealing fall into several categories, all of which are at odds with the basic procedural posture of deciding a case on demurrer: Either they say (a), well, it happened, but not after the merger (like the assumption of the debt); or (b) if it did happen after the merger (like paying too much for the milling facility), it was just an improvident business decision; or (c) there's no intentional misconduct fraud or knowing violation of law.

Well, those may be valid defenses in other procedural contexts, but on demurrer, the reasonable inferences are drawn in favor of the complaint. And it is very reasonable here to draw an inference that the four defendant directors used the reverse merger form to implement a general plan to take the investors' money and send it to themselves in the form of non-arms length deals with companies they controlled.

B. The Business Judgment Rule

The second and main substantive reason the trial court sustained the demurrer without leave to amend was the idea that everything in the complaint was covered by the business judgment rule.

The business judgment rule is essentially a presumption that corporate directors act in good faith. As explained by the court in Everest Investors 8 v. McNeil Partners (2003) 114 Cal.App.4th 411, 429 (Everest Investors 8): "The business judgment rule is a judicial policy of deference to the business judgment of corporate directors in the exercise of their broad discretion in making corporate decisions.... 'The rule establishes a presumption that directors' decisions are based on sound business judgment, and it prohibits courts from interfering in business decisions made by the directors in good faith and in the absence of a conflict of interest.'"*fn34

An important exception to the business judgment rule arises when circumstances inherently raise an inference of conflict of interest. As the court in Everest Investors 8 went on to explain: "An exception to this presumption exists in circumstances which inherently raise an inference of conflict of interest.... The business judgment rule does not shield actions taken without reasonable inquiry, with improper motives, or as a result of a conflict of interest." (Everest Investors 8, supra, 114 Cal.App.4th at p. 430, italics added.)

Here, there are circumstances aplenty that raise an inherent inference of conflict of interest: Hi-Tech and the mining companies were all allegedly under the control of at least three of the four defendant directors (Booth, Kangas, and Easterbrook). On top of that, there are the postmerger actions we have just noted. The defendant directors had VitroTech assume $14.5 million of Hi-Tech's debt. The defendant directors failed to assure actual transfer of assets from Hi-Tech to VitroTech, but they did transfer. VitroTech stock to Hi-Tech and the mining companies. On top of all that, they had VitroTech buy a milling facility from Hi-Tech at an inflated price. These postmerger decisions on the part of the four defendant directors readily raise an inference of self-dealing, improper motive, and conflict of interest.

C. Miscellaneous Causes of Action

1. Aiding and Abetting

Both California and Nevada law provide for aiding and abetting liability when board directors are aware that a fellow board director has violated a fiduciary duty to the shareholders, and knowingly and substantially assist in that breach. (Cf. Casey v. U.S. Bank Nat. Assn. (2005) 127 Cal.App.4th 1138, 1144 with G.K. Las Vegas Limited Partnership v. Simon Property Group, Inc. (D. Nev. 2006) 460 F.Supp.2d 1246, 1261.) Since the complaint alleges postmerger actions showing a breach of fiduciary duty, and the complaint also treats the four defendant directors as entirely united in those actions, plus alleges they were self-interested in those actions, it is a reasonable inference that each of the directors knowingly and substantially assisted in those breaches.

2. Civil Conspiracy

What we have just said also applies equally to the civil conspiracy claim. The complaint is susceptible of the reasonable inference that the four defendant directors contrived to send assets from VitroTech to their own firms in breach of their fiduciary duties to the shareholders.

3. Unjust Enrichment, Accounting, and Constructive Trust

What we have said above about the breach of fiduciary duty and self-dealing applies to the remaining three causes of action for unjust enrichment, accounting and constructive trust. The four defendant directors here assert:

(a) Certain transfers occurred prior to the merger. This fails because, in the context of a demurrer, it is mere wishful thinking -- substituting one's own facts in place of those alleged in the complaint.

(b) Other transfers occurred after October 2004 when the four defendant directors left the board. This fails because it ignores the defendant directors' continued alleged interest in Hi-Tech and the mining companies. It also ignores the common sense inference that one can arrange, while one is on a board of directors, to have a self-interested deal consummated after one has resigned the corporate directorship.

(c) The property from VitroTech didn't, strictly speaking, end up in the hands of any of the four defendant directors. This argument fails because it ignores the allegations that the defendant directors were beneficially interested in the companies where the property did end up.


The judgment of dismissal is reversed. Appellant shall recover his costs on appeal.


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