Court File and Parties
Court File No.: CV-19-00612596 Date: 2019-05-30 Ontario Superior Court of Justice
Between: James Millership and Robert Segal, Applicants – and – HyperBlock Inc., Respondent
Counsel: Alistair Crawley and Mitchell Fournie, for the Applicants Kevin Richard and Martin Mendelzon, for the Respondent
Heard: April 23, 2019
Reasons for Decision
Dietrich J.
Overview
[1] The Applicants, James Millership and Robert Segal participated in an amalgamation that took place pursuant to a plan of arrangement (the “Arrangement”) among HB Technologies Corp. (“HB Technologies”), Project Spokane LLC (“Project Spokane”) and CryptoGlobal Corp. (“CryptoGlobal”).
[2] Prior to the Arrangement, Mr. Millership and Mr. Segal were part owners and managers of CryptoGlobal. Following the Arrangement, they became minority shareholders in the amalgamated company, HyperBlock Inc. (“HyperBlock”).
[3] Within the first quarter following the closing of the Arrangement on July 10, 2018, HyperBlock experienced a significant post-closing decline in value. HyperBlock recorded significant write-offs of the value acquired from the Project Spokane assets as well as the goodwill component of Project Spokane.
[4] The Applicants became concerned that the business of HyperBlock was being conducted in an oppressive manner and prejudicial to the interests of the shareholders.
[5] Of particular concern to them is the purchase by HyperBlock of the business and assets of Project Spokane. The Applicants allege that Sean Walsh has a conflict of interest because he is both the CEO of HyperBlock and the majority shareholder of Project Spokane. They query whether the purchase of the Project Spokane assets was made based on a substantial over-valuation from which Mr. Walsh benefited significantly.
[6] They observe that since the purchase, the assets failed to perform and have generated only a fraction of the revenue represented in the financial statements and at investor presentations. Also, the major business line and source of revenue ceased entirely after the closing and Mr. Walsh has largely been absent, having taken up residence in Puerto Rico.
[7] In light of these concerns, and others, they seek the appointment of BDO Canada Limited as an independent, arm’s length inspector to conduct an investigation.
[8] More recently, HyperBlock issued a press release on April 18, 2019, indicating that it would not be in a position to file its audited financial statements and associated filings for the financial year ending December 31, 2018, due by April 30, 2019. The press release also disclosed the resignation of HyperBlock’s interim-CFO and three members of the Board of Directors.
[9] Even more recently, on May 17, 2019, HyperBlock announced that as a result of further delay in filing its audited financial statements and associated filings, it had been issued a cease trade order by the Ontario Securities Commission.
[10] For the reasons that follow, I find that the appointment of an independent, arm’s length inspector to conduct an investigation is appropriate.
Factual Background
[11] Prior to the Arrangement, Mr. Walsh, Eric So and Ronald Spoehel were all shareholders of HB Technologies. Mr. Walsh, as the controlling shareholder of Project Spokane, holds 80% of the shares.
[12] The Arrangement was intended to create a North American market leader servicing the cryptocurrency and blockchain markets, the centerpiece of which would be Project Spokane. Project Spokane operates a cryptocurrency mining facility in Montana, U.S.A., and was held out as having four revenue streams, namely “self-mining”, “hashrate” sales, server co-location hosting, and second-hand server sales.
[13] The Arrangement was seen as advantageous because CryptoGlobal could close its Canadian facilities and migrate its servers to Montana where power was cheaper and space was plentiful. HB Technologies would receive an influx of CryptoGlobal’s powerful servers and CryptoGlobal could put its servers to use under Project Spokane’s four diverse revenue streams.
[14] Mr. Walsh and HB Technologies advanced the premise that this diverse business model would weather downturns in the market and offer a competitive advantage over companies focused on self-mining. Hashrate sales, for example, were pitched as taking the variability out of the cryptocurrency market by diminishing risk through the receipt of large upfront payments.
[15] HB Technologies would benefit from becoming a publicly listed company and CryptoGlobal, already a public company, provided the vehicle through which HB Technologies could achieve this goal. As of May 2018, HB Technologies had raised over $16 million from investors, which was locked in escrow pending the completion of the Arrangement and HyperBlock’s public listing.
