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Liquidx Inc. v. Brooklawn Capital, LLC

United States District Court, S.D. New York

May 23, 2017

LIQUIDX INC., Plaintiff,

          OPINION & ORDER

          WILLIAM H. PAULEY III, District Judge.

         Plaintiff LiquidX Inc. brings this declaratory judgment action against Defendants Brooklawn Capital LLC, Brooklawn Capital Fund LLC, and Brooklawn Capital Fund II, LP (collectively, “Brooklawn”), seeking a declaration that LiquidX is not the alter ego of non-party The Receivables Exchange (“TRE”) and that Brooklawn cannot compel LiquidX to join a Louisiana arbitration proceeding between Brooklawn and TRE.

         In September 2016, this Court entered an order enjoining the arbitrator from deciding the question of whether LiquidX is the alter ego of TRE. Thereafter, this Court conducted a four-day bench trial and now makes the following findings of fact and conclusions of law pursuant to Federal Rule of Civil Procedure 52. Specifically, this Court holds that LiquidX is the alter ego of TRE and may be joined to the Louisiana arbitration.


         This dispute arises out of the demise of TRE, an electronic exchange for accounts receivable founded in 2007. Brooklawn, a Grand-Cayman-based investment vehicle and onetime trader on the TRE platform, brought an arbitration proceeding against TRE in August 2015 pursuant to a binding arbitration agreement. Shortly thereafter, LiquidX purchased TRE's debt and foreclosed on its assets, leaving Brooklawn (and other contingent creditors) with little more than a name to litigate against. When Brooklawn sought to join LiquidX to the arbitration, LiquidX filed this action seeking a declaration that joinder would be improper.

         The essence of the parties' dispute revolves around what happened in the months leading up to January 1, 2016, when TRE ceased operations and LiquidX began running the same business under its own name. Brooklawn alleges that LiquidX, with the help of TRE's management, engineered a default on TRE's debt so that LiquidX could buy the business for pennies on the dollar and shed the exposure to Brooklawn's arbitration claims. LiquidX paints the picture of a standard foreclosure on a distressed borrower, with the concomitant unfortunate outcomes for junior, unsecured creditors like Brooklawn. As discussed below, this Court finds that the evidence supports Brooklawn's version of events.

         A. The Receivables Exchange and the Final Funding Round

         TRE was a financial technology company that operated an online exchange for accounts receivable-i.e. debts held on a company's books, such as scheduled payments for goods shipped on credit. The platform allowed companies to access short-term liquidity by selling these accounts at a discount to buyers on the exchange, who would then become the creditors on these accounts and would profit if and when the debtor paid the account in full.

         By the fall of 2013, TRE had raised nearly $60 million from a variety of venture capital entities over five rounds of funding. (See Joint Set of Admitted Exhibits (“JX”), ECF No. 66, Ex. 84.) Four of these shareholders-including Bain Capital Ventures (“Bain”)- contributed the majority of this capital and held board seats. (JX 63, 84.) Bain invested in July 2010. (Trial Transcript at 159:19.)

         Nevertheless, TRE found itself in dire financial straits, having tapped nearly all of its funding while still suffering substantial quarterly losses. (Tr. at 171:18-24.) Bain asked John Connolly, a managing director of the partnership and experienced corporate manager, to step into Bain's board seat and try to salvage Bain's investment. (Tr. at 160:13.) After reviewing TRE's financials, Connolly and the board decided to dramatically reduce the company's headcount in order to slow TRE's “burn rate” while the board sought additional funding. The board also replaced TRE's management and, in March 2015, brought in a new CEO, James Toffey, another veteran executive and entrepreneur. (See JX 14 at 3.) Finally, the board secured a $3.25 million loan from Comerica Bank in December 2014 to extend TRE's financial runway during the search for new funding. (JX 1.) The loan included a covenant that TRE would open an account with Comerica and maintain a balance of at least $2 million. (JX 1.)

