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Silverberg v. Padda

Court of Chancery of Delaware

September 19, 2019

JEFFRIE J. SILVERBERG, ANSHELL, INC., C. CHRISTY BARTON, SHERILL BARTON, BRADLEY CREGER, SHELDON DROBNY, DWAIN FORD, PETER KROLL, KEN MASHBURN, JACQUELINE MASHBURN, SERGIO NESTI, DAVID RIVERS, MARK SPERBER and MARK VICTOR, Plaintiffs,
v.
SHAN PADDA f/k/a KULDARSHAN PADDA, SAM TONEY, M.D., JOSEPH CARTER McNABB, DAVID J. LIPTAK, MARK DeSALVO, NORA McGUIRE, KEVIN J. KOBIELSKI, STEVEN F. LUX, CHARLENE FRIZZERA, BRADLEY M. FLUEGEL, JOHN TRBOVICH, JENNIFER DUNHAM, RIVER CITIES CAPITAL FUND II, LP, RIVER CITIES SBIC III, LP, WEST BROADWAY INTERACTIVE PARTNERS, LLC, SPRING STREET PARTNERS, L.P., MIDWEST ECONOMIC OPPORTUNITY FUND II, LP, HEALTHNOW HOLDINGS, INC., STONEHENGE GROWTH CAPITAL, LLC, STONEHENGE GROWTH EQUITY PARTNERS, LLC, BOCF, LLC, ARSENAL VENTURE PARTNERS, II, L.P., ARSENAL VENTURE PARTNERS IIA, L.P., ARSENAL VENTURE PARTNERS II - FLORIDA, L.P., FLORIDA OPPORTUNITY FUND, INC., TRIDENT HEALTH INTEGRATED, INC., STONE POINT CAPITAL, LLC, and HEALTH INTEGRATED, INC., Defendants.

          Submitted: June 27, 2019

          Robert Karl Hill, SEITZ, VAN OGTROP & GREEN, P.A., Wilmington, Delaware; Eric W. Berry, BERRY LAW PLLC, New York, New York; Counsel for Plaintiffs Jeffrie J. Silverberg, Anshell, Inc., Sherrill Barton, Bradley Creger, Sheldon Drobny, Dwain Ford, Peter Kroll, Ken Mashburn, Jacqueline Mashburn, Sergio Nesti, David Rivers, Mark Sperber, and Mark Victor.

          Marc S. Casarino, Nicholas R. Wynn, Christopher S. Marques, WHITE AND WILLIAMS LLP, Wilmington, Delaware; Counsel for Defendants Shan Padda, Sam Toney, Joseph Carter McNabb, David J. Liptak, Mark DiSalvo, Nora McGuire, Kevin J. Kobielski, Steven F. Lux, Charlene Frizerra, Bradley M. Fluegel, John Trbovich, Jennifer Dunham, and Health Integrated, Inc.

          Thad Bracegirdle, Scott B. Czerwonka, WILKS, LUKOFF & BRACEGIRDLE, LLC, Wilmington, Delaware; Robert P. Johnson, Emily G. Monton, Emily M. Gallagher, THOMPSON HINE LLP, Cincinnati, Ohio; Counsel for Defendants River Cities Capital Fund II, LLP, River Cities SBIC, III, LP, Midwest Economic Opportunity Fund II, LP, Stonehenge Growth Capital, LLC, Stonehenge Growth Equity Partners, LLC and BOCF, LLC.

          Samuel A. Nolen, RICHARDS, LAYTON & FINGER, P.A., Wilmington, Delaware; John A. Tucker, FOLEY & LARDNER, LLP, Jacksonville, Florida; Counsel for Defendants Arsenal Venture Partners II, L.P., Arsenal Venture Partners IIA, L.P., Arsenal Venture Partners II – Florida, L.P., and Florida Opportunity Fund, Inc.

