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Urdan v. WR Capital Partners, LLC

Court of Chancery of Delaware

August 19, 2019

JONATHAN URDAN and WILLIAM WOODWARD, Plaintiffs,
v.
WR CAPITAL PARTNERS, LLC, a Delaware limited liability company, WR E3 HOLDINGS, LLC, a Delaware limited liability company, HENRI TALERMAN, FRANK E WALSH III, and BRADLEY D. KNYAL, Defendants, and ENERGY EFFICIENT EQUITY, INC., a Delaware corporation, Nominal Defendant.

          Date Submitted: May 24, 2019

          Elena C. Norman, Benjamin M. Potts, YOUNG CONAWAY STARGATT & TAYLOR, LLP, Wilmington, Delaware; Louis R. Miller, Daniel S. Miller, Jeffery B. White, MILLER BARONDESS, LLP, Los Angeles, California; Counsel for Plaintiffs.

          Kenneth J. Nachbar, Alexandra M. Cumings, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware; Counsel for Defendants.

          MEMORANDUM OPINION

          LASTER, V.C.

         A co-founder of a company and one of its early investors sued a private equity fund, its affiliates, and the two fund principals who served on the company's board of directors. The plaintiffs allege that after loaning the company funds and gaining representation on the board, the defendants used the rights they secured in the loan agreement to cut off the company's other financing options. Once the company was desperate for capital, the defendants extracted onerous terms that solidified the defendants' control. They then proceeded to dilute the plaintiffs through interested transactions.

         The defendants moved to dismiss the complaint. They point out that after filing suit, the plaintiffs sold their shares. They contend that the plaintiffs thereby lost the ability to assert derivative claims. The same principle would foreclose the plaintiffs' ability to assert direct claims. The only remaining claims are for fraud and unjust enrichment, and the defendants contend that the complaint fails to plead the elements of these claims.

         This decision agrees with the defendants. The motion to dismiss is granted.

         I. FACTUAL BACKGROUND

         The facts are drawn from the plaintiffs' complaint and the documents that are integral to the pleading. At this stage of the proceedings, the complaint's allegations are assumed to be true, and the plaintiffs receive the benefit of all reasonable inferences.

         A. The Company

         In 2014, plaintiff Jonathan Urdan and non-party Kevin Kurka co-founded Energy Efficient Equity, Inc. (the "Company"), which is a Delaware corporation operating in the property-assessed, clean-energy ("PACE") financing industry. In a PACE financing arrangement, a financial intermediary like the Company partners with a local municipality to loan homeowners money for energy-saving improvements, and the homeowners repay the loans through additional tax assessments added to their property tax bills. The municipality authorizes the financial intermediary to assess the value of the improvements and collect the property taxes. The municipality also authorizes the financial intermediary to issue bonds backed by the property tax assessments. The financial intermediary uses proceeds from the bond issuances to fund the loans to homeowners.

         The PACE financing industry is still young. California was the first state to approve PACE financing for home improvements in 2008, and although over thirty states have established PACE programs, almost all of the PACE volume is currently concentrated in California and Florida. In most states, PACE financing is also available for commercial properties, but this market largely remains untapped. As one of a limited number of firms operating in a high-potential industry, the Company had significant prospects for growth.

         B. The Company's Initial Governance And Capital Structure

         From the Company's founding until May 31, 2016, the members of the Company's board of directors (the "Board") were Urdan, Kurka, and plaintiff William Woodward, who was the Company's first outside investor. Urdan acted as president and CFO, and Kurka acted as CEO.

         From the Company's founding until May 31, 2016, Urdan, Kurka, and Woodward owned 100% of the Company's equity. The following table summarizes the Company's capitalization as of May 30, 2016, with separate accounts for each person summed together.

Stockholder

Common Stock

Series A Preferred

Convertible Debt

Fully Diluted

Kurka

1, 710, 000

0

0

1, 710, 000

Urdan

1, 710, 000

80, 000

170, 000

1, 960, 000

Woodward

400, 000

100, 000

170, 000

670, 000

TOTAL

3, 820, 000

180, 000

340, 000

4, 340, 000

         C. WR Capital And The 2016 Financing

         Defendant WR Capital Partners, LLC is a private equity fund based in Morristown, New Jersey. Defendants Henri Talerman and Frank E. Walsh III manage the fund, which invests in companies with valuations between $50 million and $500 million.

