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Kenneth Cleveland et al v. Robert v. Johnson et al

October 11, 2012

KENNETH CLEVELAND ET AL., PLAINTIFFS AND RESPONDENTS,
v.
ROBERT V. JOHNSON ET AL., DEFENDANTS AND APPELLANTS.



APPEAL from a judgment of the Superior Court for the County of Los Angeles. Michael B. Harwin, Judge. (Los Angeles County Super. Ct. No. LC 073219)

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

CERTIFIED FOR PUBLICATION

Affirmed.

SUMMARY

Kenneth Cleveland and William Bickley sued Robert V. Johnson and Internet Specialties West, Inc. (IS West). At trial before a jury, they asserted claims for breach of contract, breach of fiduciary duty, and false promise in connection with a $75,000 investment made pursuant to a February 1995 agreement. The jury found no false promise, but awarded more than $3.8 million for breach of contract, based on successor liability and ratification theories. The jury also found a breach of fiduciary duty and awarded punitive damages.

Defendants contend the findings of successor liability, ratification, and breach of fiduciary duty were not supported by substantial evidence; the damages awarded for breach of contract exceeded those allowed by the contract; and the punitive damages award must be reversed. They also assert instructional error in connection with the successor liability, ratification, and breach of fiduciary duty claims, and inconsistent special verdict findings.

We find no merit in any of these contentions and affirm the judgment.

FACTUAL AND PROCEDURAL BACKGROUND

From 1993 to October 1995, Kenneth Cleveland was the accountant for Interactive Strategies, Inc. (ISI), a telecommunications company in the pay-per-call industry that provided equipment and processed phone calls, primarily involving adult-content material. Bickley was a Cleveland friend of long standing whose financial affairs Cleveland handled.

Defendant Johnson was ISI's president and a director and shareholder. ISI's other officers and shareholders were Edward Hastings and Brian Spitler. Early in 1995, Johnson approached Cleveland, telling him that he had an interesting proposal Cleveland should hear. Johnson and his partners, Spitler and Hastings, "were thinking about starting a different company" to provide access to the internet. One of the reasons Johnson approached Cleveland was that anyone making such a risky investment would have to be familiar with Johnson, Spitler and Hastings and believe in their talent. The new business was to operate as an internet service provider offering dial-up Internet connections to its customers. After several meetings with Johnson and Spitler and after reviewing a cost analysis and revenue projections Spitler provided, showing start-up costs of $72,315, Cleveland and Bickley (collectively, Cleveland), agreed to invest $75,000 in the project. During the pre-investment meetings and calls, Johnson told Cleveland the new business "was going to be a separate division, and it was totally different than what they were doing on the other side of the telecommunications and in the adult information." Johnson told Cleveland the new internet project "was going to be separate from what their current business was," and "it was going to be a separate division only until it could get going enough to become its own company." The separate operation of the internet project from ISI's adult phone business was significant to Cleveland and Bickley for several reasons, including Cleveland's belief ISI was losing money, Cleveland's personal beliefs, and Bickley's career, which had emphasized wholesome family entertainment.

Cleveland drafted a memorandum to ISI summarizing the agreement between ISI and Bickley/Cleveland Communications, and discussed its terms by telephone with Jerry Smith, the attorney for ISI, who had no changes and said "it looked fine." Johnson reviewed the agreement and had no changes. The agreement was then signed by Brian Spitler for ISI and by Cleveland for Bickley/Cleveland Communications.*fn1

The terms of the agreement between ISI and Cleveland were these: Cleveland would provide $75,000 of capital "to be used by [ISI] to develop and implement a program to allow access to the InterNet information network." All expenditures of the capital provided were to be at ISI's sole discretion, so long as they were related to the internet project. Net cash receipts of the project were defined as gross receipts from the sale of internet software packages or internet access fees, "less all applicable expenses directly related to the InterNet project." Cleveland was to receive 100 percent of the net cash receipts from the internet project "until all capital invested by Bickley/Cleveland has been recouped. At that time Bickley/Cleveland Communications shall be paid 5% of gross receipts from the InterNet project."