          Gregory W. Hauswirth, LEECH TISHMAN FUSCALDO & LAMPL, LLC, Wilmington, Delaware; David A. Weicht, Lisa A. Mantella, LEECH TISHMAN FUSCALDO & LAMPL, LLC, Pittsburgh, Pennsylvania; Counsel for Defendants West Broadway Interactive Partners, LLC, Spring Street Partners, L.P.

          Edward B. Micheletti, Lauren N. Rosenello, Bonnie W. David, Andrew D. Kinsey, SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP, Wilmington, Delaware; Counsel for Defendants Stone Point Capital, LLC and Trident HI, Inc.

          David J. Teklits, Thomas P. Will, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware; Alan J. Bozer, PHILLIPS LYTLE LLP, Buffalo, New York; Counsel for Defendants HealthNow Holdings, Inc.

          MEMORANDUM OPINION

          McCORMICK, V.C.

         In 2017, substantially all of the assets of Health Integrated, Inc. were acquired by a third-party. Health Integrated's preferred stockholders received the entirety of the consideration from this transaction in accordance with the liquidation preferences set forth in the company's Certificate of Incorporation. The common stockholders, including the plaintiffs, received nothing. The plaintiffs were among the company's earliest investors. They acquired Health Integrated common stock before the first issuance of preferred stock and were unaware that the company had issued any preferred stock with liquidity preferences. They were surprised to receive no consideration from the asset sale and commenced this litigation. In their complaint, the plaintiffs accuse the Health Integrated board members who approved each financing transaction of doing so in breach of their fiduciary duties. They further claim that the counterparties to the financing transactions aided and abetted these breaches.

         The complaint is ambitious, asserting twenty-two claims against twenty-eight parties. The defendants responded with equal ambition, moving to dismiss the complaint in its entirety. The defendants collectively filed fourteen different briefs making eighteen different arguments for dismissing the claims against them. In the end, three of their arguments do most of the work. This decision holds that: Certain of the counts plead derivative claims and that the complaint fails to meet the standard for pleading demand futility under Court of Chancery Rule 23.1. Certain of the claims are untimely and barred by the doctrine of laches. And certain of the counts otherwise fail to state a claim.

         All that potentially survives the defendants' motions are a handful of claims challenging two preferred stock issuances and related amendments to the Certificate of Incorporation in January 2016 and June 2016, plus a claim seeking an annual stockholder meeting pursuant to Section 211 of the Delaware General Corporation Law. This decision requests targeted supplemental briefing concerning those issues.

         I. FACTUAL BACKGROUND

         The facts are drawn from the Second Amended Complaint, [1] documents it incorporates by reference, and judicially noticeable facts.

         A. Formation and Initial Capitalization of Health Integrated

         Health Integrated, Inc. ("Health Integrated" or the "Company") was incorporated in Delaware in 2003 by Shan Padda and Sam Toney, who held Health Integrated common stock and originally comprised the Company's board of directors.

         The plaintiffs own Health Integrated common stock. Most of them, Anshell, Inc., Christy Barton, Sherill Barton, Bradley Creger, Sheldon Drobny, Dwain Ford, Peter Kroll, Ken Mashburn, Jacqueline Mashburn, Sergio Nesti, David Rivers, Mark Sperber, and Mark Victor, invested in a company named CMS HealthCare Acquisition, LLC between 2000 and 2002, and their CMS shares were exchanged for shares in Health Integrated thereafter. One plaintiff, Jeffrie J. Silverberg, invested directly in Health Integrated in January 2004 and March 2004.

         Health Integrated has not noticed or conducted a stockholder meeting since at least 2004.

         B. The Financing Transactions

         At various times, Health Integrated relied on financing from private investors. It did so using a combination of preferred stock and convertible debt. In their complaint, Plaintiffs challenge each financing round described below.

         1. Financing Transactions Before April 2014

         In March 2003, Health Integrated's Certificate of Incorporation was amended to authorize Series A and Series B preferred stock. Around that time, the Company sold Series A preferred stock to Defendant West Broadway Interactive Partners, LLC ("West Broadway") and the predecessor of Defendant Midwest Economic Opportunity Fund II, LP ("Midwest"). In April 2003, the Company sold additional Series A preferred stock to Defendant River Cities Capital Fund II, LP or River Cities SBIC III, LP (collectively "River Cities"). West Broadway, Midwest, and River Cities purchased additional Series A preferred stock in late 2003 and in the first quarter of 2004.

