8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 1 of 30 - Page ID # 851 UNITED STATES DISTRICT COURT DISTRICT OF NEBRASKA ANIL AGARWAL, ) 8:03CV56 ) Plaintiff, ) ) vs. ) ) SANDY DALAL, LTD, ) ) MEMORANDUM OPINION Defendant/ ) AND ORDER Counterclaim-Plaintiff, ) ) vs. ) ) ANIL AGARWAL, ) ) Counterclaim-Defendant/ ) Plaintiff ) ) and ) ) RELIANT GLOBAL SERVICES, ) ) Counterclaim-Defendant. ) Plaintiff, Dr. Anil Agarwal, sued defendant Sandy Dalal, Ltd. (SDL), for breach of contract. SDL asserted several affirmative defenses and filed a counterclaim against Dr. Agarwal and Reliant Global Services, Inc. (Reliant) alleging breach of contract. Both parties waived their right to a jury trial and a bench trial was held. FINDINGS OF FACT The court finds the following facts have been proven by a preponderance of the evidence: 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 2 of 30 - Page ID # 852 SDL is a closely-held fashion design company that marketed the designs of Sandy Dalal. Sandy Dalal’s mother, Loma Agashiwala, is the CEO. Mahesh Agashiwala is an accountant and Sandy Dalal’s father. Sandy Dalal and Arun Agarwal, Dr. Agarwal’s son, met while they were students at the University of Pennsylvania in the late 1990s. In June of 1999, Arun Agarwal and Loma and Mahesh Agashiwala began to discuss an investment in SDL. The parties signed an “Operating Agreement” dated “6/99." The agreement provided that “Reliant Global Services, a Nebraska incubator, has assumed responsibility to Sandy Dalal, Ltd. for the payment of accrued expenses up to $1 Million as of December 31, 1999. The purpose of his [sic] involvement includes marketing, promoting, and coordinating special events for Sandy Dalal, Ltd.” The document was signed by Loma Agashiwala and Dr. Agarwal, for Reliant Global Services. Def.’s Ex. 138. Reliant Global Services is a Nebraska corporation. Reliant actively invested in a number of businesses, including SDL. Arun Agarwal was involved with Reliant as an asset manager. Tr. 63. Arun Agarwal testified that at the time Reliant began its relationship with SDL, the corporation was beginning to focus on “incubating entities,” that is, investing in companies at the early stages of development. Tr. 87-88. Arun Agarwal testified that the ultimate goal for these investments was that they would “synergize with” other 2 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 3 of 30 - Page ID # 853 companies in Reliant’s portfolio. Tr. 87-88. The primary shareholder in Reliant was Dr. Agarwal, although there were other investors. Tr. 114. When Arun Agarwal was asked whether other shareholders would have been consulted regarding Reliant’s agreements with SDL, he responded as follows: [Counsel for SDL]: Would there be a member vote to approve this arrangement? [Arun Agarwal]: I don’t know during the course of Reliant Global Services whether we were that formal per se, but we’d certainly have meetings and discuss. Tr. 76. Negotiations between SDL and Arun and Dr. Agarwal continued after the operating agreement was signed. SDL contends that the parties reached a verbal agreement in the fall of 1999 in which Agarwal would provide $1.5 million in capital to SDL. See Pl.’s Posttrial Br. at 7. SDL contends that this verbal agreement for a $1.5 million equity investment is embodied in the written agreement in which Reliant assumed responsibility for $1 million worth of SDL’s expenses and a contract in which Dr. Agarwal agreed to provide an additional $500,000 as a convertible loan. Loma Agashiwala testified that the parties discussed a $1.5 million investment, with $500,000 to be invested before the end of 1999. Tr. 147-149. Arun Agarwal testified that between his father and Reliant, they committed a total of $1.5 million to SDL, which included the $1 million in expenses covered in the operating agreement and the $500,000 convertible debt agreement. Tr. 112. 3 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 4 of 30 - Page ID # 854 On December 28, 1999, Dr. Agarwal entered into a convertible debt agreement with Global Marketing, L.L.C., which is the marketing arm of SDL. Arun Agarwal drafted an agreement under which his father would “place” $500,000 with SDL as convertible debt. The debt would mature in December of 2002, with an annual interest rate of 8.5 percent. The agreement gave Dr. Agarwal the option of converting the debt to an equity interest in SDL valued at $5 million. The parties understood that this meant that if the company was worth $5 million, Dr. Agarwal’s investment would be worth 10 percent of the value of the company, or $500,000. If the company was worth $7 million, the investment would be worth $700,000. The convertible preferred debt agreement provides: Sandy Dalal, Ltd. (the “Company”) and Anil Agarwal (the investor) agrees [sic] that on or before December 31, 1999, the investor will place $500,000 (Five Hundred Thousand Dollars) as 8.5% Convertible Preferred Debt. The two parties agree on the following: 1. The debt is maturing on December 31, 2002, will accrue at 8.5%. The interest is paid upon maturity at a simple interest rate. 2. The Company agrees that the money will be converted at a $5MM valuation upon prior to maturity at investor’s option. 