Zanfardino v. Kay

1

CONSTANTINO ZANFARDINO, Derivatively on Behalf of Nominal Defendant ZERIFY, INC., Plaintiff, v. MARK L. KAY, ROMARAO PEMMARAJU, AND GEORGE WALLER, Defendants, and ZERIFY, INC., Nominal Defendant.

Civil Action No. 22-7258

United States District Court, D. New Jersey

November 28, 2023

NOT FOR PUBLICATION

OPINION

ARLEO United States District Judge

THIS MATTER comes before the Court by way of Motions to Dismiss (the “Motions”) filed by Defendants Mark L. Kay (“Kay”), Romarao Pemmaraju (“Pemmaraju”), and George Waller (“Waller,” and together with Kay and Pemmaraju “Defendants”), ECF No. 19, and Nominal Defendant Zerify, Inc. (“Zerify” or the “Company”), ECF No. 22. Plaintiff Constantino Zanfardino (“Plaintiff”) opposes the Motions. ECF No. 20. For the reasons set forth herein, the Motions are GRANTED in part and DENIED in part.

I. BACKGROUND

A. Factual Background

Zerify is a software development and services organization that is incorporated in Wyoming. Compl. ¶¶ 6, 11. Defendants are executives and sole directors of the Company who reside in Pennsylvania, New Jersey, and New York. Id. ¶¶ 7-10. Plaintiff is a shareholder who resides in California. Id. ¶ 5. Plaintiff pursues this derivative action against Defendants and on behalf of Zerify for alleged wrongdoing in the management of the Company. Id. ¶ 1.

Plaintiff alleges that Defendants engaged in four forms of wrongdoing as managers of Zerify. First, Plaintiff alleges that Defendants cemented their control of the Company by issuing preferred stock to themselves and approving reverse splits. Second, Plaintiff alleges that Defendants received excessive compensation from Zerify by issuing common stock, warrants, and other shares to themselves despite poor organizational finances. Third, Plaintiff alleges that Defendants issued shares to Auctus Fund LLC (“Auctus”) and Crown Bridge Partners LLC (“Crown Bridge”) that were not commensurate with services rendered to the Company. Fourth, Plaintiff alleges that Defendants used Zerify resources to acquire equity in BlockSafe Technologies, Inc. (“BlockSafe”) for themselves and then engineered an agreement between the Company and BlockSafe for their own benefit.

1. Issuance of Preferred Stock and Approval of Reverse Splits

Zerify was initially incorporated in New Jersey as Strikeforce Technical Services Corporation and Strikeforce Technologies, but the Company was ultimately redomiciled in Wyoming, where it created Series A preferred stock with voting rights. Id. ¶¶ 12-13, 15. Thereafter, Defendants obtained 80% of the voting rights in Zerify by issuing three shares of preferred stock to themselves for little-to-no consideration. Id. ¶¶ 16-17. The preferred stock issuance “set the stage” for reverse splits, which were approved “in connection with” other share issuances that cemented Defendants' control of the Company. Id. ¶¶ 18-21, 22-23, 33.

2. Issuance of Common Stock, Other Shares, and Warrants

Since its founding, Zerify has been in poor financial health. Id. ¶ 14. In 2020 and 2021, the Company's losses exceeded $10 million and $17 million respectively, with more than $5 million in SG&A expenses attributable to increased employee compensation. Id. ¶¶ 26, 63, 6871, 80. Despite these conditions, Defendants received excessive compensation by issuing common stock to themselves upon the cashless exercise of options. Id. ¶¶ 24-25, 38-42, 59-63, 72, 77-81, 87-88. For example, over $2 million worth of common stock was issued to Pemmaraju, id. ¶¶ 24, 60, and over 9 million shares were issued to Waller, id. ¶¶ 41, 78. Likewise, Defendants issued other shares to themselves as compensation, id. ¶¶ 19, as well as warrants, which “set[] the stage for additional stock compensation” at a price that could be adjusted by the directors, id. ¶¶ 34-37.

3. Auctus and Crown Bridge Transactions

Zerify issued tens of million shares of common stock to Auctus in connection with financing services, debts, and cancelled warrants. Id. ¶¶ 27-28, 64-65, 73-74, 77-78. However, the value of certain shares did not account for reverse splits, id. ¶ 66, and the more than $6 million value of other shares eclipsed the less than $5 million financing rendered by Auctus, id. ¶¶ 29, 75-76. Similarly, the Company issued over $1 million worth of common stock to Crown Bridge to settle a $45,000 debt, id. ¶¶ 50-51, 53, 58, and it did so without adjusting the price to reflect a reverse split, id. ¶ 52. Around this time, the SEC also sued Crown Bridge for “the offering of penny stocks” in violation of securities laws. Id. ¶¶ 54-57.