         In 2005, Health Integrated's Certificate of Incorporation was further amended to modify the rights and preferences in connection with an offering of Series B preferred stock. The Company sold Series B preferred stock to West Broadway, River Cities, Midwest, West Broadway, and HealthNow New York, Inc. ("HealthNow")-a predecessor of Defendant HealthNow Holdings, Inc.

         In November 2006, April 2007, and December 2007, Health Integrated issued debt instruments convertible into Series B preferred stock. River Cities, West Broadway, and Midwest acquired the convertible notes.

         In January 2009, Health Integrated issued additional notes convertible into Series B preferred stock as well as warrants to River Cities and Defendants Stonehenge Growth Capital, LLC, Stonehenge Growth Equity Partners, LLC, and BOCF, LLC (collectively, "Stonehenge").

         In January 2011, Health Integrated amended the 2009 notes issued to River Cities and Stonehenge. In 2012, Health Integrated issued a note to Midwest that was convertible into Series B preferred stock. In April 2013, Health Integrated amended that note. As to both of these note amendments, the Second Amended Complaint only generically alleges that the amendments provided "additional preferences and rights."[2]

         2. Financing Transactions After April 2014

         In March 2015, Health Integrated issued more notes convertible to Series B preferred stock as well as warrants that allowed the noteholders to purchase a specified allotment of common stock. River Cities, Midwest, and Stonehenge were among the participants in this note offering. Defendant Trident Health Integrated, Inc. ("Trident") also participated in this offering.

         On January 13, 2016, Health Integrated offered convertible debentures (the "January 2016 Notes Offering"). The debentures were convertible into Series B preferred stock, and the participants also received warrants that granted them the rights to purchase common stock. Trident, Midwest, River Cities, and Stonehenge participated in this offering. Defendants Arsenal Venture Partners II, L.P., Arsenal Venture Partners IIA, L.P., Arsenal Venture Partners II-Florida, L.P. (collectively, "Arsenal") and Defendant Florida Opportunity Fund, Inc. ("Florida Opportunity") were new participants in this offering. This offering, in conjunction with the March 2015 round of financing, afforded Trident, Arsenal, and Florida Opportunity certain financial protections.

         In June 2016, Health Integrated approved a new offering of notes convertible to a new stock issuance classified as Series C preferred stock (the "June 2016 New Notes Offering"). The Series C preferred stock had liquidation rights superior to all other classes of stock. Holders of notes convertible to Series B preferred stock-River Cities, Stonehenge, and Midwest-exchanged those notes for new notes convertible to Series C preferred stock without contributing any additional capital. HealthNow was awarded warrants redeemable for up to $1 million of Series C preferred stock in exchange for continuing or extending its business relationship with the Company. All other holders were subordinated to the holders of Series C preferred stock in the event of a liquidation of the Company. In addition, the June 2016 New Notes Offering modified an existing management equity carve-out to (i) equal five percent of the adjusted enterprise value of the Company and (ii) guarantee distributions to management after Series C preferred stockholders but before any Series B or B-1 preferred stockholders.

         Under the terms of the June 2016 New Notes Offering, the Company and its existing shareholders also agreed to a "drag-along" provision where all stockholders would follow any vote approved by Arsenal, Florida Opportunity and Trident.[3]

         C. The Asset Sale

         On December 26, 2017, substantially all of the assets of Health Integrated were acquired by an affiliate of Exlservice Holdings, Inc. for $22 million. This consideration satisfied the bulk of the Series C preferred stock's liquidation preferences. The common stockholders received no consideration.

