Scott Garrett and Pamela Jane Garett v. Cook et al

UNITED STATES BANKRUPTCY COURT
FOR THE DISTRICT OF NEW MEXICO
In re:
DANIEL WILLIAM COOK and
YOLANDA T. COOK,
Debtors. 	No. 7-04-17704 SA
SCOTT GARRETT and
PAMELA JANE GARRETT, TRUSTEES
OF THE SCOTT GARRETT AND PAMELA
GARRETT FAMILY TRUST DATED JUNE 14, 1999,
Plaintiffs, 	Adv. No. 08-1074 S
v.
DANIEL WILLIAM COOK and
YOLANDA T. COOK,
Defendants.
MEMORANDUM OPINION ON DEFENDANTS’ MOTION
TO REQUIRE GARRETTS TO POST SECURITY
This matter is before the Court on Defendants’ Motion to
Require Garretts to Post Security (doc 5), Garretts’ Objection
and Brief in Response to Defendants’ Motion to Require Garretts
to Post Security (doc 11), a Reply to Garretts’ Objection and
Brief (doc 13), and Garretts’ Surreply to Debtor’s Reply (doc
14). 	This is a core proceeding to determine the dischargeability
of debt. 	28 U.S.C. § 157(b)(2)(I).
FACTS
Daniel and Yolanda Cook (“Cooks”) filed a voluntary Chapter
11 petition on October 21, 2004. 	On August 16, 2006 the Court
appointed a Chapter 11 Trustee. 	Doc 379. 	On February 14, 2008
the Chapter 11 Trustee resigned. 	Doc 674. 	On March 20, 2008 the
Court converted the case to Chapter 7. 	Doc 726. 	The first
meeting of creditors was scheduled for April 18, 2008 and the
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1A separate Motion to Dismiss filed by the Debtors raises an
issue of the identities/capacities/roles of the Garretts and
questions ownership of certain stock held by the Garretts or
their family trust. 	Those questions will be dealt with in
another Memorandum. 	Therefore, references to the Garretts in
this Memorandum are intended to include all their roles.
2That section provides:
1. As used in this section “corporation” includes an
unincorporated association, and “board of directors” includes the
managing body of an unincorporated association.
2. In an action brought to enforce a secondary right on the part
of one or more shareholders in a corporation or association,
incorporated or unincorporated, because the corporation or
association refuses to enforce rights which may properly be
asserted by it, the complaint must be verified by oath and must
aver that the plaintiff was a shareholder at the time of the
transaction of which he complains or that his share thereafter
(continued...)
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last day to oppose discharge or dischargeability was June 17,
2008. 	Scott Garrett and Pamela Jane Garrett 1 timely filed the
above captioned adversary proceeding that contains six counts.
The first three counts seek a judgment against the Cooks under 11
U.S.C. §§ 523(a)(2)(A), 523(a)(4) and 523(a)(6) respectively in
favor of the Garretts. 	Counts 4, 5 and 6 seek a judgment against
the Cooks under the same three code sections, but in favor of the
Garretts in a derivative capacity on behalf of Trenchless
Infrastructure Technologies, Inc. f/k/a Hydroscope Group, Inc.,
n/k/a Hydroscope Integrated Technologies, Inc. (“Hydroscope”), a
Nevada corporation whose principal place of business is in
Albuquerque, New Mexico.
The Cooks promptly filed their Motion to Require Garretts to
Post Security under Nevada Revised Statutes 41.520 2. 	They allege
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2(...continued)
devolved on him by operation of law. The complaint must also set
forth with particularity the efforts of the plaintiff to secure
from the board of directors or trustees and, if necessary, from
the shareholders such action as he desires, and the reasons for
his failure to obtain such action or the reasons for not making
such effort.
3. In any such action, at any time within 30 days after service
of summons upon the corporation or any defendant who is an
officer or director of the corporation, or held such office at
the time of the acts complained of, the corporation or such
defendant may move the court for an order, upon notice and
hearing, requiring the plaintiff to furnish security as
hereinafter provided. Such motion must be based upon one or more
of the following grounds:
(a) That there is no reasonable possibility that the prosecution
of the cause of action alleged in the complaint against the
moving party will benefit the corporation or its security
holders.
(b) That the moving party, if other than the corporation, did not
participate in the transaction complained of in any capacity.
