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Deutsch v. Zst Digital Networks, Inc.

Court of Chancery of Delaware

June 14, 2018

PETER E. DEUTSCH, Plaintiff,
v.
ZST DIGITAL NETWORKS, INC., Defendant.

          Date Submitted: March 26, 2018

          Theodore A. Kittila, James G. McMillan, III, HALLORAN FARKAS KITTILA LLP, Wilmington, Delaware; David Graff, ROBINS KAPLAN LLP, New York, New York; Attorneys for Receiver Robert W. Seiden.

          David L. Finger, FINGER & SLANINA, LLC, Wilmington, Delaware; Attorney for Non-parties Bo Zhong and Lin Zhong.

          MEMORANDUM OPINION

          LASTER, V.C.

         ZST Digital Networks, Inc. (the "Company") is a Delaware corporation which, through three intermediate holding companies, owns an operating company that does business in China and is organized under Chinese law. The Company raised capital by accessing the public markets in the United States. It has since delisted.

         Peter Deutsch owns a significant block of stock in the Company. Deutsch sought books and records from the Company. The Company failed to appear, defaulted, and judgment was entered against it.

         Deutsch sought to enforce the default judgment. The Company failed to comply. Deutsch demonstrated that the Company was in contempt of this court's order.

         As a coercive sanction, I appointed a receiver with the authority to cause the Company to comply with the judgment. The receiver has spent five years and invested significant resources attempting to cause the Company to comply. The receiver has obtained additional orders from this court imposing further sanctions for contempt. The receiver also has secured the assistance of other courts in multiple domestic and international jurisdictions.

         After other coercive sanctions proved ineffective, the receiver moved for the issuance of bench warrants calling for the arrest of two senior officers of the Company. Both are Chinese nationals, but they frequently visit the United States. Because of arrangements that the United States government has made for the enforcement of arrest warrants, issuing the bench warrants should result in the senior officers being arrested when next they visit the United States.

         The senior officers previously ignored this action. Faced with the current motion, they hastily appeared and raised a slew of objections, which this decision rejects. This decision nevertheless holds that the facts of the case call for additional proceedings before issuing arrest warrants.

         The receiver shall submit a form of order that specifically directs the two officers to take or cause the Company to take the actions which the Company has failed to take to date. The order shall require compliance within sixty days. If the officers fail to comply with that order, then the receiver may seek the issuance of bench warrants as a coercive sanction for contempt.

         I. FACTUAL BACKGROUND

         The Company defaulted in this action, with the consequence that the court "accepts as true all the averments in the complaint, as a matter of law."[1] Other facts are drawn from prior rulings in this case, the receiver's periodic reports to the court, the Company's public filings, the current motion for contempt, and documents submitted in connection with the motion. Because the Company and its principals have steadfastly ignored this proceeding, the court has not yet conducted an evidentiary hearing with the benefit of adversarial presentations. The description of the factual background in this decision, therefore, does not represent formal factual findings. It rather represents how the record appears at this stage.

         A. The Holding Company Structure

         The Company is the ultimate parent entity in a holding company structure. Through its subsidiaries, the Company is "principally engaged in supplying digital and optical network equipment to cable systems operators in the Henan Province of China."[2] Bo Zhong is the Chairman of the Board and Chief Executive Officer of the Company. His son, Lin Zhong, is a director and Chief Financial Officer of the Company.[3]

         The Zhongs used the Company as a vehicle for accessing the U.S. capital markets. In October 2009, the Zhongs and the Company completed an underwritten, all-secondary offering and listed the Company's shares on the NASDAQ Global Market.[4] The offering raised approximately $29, 976, 960. After the offering, the Zhongs controlled 43.57% of the Company's shares.[5]

         The Company's principal asset is its ownership of 100% of the equity of World Orient Universal Limited, a corporation organized under the laws of the British Virgin Islands. World Orient in turn owns 100% of the equity of Global Asia Universal Limited, also organized under the laws of the British Virgin Islands. Global Asia owns 100% of the equity of EverFair Technologies, Ltd., a corporation organized under the laws of Hong Kong. For simplicity, this decision refers to World Orient and Global Asia as the "BVI Subsidiaries" and to EverFair as the "Hong Kong Subsidiary."