         D. Padda's Allegedly False Statements

         The Second Amended Complaint refers to a 2001 SEC action against Padda concerning his role with a business unrelated to Health Integrated. Padda consented to an entry of final judgment in that case, which required him to pay a civil penalty and permanently enjoined him from engaging in a number of unlawful acts. SEC rules require that a public company disclose these types of injunctions against a director or executive officer. The SEC injunction does not expressly prohibit Padda from having any association with a public company, but Plaintiffs allege that it frustrated Health Integrated's ability to engage in an initial public offering because of the risk associated with Padda's role as Health Integrated's CEO. Because Health Integrated remained a private company, Plaintiffs were unaware of the injunction against Padda.

         Plaintiffs additionally allege that in December 2003 and February 2004, Padda verbally indicated an intention "to cause Health Integrated to engage in a public offering or sale of the company within the near future, and that a public offering or sale of the company would enable Silverberg to liquidate any investment he made in Health Integrated and that he would be one of [a] small group of approximately 20 initial investors."[4] Plaintiffs further allege that Silverberg relied upon these statements when determining to invest in the Company.

         In a May 24, 2004 letter "received by some but not all of the holders of common stock, " Padda described Health Integrated as a "profitable" enterprise.[5]The May 2004 letter informed its recipients of the Series A preferred stock transaction. The Second Amended Complaint does specify who among the Plaintiffs received the letter and does not allege with particularity that any Plaintiff relied upon the contents of the letter to his or her detriment.

         In a January 24, 2005 letter Plaintiffs describe as written to "shareholders, " Padda stated: "We continue to tweak the organization's personnel and processes while we still have the luxury of doing it as a private company."[6] Plaintiffs allege that the January 2005 letter's reference to being a private company "suggested that Health Integrated might soon undertake a public offering."[7] The Second Amended Complaint does not specify who among the Plaintiffs received the letter and does not allege with particularity that any Plaintiff relied upon the contents of the letter to his or her detriment.

         In a January 12, 2006 letter to "shareholders, " Padda advised, among other things, that (i) several board members were "representatives of the financial institutions that have invested significant amounts of capital in [Health Integrated]" and (ii) the Company's investment advisors had recommended more enterprise value was necessary, "including possibly taking in further investment, " before a liquidation event could be realized.[8] The January 2006 letter identified that Blue Cross Blue Shield of New York had made a significant investment in the Company. The Second Amended Complaint does not specify who among the Plaintiffs received the letter and does not allege with particularity that any Plaintiff relied upon the contents of the letter to his or her detriment.

         In a July 30, 2009 letter to "holders of the common stock, " Padda referenced the Company's ongoing discussions with strategic investors about a potential liquidity event.[9] The July 2009 letter indicated "[w]e hope to have some definitive information to share with you about this in the near future."[10] The Second Amended Complaint does not specify who among the Plaintiffs received the letter and does not allege with particularity that any Plaintiff relied upon the contents of the letter to his or her detriment.

         In a March 12, 2010 email, Padda informed Plaintiff Drobny that the Company had retained an investment banking firm for the purpose of making introductions to new investors interested in buying out the original shareholders.[11] The Second Amended Complaint speculates that Padda did so with the intention of having Drobny pass along the information to other Health Integrated stockholders.

         In a May 28, 2013 email, Padda expressed to Plaintiff Ford on May 28, 2013: "You had reached out to me a little while ago asking if things continue to break our way. Looks like all of the hard work for so many years is paying off soon. Hang in there."[12] The Second Amended Complaint argues that Padda's email should be interpreted to mean "a liquidity event was in the offering" and that Padda intended for Ford to disseminate such information to other Health Integrated shareholders.[13]

         In an April 14, 2014 letter, Padda wrote to certain unidentified shareholders to disclose that institutional investors had invested in Health Integrated in excess of $20 million. Padda also summarized the distributional preferences of the preferred stock.

         In an October 8, 2015 letter, Padda generally described the Company's growth and its retention of investment banker William Blair and auditor Ernst & Young to guide a potential liquidity event. The October 2015 letter explained William Blair's advice regarding delaying exploration of the liquidity event until at least the following year. The Second Amended Complaint does not specify who among the Plaintiffs received the letter and does not allege with particularity that any Plaintiff relied upon the contents of the letter to his or her detriment.

