A Recent Decision in the Toys “R” Us Bankruptcy Litigation May Have An Impact on Board Membership

Key Takeaways

• The U.S. Bankruptcy Court for the Eastern District of Virginia recently published a critical opinion in a high profile dispute between Toys “R” Us’ creditors and some of the officers and directors of the once venerable toy company.
• The opinion reaffirms bankruptcy courts’ willingness to apply the law of the case from debtor in possession financing orders towards later events in the case.
• However, the opinion also demonstrates that a court will be unlikely to provide any similar protection for pre-bankruptcy activities that may be a part of post-petition negotiations or discussions.

Why It Matters

The bankruptcy court authorized the Toys “R” Us liquidation trust to continue with its action against former officers and directors for various breaches of fiduciary duty.  The officers and directors attempted, in part, to use a previously entered bankruptcy court opinion to shield certain prepetition actions, but was unable to convince the court.  The impact of this decision could chill individuals’ willingness to serve as a director of a troubled business. 

Background      

On September 18 and 19, 2018, Toys “R” Us, Inc. and twenty-four affiliated entities (collectively, the “Debtors”) filed for chapter 11 protection in the Bankruptcy Court.  After attempting to operate their businesses, the Debtors eventually closed their stores and filed their “Third Amended Chapter 11 Plan of TRU” (the “Plan”), which was  confirmed on December 17, 2018. 

The Plan specifically provided that an entity named the TRU Creditor Litigation Trust (the “Trust”) was the successor-in-interest to the Debtor with respect to “any Non-Released Claims that were or could have been commenced or asserted by, or on behalf of, any of the Debtors or their estates prior to the applicable Effective Date.”  The term “Non-Released Claims” included claims against the Debtors’ directors and officers.

 After confirmation, the Trust filed a complaint  against certain officers and directors (collectively, the “Defendants”) in the Supreme Court of the State of New York, New York County (the “State Court”).  The complaint contained various causes of action for breach of fiduciary duty relating to the authorization of (i) payment of advisory fees, (ii) payment of executive bonuses, and (c) debtor-in-possession financing that had been approved (collectively, the “Fiduciary Duty Claims”).  Additional causes of action, which had been assigned to the Trust by trade vendors, included fraudulent concealment, negligent concealment and negligent omission, fraud/misrepresentation/deceit, negligent misrepresentation, and negligence (the “Vendor Claims”).    In total, the Trust sought damages of over $600 million.  The case was removed to the U.S. District Court, Southern District of New York (the “District Court”) and then referred to the Bankruptcy Court in Virginia.

After conducting discovery, the Defendants filed a summary judgment motion.   A portion of the motion focused on the fourth cause of action, which concerned certain Defendants’ authorization of  debtor-in-possession (“DIP”) financing.  In particular, the Defendants pointed to language in the final DIP order stating that the terms of the financing “were fair and reasonable . . . [and] reflect the DIP Loan Parties’ exercise of prudent business judgment consistent with their fiduciary duties.”  Since the Final DIP Order was “binding upon all parties in interest in these Chapter 11 cases, including . . . any . . . fiduciary appointed as a legal representative of any of the Debtors,” the Defendants stated that the Trust was barred by the law of the case doctrine from stating that entry into the agreement supporting the Final DIP Order was a breach of fiduciary duty.  The Bankruptcy Court agreed with the Defendants’ arguments, and the Defendants were thus protected by a prior Bankruptcy Court order.

However, the Defendants did not fare as well as to their request for summary judgment as to their approval of certain bonus payments.  Prior to the bankruptcy filing, the Defendants had negotiated retention bonuses to approximately 117 executives and management-level employees.  After the filing of the Debtors’ bankruptcy cases, the Unsecured Creditors Committee (the “Committee”) negotiated some concessions to the retention bonuses (the “Bonuses”) which were reflected in a later Court order approving a postpetition transaction.  Accordingly, the Defendants stated that they were again protected by the business judgment rule.  The Bankruptcy Court disagreed, in part because the Bonuses were paid prepetition and there was no postpetition order directly approving the Bonuses.  Further, the Committee’s prior pleading in support of the Bonuses ensured that claims against the Defendants would be preserved.  Finally, the Court stated that the evidence submitted by the Trust, if proven, would be sufficient to establish a breach of fiduciary duty.

The Bankruptcy Court went on to analyze the Trust’s claims regarding the prepetition advisory fees.  The Defendants argued that there was “undisputed evidence” that the Debtors were solvent at the time of those payments and that such payments were appropriate under state law.  The Defendants also critiqued the Trust’s evidence on the matter, stating it was insufficient. The Bankruptcy Court disagreed, finding that the Trust’s expert opinion “is but one piece of evidence that must be assessed by the trier of fact.”  Hence, the advisory fee cause of action is to be determined at trial.

The Defendants were also unable to eliminate the Vendors Claims.  Arguments relating to standing, previously executed critical vendor agreements, and an alleged lack of evidence on certain tort elements failed at the summary judgment level.

Accordingly, after reviewing thousands of pages of pleadings and evidence, the Bankruptcy Court decided that the Trust will be able to proceed to trial on seven of the eight causes of action in the Complaint.

The Bankruptcy Court’s decision was likely not a surprise to the parties involved in the Debtors’ bankruptcy case.  A bankruptcy court will generally rule that language in its prior orders is law of the case and controlling in all later proceedings in the case.  Hence, the protective language in the Final DIP Order did protect the Defendants.  However, in contrast, a court is unlikely to protect prepetition activity through usage of some sort of postpetition hook.  The Defendants in this case were unable to successfully claim that the Committee’s postpetition actions arguably relating to the Bonuses and a related order had the effect of the Court “blessing” the prepetition Bonuses.  Finally, the Court refused to dismiss the other causes of action, stating that the Trust had submitted “sufficient evidence from which a trier of fact may reasonably find in favor of the Trust” and “[i]n this case, the credibility of the witnesses, particularly the Defendants, is particularly important.”

This decision certainly raises the question of whether  a businessperson want to serve as a director when there is a possibility that creditors would later bring an action against her/him for prepetition actions?  There is likely D&O insurance in the present case, but the policy may not cover intentionally fraudulent actions. This litigation will be worth monitoring.