Court Opinion

ID: 9387758
Source: CourtListenerOpinion
Date Created: 2023-04-18 21:01:08.073259+00
Date Added: 2024-06-11T17:18:15.443709
License: Public Domain

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                                            UNPUBLISHED

                               UNITED STATES COURT OF APPEALS
                                   FOR THE FOURTH CIRCUIT

                                              No. 21-2172

        MARTIN SMILEY; RONALD DURANDO;                         ABRAHAM       BIDERMAN;
        GUSTAVE DOTOLI; EDWARD SUOZZO,

                            Plaintiffs – Appellants,

                     v.

        ANSHU BHATNAGAR,

                            Defendant – Appellee.

        Appeal from the United States District Court for the District of Maryland, at Greenbelt.
        Paul W. Grimm, Senior District Judge. (8:20-cv-02633-PWG)

        Argued: October 26, 2022                                          Decided: April 17, 2023

        Before NIEMEYER, DIAZ, and RUSHING, Circuit Judges.

        Affirmed in part, vacated in part, and remanded by unpublished per curiam opinion.

        ARGUED: Thomas C. Costello, COSTELLO LAW GROUP, Towson, Maryland, for
        Appellants. Tamar S. Wise, COZEN O’CONNOR, New York, New York, for Appellee.
        ON BRIEF: Anne L. Preston, COSTELLO LAW GROUP, Towson, Maryland, for
        Appellants. Joseph P. Dever, Jr., COZEN O’CONNOR, New York, New York, for
        Appellee.

        Unpublished opinions are not binding precedent in this circuit.
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        PER CURIAM:

               Martin Smiley and four other shareholders of mPhase Technologies, Inc., sued

        Anshu Bhatnagar, mPhase’s Chief Executive Officer (CEO), for breach of contract, fraud,

        negligent misrepresentation, and breach of fiduciary duty. The district court granted

        Bhatnagar’s motion to dismiss, concluding the claims were derivative and must be brought

        on behalf of the corporation. We largely agree with the district court but vacate and remand

        as to the fraud and negligent misrepresentation claims, which are based, at least in part, on

        allegations of special injury.

                                                     I.

               Plaintiffs allege the following facts, which we accept as true when considering

        Bhatnagar’s motion to dismiss. See E.I. du Pont de Nemours & Co. v. Kolon Indus., Inc.,

        637 F.3d 435, 448 (4th Cir. 2011). Plaintiffs are shareholders of mPhase, a publicly held

        microfluidics and nanotechnology company incorporated in New Jersey. They are the

        former Chief Financial Officer and General Counsel, CEO and President, Chief Operating

        Officer, and Directors of mPhase. Before January 2019, Plaintiffs collectively held the

        majority of common shares, voting control over mPhase’s board of directors, and

        management control over the company’s operations.

               On behalf of mPhase, Plaintiffs negotiated for Bhatnagar to take over control and

        management of the company. The negotiations continued for years, during which Plaintiffs

        satisfied Bhatnagar’s preliminary requests to reduce mPhase’s debt obligations, most of

        which were owed to Plaintiffs, and to update its regulatory filings. Then, in late 2018 and

        early 2019, Bhatnagar attended three meetings with Plaintiffs, during which the parties

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        reached an agreement whereby Plaintiffs would relinquish control and management of

        mPhase to Bhatnagar in exchange for certain promises. Specifically, Bhatnagar assured

        Plaintiffs he would not engage in any transaction that would cause mPhase to issue stock

        below a certain price floor for the first three years he was CEO. He also promised to use

        capital Plaintiffs raised in the future to satisfy an mPhase debt obligation known as the

        “Fife Debenture.” J.A. 38. Without these promises, Plaintiffs were unwilling to transfer

        control of mPhase, resign their positions with the company, or agree to reduce or

        subordinate additional mPhase debt obligations owed to them personally. In January 2019,

        mPhase executed a Transition Agreement with Bhatnagar, pursuant to which Plaintiffs

        resigned their officer and director positions, Bhatnagar assumed the role of CEO, and

        mPhase’s debt to Plaintiffs was converted to equity.

               Plaintiffs allege that Bhatnagar subsequently violated the Transition Agreement and

        his assurances to them in two ways. First, Bhatnagar used the capital Plaintiffs raised to

        fund a new venture instead of paying off the Fife Debenture as promised. Second,

        Bhatnagar arranged financing transactions without the promised price floor protections,

        resulting in the issuance of convertible debentures that ultimately diluted the value of

        Plaintiffs’ stock. According to Plaintiffs, Bhatnagar undertook those transactions to help

        him fulfill the conditions of his earnout of common stock, resulting in his current status as

        the majority shareholder with voting control of mPhase.

               Plaintiffs sued Bhatnagar in Maryland district court for breach of contract, fraud,

        negligent misrepresentation, and breach of fiduciary duty. They seek at least $5 million in

        damages, which Plaintiffs attribute to the diminution in value of their collective shares. In

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        addition, Plaintiffs assert that Bhatnagar’s allegedly deceptive conduct caused the loss of

        their status as majority shareholders with voting control, loss of their director and officer

        positions, loss of salaries and fees for services paid by mPhase, and loss of personal debt

        obligations converted to equity in the transfer of control. Bhatnagar moved to dismiss for

        lack of so-called “shareholder standing,” and the district court granted the motion.

        Plaintiffs timely appealed.

                                                      II.