During negotiations, Cleveland asked for a "say in management," but "Johnson and the others" were "adamant about not giving [Cleveland] a say in management or a place on the board" because "Johnson had the expertise and the equipment and what was needed to make it run," and Cleveland "had no problem with that." The quid pro quo was the gross receipts clause.

The agreement was signed and the $75,000 was provided to ISI on the same day, February 9, 1995. ISI recorded The Central Connection as a fictitious business name on February 17, 1995.

On February 14, 1995, Johnson, as president of ISI, entered into leasing agreements for the start-up equipment necessary to operate The Central Connection. Kristina Di Paola (then Kristina Nolan) was hired in February 1995 as a full-time employee to run The Central Connection. Johnson and Spitler told her that The Central Connection was established to be separate from ISI, "because they wanted to be a community internet service provider" and wanted no conflicts with ISI's adult entertainment business. Johnson "did the early setup of all the hardware" and taught Di Paola about the equipment racks, modem pool and the like. She considered Johnson her direct supervisor and reported to him. The Central Connection had its own office separate from and adjacent to the ISI offices, and its own phone number. Di Paola resigned in July 1995 and was replaced by Aaron Schultz.

At a lunch in August 1995, Hastings, who was the financial officer, told Cleveland that The Central Connection "was [limping] along and losing money" and "we weren't taking in clients as quickly as we thought . . . ." Hastings "thought it would still work because they were, they were still advertising, they were still bringing in customers, and he thought it still had a chance to go." Cleveland asked for some financial information, and on September 18, 1995, Hastings wrote a memo to Cleveland with an update on The Central Connection. Hastings enclosed a profit and loss statement for The Central Connection showing revenues of $4,500 per month against operational costs of $10,000 per month, and a summary report showing expenses of $43,000 ISI had paid for The Central Connection through August 1995 (exclusive of rent and utilities); Hastings observed that this would continue for several months and the overall expenses would exceed $75,000. Hastings's memo also stated that: "In regard to the repayment of your investment after much discussion and consideration repayment can only come from The Central Connection. We would propose that all monies above overhead for The Central Connection go to pay you back first. After you are paid back then Central Connection would pay back ISI for [its] investment."

This information and other inquiries Cleveland made in 1995 and 1996 satisfied him that his investment was not being misused. Cleveland spoke to Richard Marks, a lawyer for ISI, in October 1996, and understood from Marks that The Central Connection was still in operation. Cleveland knew it would "be a long time . . . before [The Central Connection] has enough revenue coming in to make up for all the losses and then have enough profit to trigger any kind of . . . repayment of the capital"; and that "if we make a profit they would let me know."

Then, in September 1998, Cleveland found out that financial officer Hastings had moved to Palm Springs in March or April of that year. Cleveland called Jerry Smith, ISI's lawyer, about Hastings's move, and asked Smith if Hastings was no longer with The Central Connection. Smith told Cleveland that he knew Hastings had moved, Spitler had left the area, and The Central Connection had failed. Smith (who was also Cleveland's lawyer) said he (Smith) was working with Johnson on a completely different project. A few months later, Cleveland encountered Johnson by chance, and Johnson, when asked, said that The Central Connection "didn't make it."

In May 2005, Cleveland was in the market for computer services for his company, and the consultant he had hired referred him to defendant IS West. In short order, Cleveland discovered that Johnson was the president of IS West. A brochure showed IS West's business was similar to that of The Central Connection - access to the internet, web page hosting "and pretty much everything that Central Connection was going to start doing." The brochure stated IS West was founded in 1996 and described it as the largest internet service provider (ISP) in the Conejo Valley.