The court on application of the corporation or any defendant may,
for good cause shown, extend the 30-day period for an additional
period or periods not exceeding 60 days.
4. At the hearing upon such motion, the court shall consider such
evidence, written or oral, by witnesses or affidavit, as may be
material:
(a) To the ground or grounds upon which the motion is based; or
(b) To a determination of the probable reasonable expenses,
including attorney's fees, of the corporation and the moving
party which will be incurred in the defense of the action. If the
court determines, after hearing the evidence adduced by the
parties at the hearing, that the moving party has established a
probability in support of any of the grounds upon which the
motion is based, the court shall fix the nature and amount of
security to be furnished by the plaintiff for reasonable
expenses, including attorney's fees, which may be incurred by the
moving party and the corporation in connection with such action,
including expenses which the corporation may incur by reason of
any obligation which it may have to indemnify its officers or
directors pursuant to NRS 78.7502 or otherwise. A determination
by the court that security either must or must not be furnished
or must be furnished as to one or more defendants and not as to
others shall not be deemed a determination of any one or more
issues in the action or of the merits thereof. The corporation
(continued...)
Page -3-
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2(...continued)
and the moving party have recourse to the security in such amount
as the court determines upon the termination of the action. The
amount of the security may thereafter from time to time be
increased or decreased in the discretion of the court upon
showing that the security provided has or may become inadequate
or is excessive. If the court, upon any such motion, makes a
determination that security must be furnished by the plaintiff as
to any one or more defendants, the action must be dismissed as to
such defendant or defendants, unless the security required by the
court is furnished within such reasonable time as may be fixed by
the court.
5. If any such motion is filed, no pleadings need be filed by the
corporation or any other defendants, and the prosecution of the
action must be stayed, until 10 days after the motion has been
disposed of.
Page -4-
that there is no reasonable possibility that the derivative
actions will benefit the corporations, because the corporations
are not creditors of the debtors. 	They also claim the complaint
is defective because it was not verified as required by the
Nevada statute.
The Garretts first responded by filing a verification. 	Doc
7. 	Then, in their objection and brief, doc 11, they argue that
there is a reasonable possibility that the corporation could
benefit from the dischargeability actions. 	They also argue that
N.R.S. 41.520 is a Nevada procedural law that should not be
applied by the Bankruptcy Court which instead should apply New
Mexico or Federal procedural law.
DISCUSSION
1. 	Nevada Revised Statutes 41.520 is substantive law.
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Page -5-
Derivative actions, for many years the most
effective protection of shareholders against abuses by
corporate management, have often been misused by
shareholders suing with the hope of winning large
attorney's fees or private settlements, and with no
intention of benefiting [sic] the corporation on behalf
of which suit is theoretically brought. 	Among the
devices designed to remedy the evil of such strike
suits, security for expenses legislation, originating
in New York, is one of the most controversial. 	The New
York statute has served as the basis for similar
legislation in other states.
Note, Security for Expenses Legislation–-Summary, Analysis, and
Critique, 52 Colum. L. Rev. 267, 267-68 (1952)(Footnotes
omitted). 	Nevada Revised Statutes 41.520 is Nevada’s version of
a security for expenses legislation.
In Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541,
555-56 (1949), the United States Supreme Court analyzed New
Jersey’s security for expenses legislation and found it to be
substantive law, not a mere procedural device:
[T]his statute is not merely a regulation of procedure.
With it or without it the main action takes the same
course. 	However, it creates a new liability where none
existed before, for it makes a stockholder who
institutes a derivative action liable for the expense
to which he puts the corporation and other defendants,
if he does not make good his claims. Such liability is
not usual and it goes beyond payment of what we know as
‘costs.’ 	If all the Act did was to create this
liability, it would clearly be substantive. 	But this
new liability would be without meaning and value in
many cases if it resulted in nothing but a judgment for
expenses at or after the end of the case. 	Therefore, a
procedure is prescribed by which the liability is
insured by entitling the corporate defendant to a bond
of indemnity before the outlay is incurred. 	We do not
think a statute which so conditions the stockholder's
action can be disregarded by the federal court as a
mere procedural device.
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Page -6-
2. 	The Court should apply Nevada’s substantive law.
Diversity courts must apply the choice-of-law rules of the
forum state. 	Klaxon Co. v. Stentor Elec. Mfg. Co., 313 U.S. 487,
496 (1941). 	Bankruptcy courts, however, sit pursuant to a
special grant of federal jurisdiction, not through an accident of
geography. 	Limor v. Weinstein & Sutton (In re SMEC, Inc.), 160
B.R. 86, 89 (M.D. Tenn. 1993).