[16] Between December 2017 and February 2018, HB Technologies purchased from Project Spokane 1,447 cryptocurrency “mining” servers in exchange for US$9,500,000. These servers never left the Project Spokane facility and were then hosted by Project Spokane for a fee of US$772,982.
[17] Between January and July 2018, HB Technologies entered into a purchase agreement with Mr. Walsh and Project Spokane to buy the majority of the remaining assets of Project Spokane for approximately US$65 million. The purchase price would be satisfied by the payment of approximately US$11 million in cash and a US$4 million promissory note, with the remainder being paid in shares and subscription rights.
[18] Mr. Walsh and HB Technologies made several representations that justified the US$65 million purchase price, including that Project Spokane had generated US$22.5 million in revenue for the period ending December 31, 2017. A chart prepared by Canaccord Genuity for May 20, 2018, projected HyperBlock’s 2018 revenue to be on track for over US$40 million, having already received revenue from new hashrate contracts at a rate of US$2 million a month to that date. It also listed hosting revenue at $1.6 million per month and server sales at $500,000 per month. It forecasted that these receipts would re-occur for the remainder of the year.
[19] HB Technologies and Project Spokane, combined, was presented as generating US$28 million in Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) of US$2.6 million per month. These figures were generated by Project Spokane.
[20] A number of other representations were made. Mr. Walsh held himself out as a former NASA engineer and cryptocurrency industry veteran. HB Technologies was described as having a strong relationship with Roger Ver, a bitcoin investor, which allowed HyperBlock to be the sole wholesale hashrate supplier to Bitcoin.com. Project Spokane had a fully-funded build out prepared for the Montana facility and by May 2018 approvals had been received to move forward with expansion. Also, HB Technologies was, at that time, in the process of raising $40 million from investors in a subscription offering (the “Subscription Receipt Offering”) that would be used to support the purchase of Project Spokane.
[21] HyperBlock had raised over $16 million in cash from investors who spent $1.75 per subscription receipt. These investors expected to convert each receipt into one common share of HyperBlock once approved for public listing.
[22] The Plan of Arrangement was approved by the shareholders of both companies and approved by this court.
[23] Within weeks of the final closing on July 10, 2018, financial results emerged that called into question both the representations made by HB Technologies and Project Spokane, and Mr. Walsh’s intention to remain involved with the company. By April 2019, he had not visited the new corporate headquarters and he has not been an active participant in the management of the company.
[24] A number of discrepancies arose causing serious concern about the financial state of the combined company. An email message from CFO Tim Smart, sent July 22, 2018, noted a US$2 million monthly shortfall in EBITDA. A week later, Mr. Smart resigned as CFO.
[25] Between July 30, 2018 and August 24, 2018, the Applicants began their own investigation into the financial state of HyperBlock and the Project Spokane purchase by calling a meeting among the principals: Mr. So, Mr. Smart, Mr. Walsh, and a banker from Canaccord Genuity. At this meeting Mr. So presented a very different financial model that showed a significant decline in revenues, a net drop in server sales and a decline in hosting revenue.
[26] In response to a request for a cash flow statement, the Applicants learned, on August 8, 2018, that there had been a virtual disappearance in Project Spokane’s revenue streams. Mr. Millership determined that only weeks after closing, Project Spokane was projected to generate US$727,000 in cash per quarter (approximately US$3 million annually) despite having been sold as capable of generating over US$20 million annually.
[27] Between August 15 and 24, 2018, the Applicants held a number of meetings and conference calls during which they learned, among other things, that for the period ending March 31, 2018, Project Spokane presented $6,307,684 of Unearned Revenue associated with the hashrate and hosting contracts being sold to HyperBlock, but, when the Arrangement closed, none of the cash associated with the deferred revenue was transferred to HyperBlock; it appeared that Project Spokane kept the cash. It also appeared that Project Spokane retained the entire $750,000 upfront payment of hashrate sales and daily maintenance fees for July 2018 despite the fact that HyperBlock paid the entire electricity bill for that month.