3. The Company agrees not to dilute the investor’s position without written consent. Timely consent is needed. 4. The Company agrees that the debt will remain senior to all other forms of capital investment except to the financial institutions unless authorized in writing by the investor. Timely consent is needed. 4 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 5 of 30 - Page ID # 855 5. If Company can pay off the debt earlier, the investor will have to decide whether to immediately convert to an equity percentage or take money back. 6. This agreement will be governed by The Laws of The State of New York. Pl.’s Ex. 1. The agreement was signed by Loma Agashiwala and Dr. Agarwal. Arun Agarwal’s name was crossed out and replaced with Anil Agarwal. The change was initialed by Dr. Agarwal and Loma Agashiwala. On December 28, 1999, Arun Agarwal sent a $500,000 check made payable to Global Marketing, L.L.C., for the convertible loan. The check was drawn on Dr. Agarwal’s account. In a letter accompanying the check, Arun Agarwal stated “I believe to complete the deal, we will need to produce a non- recourse, promissory note for the remaining $1MM in deductions (to total $1.5MM).” Ex. 220. Dr. Agarwal had large capital gains from other investments in 1999. He was looking for business losses that he could use to offset his capital gains and reduce his tax liability for 1999. While negotiating the terms of the convertible debt, Arun Agarwal and Loma Agashiwala discussed Dr. Agarwal’s need for investment losses in 1999, and whether the $500,000 convertible debt could be used as such an investment loss. The check accompanying the agreement was made payable to Global Marketing, L.L.C., because SDL is a “C” corporation. A “C” corporation cannot pass losses to investors. Arun Agarwal told Loma Agashiwala that his accountant could pass the loss from 5 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 6 of 30 - Page ID # 856 an L.L.C. to Dr. Agarwal, thus reducing Dr. Agarwal’s capital gains taxes for 1999. As part of the discussion about the terms of the convertible debt agreement, Arun Agarwal informed Loma Agashiwala that Dr. Agarwal intended to claim a loss on his taxes of approximately $1.5 million for the $500,000 investment. In a fax to Agashiwala dated December 23, 1999, Arun Agarwal stated “we can discuss the tax arrangements (3:1) tomorrow and conclude this deal.” Ex. 218. On December 29, 1999, Agashiwala and Dr. Agarwal signed a letter that “confirms Global Marketing, LLC’s ability and intent to give deductions for investments made to the Company at a three-to- one ratio. The intent is to conclude a $500,000 investment with $1.5MM in deductions.” Ex. 32. On February 24, 2000, Arun Agarwal requested a copy of the operating agreement for Global Marketing, and “any financial information regarding the activity of Global Marketing.” He wanted the information to prepare Dr. Agarwal’s 1999 tax return. See Ex. 146. On April 18, 2000, Arun Agarwal sent Loma Agashiwala an “open ended Letter of Understanding which will allow the deal to be struck as we have been attempting. This will allow us to complete taxes upon finding a suitable company to use for deductions.” The 6 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 7 of 30 - Page ID # 857 letter contained a copy of the Letter of Understanding1 and Operating Agreement mentioned above, which Loma Agashiwala was supposed to sign. Def.’s Ex. 224. Loma Agashiwala testified that she did not provide additional financial information because the three-to-one tax deduction did not seem legal. She did not understand how the $500,000 could be claimed as a bad debt or lost investment, and she did not understand how Dr. Agarwal could claim a loss that was three times the size of the investment. On May 23, 2000, Arun Agarwal requested “detailed expenses accounting for the $1.468 MM in expenses for 1999 so that we can substantiate the tax returns.” He also indicated that he was meeting with another potential investor. Upon receipt of the signed operating agreement, letter of understanding, and financial information, Arun Agarwal would discuss the convertible note agreement and a new investment that would occur in 30 to 60 days. Def.’s Ex. 228. In another fax dated May 23, 2000, Arun Agarwal stated “[a]fter repeated and failed attempts to close our deal, I am disappointed that this deal is having difficulty closing. I am making a final request to spend time to close the deal this week otherwise demand for repayment will be made.” Def.’s Ex. 227. 