Sun Capital wins reprieve from asset freeze

A recent court case signals that the SEC intends to pursue fraud cases more aggressively, seeking relief from the business partners of the plaintiff

Boca Raton-based Sun Capital Partners recently won the dismissal of an asset freeze order from the US Securities and Exchange Commission, in which the Commission sought relief not just from those accused of committing fraud, but their business partners as well. The Commission attempted to name the private equity firm as a relief defendant in relation to alleged fraud committed by one of its lenders. Though the judge found in favor of Sun Capital, private equity firms should take note of two important implications of the case: first, that it’s imperative to know your lenders, and second, that the SEC appears set on taking a more aggressive stance in fraud cases that could impact anyone who does business with the defendant.

On 20 April 2009 the SEC filed a complaint in the United States District Court for the Middle District of Florida against Naples, Florida-based asset manager Founding Partners Capital Management and its principal William Gunlicks, alleging that the firm had fraudulently invested $550 million. The firm told its investors that it loaned the money to Sun Capital for the purpose of purchasing short-term, highly liquid account receivables that fully secured the loans. Later, the loan provisions were amended to allow Sun Capital to purchase account receivables that were longer term, less liquid and riskier – without the approval of Founding Partners’ investors.

The SEC did not accuse Sun Capital guilty of any wrongdoing, but named it a relief defendant and sought an asset freeze on the $550 million in order to prevent further dissipation of investors’ funds and to preserve assets that could be used to pay disgorgement. Sun Capital responded that it could not be named a relief defendant, and therefore the SEC could not go after the loans.

A proper relief defendant has no ownership interest in the assets that are the subject of litigation, for example, if a bank that is holding a defendant’s assets. Sun Capital argued that it does have a legitimate claim to and ownership interest in the loans it received from Founding Partners: its use of the money was entirely in accordance with the loan provisions, even if Founding Partners fraudulently obtained the money from its investors in the first place.

In making its case for the asset freeze, the SEC contended that only a complete ownership claim to the assets in question was enough to disqualify Sun Capital from being named a relief defendant. The Court found that case law only requires an “ownership interest”, not a complete bundle of ownership rights.

“Sun Capital is far from a ‘paradigmatic’ nominal defendant: a trustee, agent or depository,” US District Judge John Steele wrote. “The Complaint affirmatively alleges facts showing that Sun Capital has a legitimate ownership interest in and/or legitimate claim to the loan proceeds. This precludes Sun Capital from being a proper relief defendant even if, as the SEC argues, its claim is subordinate to the ownership claims of investors.”

The SEC additionally suggested that further investigation could reveal that Sun Capital is somehow in violation of its loan agreements, and lacks even a partial ownership claim to the assets. The Court found that element of the SEC’s claim faulty as well: “The Court does not find that such a sue-first-and-sort-out-the-facts-later approach is compatible with the Federal Rules of fundamental fairness”, Judge Steele wrote.

Despite Sun Capital’s victory in this case, the SEC’s actions should send up a red flag for private equity firms, says Sarah Gold, the partner at Proskauer Rose who led Sun Capital’s defence.
“The SEC tried to expand the purpose of [naming a relief defendant] and seek an asset freeze, a receivership – substantive relief they usually request when they name a defendant who has engaged in wrongdoing or when they get a judgment against a defendant – from Sun Capital even though it wasn’t accused of any wrongdoing,” she says. “It’s certainly significant if the SEC is moving in that kind of direction. In today’s regulatory climate it’s something everybody should be alert to.”