         At the base of the tower is Zhenzhou Shenyang Technology Company Limited, an entity organized under the laws of the People's Republic of China and controlled by the Hong Kong Subsidiary. Directly or through additional subsidiaries of its own, Zhenzhou Shenyang carries out the Company's business operations. For simplicity, this decision calls it the "Operating Company."

         B. The Company Goes Dark.

         After its IPO, the Company made a series of regular periodic reports and appeared to be financially healthy.[6] That changed on March 26, 2012, when the Company announced that its outside auditors had resigned. In their public resignation letter, the auditors stated that the Company had obstructed their efforts to verify its cash and account balances, preventing the auditors from satisfactorily completing their audit for fiscal year 2011 and forcing them to resign.[7] The auditors also stated that they could no longer certify the results of their audit of the Company's financial statements for fiscal year 2010.

         On April 6, 2012, the Company announced that it was voluntarily delisting its shares from the NASDAQ. The Company stated that its shares would continue to be available for over-the-counter trading.[8]

         On May 29, 2012, the Company announced the resignation of Li Zhi Tian, a director who served on the Audit Committee and the Compensation Committee and who chaired the Nominating Committee.[9]

         On August 13, 2012, the Company terminated its listing with the United States Securities and Exchange Commission.[10] Following the termination, the Company was no longer obligated to make periodic filings with the SEC.

         C. The Section 220 Action

         Deutsch is one of the Company's largest outside investors. He currently holds 3, 931, 370 shares of the Company's common stock.[11]

         On September 20, 2012, Deutsch sent the Company a demand for books and records pursuant to Section 220 of the Delaware General Corporation Law (the "DGCL").[12]Deutsch provided a list of information that he sought on an attached schedule.

         On October 16, 2012, the Company responded. Acting through its counsel, Pillsbury Winthrop Shaw Pittman LLP, the Company rejected the demand as technically deficient and demanded that Deutsch conduct any inspection in China.[13]

         On October 18, 2012, Deutsch provided a revised demand that addressed the technical objections. He requested that any inspection occur in New York or Delaware.[14]On November 2, 2012, Pillsbury Winthrop relayed a letter from the Company reiterating that any inspection must take place in China.[15]

         On November 7, 2012, Deutsch filed this action and moved for an expedited schedule. A telephonic scheduling hearing was set for November 16. Pillsbury Winthrop declined to appear, conveniently asserting that although the firm had represented the Company in responding to the Section 220 demand, the firm had not been retained to represent the Company to handle the ensuing Section 220 proceeding.[16] A lawyer with the Delaware law firm of Bayard, P.A. joined the conference but stressed on several occasions that he had not yet been retained by the Company.[17]

         I established an expedited schedule consistent with the summary nature of the proceeding. To facilitate a prompt disposition of the action, I ordered the Company to answer the complaint by November 21, 2012.[18] The Company did not file an answer by this deadline.

         On November 26, 2012, Deutsch moved for entry of default judgment.[19] When the Company did not make any effort to appear or respond to the motion, I held that the Company had defaulted and entered default judgment.[20]

         The default judgment granted Deutsch the right to inspect the books and records he sought. It also awarded Deutsch his attorneys' fees and costs.

         D. The Appointment Of The Receiver

         The Company made no effort to comply with the default judgment. On January 25, 2013, Deutsch moved to hold the Company in contempt.[21] By order dated January 31, I required the Company to show cause why it should not be held in contempt and set March 18 as the deadline for the Company to file a response.[22] The Company did not file a response. Accordingly, by order dated March 20, I held that the Company had violated the default judgment and was in contempt.[23]

         The order finding the Company in contempt awarded Deutsch the relief he had requested in his motion. That relief included (i) the attorneys' fees and costs incurred prosecuting the contempt claim, (ii) an option to put his shares to the Company at a price of $8.21 (the "Put Right"), and (iii) the appointment of a receiver pursuant to Section 322 of the DGCL "for the purpose of enforcing the Company's compliance with the Court's orders."[24]