         In early 2016, Talerman and Walsh approached Urdan, Kurka, and Woodward about investing in the Company. They touted their background and expertise in small-cap investing and stressed that they approached investing as a partnership with management. Walsh assured Urdan that if WR Capital invested in the Company, they would be "working together as partners." Compl. ¶ 51. The WR Capital website likewise represented that "[a]ll private investments are made in cooperation with management and directors of the portfolio company." Compl. ¶ 49.

         With the assistance of counsel, the Company negotiated with WR Capital over the terms of a financing (the "2016 Financing"). On May 31, 2016, the 2016 Financing closed.

         The centerpiece of the 2016 Financing was a loan agreement between the Company and WR E3 Holdings, LLC ("WR Sub"), a wholly owned subsidiary of WR Capital (the "Loan Agreement"). The Loan Agreement provided the Company with a revolving credit line of $5 million, which the Company could draw on in increments of at least $100, 000. Drawn amounts would accrue interest at 10% per annum. As security for the loan, Urdan, Kurka, and Woodward granted WR Capital a first priority security interest in all of their holdings of Company stock, both common and preferred.

         Section 5 of the Loan Agreement, titled "Negative Covenants," identified fifteen categories of actions that the Company could not take without the prior written consent of WR Sub. The list included raising capital from outside investors and engaging in significant corporate transactions.

         Section 7.1 of the Loan Agreement, titled "Events of Default," identified twelve events that would entitle WR Sub to declare outstanding draws on the credit facility immediately due and payable. The list included either Urdan or Kurka being terminated for cause, using that term as defined in their respective employment agreements.

         As additional consideration for the Loan Agreement, the Company issued a warrant to WR Sub that authorized the purchase of up to 2, 307, 000 shares of Company common stock at $0.01 per share, exercisable in proportion to the level of draws on the credit facility. If fully exercised, the shares issued pursuant to the warrant would represent 31% of the Company's fully diluted equity. Section 1.2 of the Loan Agreement included an option for WR Sub to increase the size of the credit facility by up to $3 million, which WR Sub could exercise in its "sole discretion." If WR Sub elected to exercise this option, then the number of shares covered by the warrant would increase by 1% for each $1 million of additional credit. If WR Sub exercised the option in full, then it would receive the right to purchase an additional 379, 034 shares. That would bring the total number of shares available under the warrant to 2, 686, 034 shares, representing 34% of the Company's fully diluted equity.

         The plaintiffs allege that the term sheet for the 2016 Financing made clear that the 379, 034 shares that WR Sub would receive if it exercised its option to provide another $3 million of capital established an upper bound on the amount of equity that WR Capital and its affiliates would receive for that amount of incremental financing. The plaintiffs allege that they negotiated this point because they did not want WR Capital to be able to take advantage of the Company if it required more capital.

         As part of the 2016 Financing, the Company and WR Sub entered into a third agreement pursuant to which WR Sub paid $500, 000 to acquire 301, 979 shares of Series B Preferred Stock, reflecting a price of $1.65 per share. The Series B Preferred Stock was convertible into common stock.

         As part of the 2016 Financing, the Board was expanded to five seats, and WR Sub received the right to appoint two members of the Board. WR Sub appointed Talerman and Walsh.

         Also in May 2016, a wholly owned subsidiary of the Company borrowed $75 million from Oaktree Capital Management (respectively, the "Oaktree Loan" and "Oaktree"). The Oaktree Loan was secured by all of the assets of the Company, and Oaktree also received a pledge of all of the plaintiffs' stock and WR Sub's stock.

         The following table summarizes the Company's capitalization after the 2016 Financing, assuming the Company drew all of $5 million authorized by the Loan Agreement, with separate accounts for each person summed together.

Stockholder

Common Stock

Series A Pref.

Series B Pref.

