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Defense lawyers thought they had a slam dunk two years ago when a group of employees filed fraud claims against their bankrupt company’s venture capital backers and chief executive officer. In most circumstances, venture capital firms don’t get named in such actions because they’re not directly involved in the management of the companies they fund. And lawyers for VCs were also counting on backpay claims by employees being handled in bankruptcy court. So far, they’ve been wrong. The lawsuit is still winding its way through the San Francisco courts, having survived two defense attempts to have the case dismissed. As a result, the action against Genstar Capital is casting an ominous shadow over Silicon Valley’s venture capital community, which could be vulnerable to further suits if a jury sides with the employees of Skyway Freight Systems Inc., which operated out of the San Francisco International Airport. “[VCs] rely on the bright line between investing and employing,” said Fred Alvarez, a Wilson Sonsini Goodrich & Rosati partner in Palo Alto, Calif., who is representing Genstar. “And we hope this case will make sure that line stays in place.” The lawsuit, Malcolm Smith v. Genstar Capital, 313964, was filed in July 2000, just three months after the Nasdaq started tumbling. During that summer, frightened investors stopped putting out capital, letting their riskier investments fail. That had employees crying foul, and defense lawyers were bombarded with claims from executives to temporary workers who claim they were victims of fraud. But few of the allegations turned into court cases. Skyway’s employees, however, banded together and filed a single complaint, accusing Genstar, which is based in San Francisco, and Skyway’s chief executive officer, Chris Healy, of disseminating false information about the company’s finances so they would keep working after the company ran out of money to pay them. “They [the defendants] were obviously in a downward spiral … they needed to keep the knowledge capital from leaving in an uncontrolled fashion,” said plaintiffs’ lawyer Joseph Clapp, a Herron & Herron partner in San Francisco. “They needed them to stick around until they dumped them.” The suit alleges that in a period of three weeks during spring 2000, Healy sent e-mails that painted a rosier picture of the company’s financial health than he and the investors knew was true at the time. The first e-mail on March 16 told employees the company had secured a new investment round and was financially sound. The second e-mail on March 30 said the company was going out of business, but was not filing for bankruptcy. A week later, the suit says, the company filed for Chapter 7 bankruptcy. “The plaintiffs would not have remained employed if they knew that Skyway was unable to pay for their services and that Skyway was unable to pay for their employment benefits,” said an amended complaint, which was filed in January. The employees are seeking several weeks of unpaid wages, reimbursement for unpaid insurance claims and accrued vacation time. Plaintiffs are seeking class certification for Skyway’s 625 workers. A procedural hearing is set in the case for April 29 before San Francisco Superior Court Judge Ellen Chaitin. Trial is expected to begin in November. Healy’s defense lawyer, Gordon McAuley, senior counsel at Hanson, Bridgett, Marcus, Vlahos & Rudy in San Francisco, said the executive did nothing wrong, but he declined to comment further because it’s a pending matter. But Alvarez said the facts don’t add up to a fraud claim and that the employees should pursue their claims for unpaid wages and other expenses in bankruptcy court, which is set up to handle them. “He’s clearly trying to circumvent the bankruptcy process by going after the investors in the company,” Alvarez said of the plaintiffs’ lawyer. The allegations leveled in the suit also draw in securities-related issues, Alvarez said. “In a sense they’re almost bringing a securities claim against the employers, saying you have a duty to disclose much more about the finances of the company so we could make an investment decision about whether or not” to keep working, Alvarez said. He added that the suit almost demands that internal company communications should be held to the same standard as a filing with the Securities and Exchange Commission. “That’s a very novel and dangerous theory,” Alvarez said. Clapp dismissed the comparison, saying the employees aren’t demanding a specific level of disclosure. “What we’re saying is, if you tell somebody — the employees — something, you should tell them the truth,” Clapp said. Regardless of whether securities laws come into play, the suit is an interesting one to Valley employment litigators and venture capital lawyers. “It opens up a whole new line of attack,” said Gary Siniscalco, an Orrick, Herrington & Sutcliffe partner in San Francisco. He said that given the right factual circumstances, investors having substantial control over a company’s operation or VCs who get involved with corporate communications may find themselves exposed. But the suit isn’t an easy win for plaintiffs either, he said. It’ll be hard for them to prove they all suffered equally and, therefore, deserve to be a class. “We’re seeing more and more creative plaintiffs’ lawyers coming up with theories either to expand the basic claims against companies or to expand who they can go after,” Siniscalco said. “[They are] trying to look for some deep pockets when there isn’t one around.”

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