4. BlockSafe Transactions

Zerify utilized $1 million from the Auctus financing to acquire equity in BlockSafe. Id. ¶ 30. Although the transaction was made possible with Company resources, Defendants acquired for themselves a 31% equity interest, to be held alongside the 69% interest acquired by Zerify. Id. ¶¶ 30, 32, 67, 82-86. Defendants then engineered an agreement between BlockSafe and the Company to secure for themselves “a $36,000 per month ‘management fee'” and “a $5 million fee payable over 5 years.” Id. ¶¶ 31, 67.

B. Procedural Background

On June 10, 2022, Plaintiff issued a written demand to Defendants. Id. ¶¶ 43-44. Specifically, Plaintiff demanded that Defendants “investigate breaches of fiduciary duty, mismanagement, and other violations of law” by the directors and “consider any remedies to be sought as a consequence” of the wrongdoing. ECF No. 1.2 at 2. As a basis for the demand, Plaintiff stated that Defendants used preferred stock to retain control of Zerify and approve reverse splits, “which massively diluted the shareholders and made the shareholders' investments in [the Company's] shares worthless.” Id. at 2-3. Plaintiff also stated that “select individuals or entities received shares in [Zerify] to make them whole,” and he posed questions to Defendants about various transactions. Id. at 3.

On August 19, 2022, Defendants rejected Plaintiff's demand. Compl. ¶¶ 47-48. In the rejection, Defendants indicated that the transactions in question were already disclosed and that an additional disclosure was filed to address Plaintiff's concerns. ECF No. 1.4 at 2. As Defendants' responses illustrated, Plaintiff's concerns were related to compensation, the issuance of common stock and warrants, and the Auctus, Crown Bridge, and BlockSafe transactions. Id. at 3-6. Defendants concluded that “no further action [was] warranted” regarding these issues because the disclosures did not show “any wrongdoing” on the part of the Company or its directors. Id. at 6.

On December 13, 2022, Plaintiff filed this lawsuit against Defendants and on behalf of Zerify for breach of fiduciary duties, unjust enrichment, and corporate waste. Compl. ¶¶ 110-26.

Defendants and the Company both moved to dismiss, ECF Nos. 19, 22, and Plaintiff opposed the Motions, ECF No. 20.

II. Legal Standards

A. Federal Rule of Civil Procedure 12(b)(6)

Under Federal Rule of Civil Procedure 12(b)(6), a party may move to dismiss a complaint for failure to state a claim to relief. Fed.R.Civ.P. 12(b)(6). For purposes of a motion to dismiss, the district court accepts the facts alleged in the complaint as true and draws all reasonable inferences in favor of the non-moving party. N.J. Carpenters & the Trustees Thereof v. Tishman Const. Corp. of N.J., 760 F.3d 297, 302 (3d Cir. 2014). While the complaint need not contain detailed factual allegations, Fed.R.Civ.P. 8(a), it must contain “enough facts to state a claim to relief that is plausible on its face,” Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007). The complaint is facially plausible if it “allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009). Thus, “conclusory or bare-bones allegations will no longer survive a motion to dismiss.” Fowler v. UPMC Shadyside, 578 F.3d 203, 210 (3d Cir. 2009) (citations omitted).

B. Federal Rule of Civil Procedure 23.1(b)(3)

Under Federal Rule of Civil Procedure 23.1(b)(3), a derivative complaint must “state with particularity: (A) any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members; and (B) the reasons for not obtaining the action or not making the effort.” Fed.R.Civ.P. 23.1(b)(3). “Although Federal Rule of Civil Procedure 23.1 provides the procedural vehicle for addressing the adequacy of a derivative plaintiff's pleadings, [t]he substantive requirements of demand are a matter of state law.” Freedman v. Redstone, 753 F.3d 416, 424 (3d Cir. 2014) (alteration in original) (citations omitted).

So too, “the power of a board of directors to continue or to discontinue a cause of action brought on behalf of the corporation is governed by the state law, or the business judgment rule, of the state of incorporation.” Abrams v. Koether, 766 F.Supp. 237, 249 (D.N.J. 1991) (citing Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 101 (1991)).

Under Wyoming law,^[1] a derivative proceeding cannot commence until “a written demand has been made upon the corporation to take suitable action” and “ninety (90) days have expired from the date the demand was made unless the shareholder has earlier been notified that the demand has been rejected by the corporation.” Wyo Stat. Ann. § 17-16-742(a). If the demand has been rejected, “the complaint shall allege with particularity facts establishing . . . that a majority of the board of directors did not consist of qualified directors at the time the determination was made.” Wyo. Stat. Ann. § 17-16-744(c)(i). Alternatively, the derivative proceeding will be dismissed if a majority vote of qualified directors “has determined in good faith after conducting...