Unfortunately, the [Bankruptcy] Code provides no
guidance on the manner in which conflicts of state law
should be resolved. 	In the absence of any such
direction, some courts have resorted to the rule in
diversity of applying the choice of law provision of
the forum state. 	See In re Velasco, 13 B.R. 872, 874
(Bankr. W.D. Ky. 1981); In re Maplewood Poultry Co., 2
B.R. 550, 553 (D. Me. 1980). 	Other courts have
concluded that they may make an independent choice of
law, and have usually done so by assessing with which
state the action in question has the most significant
contacts. 	See In re Kaiser Steel Corp., 87 B.R. 154,
157-60 (Bankr. D. Colo. 1988); In re Barney Schlogel,
Inc., 12 B.R. 697, 700 (Bankr. S.D. N.Y. 1981); see
also In re Holiday Airlines Corp., 620 F.2d 731, 734
(9th Cir.1980); 	In re Wallace Lincoln-Mercury Co., 469
F.2d 396, 400 n. 1 (5th Cir. 1972).
Courts taking the latter approach rely on the
Supreme Court's opinion in Vanston Bondholders
Protective Comm. v. Green, 329 U.S. 156, 67 S.Ct. 237,
91 L.Ed. 162 (1946). 	In deciding what law to apply to
determine a creditor's claim for interest on unpaid
interest, the Court observed that
obligations ... often have significant
contacts in many states, so that the question
of which particular state's law should
measure the obligation seldom lends itself to
simple solution. In determining which contact
is the most significant in a particular
transaction, courts can seldom find a
complete solution in mechanical formulae of
the conflicts of law. Determination requires
the exercise of an informed judgment in the
balancing of all the interests of the states
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Page -7-
with the most significant contacts in order
best to accommodate the equities among the
parties to the policies of those states.
Id. at 161-62, 67 S.Ct. at 239.
Id. at 89-90.
The parties did not point out any New Mexico cases dealing
with choice of law questions for derivative actions filed in New
Mexico relating to foreign corporations. 	The Court also found
none. 	However, New Mexico generally follows the Restatement of
Conflicts of Laws. 	See, e.g., Ferrell v. Allstate Ins. Co., 144
N.M. 405, 422, 188 P.3d 1156, 1173 n.3 (2008). 	The Restatement
(Second) of Conflict of Laws § 309 states:
The local law of the state of incorporation will be
applied to determine the existence and extent of a
director's or officer's liability to the corporation,
its creditors and shareholders, except where, with
respect to the particular issue, some other state has a
more significant relationship under the principles
stated in § 6 to the parties and the transaction, in
which event the local law of the other state will be
applied.
Therefore, it appears that if the Bankruptcy Court were to follow
New Mexico’s probable choice of law, it would apply Nevada law
because the corporation is a Nevada corporation. 	See also
Labovitz v. Washington Times Corp., 900 F.Supp. 500, 503 (D. D.C.
1995), aff’d., 172 F.3d 897 (D.C. Cir. 1999)(“When a particular
claim addresses matters of corporate governance or other internal
affairs of the organization, most states apply the law of the
state where the corporation is incorporated.”)
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However, even if the Bankruptcy Court were to make an
independent assessment of which law to apply based on the most
significant contacts, it would chose Nevada. 	The main issue to
be determined in Counts 4 through 6 are whether the Cooks have
any liability to the corporation for the acts alleged by the
Garretts. 	Nevada law defines the scope of liability of a
director to a Nevada corporation. 	See N.R.S. § 78.138(7).
Nevada has the most significant contacts to this case.
3. 	Conclusion.
The Court finds and concludes that it should apply N.R.S. §
41.520. 	The Court will schedule the hearing anticipated by that
section to determine if security should be required and, if so,
the amount.
Honorable James S. Starzynski
United States Bankruptcy Judge
Date entered on docket: April 15, 2009
Copies to:
Chris W Pierce
Attorney for Garretts
Hunt & Davis, P.C.
P.O. Box 30088
Albuquerque, NM 87190-0088
Daniel J Behles
Cuddy & McCarthy, LLP
7770 Jefferson NE, Suite 305
Albuquerque, NM 87109
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