[28] The Applicants also learned about numerous unexplained payables owing to Project Spokane as well as a general cash shortfall for HyperBlock. During an August 15, 2018 call, it was revealed that Project Spokane had debts of US$840,000 despite its obligation to contribute $500,000 on closing. Consequently, it contributed inventory instead, the value of which was questionable.
[29] Despite the fact that HyperBlock’s business operations were now focused in Montana, it had not opened a US bank account but rather allowed Project Spokane to incur payables on its behalf and invoice HyperBlock. Access to information relating to the flow of money in and out of the company, including the “crypto wallets” containing millions of dollars in HyperBlock’s crypto currency holdings remained concentrated in the hands of Mr. Walsh.
[30] Material changes to the underlying business were also revealed in August of 2018, including a change to the relationship with Mr. Ver and Bitcoin.com. This change virtually eliminated HyperBlock’s ability to sell new hashrate. Hashrate sales, which were presented as comprising 42% of the revenue of HB Technologies prior to close had become virtually nil after the closing.
[31] At this time, the Applicants also discovered irregularities in the servers. In addition to there being a shortfall in the number of servers, Mr. Millership learned that 97% of the servers had already been sold on lifetime contracts prior to the closing making them unavailable to sell new hashrate contracts. In addition, Bitcoin.com was changing its fee structure resulting in a lower daily fee.
[32] The Applicants also learned that the fully-funded build out of the Montana facility was no longer viable and required new sources of financing.
[33] The consequence of these changes was a write-off of virtually all of the value acquired from the Project Spokane assets.
[34] In the interim financial statements for the period ending June 30, 2018, HyperBlock incurred an impairment charge of US$6,861,000 on the US$9,500,000 used to purchase the Project Spokane servers in December 2017 – February 2018.
[35] The entire goodwill component of Project Spokane (valued at US$21.5 million prior to closing) was written off in the first financial quarter.
Position of the Parties
The Applicants’ Position
[36] The Applicants assert that within one quarter of the July 2018 closing, there has been a collapse in every one of Project Spokane’s major revenue streams, a flurry of new and unexplained payables purportedly owing to Project Spokane, a significant write-down of approximately US$21.5 million in goodwill, a material negative change in the relationship with Mr. Ver and Bitcoin.com, a delay in what was presented as a fully-funded expansion of the Montana facility, irregularities in the number of servers, and a discernible lack of initiative on the part of Mr. Walsh and the current board of directors to provide information to justify the situation.
[37] The Applicants also assert that the collapse of all four revenue streams cannot be explained by the marketplace, as the Respondents assert.
[38] The Applicants further assert that at the time of the Arrangement, HB Technologies had raised between $16 million and $30 million through the Subscription Receipt Offering. In order for HyperBlock to release the proceeds from escrow and make the payments to Mr. Walsh and Project Spokane, HB Technologies was required to complete the Arrangement and list the resulting company on a public stock exchange. If HB Technologies did not acquire CryptoGlobal, it would have breached the escrow conditions and the subscription receipts would have been cancelled and the proceeds returned to the investors. The Applicants assert that Mr. Walsh and HB Technologies presented an overvalued company in Project Spokane in order to justify HyperBlock’s Subscription Receipt Offering as well as the ultimate $65 million purchase price.
[39] Specifically, the Applicants contend that Mr. Walsh and Project Spokane arranged for a series of one-time revenue items used to artificially inflate Project Spokane’s revenue and EBITDA figures in order to justify the $1.75 subscription receipt. Examples of these revenue items include: i) the one-time use of Mr. Ver’s mining servers to generate inflated EBITDA figures associated with Project Spokane’s second-hand server sale business; ii) a one-time sale of 500 servers to Ryan Alter, named by Dan Stivers as a strategic resource to boost the purported revenue associated with Project Spokane’s second-hand server sale business; and iii) an alleged partnership with Bitcoin.com to boost the purported potential for future hashrate sales and deferred revenue intended to flow through to the new company. Mr. Millership deposed that when he confronted Mr. Smart on these issues, he was told that HB Technologies representatives had “financially engineered the rationale to reach the EBITDA to support what was needed for the deal.”