Warrants

Convertible Debt

Fully Diluted

Kurka

1, 710, 000

0

0

0

0

1, 710, 000

Urdan

1, 710, 000

132, 199

0

0

170, 000

2, 012, 199

Woodward

400, 000

165, 249

0

0

170, 000

735, 249

WR Capital

0

0

301, 979

2, 307, 033

0

2, 609, 012

Oaktree

0

0

0

395, 311

0

395, 311

TOTAL

3, 820, 000

297, 448

301, 979

2, 702, 344

340, 000

7, 461, 771

         D. WR Capital Exercises Effective Control.

         In early 2017, WR Capital issued "New Governance and Operating Procedures" that specified how Kurka, the Company's CEO, was to conduct business. Compl. ¶ 71. WR Capital refused to approve any additional draws under the Loan Agreement until Kurka signed the document and agreed to abide by it. In an email dated March 25, 2017, Walsh confirmed to Urdan that WR Capital would not approve draws until Kurka signed, stating: "Consistent with our discussions last week we will not consider funding this [credit draw] until [Kurka] signs the 'rules of the road' letter [Talerman] sent yesterday." Id. WR Capital did not have the right to impose this condition before funding a draw.

         Effective April 23, 2017, WR Capital terminated Kurka's employment for cause. WR Capital took this action unilaterally, without any Board vote, and without having authority to do so.

         As a result of his termination, Kurka lost his seat on the Board. His departure left the Board with just four members: Urdan, Woodward, Talerman, and Walsh. Because they represented half of the Board, WR Capital's two representatives could block the Board from taking action.

         In May 2017, WR Capital hired defendant Bradley D. Knyal as CEO. The plaintiffs wanted to hire a new CEO with experience in technology or green energy financing and had lined up a qualified candidate. WR Capital rejected the plaintiffs' candidate and hired Knyal because he was Walsh's golfing buddy, even though he had no experience in technology or green energy financing. WR Capital then negotiated the terms of Knyal's employment without input from the Board and installed him as CEO without complying with the Company's bylaws. As part of Knyal's compensation package, WR Capital caused the Company to grant Knyal equity representing 12% of the fully diluted shares. The plaintiffs' candidate, by contrast, was prepared to accept only a 2% equity stake. The plaintiffs allege that WR Capital gave Knyal a much larger stake to ensure his loyalty to WR Capital. According to the complaint, when Urdan objected to Knyal, Walsh screamed at him, "Brad Knyal is going to be CEO of [the Company], period, full stop." Compl. ¶ 74.

         By June 2017, through these steps, WR Capital had established working control over the Company. Through the Loan Agreement, WR Capital controlled the Company's sole source of cash, and on at least one occasion, WR Capital had threatened to shut off access unless management did what WR Capital wanted. The negative covenants in the Loan Agreement enabled WR Capital to block the Company from accessing other sources of financing and gave WR Capital extensive veto rights over the Company's operations. With Kurka gone, WR Capital's representatives comprised one half of the Board, giving them the ability to block action at the board level. Through Knyal, WR Capital controlled the Company's day-to-day operations and management team.

         WR Capital did not yet possess hard mathematical control at the stockholder level, falling just short even with Knyal's shares added to what WR Capital owned. But with the multiple levers of power that WR Capital had at its disposal, WR Capital wielded effective control. Even in terms of representation on the Board, WR Capital's lack of an outright majority of the voting power mattered little, because its representatives served pursuant to contractual director-designation rights. Consequently, they could not be removed by the holders of a majority of the voting power.

         E. WR Capital Manufactures A Financing Crisis.

         During 2017, WR Capital used its governance rights to block the Company from pursuing strategic alternatives. In early 2017, a prominent PACE financing company expressed interest in acquiring the Company for at least $15 million. After the two firms entered into a non-disclosure agreement and engaged in preliminary talks, WR Capital asserted that it would exercise its right under the Loan Agreement to block any transaction. WR Capital also turned down requests by Oaktree and the plaintiffs to raise financing from third-party investors.

         By June 2017, the Company needed capital. Talerman played up the sense of urgency, telling the plaintiffs that the Company risked missing payroll and could have to file for bankruptcy. He told Urdan that the Company needed a new injection of capital to stay in business.

         Under the terms of the 2016 Financing, WR Capital had the option to provide another $3 million in credit under the Loan Agreement in return for warrants to purchase 379, 034 shares. Rather than exercising its option, WR Capital offered to provide the Company with an additional $3 million in revolving credit in return for warrants to purchase 8, 524, 478 shares (the "2017 Financing"). That amount of equity represented an increase of 2249% over the number of shares that WR Capital would have received for exercising its option under the 2016 Financing. WR Capital also insisted on the right to fill three of the Company's five seats on the Board as part of the 2017 Financing.

