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Deutsch v. ZST Digital Networks, Inc., C.A. No. 8014-VCL (Del. Ch. June 14, 2018) (Laster, V.C.)

June 14, 2018

In this memorandum opinion, the Delaware Court of Chancery declined to grant a receiver’s motion for the issuance of bench warrants calling for the arrest of two senior officers of ZST Digital Networks, Inc. (“ZST”), a Delaware corporation that failed to comply with a default judgment entered in 2013 ordering the inspection of its books and records.  The Court held that due process required providing the officers one final opportunity to comply with its orders before issuing bench warrants for their arrest.

ZST is a Delaware corporation and the ultimate parent entity of Zhenzhou Shenyang Technology Company Limited (the “Operating Company”), an entity organized under Chinese law that supplies network equipment to cable operators in China.   ZST owns the Operating Company through various subsidiaries organized under the laws of the British Virgin Islands (the “BVI Subsidiaries”) and Hong Kong (the “Hong Kong Subsidiary”). Bo Zhong is ZST’s Chairman of the Board and CEO.  His son Lin serves as a director and CFO.  ZST voluntarily delisted its shares from the NASDAQ in 2012 after its outside auditors resigned, allegedly because ZST had obstructed the auditors’ efforts to verify its cash and account balances. Following the delisting, plaintiff, one of ZST’s largest stockholders, sought inspection of ZST’s books and records pursuant to Section 220 of the Delaware General Corporation Law (“DGCL”).  When the company failed to comply, the stockholder brought this action in the Court of Chancery.

ZST thereafter failed to respond or otherwise appear in response to the Section 220 action, and the Court entered default judgment against it permitting the stockholder to inspect its books and records.  ZST made no effort to comply with the default judgment.  The stockholder then moved the Court to hold ZST in contempt.  Once again ZST failed to appear or comply with the Court’s order.  Accordingly, on March 20, 2013, the Court held ZST in contempt for violating the default judgment and appointed a receiver pursuant to Section 322 of the DGCL for the purpose of compelling ZST and its subsidiaries to comply with the Court’s order.  Pursuant to the broad powers granted to him by the Court, the receiver removed the boards of directors of the BVI Subsidiaries and the Hong Kong Subsidiary.  When the sole director of the Hong Kong Subsidiary moved to intervene, the Court entered an order (the “Conditions Order”) setting forth conditions for the post-default judgment participation of ZST and its affiliates in the Delaware proceedings.  ZST was ordered to pay the receiver’s fees, post a $5 million bond, and provide the stockholder and receiver access to its financial statements.  ZST failed to comply with the Conditions Order.  The receiver then moved for an order establishing procedures to sell the Hong Kong Subsidiary.  The Court granted the unopposed motion.

The Zhongs refused to cooperate with the receiver’s efforts to sell the Hong Kong Subsidiary.  They barred physical access to the Operating Company’s Chinese facility and refused to divulge its financial information.  Their actions forced potential buyers of the Hong Kong Subsidiary to withdraw viable offers.  In July 2016, the receiver and Bo Zhong appeared to reach an agreement to settle a lawsuit that the receiver had brought in a Chinese court to remove Bo as director of the Operating Company.  Bo eventually reneged.  The receiver moved the Court to issue bench warrants for the arrest of the Zhongs to compel their compliance with the numerous Court orders that had gone ignored for over five years.

The Court first addressed the parties’ procedural arguments.  The receiver contended that the Zhongs could not appear or make submissions to the Court without satisfying the requirements imposed upon ZST by the Conditions Order.  Noting that it was ZST and not the Zhongs who had defaulted, the Court held that due process required the Zhongs be given an opportunity to respond to the receiver’s motion to impose coercive sanctions upon them without first having to satisfy ZST’s obligations.  Next, the Court addressed the Zhongs’ claim that they could not be held in contempt because they were not formal parties to the case.  The Court rejected this argument, making clear that an order issued to a corporation extends to the officers, directors, and employees who act on its behalf.  The Court similarly dispensed with the Zhongs’ contention that it lacked personal jurisdiction over them. The Zhongs’ status as directors and officers of a Delaware corporation provided the requisite statutory and constitutional bases for the Court to exercise personal jurisdiction.

The Court then turned to the due process concerns raised by the receiver’s motion.  As a preliminary matter, the Court determined that the receiver’s motion sought a finding of civil rather than criminal contempt because any potential imprisonment would last only until the Zhongs ceased their contemptuous conduct.  Therefore due process required only that the Zhongs be afforded notice and an opportunity to be heard—and not the more stringent procedural requirements, including trial, afforded those facing a potential finding of criminal contempt. Although finding that it possessed the authority to impose the requested sanctions, the Court held that due process required further proceedings before it could issue bench warrants for the Zhongs’ arrest.  

The Court identified a series of due process concerns around notice, chief among them the fact that the receiver sought to hold the Zhongs in contempt of Court orders that never identified them by name.  The Court recognized that its previous orders merely set forth general obligations of ZST and did not demand or direct the Zhongs to take specific actions.  The fact that the Zhongs are foreign nationals who may not have understood the personal jeopardy they faced also weighed against finding adequate notice.

Addressing whether the Zhongs had been afforded an adequate opportunity to be heard, the Court first noted that the U.S. Constitution establishes a floor rather than a ceiling for procedural due process.  The Court ordered additional hearings despite determining that the Zhongs had been afforded an adequate opportunity to be heard through their briefs and opposition to the receiver’s motion.  The Court emphasized that imprisonment for civil contempt requires careful scrutiny and extensive fact-finding.  Accordingly, the Court requested that the receiver submit an order directing the Zhongs to take specific actions to comply with the Court’s previous orders, after which the Zhongs would have sixty days to comply  before the receiver may renew his motion.

The full opinion is available here