         E. This Litigation

         Plaintiffs commenced this litigation on April 4, 2017. Plaintiffs filed an Amended Complaint on October 26, 2017, which the defendants moved to dismiss on January 9, 2018.[14] Plaintiffs then filed the Second Amended Complaint on August 28, 2018, and the defendants renewed their motions to dismiss on September 12, 2018. The Court heard oral arguments on June 12, 2019.

         II. LEGAL ANALYSIS

         The Second Amended Complaint asserts twenty-two Counts.[15] Of those Counts, thirteen accuse the Health Integrated board members who approved particular rounds of financing of doing so in breach of their fiduciary duties. Certain of those counts also allege that the stockholders who amended the Company's Certificate of Incorporation to facilitate certain of the financing transactions breached their fiduciary duties as controllers. An additional six of those counts accuse counterparties to the financing rounds of aiding and abetting breaches of fiduciary duties. Count Twenty-One effectively seeks a remedy in the form of a declaratory judgment that certain amendments to Health Integrated's Certificate of Incorporation were byproducts of these alleged breaches and are thus void or voidable. In addition, Count Five asserts claims of fraud and fraudulent inducement against Padda for statements and omissions made between 2000 and 2014, [16] and Count Twenty-Two seeks to compel an annual meeting of stockholders pursuant to Section 211 of the Delaware General Corporation Law. This decision refers to the fiduciary duty and aiding and abetting claims as the "Fiduciary Claims, " the fraud and fraudulent inducement claims of Count Five as the "Fraud Claims, " and the claim pursuant to Section 211 of Count Twenty-Two as the "Section 211 Claim."

         The defendants have moved to dismiss all twenty-two claims on myriad bases.[17] This decision focuses on the arguments that the Second Amended Complaint failed to plead demand futility as required by Rule 23.1 and that the claims are time-barred or otherwise fail under Rule 12(b)(6).

         A. Rule 23.1

         The defendants argue that all of Plaintiffs' claims are derivative and thus subject to the demand requirements of Rule 23.1, which the Second Amended Complaint does not meet. Plaintiffs respond that all but one of their claims are also direct in nature and thus not subject to dismissal under Rule 23.1. They further contend that the Second Amended Complaint adequately alleges demand futility.

         1. The Fiduciary Claims Are Derivative.

         The Fiduciary Claims allege that between 2004 and 2016, various compositions of the Board approved several rounds of corporate financing, which diluted the value of Plaintiffs' stock. "Normally, claims of corporate overpayment are treated as causing harm solely to the corporation and, thus, are regarded as derivative. . . . Such claims are not normally regarded as direct, because any dilution in value of the corporation's stock is merely the unavoidable result (from an accounting standpoint) of the reduction in value of the entire corporate entity, of which each share of equity represents an equal fraction."[18] Likewise, claims that a corporation overpaid for corporate financing, thereby diluting the value of its stock, are quintessentially derivative.[19]

         In this case, Plaintiffs concede that the Fiduciary Claims are derivative, but argue that they should also be regarded as direct under the Delaware Supreme Court's holding in Gentile v. Rossette. Under Gentile and its progeny, minority stockholders may seek relief directly when a controller or control group extracts a benefit at the expense of the minority's economic and voting rights. For a Gentile theory to be viable, at a minimum, a plaintiff must plead facts sufficient to establish a controller or control group.[20] Plaintiffs' Gentile theory falls apart because they have failed to allege the existence of either.

         Under Delaware law, one way to establish control sufficient to give rise to concomitant fiduciary duties is to demonstrate that a stockholder or group of stockholders control a majority of the corporation's voting equity.[21] Plaintiffs pursue the group theory in this case, alleging that multiple individual stockholders owning equity in the aggregate of over fifty percent should be treated as a group with concomitant fiduciary duties. To demonstrate the existence of a control group, Plaintiffs must show that the investors "are connected in some legally significant way-e.g., by contract, common ownership, agreement, or other arrangement-to ...


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