[40] The Applicants argue that the current board and management of HyperBlock are conflicted and cannot undertake a truly objective view of the Arrangement. In support of this argument, they assert that Mr. Walsh was the recipient of the majority of the cash paid out to Project Spokane at the closing. The Applicants argue that even if Mr. Walsh was not involved in the negotiations regarding the purchase of assets from Project Spokane as an essential part of the Arrangement, he was in the process of amassing a substantial shareholding in HB Technologies for pennies a share when the first contract with Project Spokane was signed in 2017, giving him a significant interest in both sides of the deal. Further, Mr. So (Chair of the Board) and Mr. Spoehel (the Independent Director) were also receiving millions of HB Technologies shares issued at pennies per share in late 2017 and early 2018. Mr. So, they assert, has a consulting agreement with HyperBlock that pays $25,000 per month. Mr. Stivers, a close associate of Mr. Walsh, received a bonus in December 2018 worth nearly 3.5% of the company, for assisting to arrange a bank loan with the Bank of Montana.
[41] The Applicants further assert that the management and directors are attempting to conceal, obfuscate, or distract from the true state of HyperBlock’s affairs. Notwithstanding the Applicants’ complaints to the Board of Directors, their concerns have not been addressed to their satisfaction.
The Respondent’s Position
[42] The Respondent asserts that the financial state of HyperBlock owes to the poor performance of the assets of CryptoGlobal and the failure by Mr. Millership and Mr. Segal to disclose various liabilities.
[43] It also asserts that the Applicants received full disclosure prior to the Arrangement and approved the purchase of the assets from Project Spokane, including the valuation of the servers. Hence, it argues that they cannot now complain that the Project Spokane assets were overvalued.
[44] The Respondent further contends that Mr. Millership does not understand the relevant accounting principles applied in the creation of the financial statements.
[45] The Respondent asserts that the decline in cryptocurrency prices coincided with the closing of the Arrangement. Accordingly, the post-closing decline in value is a consequence of external market forces that have had an impact on the cryptocurrency market generally and are beyond its control.
Issues
[46] The issues to be considered in this matter are as follows:
- Does the record establish a prima facie case of oppression?
- If so, is it appropriate for the Court to order an investigation?
Analysis
[47] Section 161(2) of the Ontario Business Corporations Act, R.S.O. 1990, c. B.16 (“OBCA”) sets out the criteria to be considered in ordering an investigation:
(2) Where upon an application under subsection (1), it appears to the court that,
(a) the business of the corporation or any of its affiliates is or has been carried on with intent to defraud any person,
(b) the business or affairs of the corporation or any of its affiliates are or have been carried on or conducted, or the powers of the directors are or have been exercised, in a manner that is oppressive or unfairly prejudicial to, or that unfairly disregards, the interests of a security holder,
(c) the corporation or any of its affiliates was formed for a fraudulent or unlawful purpose or is to be dissolved for a fraudulent or unlawful purpose, or
(d) persons concerned with the formation, business or affairs of the corporation or any of its affiliates have in connection therewith acted fraudulently or dishonestly,
the court may order an investigation to be made of the corporation and any of its affiliates.
Prima Facie Case of Oppression
[48] The jurisprudence confirms that the evidentiary threshold to appoint an inspector pursuant to s. 161 of the OBCA is low. In [Royal Trustco Ltd., Re, 1981 CarswellOnt 120 at para. 18, 14 B.L.R. 307 (Ont. H.C.)], Justice Eberle, quoting from Justice Galligan in his reasons for an earlier ex parte order in that same matter, stated: “Having regard to the fact that the relief provided for in the section is an investigation, it seems to me that a Court is entitled to make an order for an investigation if it appears on the face of the material submitted to the Court that there is good reason to think that the conduct complained of may have taken place.”