         Having staunched the financial bleeding, the TRE board embarked on an extensive campaign for a sixth round of funding during the summer of 2015. None of the existing investors were willing to contribute additional capital, so the board pitched the investment to a wide variety of venture capital and private equity firms. (Tr. at 176:8-16.) Most of these targets passed on the investment, citing the complicated capital structure and problems with TRE's sales pipeline. (Tr. at 295:23-296:21.) TRE was, in short, old news; a large group of investors had contributed substantial capital over five funding rounds but the company was still operating at a loss, and the financiers who had passed on the earlier rounds saw no reason to get involved at this stage. One potential investor, Pivot, offered a term sheet that the board rejected because the investment was too small. (Tr. at 182:13-20.) Broadridge, another prospect, entered into negotiations but ultimately declined to invest, indicating that it would take a second look if TRE managed to close a successful funding round. (Tr. at 341:25-342:7.)

         Then, in TRE's darkest hour, dawn broke in the form of Gary Mueller, a successful investor and entrepreneur who had been approached by Connolly in the summer of 2015. (Tr. at 7:14-18.) Connolly and Mueller were business acquaintances who had served together on multiple corporate boards. (Tr. at 7:25-8:9.) Notwithstanding TRE's struggles, Mueller was enticed; he liked the new management team, considered the market opportunity “compelling, ” and envisioned an “upside . . . in the $300-500 [million] range.” (JX 99.) In August 2015, Mueller provided the TRE board with a term sheet that offered an investment of up to $5 million at a “pre-money” valuation of $18.21 million. (JX 34.) The board accepted these terms and agreed, on behalf of the firms that the board members represented, to contribute an additional $5 million if Mueller would “lead” the financing round. (Tr. at 189:12-24, 190:7- 191:2.) With the terms in place, Mueller began his diligence in earnest and set a closing date of September 28, 2015.

         In late September, Mueller and the TRE board were optimistic that the funding round would close as scheduled. Board members expressed excitement about such an experienced executive as Mueller joining the team and offered “congrats all around” in the week before the closing date. (JX 103.) On September 25, however, disaster struck. An arbitrator awarded Solaia Capital, another aggrieved TRE customer, with $186, 000 in damages on claims very similar to those asserted in the Brooklawn arbitration. (JX 16.) Although the award was relatively small, the board immediately realized the implications; TRE was now significantly more exposed to Brooklawn, which was seeking more than $8 million in its arbitration. (Tr. at 343:20-23.) The TRE board held an emergency weekend meeting and informed Mueller of the Solaia award on September 28. (JX 16.) Mueller, the veteran financier, was similarly quick on the uptake. He reviewed the award and, after discussing it with TRE's management, canceled the funding round on the very day it was set to close. (Tr. at 27:15-20; 64:9-13.) As quickly as it had been rescued, TRE once again faced financial ruin.

         B. The “NewCo” Plan

         Although Mueller was “done” with TRE as soon as he finished reading the arbitrator's award, he was not ready to walk away from the opportunity entirely. (Tr. 27:18.) By October 1, two days after he canceled the funding round, Mueller was working with Toffey (the president and CEO of TRE) on an alternative plan-instead of investing directly, Mueller would form a “NewCo” to purchase TRE's loan from Comerica and foreclose on TRE's assets as the first-priority secured creditor. (JX 128, 136.) Comerica, aware of the failed funding round, sent a letter on October 15 outlining several different options for TRE to avoid default, including a “going-concern” sale or an outright sale of TRE's assets. (JX 46.) Toffey declined to consider these alternatives and instead pursued Mueller's proposal, which he considered a “global opportunity.” (JX 134.) Three TRE insiders-Toffey, Connolly, and finance chief James Kovacs-planned to invest in “NewCo” and join Mueller there after the foreclosure.

         An integral part of this plan was keeping it from the other members of TRE's board, whom Connolly and Mueller did not intend to include in “NewCo.” Starting in October 2015, the three TRE insiders stopped using their TRE email accounts to communicate with Mueller and switched to their personal Gmail accounts. (Tr. 148:8-16, 349:13-19.) When Toffey inadvertently sent an email about “NewCo” from his TRE account, Mueller reminded everyone on the list to “use [their] G-mail addresses” for “NewCo” business. (JX 140.) The only TRE board member besides Connolly who testified at trial stated that he did not know that Connolly, Kovacs, and Toffey were working with Mueller during October 2015, but that he would have “certainly . . . looked into” it if he had been ...

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