Is the Board to Blame?

In a legal battle stemming from the Toys “R” Us Inc. (TRU) bankruptcy, a bankruptcy trust representing creditors, including former employees and trade vendors, has filed a lawsuit against former CEO David Brandon, TRU executives, directors, and private equity owners. The complaint alleges a conspiracy to conceal TRU's true financial state, leading to post-bankruptcy losses of $800 million, $1.76 billion in unpaid pre-bankruptcy claims, and the displacement of 31,000 employees.

The lawsuit claims that, despite signs of financial trouble, TRU continued making credit-based purchases from suppliers between December 2017 and March 14, 2018, ultimately accumulating $600 million in orders. This was done under the guidance of the company’s board, which assured suppliers of TRU's imminent emergence from bankruptcy.

Under Delaware law, directors of solvent corporations owe their duties to the corporation, not creditors. However, when a company becomes insolvent, directors maintain fiduciary duties to the corporation and its residual claimants, which include creditors. The lawsuit questions the board's actions, suggesting negligence in pursuing a business strategy that led to increased insolvency.

Directors, under the "business judgment rule," are generally protected if decisions are made on an informed basis, in good faith, and in the honest belief that it serves the corporation's best interests. The complaint challenges whether the TRU board acted prudently and whether it should be held liable for the alleged mismanagement that exacerbated the company's financial downfall.

In cases like TRU, Sears, and Forever 21, where companies face administrative insolvency, the role of a Chief Restructuring Officer (CRO) becomes crucial. CROs are tasked with overseeing compliance with bankruptcy rules and ensuring the company remains administratively solvent. The lawsuit suggests that the TRU board may have overlooked warning signs and allowed management to incur additional debt knowingly.

To shield themselves from liability, boards should implement robust reporting practices, with regular updates on accrued liabilities, outstanding orders, and financial projections. It is crucial for boards to challenge assumptions, rely on the expertise of CROs, and establish guardrails for unpaid administrative claims. If a board follows due diligence and acts in good faith, it may be insulated from liability, unless it knowingly permits unreasonable excesses or acts recklessly.

This analysis emphasizes the importance of boards relying on restructuring professionals and CROs to navigate financial distress successfully while safeguarding the interests of all stakeholders. It also highlights the need for boards to proactively manage risks, challenge assumptions, and demonstrate a commitment to maximizing value for the company and its creditors.