         In an email dated May 6, 2017, Walsh told the plaintiffs that the 2017 Financing was "by design expensive and not priced at 'arms length.'" Compl. ¶ 81. The financing valued the Company at approximately $4 million, even though a third-party acquirer had expressed interest just three months earlier in purchasing the Company for $15 million. Three months later, after solidifying its control, WR Capital would seek new financing at a proposed valuation of $30-$50 million, and one third-party investor would propose a valuation of $60 million.

         The plaintiffs attempted to negotiate with WR Capital, but Walsh and Talerman refused to budge. Instead, Talerman threatened that if the plaintiffs did not accept WR Capital's terms, then WR Sub would declare an event of default based on Kurka's termination, accelerate the amounts due under the Loan Agreement, and exercise its rights as a secured creditor, which included the right to levy on all of the equity owned by the plaintiffs and Kurka.

         With WR Capital having cut off all other financing alternatives, and facing the threat of the complete loss of their investment, the plaintiffs agreed to WR Capital's terms. The 2017 Financing closed in July 2017. The following table summarizes the Company's capitalization after the transaction, assuming the Company drew the full $8 million provided by WR Capital, with separate accounts belonging to each stockholder summed together. Unlike prior tables, this table includes shares in the employee pool. It lists options in the employee pool in the "Warrants" column.

Stockholder

Common Stock

Series A Pref.

Series B Pref.

Warrants

Convert. Debt

Fully Diluted

Knyal

2, 312, 000

0

0

0

0

2, 312, 000

Urdan

1, 710, 000

322, 046

0

0

170, 000

2, 202, 046

Woodward

400, 000

402, 557

0

0

170, 000

972, 557

WR Capital

0

0

301, 979

11, 831, 511

0

12, 133, 490

Oaktree

0

0

0

395, 311

0

395, 314

Employee Pool

800, 300

0

0

444, 444

0

1, 244, 744

TOTAL

5, 222, 300

724, 603

301, 979

12, 671, 266

340, 000

19, 260, 151

         F. WR Capital Consolidates Control And Pursues Self-Interested Transactions.

         After securing mathematical control at the stockholder level and board level through the 2017 Financing, WR Capital fired the Company's longstanding outside counsel and hired a new firm. Then, on January 31, 2018, they notified Urdan that he was terminated from his positions with the Company, effective May 31, 2018.

         In February 2018, WR Capital caused the Company to engage in an interested bridge financing (the "2018 Financing"). WR Capital sponsored the financing and gave Oaktree and Knyal the right to participate as co-sponsors. As consideration for providing the 2018 Financing, the sponsors received millions of additional shares. Through the 2018 Financing, the Company received an incremental credit facility of $2.5 million, with only $500, 000 provided at closing.

         Later in 2018, WR Capital and Knyal pursued an investment from a third party that would provide them with side benefits. WR Capital and Knyal also explored a sale of the Company that would provide them with side benefits. The complaint describes these events as the "Spring 2018 Capital Raise." The complaint does not allege that any transaction resulted from these efforts.

         G. This Litigation

         In May 2018, the plaintiffs filed this lawsuit. The complaint asserted eight counts:

• Count I contends that WR Capital, WR Sub, Talerman, and Walsh owed fiduciary duties to the Company and its minority stockholders, which they breached by extracting the 2017 Financing and the 2018 Financing, by engaging in the events leading up to those transactions, and by pursuing the Spring 2018 Capital Raise.
• Count II contends that Knyal owed fiduciary duties to the Company and its stockholders, which he breached by extracting personal benefits from the 2018 Financing and by pursuing the Spring 2018 Capital Raise.
• Count III contends that Knyal aided and abetted WR Capital's breach of its fiduciary duties to the Company and its stockholders by helping WR Capital extract the 2017 Financing and the 2018 Financing as well as by pursuing the Spring 2018 Capital Raise.
• Count IV contends that WR Capital, WR Sub, Talerman, and Walsh fraudulently induced the plaintiffs to cause the Company to enter into the 2016 Financing.
• Count V contends that WR Capital, WR Sub, Talerman, and Walsh engaged in fraudulent concealment when they induced the plaintiffs to cause the Company ...

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