Within a span of two weeks, in two separate cases by two different judges, the Delaware Court of Chancery opened the door wide open to a powerful remedy for minority shareholders of Delaware corporations – receivership – in an area where receivership is rarely used – solvent companies which are operating as going concerns. Perhaps even more significantly, one of the cases in which a receiver was appointed involved a publicly held company, albeit one that had ceased filing reports with the SEC. It is almost unheard of for a receiver to be appointed for a public company – particularly for a solvent company which is a going concern – and especially in the business friendly state of Delaware.
Though these cases may in some respects reflect their particular facts, together they should sound a clear warning to Delaware corporations, shareholders and their counsel that judges are more willing to consider ordering appointment of a receiver in cases involving extreme corporate misconduct, notwithstanding that the company is a solvent going concern or is publicly held.
Deutsche v. ZST Digital Networks, Inc. (Del.Ch. C.A. No. 8014-VCL, March 20, 2013)
ZST Digital Networks, Inc. had a background which has become a common story in recent years – a Chinese company with substantial assets and revenues, going public in the U.S. through a “reverse merger” – followed by a listing on a major U.S. exchange, in this case Nasdaq – followed by a reversal of fortune amidst allegations of securities and accounting fraud. As the story goes, the company’s auditors, a Chinese affiliate of BDO Seidman, resigned amidst concerns over ZST’s accounting practices. Shortly thereafter ZST Digital voluntarily delisted its stock from Nasdaq, citing its inability to meet Nasdaq listing standards – quickly followed by class action litigation alleging accounting improprieties – including maintaining two sets of books (one for the SEC and one for China). Three months later ZST ceased filing reports with the SEC by filing SEC Form 15, in what is commonly referred to as “going dark.” However, the company continued to conduct business through its Chinese subsidiary, and its stock continues to trade over the counter on the “pink sheets,” as do many non-SEC reporting companies.
The plaintiff, Peter Deutsche, a ZST shareholder claiming to own over 3 million shares of ZST, demanded access to ZST’s books and records pursuant to Section 220 of the Delaware General Corporation Law (“DGCL”). ZST, through its counsel Pillsbury Madison and Sutro, advised Mr. Deutsche that ZST’s books and records would only be made available in China. Not satisfied with this response, Deutsche filed an action in Delaware Court of Chancery seeking certain of ZST’s books and records under DGCL § 220. ZST did not appear in the action.
In December 2012 the court entered an order directing ZST to provide books and records to the plaintiff. When ZST ignored the court order, the plaintiff filed a motion for contempt of court, seeking both a right by the plaintiff to “put” his shares back to ZST at a price based upon the book value disclosed in the last filed SEC report, or $8.21 per share, or $30 million. Plaintiff also sought the appointment of a receiver under DGCL §322 for the purpose of enforcing the court’s orders. In March 2013, the court entered two orders: one granting plaintiff’s right to put his shares back to ZST for $30 million; the other appointing a receiver to enforce the order requiring the buyback of the shares – granting the receiver broad powers to take control of the assets of ZST.
The court in Deutsche grounded its decision on the express statutory authority of a Delaware court to appoint a receiver and impose other relief in order to enforce its orders under DGCL §322. However, the use of this receivership statute by a Delaware court is unprecedented in two respects: (1) it created a right to put shares back to a public Delaware corporation that refuses to respond to a statutory request to inspect its records; and (2) it appointed a receiver having broad powers for a publicly held company, and in a situation where the company was solvent and dissolution was not contemplated.
Experienced practitioners may view this case as one limited to its particular facts: a defendant that never bothered to appear in court, and then thumbing its nose at a court order, presumably under the impression that a U.S. court had no real power to force a China based company to make its records available in the U.S. However, when viewed together with the unrelated case, Zutrau v. Jansing, a potentially different picture emerges as to the broadening scope of receiverships for Delaware corporations.
Zutrau v. Jansing (Del.Ch. C.A. No. 7457-VCP, March 18, 2013)
Zutrau involved a minority shareholder in a private Delaware corporation who brought a shareholder derivative action alleging fraud, gross mismanagement and other corporate misconduct against an individual who was the President, sole director and majority shareholder. Part of the relief sought in the complaint was the appointment of a receiver over the business of the corporation. The defendant sought dismissal of the pleading on the grounds that appointment of a receiver was not a remedy authorized under Delaware law. Specifically, the defendant contended that there was no statutory basis for the appointment of a receiver, as the corporation was neither insolvent (DGCL §291) nor was there deadlock in the management by the directors or shareholders (DGCL §226). Therefore, a cause of action seeking appointment of a receiver of a solvent corporation which was not deadlocked must fail as a matter of law.
The court in Zutrau rejected the argument that a receiver may only be appointed where there is a statutory basis, such as insolvency or corporate deadlock. Instead, it ruled that a party can state a claim for appointment of a receiver upon a strong showing of fraud, gross mismanagement, affirmative misconduct by officers, or extreme circumstances showing imminent danger of great loss.
Corporations domiciled in Delaware, as well as their shareholders, should be aware of the willingness of the Delaware Court of Chancery to impose a receivership in cases where a shareholder demonstrates serious, ongoing corporate misconduct – even where the corporation is a solvent going concern or the corporation is publicly held.
About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies. For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.