[49] In Catalyst Fund General Partner I Inc. v. Hollinger (2004), 48 B.L.R. (3d) 194 (Ont. S.C.) (“Catalyst Fund”), Justice Campbell confirmed that an inspector will be appointed if there is an appearance of oppressive conduct and the applicant has made out a prima facie case. At para. 39, Justice Campbell states:
… In the case of an oppression remedy, the reasonable expectation is determinable on the material before the Court. In the case of inspection relief, there must be at the very least an index of suspicion or appearance that reasonable shareholder expectations have not been met in viewing the actions or non-actions of management and directors. It is then appropriate to test that prima facie case with an inspection to determine whether further relief is warranted.
[50] In Jones v. Mizzi, 2016 ONSC 4907, at para. 16, Justice Hainey held that where the facts presented raise an “index of suspicion” (in that case, a failure to provide financial statements), an investigation may be ordered.
[51] In Catalyst Fund, Justice Campbell stated, at para. 43: “The purpose of a [Canada Business Corporations Act] s. 229 Investigation is to find relevant facts: in this case, what payments were made to persons who were officers and directors of a number of related companies, in what capacities funds were received, whether they were properly authorized and with appropriate disclosure of any conflict.”
[52] On the duty of a company to provide its shareholders with audited financial statements, the Ontario Court of Appeal, in Packall Packaging Inc. v. Ciszewski, 2016 ONCA 6, at para. 28, stated:
It is a core obligation of a corporation to its shareholders to provide them with an annual report card of the corporation’s financial position in the form of audited financial statements …
[53] I am satisfied on the evidentiary record before me that there is an appearance of oppressive conduct by HyperBlock and that the reasonable expectations of the Applicant shareholders have not been met.
[54] The Applicants have demonstrated a prima facie case that the business of HyperBlock may be being conducted in a manner that is oppressive, or that is prejudicial and unfairly disregards the interests of the shareholders.
[55] The evidence shows that external market forces do not fully account for the precipitous change in the financial status of HyperBlock in the first financial quarter following the closing. The record shows that the downward movement in crypto currencies from their historic high began in January 2018 and was established by April 2018. When the Arrangement closed in July 2018, prices for bitcoin had been hovering between lows of about US$6,000 and highs of about US$8,000 for over three months, and they remained at this level for another three months after the Arrangement closed, until November 2018.
[56] The losses experienced by CryptoGlobal in the transfer of its assets to Montana similarly cannot be said to have caused the significant decline in the value of HyperBlock. The record shows that those losses were anticipated as part of the cost of CryptoGlobal winding down its operations in Canada.
[57] As noted by Justice Campbell in Catalyst Fund, inspection relief is warranted where there is an index of suspicion that shareholder expectations have not been met in viewing the actions of the directors and management. In the case at bar, this index of suspicion is evidenced by the following actions and inaction of the management and directors of HyperBlock:
- Project Spokane appears to have functioned as a conduit through which large amounts of cash have flowed out of HyperBlock. Its senior officers and directors of HyperBlock have refused or been unwilling to address this issue, or have simply acquiesced to the situation. The CEO, Mr. Walsh, has refused to address these concerns and has taken up residence in Puerto Rico.
- Since the closing, three Chief Financial Officers, or interim-Chief Financial Officers, have resigned.
- When the controller, Manchula Srikarunna, resigned in September 2018, she cited the inability to access any information from Project Spokane as one of her reasons. The replacement controller, Carolyn Bond, was terminated in 2018.
- No explanation has been given for the failure of HyperBlock to open its own U.S. bank account and its decision to instead use the Project Spokane U.S. bank account over which HyperBlock has no direct supervision.
- The directors have refused to initiate inquiries into the suspected misconduct or irregularities in the business of HyperBlock, and appear to trust Mr. Walsh, the CEO and majority shareholder, without question.
- There exists the possibility that Mr. Walsh and HB Technologies presented an overvalued company in Project Spokane in order to justify HyperBlock’s Subscription Receipt Offering and the ultimate $65 million purchase price.
- HyperBlock issued a press release on April 18, 2019, stating that it is not in a position to file its audited financial statements on a timely basis, and that three of its directors, including Mr. So, resigned from the board, and its interim-CFO also resigned.
