Bankruptcy Judge Finds Conflict of Interest in eToys Case

A law firm that represented Internet toy retailer eToys Inc. in bankruptcy court must return part of its fees because the firm failed to disclose a conflict of interest stemming from its representation of eToys' creditors in other litigation.

The company's bankruptcy ended in a liquidation plan approved in November 2002 by Judge Mary F. Walrath of the U.S. Bankruptcy Court for the District of Delaware.

During the case a tangle of questionable relationships formed among various professionals hired by eToys, the company's creditors and even eToys' post-bankruptcy CEO.

Several parties, including the U.S. trustee, protested and asked Judge Walrath to impose sanctions.

In a recent decision Judge Walrath said eToys' bankruptcy counsel, Wilmington, Del.-based Morris, Nichols, Arsht & Tunnell, failed to disclose that its clients included New York investment bank Goldman Sachs & Co., which eToys had hired for pre-bankruptcy financial advice.

The company had paid Goldman about $3 million to arrange a sale, merger or financing to prop up its ailing toy business, but Goldman was required to refund $2.5 million if it was unsuccessful, the judge said.

The toy company filed for bankruptcy in March 2001 and Goldman eventually returned the money in August that year.

Because of Morris, Nichols, Arsht & Tunnell's existing client relationship with Goldman, Judge Walrath ruled that MNAT must refund fees eToys paid for time spent on the Goldman matter.

"There was an actual conflict [of interest] beginning in May 2001, when MNAT learned that [eToys] had a claim against Goldman," she said. "Disclosure at that time was mandated."

The judge added that it was too late to disqualify MNAT "because the case is now over." She refrained from forcing MNAT to disgorge all fees earned after May 2001 but noted she could have done so.

Judge Walrath also ordered MNAT to refund fees billed in connection with the settlement of a $72,000 claim against eToys by General Electric Capital Corp., which was MNAT's client in another case.

Yet another alleged conflict of interest caused the judge to frown on eToys interim CEO Barry Gold, a distressed-company turnaround specialist, for failing to disclose his business ties to a partner in New York-based Traub, Bonacquist & Fox, a law firm representing a group of eToys creditors.

The judge noted that Gold, as a corporate officer, was not a "professional" under the Bankruptcy Code who needed to disclose relationships that might affect his loyalty to the debtor.

But she added, "In the future ... the failure of an officer of a debtor to disclose such relationships will subject that officer to review and possible disgorgement of compensation if the court concludes that the relationship constitutes an actual conflict of interest."

The judge went on to find that, despite Gold's participation in a turnaround business operated by Traub Bonacquist partner Paul Traub, Gold had no actual conflict of interest in his eToys role.