Jun 30, 2022 - Economy & Business

Toys R Us bankruptcy lawsuit could shake private equity

Illustration of a colorful toy gavel.
Illustration: Gabriella Turrisi/Axios

Toys R Us is long gone, but its former private equity owners still can't shake it.

Driving the news: A U.S. bankruptcy court judge has ruled that a creditor lawsuit can proceed against a group of the bankrupt retailer's former top executives and directors, including partners of Bain Capital and KKR.

Flashback: Toys R Us went under in 2017, causing around 3,000 employees to lose their jobs.

  • There was plenty of blame to go around. The PE firms for larding on too much debt. The senior lenders for refusing to negotiate. Management for failing to innovate.
  • The PE firms would later create a $20 million severance fund for fired workers. They also realized slight profit at the GP level from Toys, even though LPs were wiped clean.

The case: Creditors allege that the company spent around $600 million on goods and services between filing for Chapter 11 bankruptcy and liquidating its stores, without adequately disclosing to vendors that the company's finances were dire enough that shutdowns were likely.

  • Plaintiffs also take issue with advisory fees paid to the company's private equity sponsors between 2014 and 2017, plus certain management bonuses.
  • Judge Keith Phillips allowed both claims to proceed. He did, however, dismiss allegations that the company's decision to take on debtor-in-possession financing was a breach of fiduciary duty.

What to know: Private equity representatives on company boards are generally covered by directors and officers (D&O) liability insurance, although such policies typically include deliberate fraud exemptions.

  • No comment on the ruling from either Bain or KKR, and it's unclear how their specific D&O policies would (or wouldn't) be applied were the firms to lose in court.
  • It's also worth noting a line from the defendants' failed request for summary judgment, which doesn’t do much for the reputation of either PE or people like former Toys CEO Dave Brandon: “So long as a company is not insolvent, its Board members owe a fiduciary duty to the company and its owners, and can take actions that benefit the owners to the detriment of the company.”

The bottom line: Were the creditors to prevail, no matter the particular insurance coverage, it could shake the private equity model. They basically are arguing for a de facto clawback from the company’s private equity owners, much like a PE fund could owe its limited partners were an investment to lose money, based on pre-insolvency fees.

  • In theory, this could apply to monies being earned today by PE directors on any portfolio company board.
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