Cleveland accessed and reviewed IS West's web page and the press releases included there. One of them, dated January 5, 1996, stated that IS West "will file to become a California Corporation. Established in 1995 as Central Connections, Internet Specialties West, Inc. will be a high speed ISP in Los Angeles and Ventura County." The press release showed IS West was located at the same business center location that had housed The Central Connection. Also on the web site was an article from a community newspaper in February 2004 about IS West. According to the article, "It all started in 1995 when Johnson . . . founded IS West as a dial-up ISP with 30 modems and one employee in a 200-square foot building." (The writer later testified that the information would have come from a source at IS West.) The "30 modems" corresponded to the number of modems The Central Connection had when it began operations. Cleveland then found that IS West had been incorporated on June 19, 1996, predating the time in October 1996 when Cleveland "was being told Central Connection was still going on."

Cleveland then sought legal advice, and other information came to light.

According to August 1996 corporate documents, Johnson, Hastings, and Spitler were founding shareholders, officers and directors of IS West, along with Edward Rubottom. Jerry Smith incorporated IS West. According to the organizational minutes, all of the founding shareholders contributed "$50,000 cash and equipment" (in Rubottom's case, $50,000 of services rendered), although Smith, who was IS West's corporate counsel from 1996 to 2007, testified he had seen no documents "that reflect that $50,000 was paid in."*fn2

By March 1997, when Gail Clancy joined IS West as its receptionist and bookkeeper, the company was operating as an ISP and had customers; her best estimate was "2-to 500 customers," whose records she was assigned to organize. She believed IS West had been in business "at least six months to a year" before she was hired.*fn3

In April 1997, ISI assigned equipment leases to IS West, including equipment leased for The Central Connection in February 1995.

In the fall of 1997, Michael Freedman, an ISI minority shareholder, filed a derivative suit against ISI that included a claim relating to IS West (alleging that the shareholders of ISI had usurped a corporate opportunity with regard to the formation of IS West and other entities). Before that lawsuit was filed, Jerry Smith wrote to Freedman's lawyer for settlement purposes in April 1997. Smith stated that IS West "is a new corporation which became operational as of April 8, 1997. Prior to that date, the internet operations were run as part of ISI dba The Central Connection, and the financial records are part of ISI's books."

In a declaration filed in the Freedman lawsuit in November 1997, Johnson stated: "IS West was initially a part of ISI called The Central Connection. The Central Connection developed and maintained web page sites, dial-up and high speed connection to the internet for its clients. When the business of Central Connection developed, it consisted entirely of non-adult, community and more conservative businesses such as governments, chambers of commerce and churches. There developed a tremendous concern on the part of myself and the other officers and directors of ISI that if the clients of Central Connection learned of the adult nature of ISI it would cause the loss of clients (the majority of ISI's clients are adult in nature). Therefore, the Directors agreed that it was necessary to form a separate corporation to handle the work of Central Connection, and IS West was formed. I made this decision based upon the approximately $124,000 investment that ISI had in The Central Connection. IS West was formed and has its own books, records, office space and employees. ISI carries a loan on its books in the amount of $123,783.32 to IS West and IS West carries the same amount as a debt owed to ISI."*fn4

Again in December 1997, Johnson signed a declaration stating that: "[IS West] was formed in order to preserve ISI's investment. As previously stated by me, ISI deals with adult oriented business and when Central Connection, a d.b.a. of ISI developed its clientele, the clients were churches, private individuals, civic organizations and local governments. Thus [IS West] was formed to handle the business of Central Connection. The situation was potentially disastrous for both ISI and Central Connection. The only way to continue the work was in a corporation with no connection to the adult. A debt was placed on the books on [IS West] and a loan receivable on the books of ISI to reflect this transfer."

ISI stopped doing business in December 1997 and, unknown to Cleveland, was placed in involuntary bankruptcy in January 1998, after a lawsuit (unrelated to this case) resulted in a judgment against it of almost $1.4 million. A March 1998 filing in the bankruptcy court listing ISI's creditors did not include Cleveland.

IS West eventually became a lucrative business. IS West press releases showed $540,000 in sales in 1998, $3.5 million in 2002, $5 million in 2003, and more than $6 million in revenue in 2004.

