United States District Court, S.D. New York
UNI-WORLD CAPITAL L.P., UNI-WORLD CAPITAL AIV, L.P, FRAGRANCE HOLDINGS, LLC and FRAGRANCE ACQUISITIONS, LLC, Plaintiffs,
PREFERRED FRAGRANCE, INC., HARRY POLATSEK, EZRIEL POLATSEK, SARAH POLATSEK, SOLOMON TYRNAUER, BENT PHILIPSON, BENJAMIN LANDA, and JOSEPH RUBINSTEIN, Defendants.
OPINION & ORDER
PAUL A. ENGELMAYER, District Judge.
This lawsuit, presently in discovery, involves claims arising out of plaintiffs' acquisition of an imitation-fragrance business. Plaintiffs claim, inter alia, that they purchased that business based on fraudulent misrepresentations by defendants, in violation of § 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78j(b), and the Securities and Exchange Commission's implementing rule, 17 C.F.R. § 240.10b-5 ("Rule 10b-5"). Pending before the Court now is a late-made motion by defendants to dismiss the Rule 10b-5 claim, the only federal claim in the case; such a dismissal would deprive this Court of jurisdiction over this case unless the Court were to exercise supplementary jurisdiction over the remaining state law claims. Also pending is a motion by one defendant, Ezriel Polatsek ("Ezriel"),  for relief from the Court's order enjoining him from competing with plaintiffs; that motion turns on the same legal question as the motion to dismiss, i.e., whether the 10b-5 claim states a claim such that this Court has subject-matter jurisdiction over this case. For the reasons that follow, defendants' motions are denied.
The Court assumes familiarity with the facts of this case, including specifically those set out in the Court's three previous written decisions, issued on March 6, 2014, see Dkt. 58; July 10, 2014, see Dkt. 156; and July 21, 2014, see Dkt. 166. The Court here sets forth only those facts most germane to this opinion.
A. Facts Alleged in the FAC
Preferred Fragrance, Inc. ("Preferred Fragrance") was founded in 2000. FAC ¶ 19. Preferred Fragrance is in the business of selling "designer-inspired fragrance products, " i.e., imitation fragrances, to retail chain stores such as Family Dollar and CVS. Id. As of 2010, Ezriel was CEO and Harry Polatsek ("Harry") CFO of Preferred Fragrance. Id.
In late 2010, an investment bank representing Preferred Fragrance introduced it to Uni-World Capital, L.P. and Uni-World Capital AIV, L.P. (collectively, "Uni-World"). Id. During 2011, Uni-World investigated and negotiated with Preferred Fragrance. Id. ¶¶ 20-26. In anticipation of purchasing Preferred Fragrance, Uni-World created two entities: Fragrance Acquisitions, LLC ("Fragrance Acquisitions" or "Acquisitions"), which would take over Preferred Fragrance's operations, and Fragrance Holdings, LLC ("Fragrance Holdings" or "Holdings"), Fragrance Acquisitions' parent (together, the "Fragrance Entities"). Id. ¶ 27.
On October 12, 2011, Fragrance Acquisitions purchased the assets and business of Preferred Fragrance (the "Transaction") pursuant to an Asset Purchase Agreement, see FAC Ex. A ("APA"), with Preferred Fragrance and its stockholders (collectively, the "APA Defendants"). Id. ¶ 28. Fragrance Acquisitions paid $24.5 million for the assets and business of Preferred Fragrance, id. ¶ 25, broken down as follows:
The total consideration for the purchase of the Assets and the Business as described herein (the "Total Consideration") shall be (a) an amount of cash equal to $16, 837, 000 (as adjusted in accordance with Section 2.4) plus (b) units of membership interest in the Parent [ i.e., Fragrance Holdings] (the "Parent Units") representing 18.16% of the outstanding voter equity of Parent as of the Closing (the "Rollover Units"), plus (c) the assumption of the Assumed Liabilities.
APA § 2.2 (emphases omitted). The Amended Complaint further alleges:
A significant portion of the cash consideration paid by the Company [Fragrance Acquisitions] originated from Uni-World. As part of the Transaction, Uni-World paid $10.7 million in exchange for 81% of equity in Holdings. Holdings transferred $10.7 million to [Fragrance Acquisitions] in exchange for 81.64% of [Fragrance Acquisitions'] equity.
FAC ¶ 31 (citing APA § 3.2(q)).
The total purchase price of $24.5 million was based on the parties' determination of the value of Preferred Fragrance, as measured by its earnings before interest, taxes, depreciation, and amortization ("EBITDA"). FAC ¶¶ 4, 25. To calculate Preferred Fragrance's EBITDA, Uni-World examined data and information provided by defendants, including Preferred Fragrance's financial statements, sales to key customers, and amounts paid to key suppliers. Id. ¶¶ 22-24. After lengthy discussion and analysis, the parties concluded that Preferred Fragrance's EBITDA, appropriately adjusted to reflect its sustainable cash flow, was $4.033 million. Id. ¶ 24. The purchase price of $24.5 million was obtained by multiplying the adjusted EBITDA by a multiplier of 6.075, which in turn was "derived from financial analysis of comparable companies as well as financial and operational information provided by [Preferred Fragrance]." Id. ¶¶ 25 n.1.
