The litigation in Manhattan Supreme Court between a privately-held company known as FaceCake Marketing Technologies, Inc. and minority stockholders Beryl Zyskind and Joel Gold has been plodding along for over three years, still with no resolution in sight thanks to two appellate decisions — including one handed down last week — reversing lower court orders.

Painful as it might be for the parties, there are some useful lessons for the rest of us concerning the drafting of investor agreements contemplating serial funding over a period of time in exchange for a combination of stock and company notes.

In September 2004, Zyskind and Gold each entered into an agreement with FaceCake to acquire an aggregate of $625,000 principal amount of 8% senior notes plus common stock. Each agreement called for an initial investment of $125,000 in exchange for notes and 337,500 shares, with ten subsequent, monthly investments of $50,000 each in exchange for additional notes and shares at a fixed ratio that, assuming full funding, would have given Zyskind and Gold an aggregate holding of 20% of the company’s common shares plus notes totaling $1.25 million.

The relationship quickly soured, with Zyskind and Gold accusing FaceCake’s controlling owners of withholding company information or other infractions, and FaceCake declaring defaults after Zyskind and Gold ceased making monthly payments in early 2005. In August 2005, FaceCake sent out default notices. In April 2006, FaceCake demanded Zyskind and Gold return the previously delivered shares and notes for cancellation, stating that the agreements were “contingent” on the timely funding of the full $1.25 million.

The Lawsuit

The notes matured in July 2008. In July 2010, Zyskind and Gold filed an action seeking judgment for the principal and accrued interest on ten unpaid notes totaling $650,000.  In December 2010, the court granted summary judgment in their favor, finding that the notes contained unconditional promises to pay and valid waivers of defenses (read decision here).

FaceCake appealed from the decision and, in late 2012, won a reversal from the appellate court on the ground that the notes’ waiver provision did not foreclose FaceCake’s defense based on fraud in the inducement (read decision here).

Meanwhile, the litigation intensified with the assertion of new claims and counterclaims, including damages claims by FaceCake for breach of the agreements, and claims by Zyskind and Gold for declarations that FaceCake’s cancellation of their shares was invalid and for violation of their anti-dilution rights under the 2004 agreements.

The Lower Court’s Decision Upholding Share Cancellation

In October 2011, FaceCake filed a motion to dismiss Zyskind’s and Gold’s assorted contractual and tort claims, including the claims for declaratory and equitable relief arising from FaceCake’s cancellation of their shares and failure to honor their alleged anti-dilution rights under the agreements. Read here FaceCake’s memorandum of law in support of its dismissal motion.

Zyskind and Gold opposed the motion, arguing that the stock cancellation violated the company’s representation and warranty in § 4(b)(vi) of the agreements, providing:

The Shares, upon the issuance thereof, shall be validly authorized and validly issued, fully paid, and nonassessable and will not have been issued, owned or held in violation of any preemptive or similar right of stockholder.

As to anti-dilution, Zyskind and Gold relied on § 7(e)(ii) of the agreements, providing in pertinent part:

If at any time after the date hereof, the Company proposes to issue Equity Securities, the Company shall, so long as the Investor is not in breach of any of its obligations hereunder . . . offer to issue to the Investor a portion of the Proposed Securities equal to the Investor’s Percentage Interest. [Italics added.]

Read here Zyskind’s and Gold’s memorandum of law in opposition to FaceCake’s dismissal motion.

The court ruled in May 2012, dismissing a number of Zyskind’s and Gold’s claims including those regarding stock cancellation and anti-dilution (read decision here). As to stock cancellation, the court ruled that “the plaintiffs fail to allege any specific provision in the Agreements that prevents FaceCake from cancelling the shares upon breach of the Agreements or otherwise.”

The court also ruled that Zyskind and Gold lost their anti-dilution rights under § 7(e)(ii) of the agreements because they “concede in their pleadings that they breached the terms of the Agreements by failing to make payments to FaceCake in accordance with the schedule outlined in the Agreements.”

The Appellate Court’s Reversal

Zyskind’s and Gold’s appeal from the lower court’s May 2012 ruling led to a decision last week by the Appellate Division, First Department, reinstating the stock cancellation and anti-dilution claims. Zyskind v. FaceCake Marketing Technologies, Inc., 2013 NY Slip Op 06433(1st Dept Oct. 3, 2013).

The appellate panel firmly disagreed with the lower court’s conclusion that the absence of an affirmative prohibition against cancellation in the agreements doomed the claim. On the contrary, said the court, “the agreements, which are governed by New York law, did not have to contain such a provision.” As the court further explained, quoting from § 4(b)(vi) of the agreements:

Each agreement states, “The Shares, upon the issuance thereof, shall be validly authorized and validly issued, fully paid, and nonassessable . . .” (emphasis added). Thus, these shares were shares “upon which no further payments [could] be demanded by the company” (Middleton v Wooster, 184 App Div 165, 168 [1st Dept 1918]). Plaintiffs’ shares being “fully paid” “upon the issuance thereof,” defendant’s argument that plaintiffs failed to make additional payments is unavailing. Defendant points to no provision in the agreements that would permit it to cancel shares that it had already issued because plaintiffs failed to make later payments.

The court also supported its conclusion with an observation bottomed in property law:

Furthermore, a share is the property of the shareholder, not of the corporation (Gilbert Paper Co. v Prankard, 204 App Div 83, 86 [3d Dept 1923]). Hence, the corporation has to reacquire the share to cancel it (In re Enron Creditors Recovery Corp., 407 BR 17, 40 [Bankr SD NY 2009], revd on other grounds 422 BR 423 [SD NY 2009], affd 651 F3d 329 [2d Cir 2011]). Defendant did not reacquire its stock before purporting to cancel it.  

The court next found that Zyskind’s and Gold’s concession, that they did not make all the payments required by the agreements, did not necessarily foreclose their anti-dilution claim based on their allegations “that they withheld payment because [FaceCake] failed to provide them with the financial statements required by the notes.” The court concluded:

Whether defendant’s breach excuses plaintiffs’ performance depends on whether the breach was material. At this early, pre-discovery stage, it cannot be determined as a matter of law that defendant’s failure to provide plaintiffs with financial statements was not a material breach. [Citation omitted.]

Zyskind Takeaways

  • Over eight years after their dispute erupted, and over three years into an expensive litigation, the parties in Zyskind still have no solution for a problem created in no small part by the agreement’s failure to address with any specificity the remedies for failing to fund the post-closing investments.
  • The dispute might have been avoided had the agreements provided for a company option to repurchase the shares already issued at a discounted basis and/or to pay off the notes without any prepayment premium (prepayment premiums are customary in transactions like this) and possibly at a discount to par. Another possible remedy is to provide that the investor loses its anti-dilution protections and other rights such as board observation rights.
  • The broad proviso used in the FaceCake anti-dilution clause, conditioning preemptive rights on the investor not being in breach of any of its obligations, effectively gives both sides an unhealthy incentive to put the other in breach and thereby create uncertainty that can have a negative impact on the company’s ability to raise additional capital from other investors. From the company standpoint, the proviso should specify the loss of preemptive rights upon the investor’s failure for any reason to meet its funding commitment and should expressly waive any investor defenses to the loss of its preemptive rights upon such failure.
  • From the investor standpoint, the company notes should be drafted as stand-alone, unconditional obligations by the company to repay principal and interest; should include a general merger clause or statement that the unenforceability of the underlying liabilities shall not affect or be a defense to the notes; and should not recite that the maker’s giving of the note is made in reliance on the investor’s representations and warranties.