Allegations of Self-Dealing, Uninformed Decisions, and Lack of Formalities Raise Plausible Claims for Breach of Fiduciary Duties and Debt

Allegations of Self-Dealing, Uninformed Decisions, and Lack of Formalities Raise Plausible Claims for Breach of Fiduciary Duties and Debt

Recharacterization or Subordination A complaint filed by a liquidating trustee against a private equity firm, as well as the former directors and officers of a debtor, stands as a warning for private equity firms. It particularly concerns those

deeply involved in managing insolvent companies from which they draw significant consulting or management fees. According to the complaint, the debtor operated furniture factory outlet stores. In 2016, Sun Capital, a private equity firm, acquired the debtor. Post-acquisition, the debtor's debt surged from just over $2.5 million to $32,135,306.

After the acquisition, Sun Capital replaced the debtor’s board of directors and became closely involved with the debtor’s management and operations. Sun Capital eventually recommended that the debtor acquire certain companies. The acquisitions were not successful and contributed to the debtor’s deteriorating financial condition.

In spite of these unsuccessful ventures, the debtor consistently paid hefty consulting fees to Sun Capital. The debtor even paid-off some of its debts with Sun Capital, all while having $4.7 million in outstanding vendor payments.

Later on, Sun Capital extended more loans to the debtor. These loans were often without proper documentation, and the debtor didn't explore financing options from other sources. Eventually, the debtor filed for bankruptcy.

The trustee then initiated an adversary proceeding against some D&Os and Sun Capital based on: (i) the D&Os’ breaches of their fiduciary duties to the debtor; (ii) Sun Capital's aiding and abetting of those breaches of fiduciary duties; (iii) recharacterization as equity of the debt owed to Sun Capital; (iv) equitable subordination of Sun Capital's claims;

1. avoidance of fraudulent transfers made to Sun Capital; (vi) wrongful distributions paid to Sun Capital; and (vii) D&Os’ breach of LLC agreements. The court concluded that the complaint raised plausible claims for 10 out of the 11 counts, based on the following key allegations:
2. the D&Os failed to inform themselves fully before approving the acquisitions;
3. the D&Os approved transfers to Sun Capital that were fraudulent or improper;
4. the D&Os allowed the debtor to take on significant insider debt from

Sun Capital when the debtor was insolvent or nearly insolvent;

1. Sun Capital directed the D&Os' alleged breaches as the debtor’s controlling shareholder;
2. the loans made by Sun Capital were, in effect, equity contributions because: they lacked specific repayment schedules; the debtor was inadequately capitalized; the lacked formalities, and Sun Capital stood on both sides of the transactions, among other factors.