During these negotiations, the APA Defendants represented to the buyers that, between March 31, 2011 and October 12, 2011, none of the top 10 customers or suppliers of Preferred Fragrance had "materially reduced or changed the pricing, volume, timing or other terms of its business with the Companies" or had "notified the Companies that it intends to... materially reduce or change" such terms. APA § 4.22(b); see FAC ¶¶ 32-34. The FAC alleges, however, that contrary to these representations, Harry and Ezriel had secretly agreed to materially change the terms of Preferred Fragrance's arrangements with some of its largest customers and suppliers. FAC ¶ 39. In particular, it alleges that Preferred Fragrance had (1) given its third largest customer, Rainbow, a 12% reduction in price beginning August 2011, id. ¶¶ 42-47; (2) given its eighth largest customer, Variety, a 15% reduction in price beginning May 2011, id. ¶¶ 48-53; (3) given its second-largest customer, Dollar General, a 3.73% sales discount beginning June 2011, id. ¶¶ 60-68; and (4) agreed to 2% price increases with two primary suppliers, Yiwu and Only, id. ¶¶ 54-59. These changes, if known, would have lowered the EBITDA from $4 million to $3.1 million. Id. ¶ 39. The FAC also alleges that, in 2010, Preferred Fragrance "shipped approximately 300 containers that were inappropriately classified as non-hazardous material, when they should have been classified as hazardous material, which incurs a significantly higher transport cost." Id. ¶ 69.
Relevant to other aspects of this litigation, but not the instant motions, Ezriel also entered into an employment agreement, by which he became Fragrance Acquisitions' president and chief operating officer (COO), and signed two non-compete agreements, one in the APA and one in the employment agreement. Id. ¶¶ 38, 79, 85; id. Ex. B. The FAC alleges that, during his time as president and COO, Ezriel twice converted funds belonging to the company and otherwise breached his duties as COO. FAC ¶¶ 86-110. Fragrance Acquisitions terminated Ezriel's employment effective October 10, 2013. Id. ¶ 118.
B. Procedural Background
1. The State Litigation and the Original Motions to Stay or Dismiss
On April 8, 2013, the Fragrance Acquisitions sent the APA Defendants a letter stating that it would seek indemnification for lost profits against them under the APA as a result of their alleged omissions in connection with Preferred Fragrance's sale. Id. ¶¶ 111-12. Fragrance Acquisitions and defendants then had multiple settlement discussions. Id. ¶ 114. On or around September 10, 2013, after these discussions reached an impasse, counsel for Fragrance Acquisitions told defendants' counsel that the Fragrance Entities would be "moving toward litigation." Id.
On September 13, 2013, however, before such litigation was filed, Preferred Fragrance and Ezriel filed an anticipatory action in New York Supreme Court in Kings County, seeking declaratory judgments: that (1) they had not breached the APA and thus were not obliged to indemnify the Fragrance Entities for lost profits, and (2) Ezriel's non-compete agreements were void and unenforceable. Preferred Fragrance, Inc., et al. v. Fragrance Acquisitions, LLC, et al., Index No. 505426/2013 (N.Y. Sup.Ct. filed Sept. 13, 2013) (the "Brooklyn Action"); FAC ¶¶ 116-17.
On October 10, 2013, Fragrance Acquisitions terminated Ezriel's employment, stating that the termination was for cause pursuant to the employment agreement. FAC ¶ 118.
On October 11, 2013, plaintiffs filed the original Complaint in this action. Dkt. 1. It alleged one claim under federal law, specifically, a violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 (the "10b-5 claim"). It also brought state-law claims for common law fraud and breach of contract; sought declaratory judgments that the termination of Ezriel's employment had been for cause and that the non-complete clause is valid and enforceable; and sought attorneys' fees. Id.
On October 25, 2013, the Fragrance Entities moved, in State Supreme Court, before the Hon. Carolyn E. Demarest, to dismiss or stay the Brooklyn Action in favor of this one. See Dkt. 43 at 7. On December 17, 2013, defendants here moved to stay or dismiss this action in favor of the Brooklyn Action, Dkt. 23, 27, arguing that this Court should abstain from hearing this case under Colorado River Water Conservation District v. United States, 424 U.S. 800 (1976). Defendants also argued that plaintiffs' sole federal claim, under Rule 10b-5, was deficiently pled, because it did not allege that defendants "used the mails or other instrumentalities of interstate commerce to commit the alleged fraud." Dkt. 24 at 21.
On January 7, 2014, plaintiffs filed the FAC, which attempted to cure the asserted defect in the 10b-5 claim. See FAC ¶ 130. On January 24, 2014, the defendants here again moved to stay or dismiss this action, in favor of the Brooklyn Action, under Colorado River. Dkt. 34-39. Significant here, this time, however, defendants did not move to dismiss the 10b-5 claim, or assert that that claim was improperly pled. See id. (defendants' moving papers). The parties briefed the issue, see Dkt. 43-44, 47-48, and on February 26, 2014, the Court heard argument, Dkt. 56 ("February 26, 2014 Tr.").
At argument, counsel for Preferred Fragrance and the Polatsek defendants acknowledged that they no longer contended that plaintiffs' 10b-5 claim fails to state a claim, although they still contended that the evidence developed in discovery would ultimately not substantiate that claim factually. The Court, in fact, focused defense counsel on the facial validity of that claim:
THE COURT: Let me start you off with this question, which may or may not short-circuit a lot of this discussion. Assuming the case were to stay here, would it be your intention to move to dismiss the securities fraud count, the 10b-5 count? Is there a motion to dismiss coming?
MR. SOTTILE: Your Honor, we do not anticipate an early motion to dismiss the securities count, 10b-5 claim. I do anticipate that we may end up developing evidence that would allow us to present a ...