Manhattan District Court Writes Final Chapter in Litigation Between Internet Law Library and Hedge Fund Adviser Southridge Capital Management; Orders Tech Firm to Pay Adviser Almost $1.2 Million in Attorney’s Fees on Top of Damages
Hedge Fund Law Report
On August 9, 2010, the United States District Court for the Southern District of New York (Southern District) effectively ended the decade-long litigation between Internet Law Library, Inc. (INL), its executives and several of its shareholders, and Southridge Capital Management, LLC (Southridge), its principals and affiliates, including hedge fund Cootes Drive, LLC, and its broker, Thomson Kernaghan & Co., Ltd. (TK & Co.). The litigation arose out of a “floorless” or “toxic” convertible securities purchase agreement between INL and Cootes Drive. The agreement allowed Cootes Drive to demand conversion of its INL preferred stock into common stock based on a floating conversion ratio tied to the common stock’s market price, and obligated Cootes Drive to float a $25 million line of equity, so long as INL common stock remained priced above a certain level. This arrangement arguably provided Cootes Drive and its affiliates with an incentive to aggressively short-sell INL common stock, because the further they decreased its price, the more common stock Cootes Drive could obtain on conversion (which it could use to cover its short positions and profit from the difference), and because that decrease would eliminate its obligation to provide a line of equity. The agreement proved disastrous for INL, just as it has for many other companies with similar financing arrangements. Its common stock price fell precipitously after it signed the agreement, allegedly due to Cootes Drive and its broker, TK & Co., short selling its common stock. INL filed a lawsuit against Southridge and its affiliates in a Texas district court for fraud and market manipulation. Cootes Drive filed a countersuit for breach in the Southern District after INL refused to redeem its preferred shares and to honor a promissory note. The Southern District accused INL of forum shopping, consolidated the actions, found INL’s complaint legally sufficient to survive a motion to dismiss, but then dismissed that complaint as a sanction for its flagrant disregard of court orders and discovery abuses. It then granted summary judgment to Cootes Drive, because INL had failed to provide evidence that Cootes Drive committed a material breach that would excuse INL from redeeming its preferred shares or honoring the note. It emphasized that Cootes Drive’s short-selling of a “small amount of” INL shares was only “a technical violation” of their agreement and that INL had failed to supply evidence showing that TK & Co. had shorted significant quantities of common stock at the behest of Cootes Drive. It also refused INL’s request for additional discovery to establish that connection, due in large part to its prior discovery abuses. The Court then awarded over $1.1 million in damages to Cootes Drive, and required INL to pay Cootes Drive over $1.2 million in attorney’s fees. This article surveys many of the opinions in the litigation to provide a detailed analysis of the factual background and legal analyses of various courts. The article also identifies and discusses the legal principles established by the litigation that have broad, ongoing application to private investments by hedge funds in private or public companies.