Cleveland filed this lawsuit in December 2005, six months after his discovery of the information about IS West. Cleveland alleged a design and scheme "to hijack the internet service provider business enterprise then known as Central Connection, for [defendants'] own use and profit without the burden of the obligations owed to [Cleveland]." Cleveland sought damages, both compensatory and punitive, an accounting, and an order requiring IS West to convey to Cleveland $75,000, 5 percent of IS West's gross receipts for the last 10 years (presumably from 1995 when the agreement was signed to 2005 when the suit was filed), and 5 percent of all future gross receipts of IS West.

The case was tried to a jury in February and March 2011 with IS West and Johnson as defendants. Cleveland's breach of contract cause of action rested on the theory that ISI and Johnson were promoters of The Central Connection who induced Cleveland to provide the seed money investment and entered into a pre-incorporation agreement with Cleveland, and that IS West was liable for breach of that agreement, both as the successor to ISI doing business as The Central Connection, and on a ratification theory. Cleveland asserted that IS West owed fiduciary duties to its investors, and that Johnson as a promoter had a fiduciary duty to investors to disclose all material facts and not to use his position to gain any advantage over the investors; these fiduciary duties were breached when defendants misrepresented The Central Connection's demise and concealed its metamorphosis into IS West to avoid IS West's obligations to Cleveland. Cleveland also claimed defendants induced Cleveland to invest in The Central Connection with promises they never intended to fulfill.

Defendants filed a motion to bifurcate the trial into two phases: trial by the court on equitable issues (principally successor liability) followed by a jury trial on any remaining issues. The trial court denied the motion, ruling that "both the equitable and factual issues are intertwined; that the witnesses would be virtually the same in many of these areas."

The jury rendered a special verdict, including findings that Johnson and ISI - defined as "Interactive Strategies, Inc. dba The Central Connection" - were the promoters who induced Cleveland to enter into the contract; that ISI was later incorporated into IS West; that IS West was the successor to ISI; that IS West ratified the pre-incorporation contract of ISI; that the money Cleveland paid to ISI in 1995 was an investment, not a loan; and that Cleveland's damages were $3,826,000. The jury found no false promise to Cleveland to induce him to enter into the contract.

On Cleveland's breach of fiduciary claim, the jury found Johnson and ISI owed Cleveland a fiduciary duty as promoters; that IS West owed Cleveland a fiduciary duty; that Johnson owed Cleveland a fiduciary duty as an officer and director of IS West; that both defendants knowingly acted against Cleveland's interests by failing to disclose material facts to Cleveland; that both defendants breached their fiduciary duties; that Cleveland was harmed and defendants' conduct was a cause of the harm; that Cleveland's damages under the claim for breach of fiduciary duty were zero; and that both defendants acted with malice, oppression or fraud, entitling Cleveland to punitive damages.*fn5

Because of the finding there were no damages on Cleveland's breach of fiduciary duty claim, a dispute arose on whether to proceed with the punitive damages phase of the trial. Over defense objections, the trial court submitted supplemental questions to the jury. The jury answered "yes" to questions asking if the award of zero damages was because (1) "[y]ou believed that the damages for Breach of Fiduciary Duty were duplicative of the damages you already awarded for Breach of Contract," and (2) "[y]ou did not know how to calculate Breach of Fiduciary Duty damages." The jury answered "no" to the question asking if the award of zero damages was because "[y]ou found that even though Plaintiffs were harmed . . . they had zero damages."

In the second phase of the trial, the jury awarded Cleveland punitive damages of $500,000 against Johnson and $500,000 against IS West.

Judgment was entered on the jury's verdict. The trial court denied defendants' motion for judgment notwithstanding the verdict or in the alternative for a new trial, and this appeal followed.

DISCUSSION

Defendants contend the verdicts are not supported by substantial evidence; the breach of contract damages exceed those allowed by the contract; and, because there was insufficient evidence of the breach of fiduciary duty claim, the punitive damages award must be reversed. Alternatively, defendants contend they are entitled to a new trial on grounds of instructional error (specifically, the instructions on successor liability, ratification, and breach of ...


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