- On May 17, 2019, HyperBlock announced that owing to a further delay in filing its audited financial statements, it had been issued a cease trade order by the Ontario Securities Commission.
- There may not have been proper disclosure or management of conflicts of interest relating to Mr. Walsh and his interest in both the purchase and the sale of the Project Spokane assets, as well as potential conflicts of interest between Mr. Walsh and other directors and senior management who appear to have benefited financially from their relationship to Mr. Walsh.
Appointing an Inspector
[58] This index of suspicion suggests that, without an investigation, facts that are not otherwise accessible to the Applicants will not be brought to light. In Akagi v. Synergy Group (2000) Inc., 2015 ONCA 368, at para. 69, footnote 3, the Ontario Court of Appeal confirmed the purpose of an inspector under s. 161 of the OBCA as follows:
In general, this relief is available at the instance of the shareholder where it is apparent that the corporation’s books and records are not properly kept or are inaccurate, or where there has been some deceit or oppressive conduct practised against the shareholders: … Its purpose is to ensure that a corporation discharges its core obligation to provide shareholders with an accurate picture of its financial position … The court has broad powers to make any order it thinks fit, but, in particular is empowered to appoint an inspector to conduct an investigation and to authorize the inspector to enter any premises in which the court is satisfied there might be relevant information, to examine anything and make copies of any document or record found on the premises, and to require any persons to produce documents or records to the inspector.
[59] In Khavari v. Mizrahi, 2016 ONSC 4934 at para. 41, Justice Pattillo states that the appropriateness of appointing an inspector arises from both the fact that the remedy is discretionary and extraordinary:
In considering the issue of appropriateness, the courts have had regard to a number of factors, including:
a) Whether the applicant needs access to the information; b) Whether there are better less expensive means to acquire the information; c) Whether the proposed investigation would give a tactical advantage to the applicant; and d) The expense of the investigation as compared to the benefits.
[60] The Applicants have made attempts to gain access to information that has not been forthcoming. They are entitled to audited financial statements, which were due April 30, 2019. Based on an announcement made by HyperBlock on May 16, 2019, the statements are now expected by July 31, 2019, which represents a further delay from the June 30, 2019 date by which it was expected to file its financial statements in accordance with its May 2, 2019 announcement.
[61] The Applicants do not appear to have alternative means of accessing information. The present board and senior management appear to be aligned with Mr. Walsh and would be in a conflict of interest in undertaking a truly objective review of the purchase of Project Spokane’s assets. Further, HyperBlock’s ability to perform an objective review of the transaction is hampered by the fact that those responsible for managing the financial information have resigned or been terminated. Mr. Walsh has moved to Puerto Rico, and a number of directors on the board at the time of closing, including Mr. So, and three of the company’s CFO’s or interim-CFO’s have resigned since the closing.
[62] The Applicants estimate the costs of an investigation (by BDO Canada Ltd.) to be at most, $155,000 plus disbursements. I find this cost to be reasonable especially when weighed against the benefits it may provide to HyperBlock, a company potentially worth tens of millions of dollars.
[63] The appointment of an inspector is warranted in this case, where there has been a sudden collapse of HyperBlock’s business as well as changes to underlying fundamentals of the business that cannot be fully explained by changing market conditions and have not been explained by the directors and management of HyperBlock.
Disposition
[64] An investigation is hereby ordered. I appoint BDO Canada Limited, without security, as an inspector of HyperBlock Inc. and its affiliated entities, including Project Spokane LLC, with all the rights and powers of an inspector within the meaning of sections 161, 162 and 163 of the OBCA. The parties agreed to defer submissions relating to the scope of the investigation and the powers of the inspector pending these reasons for decision. Counsel may arrange a chambers appointment with me to schedule a further hearing with regard to the inspector’s investigative mandate, following which I will finalize this aspect of my order.
Costs
[65] I encourage counsel to agree on the matter of costs. If they are unable to do so, the Applicants may file written submissions, not exceeding three pages in length (exclusive of a costs outline or bill of costs) within 10 days from the date of the final order. The Respondents may file written submissions, not exceeding three pages in length (exclusive of a costs outline or bill of costs) within 10 days thereafter.