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Summaries and analysis of recent Delaware court decisions concerning business-related litigation.
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Court of Chancery Dismisses Complaint Because a Creditor Erroneously Asserted Derivative Claims as Direct in the Hope of Escaping Bankruptcy Court Jurisdiction
Big Lot Stores, Inc. v. Bain Capital Fund VII, LLC, C.A. No. 1081-N, 2006 WL 846121 (Del. Ch. Mar. 28, 2006). In 2000, in a sponsored management buyout, a corporation sold a subsidiary business that operated a chain of toy stores (KB Toys) in exchange for $257.1 million in cash and a $45 million note due in 2010. In 2002, the new owners refinanced the business and distributed approximately $120 million to the buyout sponsor, affiliates, two officers and directors of the subsidiary that invested in the buyout, and others. In 2004, the KB Toys filed for Chapter 11 bankruptcy. Plaintiff Big Lots, Inc, an unsecured creditor and holder of the $45 million note, brought this action asserting direct claims of breach of fiduciary duties, fraud, and civil conspiracy. The plaintiff sought recovery for the amount due on the note and restitution for alleged unjust enrichment. The Court of Chancery dismissed the complaint namely because the claims were derivative in nature, not direct, and thus belong to the bankruptcy estate.
The complaint identified three sets of defendants: (1) Glazer, a long-time manager and director of KB Toys; (2) Feldman, a manager and executive of KB Toys; and (3) a group of individuals and entities affiliated with Bain Capital, LLC, a private equity investment firm. In 2000, Big Lots entered into a stock purchase agreement to sell KB to the Bain defendants, Glazer, Feldman, and other members of their management group. In its complaint, Big Lots alleged several counts of fraud and breach of fiduciary duties against these defendants. Defendants argued that these claims were derivative, belonging to the bankruptcy estate, and that Big Lots lacked standing to advance these claims. Specifically, the defendants argued that the common element of these counts was that the fundamental injury alleged is the insolvency of KB Toys, and that this insolvency injured Big Lots; thus, these claims must be derivative. The Court of Chancery began its derivative vs. direct claim analysis with the Tooley test: (1) who suffered the alleged harm--the corporation or the suing stockholder individually; and (2) who would receive the benefit of the recovery or other remedy? A direct claim is a claim on which one can prevail without showing an injury or breach of duty to the corporation. The plaintiff argued that the court should follow Production Resources Group v. NCT Group, 863 A.2d 772 (Del. Ch. 2004), where it was acknowledged that although most claims brought by a creditor against a debtor are likely to be derivative, there might be circumstances in which directors display such a marked degree of animus toward a particular creditor that they expose themselves to a direct fiduciary claim by that creditor. Unlike Production Resources where the challenged transaction occurred in the context of an already insolvent company, the complaint in this case only attempts to allege that KB Toys became insolvent as a result of the 2002 transaction. Big Lot's fundamental complaint was that the defendants caused KB Toys to become insolvent through what amounted to breached of fiduciary duty. As noted in Production Resources, these types of claims are derivative. "They do not become direct simply because they are raised by a creditor, who alleges that the breaches of fiduciary duty caused it specific harm by preventing it from recovering a debt outside of bankruptcy." Authored by: Fotini Antonia Skouvakis 302.888.5202 firstname.lastname@example.org