         On March 25, 2013, Deutsch exercised the Put Right.[25] He also submitted a form of order to appoint Robert W. Seiden as the receiver. I entered the order on March 28.[26] The order empowered the receiver to "take all actions he deems appropriate to obtain [the Company's] compliance with" the default judgment, the orders entered to date, and "such other and further orders as the Court may enter in this action."[27]

         The order granted the receiver broad powers for purposes of compelling compliance. Paragraph 3 of the order stated:

The Receiver shall have all powers generally available to a receiver appointed pursuant to 8 Del. C. § 291, unless any such power would be inconsistent with a specific provision of this Order, in which case this Order shall govern. Upon the acceptance of this appointment, the Receiver shall have full authority and control over the property and/or assets of the Company, of whatever kind and wherever located, in the United States of America, the People's Republic of China or elsewhere. This includes, without limitation, authority to seize, deal in or dispose of any property of the Company. The Receiver shall have full and unrestricted access to all books and records of the Company, in whatever mode maintained and wherever located, in the United States of America, the People's Republic of China or elsewhere. The Receiver may assert sole control over any present bank or other accounts of the Company and/or establish signature authority over such accounts as the Receiver deems appropriate. The Receiver shall have the power to commence, continue, join in, and/or control any action, suit or proceeding, of any kind or nature, in the name of the Company or otherwise, including without limitation proceedings to prevent or avoid transactions of any kind or nature that may hinder the Company's compliance with this Court's orders. The Receiver is authorized, in his sole discretion, to enlist the help of the employees or agents of the Company. The directors, officers, employees, and agents of the Company shall cooperate with the Receiver in the performance of his duties. The Receiver is authorized, in his sole discretion, to enlist the help of agents, employees or representatives of the governments of the United States of America, the People's Republic of China, or any other nation, or of any regional or local governments therein, or of any other regulatory body. The Receiver shall have the authority, but shall not be required, to petition this Court for instructions at any time or from time to time.[28]

         Paragraph 6 authorized the receiver "to act through and in the name of the Company to carry out his duties."[29] The same paragraph authorized the receiver "to execute and deliver (or cause to be executed and delivered) any document in the name of the Company, including but not limited to contracts, deeds, other documents of title, and regulatory, administrative and governmental filings."[30]

         The order also instructed the Company's officers and directors to cooperate with the receiver's efforts. Paragraph 8 stated:

The appointment of the Receiver hereunder is binding upon the directors, officers, employees, agents and stockholders of the Company, who shall cooperate with the Receiver in the performance of his duties. Neither the Company, nor [any] person acting or purporting to act on behalf of the Company, nor any director, officer, employee, agent, stockholder or creditor of the Company shall institute any proceeding in any forum other than this Court challenging any action, recommendation or decision by the Receiver.[31]

         Under this paragraph, the Zhongs are obligated to cooperate with the receiver.

         E. The Receiver Takes Control Of The BVI And Hong Kong Subsidiaries

         Using his authority, the receiver petitioned the United States District Court for the Southern District of New York for the issuance of orders authorizing the receiver to seize books and records held by the Company's former CFO, its investor relations firm, and its accountants. On April 16, 2013, the federal court issued the orders, and the receiver obtained the documents.[32]

         The receiver next began the difficult process of exercising control over the BVI Subsidiaries, the Hong Kong Subsidiary, and the Operating Company. The boards of directors of the BVI Subsidiaries resisted, necessitating efforts to replace those individuals with directors who would cooperate with the receiver. To facilitate these efforts, the receiver sought an order confirming his authority to vote the shares of the Company's direct and indirect subsidiaries, including to effectuate changes to their respective boards of directors. By order dated April 19, 2013, I confirmed that the receiver had this authority.[33]