1 Instead of indicating that Reliant was accruing expenses for SDL, this copy had blank spots to be filled in at another time. 7 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 8 of 30 - Page ID # 858 On June 6, 2000, Arun Agarwal requested invoices and accounts payable to show losses attributed to Dr. Agarwal’s involvement with SDL, and stated that upon “receiving that information, I wish to conclude the Preferred Convertible agreement.” Arun Agarwal stated that once that deal was complete, he would aggressively pursue additional financing and that he was close to finding another investor. Def.’s Ex. 229. On July 26, 2000, Arun Agarwal made another request for copies of invoices and checks to complete Dr. Agarwal’s tax return. He stated that failure to provide the financial information would “critically hurt the completion of this project and deal.” Def.’s Ex. 232. On July 27, 2000, Agashiwala stated that she never agreed to give copies of invoices and that “there is no way that I know which will permit you to take deduction [sic] in excess of the investment amount.” Def.’s Ex. 234. She had previously indicated that she did not want to jeopardize SDL’s future, but acknowledged that Arun Agarwal had told her that their accountant knew how to make the deduction and had done it before. Loma Agashiwala asked Arun Agarwal to “leave it as a 3 year convertible note and not go into the deduction aspect of it.” Pl.’s Ex. 34. After another series of requests for invoices by Arun Agarwal and a request by Loma Agashiwala for an explanation of how they could make the three-to-one deduction, Dr. Agarwal demanded the return of the $500,000 8 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 9 of 30 - Page ID # 859 plus interest and expenses on August 22, 2000. Def.’s Ex. 240. On September 8, 2000, Loma Agashiwala provided a summary of SDL’s expenses for 1999, which totaled $1,468,686. Def.’s Ex. 151 at 3. Dr. Agarwal claimed a loss of $1,510,326 on his 1999 individual income tax return from his pass through investment in Reliant. See Def.’s Ex. 127 at 35. He testified that the expenses accrued by SDL were the basis of this deduction. Tr. 45. On February 21, 2001, Arun Agarwal wrote to Loma Agashiwala and indicated that he wanted a more active role in SDL. In order to effectively participate, he wanted audited financial records, copies of sales agreements, licensing, manufacturing and distribution agreements, and other information. Pl.’s Ex. 35. In a letter dated July 23, 2001, to Mahesh Agashiwala, Arun Agarwal stated that SDL had failed to act in good faith and disclose financial information that he wanted to ensure that the investment was progressing. Pl.’s Ex. 39. Loma Agashiwala testified that after she provided the expense information in September of 2000, SDL never received additional funds from Dr. Agarwal or Reliant. Tr. 160-62. SDL was unable to obtain sufficient funding and SDL went out of business. Acting through his attorney, Thomas C. Underwood, Dr. Agarwal requested financial information on September 11, 2002, to determine whether he wanted to exercise his option to convert the debt to an equity position. Pl.’s 9 8:03-cv-00056-KES-TDT Doc # 107 Filed: 09/12/06 Page 10 of 30 - Page ID # 860 Ex. 23. After receiving no response, Underwood sent a similar letter on October 14, 2002. Pl.’s Ex. 31. Dr. Agarwal did not exercise his option to convert the debt to equity. After SDL did not repay the $500,000 loan plus interest, this lawsuit was filed. DISCUSSION Dr. Agarwal sued SDL for breach of contract to recover the unpaid $500,000 convertible debt plus interest. SDL admitted that it did not repay the loan, but alleged the following affirmative defenses: (1) the instrument was satisfied; (2) unclean hands; (3) no loan was granted to SDL by Dr. Agarwal; (4) the convertible debt was part of a larger agreement breached by Dr. Agarwal; (5) Dr. Agarwal is barred by estoppel from any relief; (6) the agreement was based on a fraudulent scheme to defraud SDL; and (7) Dr. Agarwal received the benefit of the bargain. SDL counterclaimed, alleging fraudulent inducement and that Dr. Agarwal and Reliant breached the operating agreement in which Reliant agreed to assume responsibility for up to $1 million in accrued expenses. The court has jurisdiction because the parties are diverse and the amount in controversy exceeds $75,000. At the outset, the court must determine which law applies to this dispute. In diversity cases, federal courts apply the choice of law rules of the forum state to determine which state’s 10