               “We review de novo the grant of a motion to dismiss for failure to state a claim,

        applying the same standards as the district court.” Fairfax v. CBS Corp., 2 F.4th 286, 291

        (4th Cir. 2021) (internal quotation marks omitted). “To survive a motion to dismiss, a

        complaint must contain sufficient factual matter, accepted as true, to ‘state a claim to relief

        that is plausible on its face.’” Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) (quoting Bell

        Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)); see also Fed. R. Civ. P. 12(b)(6). Like

        the parties and the district court, we will apply New Jersey law to the shareholder standing

        issue because mPhase is a New Jersey corporation. See Ark. Nursing Home Acquisition,

        LLC v. CFG Cmty. Bank, 460 F. Supp. 3d 621, 643 (D. Md. 2020) (“Maryland courts

        follow the ‘internal affairs doctrine,’ which requires application of the law of the state of

        incorporation to matters ‘peculiar to the relationships among or between the corporation

        and its current officers, directors, and shareholders.’” (quoting NAACP v. Golding, 679

        A.2d 554, 559 (Md. 1996))).

               Generally speaking, “[r]egard for the corporate personality demands that suits to

        redress corporate injuries which secondarily harm all shareholders alike are brought only

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        by the corporation.” Strasenburgh v. Straubmuller, 683 A.2d 818, 829 (N.J. 1996) (internal

        quotation marks omitted); see Franchise Tax Bd. of Cal. v. Alcan Aluminium Ltd., 493 U.S.

        331, 336 (1990) (explaining this “longstanding equitable restriction”). New Jersey courts

        follow the prevailing rule that individual stockholders “cannot sue for injuries arising from

        the diminution in value of their shareholdings resulting from wrongs allegedly done to their

        corporations” but instead “must seek recovery derivatively in behalf of the corporation.”

        Strasenburgh, 683 A.2d at 829 (internal quotation marks omitted). However, if the wrong

        causes a “special injury,” shareholders may sue directly. Id. at 829–830. “A special injury

        exists where there is a wrong suffered by a plaintiff that was not suffered by all stockholders

        generally” or “a wrong involving a contractual right of a shareholder, such as the right to

        vote, or to assert majority control, which exists independently of any right of the

        corporation.” Id. (internal quotation marks and brackets omitted). Wrongful conduct can

        give rise to both derivative and direct actions, and “a thin line often separates” the two. Id.

        at 830.

                  To determine whether Plaintiffs’ claims are derivative or direct, we consider “the

        nature of the wrongs alleged in the body of the complaint, not [Plaintiffs’] designation or

        stated intention.” Id. at 830. As the district court observed, Plaintiffs allege that Bhatnagar,

        acting out of self-interest as the CEO of mPhase, used capital to fund a new venture rather

        than pay off a corporate debt, caused the company to issue stock at a value below the price

        floor, and issued convertible debentures that ultimately diluted the value of mPhase

        common stock. These wrongs against the corporation allegedly injured all shareholders by

        causing a diminution in share value. “Actions that have the effect of depressing stock value

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        harm all shareholders and are therefore classed as giving rise to derivative claims.” Id. at

        831; see also id. at 830 (“Claims of breach of fiduciary duty . . . will also be generally

        regarded as derivative claims unless the injury to shares is distinct.”). We agree with the

        district court that Plaintiffs’ claims against Bhatnagar for actions he took as CEO of

        mPhase are derivative and cannot be brought individually.

               The district court also correctly rejected Plaintiffs’ request to treat their derivative

        claims as direct on the ground that mPhase is a closely held corporation. Plaintiffs allege

        that mPhase is “a publicly-held company,” J.A. 33, and they identify no allegations

        supporting an inference that mPhase is closely held, as that term is understood in New

        Jersey law. See, e.g., Balsamides v. Protameen Chems., Inc., 734 A.2d 721, 734 (N.J.

        1999) (noting that “shares of stock in a closely-held corporation” have “no readily available

        market”); Dugan v. Dugan, 457 A.2d 1, 5 (N.J. 1983) (“The value of stock in a closely

        held corporation is not fixed by public trading.”).

               Plaintiffs partly base their fraud and negligent misrepresentation claims, however,

        on allegations that Bhatnagar, before becoming CEO of mPhase, made false statements to

        them that caused them special injury. Specifically, during Plaintiffs’ negotiations with

        Bhatnagar, he falsely assured them that he would use future capital to satisfy the Fife

        Debenture and that he would not, for a period of three years, cause mPhase to engage in

        any financing that would cause the company to issue stock at a value below the agreed-

        upon price floor. Without these promises, Plaintiffs aver, they were “not willing to transfer

        control of mPhase to Bhatnagar, resign their positions with the [c]ompany[,] or agree to

        reduce/subordinate additional mPhase debt obligations owed personally to them.” J.A. 38.

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        Plaintiffs have alleged special injuries unique to them resulting from this wrongdoing: loss

        of their positions as officers and directors of mPhase, loss of salaries and fees for services

        paid by mPhase, and “loss of personal debt obligations owed to them by mPhase which

        they converted into equity on January 11, 2019.” J.A. 45. Plaintiffs may pursue these

        claims directly. See, e.g., United States v. Acorn Tech. Fund, L.P., 429 F.3d 438, 447 (3d

        Cir. 2005) (“[F]raud in the inducement claims are generally individual claims.”).

               Bhatnagar urges us to affirm on the alternative ground that Plaintiffs’ complaint

        fails to state a claim for fraud or negligent misrepresentation. We decline to address these

        arguments initially on appeal and instead remand for the district court to consider them in

        the first instance. See J.A. 128 (district court explaining that the dismissal was without

        prejudice because the court had not determined the merits of Plaintiffs’ claims).

        Accordingly, we affirm the district court’s dismissal of Plaintiffs’ breach of contract and

        breach of fiduciary duty claims as derivative; vacate the dismissal of Plaintiffs’ fraud and

        negligent misrepresentation claims, which are not entirely derivative; and remand for

        further proceedings.

                                  AFFIRMED IN PART, VACATED IN PART, AND REMANDED

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