         Exercising his authority, the receiver replaced the directors of the BVI Subsidiaries and sought an order from a British Virgin Islands court confirming the validity of his actions.[34] On May 31, 2013, Bo filed a lawsuit in the same court contesting the receiver's actions.[35] The British Virgin Islands court rejected Bo's efforts, and on July 25, the Eastern Caribbean Supreme Court dismissed his challenge.[36]

         The receiver next caused the second-tier BVI Subsidiary to exercise its voting power as the sole stockholder of the Hong Kong Subsidiary to remove Xue Na, the sole director of the Hong Kong Subsidiary, and appoint new directors. Na refused to recognize the legitimacy of these actions. To confirm their validity, the receiver caused the Hong Kong Subsidiary to convene an extraordinary general meeting at which Na was removed and new directors appointed.[37]

         F. Na's Attempt At Intervention

         On August 14, 2013, Na moved to intervene in this action in her individual capacity as a stockholder of the Company. She sought to modify the orders holding the Company in contempt and appointing the receiver. She argued that she had standing as a stockholder to take these steps because the receiver's actions were harming her.[38] Duane Morris LLP represented Na. At the time, Duane Morris was serving as counsel to the Company in several pending matters in other jurisdictions.

         Deutsch and the receiver opposed Na's motion. They portrayed the motion as a thinly veiled attempt by the Zhongs to defend the action by proxy after permitting the Company to default. They argued that the motion should be denied and conditions imposed on the appearance of any stockholder who sought to represent the Company.[39]

         A hearing on Na's motion was held on August 23, 2013. I ruled that the Company, not Na, was the proper party to seek the relief that Na requested and that Na had no standing to intervene in her capacity as a stockholder. I granted the Company two weeks in which to appear if it wished to seek the relief that Na had requested. I also held that the Company should have to satisfy conditions before being able to set aside the default judgment and litigate the case on the merits, such as paying the expenses that Deutsch and the receiver had incurred. Rather than imposing conditions unilaterally, I instructed the parties to confer on appropriate conditions under which the default judgment would be set aside.[40]

         On September 6, 2013, Duane Morris entered an appearance on behalf of the Company, [41] but the parties were unable to agree on an appropriate set of conditions.[42] On September 23, I held a status conference.[43] Afterwards, the parties engaged in extensive efforts to reach an amicable resolution that included teleconferences and in-person meetings, [44] but they could not reach agreement.[45]

         On November 12, 2013, I entered an Order Establishing Conditions for Defendant's Post-Default Judgment Participation in this Action (the "Conditions Order").[46] It provided that before the Company or any of its affiliates, including Na, Bo, or the Company's other directors or officers, could appear and participate in this action, the Company would have to:

• "[P]rovide [Deutsch] and [the] Receiver with (i) unaudited financial statements (i.e., balance sheets and income statements) for the quarter ended September 30, 2013 and (ii) audited financial statements for the year ended December 31, 2012. On a continuing basis, [the Company] shall provide (i) unaudited quarterly and annual financial statements within ten calendar days following the end of each such reporting period and (ii) audited annual financial statements within a reasonable period of time following the end of each reporting year."[47]
• "[P]ay to the Receiver the sum of $2, 020, 000, which sum approximates the amount of fees and expenses incurred by the Receiver through October 20, 2013, plus interest from that date until the date of payment, calculated at the legal rate compounded quarterly. In the alternative, [the Company] shall post with the Register in Chancery a bond with surety in the amount of $3 million, in a form satisfactory to the Court, and [the Company] shall make interim payments to the Receiver of $200, 000 per month until such time as all fees and expenses then due and outstanding are paid in full. If [the Company] has posted a bond, then periodically but not more frequently, [the Company] may apply to reduce the amount of the bond by the amount paid."[48]
• "For the purpose of providing security for [the Company's] outstanding debt to [Deutsch] pursuant to the [Put Right] . . . post with the Court a bond with surety, in a form satisfactory to the Court, in the amount of $5 million."[49]

         The Conditions Order gave the Company until November 29, 2013 to enter an appearance in compliance with its terms. After that, the Company would be deemed to "again have waived voluntarily its right to appear and participate in this action . . . [and] be deemed a non-party for purposes of service and access to documents filed with the Court."[50] The Company did not enter an appearance.

         G. Efforts To Sell The Operating Company

         After the parties' negotiations failed and the Company did not appear, the receiver decided to try to sell the Hong Kong Subsidiary. In December 2013, he engaged Aegis Capital Corporation to act as financial advisor in connection with the sale.[51]

         On December 17, 2013, the receiver moved for the entry of an order establishing procedures to govern the sale process.[52] No one opposed the motion. I held a hearing at which no one appeared to object. By order dated January 16, 2014, I approved the proposed sale process.[53]

         The receiver carried out a sale process in accordance with the order. His advisors sent teasers to over forty potential bidders.[54] Five potential bidders expressed interest, entered into nondisclosure agreements, and conducted diligence.[55] One bidder submitted a letter of intent offering to acquire the Hong Kong Subsidiary for $15 million, subject to due diligence and other conditions.[56] One condition required negotiations with Bo, Lin, and other members of the Operating Company's management team.[57]

         In violation of the Cooperation Paragraph in the order appointing the receiver, Bo, Lin, and the management team did not cooperate with the receiver's efforts. They refused to grant any physical access to the Operating Company's facility or to provide the bidder with additional financial information.[58] In the face of this resistance, the potential buyer withdrew.

         Undeterred, the receiver engaged Business Development Asia (HK) Ltd., a financial advisor that specializes in cross-border transactions involving Asian assets. With the assistance of the new firm, the receiver conducted a new sale process.[59] This time, approximately a dozen parties expressed interest.[60] They too wanted current financial information and cooperation from management.[61] Again in violation of the Cooperation Paragraph, Bo, Lin, and the management team again did not cooperate with the receiver's efforts.

         In October 2014, the receiver and Bo met to discuss settlement. Although they did not reach agreement, the receiver agreed to pause any enforcement efforts pending another meeting in February 2015.[62] That meeting failed to produce an agreement.[63]

         H. Transfers Of Company Assets

         On June 23, 2015, the Hong Kong Subsidiary passed a resolution (i) removing Bo as a director and the legal representative of the Operating Company and replacing him with the receiver's nominee and (ii) ordering Bo to surrender the Operating Company's registration documents and "chops."[64] Bo responded by transferring real estate and other assets worth approximately $3 million from the Company to Wilke Technology Co. Ltd., a company controlled by Lin.[65]

         The receiver sued Bo in China over the transfers.[66] On October 27, 2015, the Chinese court dismissed the lawsuit for failing to comply with certain technical requirements.[67] The dismissal was affirmed in February 2016.[68]

         In July 2016, the receiver and Bo held a face-to-face meeting in China. After a full day of negotiations, the parties reached an agreement in principle on the terms for settlement. But once the receiver returned to the United States, Bo reneged.[69]

         After the failed negotiations in the summer of 2016, the receiver spent over a year attempting to apply pressure on Bo through diplomatic channels.[70] Those efforts also failed.

         I. The Contempt Motion

         On January 11, 2018, the receiver moved for a Rule to Show Cause why Bo and Lin should not be held in contempt for failing to cooperate with the receiver. By order dated January 19, I entered an order to show cause. It stated:

1. A hearing (the "Hearing") shall be held on March 26, 2018 at 2:00 p.m. (Eastern) before Vice Chancellor J. Travis Laster, Court of Chancery of the State of Delaware, 500 North King Street, Wilmington, Delaware 19801, at which time Mr. Bo Zhong and Mr. Lin Zhong shall appear and show cause as to why they should not be held in civil and criminal contempt for this Court's orders pursuant to Court of Chancery Rule 70(b) and Rule 71, and at which time the Court may consider such other and further relief as the Court deems appropriate and enter an order of civil and criminal contempt;
2. Mr. Bo Zhong and Mr. Lin Zhong shall submit any papers in response to the Receiver's motion for an order of civil and criminal contempt not less ...

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