EToys investors claim conflict at law firm

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When online retailer eToys Inc. entered bankruptcy proceedings in 2001 and top managers quit, the company appointed a caretaker chief executive officer to help settle its debts.

That appointment is now at the center of a controversy over an alleged conflict-of-interest that could bring sanctions against one of the biggest names in bankruptcy law, Paul Traub, along with his New York-based law firm, Traub, Bonacquist & Fox.

A U.S. bankruptcy judge in Delaware, Mary Walrath, is reviewing the circumstances surrounding the CEO's appointment and weighing a motion by the bankruptcy trustee to make the law firm return $750,000 in legal fees. The Justice Department, Securities and Exchange Commission and New York state attorney general's office have contacted individuals involved in the proceedings and are watching the case closely for possible action following the court's decision, according to people familiar with the matter.

At issue is whether Mr. Traub, attorney for a group of eToys creditors, deliberately withheld information from the court about a business relationship with Barry Gold, recommended by the Traub firm for the CEO job. The two men jointly own Asset Disposition Associates, a liquidation concern that isn't involved in the eToys case, according to bankruptcy court filings. Mr. Gold also has done consulting work for Mr. Traub's firm, filings show.

The bankruptcy trustee in the case, Kelly Stapleton, has accused Mr. Traub's firm in court papers of violating federal bankruptcy law by failing to disclose his business ties to Mr. Gold. Given the firm's long experience in bankruptcy cases, "the failure to disclose is difficult to understand as inadvertent rather than deliberate," she said.

Mr. Traub declined to comment, citing the pending decision by the bankruptcy judge. Mr. Gold didn't return phone calls. In court filings, Mr. Traub concedes he should have disclosed his business ties but denies the omission was intentional. Mr. Traub characterized the breach as "inadvertent" in court documents, noting that the company was newly formed. For his part, Mr. Gold said he regrets not disclosing his involvement with Mr. Traub "not because he did anything wrong but because there was no reason not to make such a disclosure."

Mr. Traub's law firm has been involved in some of the biggest bankruptcy cases of recent years, including Enron Corp., Kmart Corp., KB Toys Inc. and Adelphia Communications Corp.

The bankruptcy-court system relies on attorneys, accountants and other professionals to fully disclose any conflicts of interest, but has little means of verification. In the eToys case, it was angry shareholders, who lost tens of thousands of dollars when eToys went bust in 2001, who brought the alleged conflict-of-interest to light.

Authorities have taken a hard line against undisclosed conflicts in bankruptcies. In 1997 the Wall Street law firm of Milbank, Tweed, Hadley and McCoy agreed to return $1.9 million in fees in a Wisconsin bankruptcy case after one of its partners, John Gellene, failed to disclose a link between his firm and a creditor in the case. Mr. Gellene later was sentenced to 15 months in prison for perjury and fined $15,000.

The court learned of the tie only after a lender in the case reported it to the bankrupt company, which then sued the law firm for malpractice. A book published last fall, "Eat What you Kill," by Georgetown University law professor Milton C. Regan Jr., reported that the two sides settled the case for between $27 million and $50 million.

In a case in 2003, Perkins Coie LLP, a Seattle law firm, was ordered by a bankruptcy court to forfeit $1.6 million in fees for a disclosure breach, which came to light only after a bank lender, quarreling with the law firm over fees, blew the whistle.

In the eToys case, the trustee initially recommended forfeiture of nearly all fees and expenses paid to Mr. Traub's firm, which amounted to $1.64 million. The recommendation later was scaled back to $750,000 as part of a proposed settlement with Mr. Traub and his law firm. The ultimate penalty will be determined by the eToys bankruptcy judge. It is uncertain when she will rule.

Also implicated in the matter is Michael Fox, who recently resigned as a partner in Mr. Traub's law firm. In court papers, the trustee accuses him of failing to disclose the relationship between Assets Disposition Associates and the law firm in another filing in the eToys case. Mr. Fox declined to comment.

An eToys shareholder, Scott Pletch, was surfing the Internet reviewing bankruptcy cases last fall, when he stumbled upon Messrs. Traub and Gold's company. "I was stunned to discover they were in business together," recalls Mr. Pletch, an electronics engineer.

A small group of shareholders reported the discovery to Judge Walrath, who asked if they wanted to conduct an inquiry through depositions and an evidentiary hearing in court. Ordinarily a lawyer would be hired for such a chore. But because the group didn't have the money for an attorney, another shareholder, Robert Alber, a disabled construction worker, volunteered to take on the task. "I was scared to death when I was told I could do this," he says. "I have no familiarity with the law. I've just watched a lot of 'Law and Order.'"

Stephen Laser Haas, a liquidator who has helped sell off some eToys assets, also agreed to help. He says he prepared "by perusing the U.S. Justice Department's Web site."

For the depositions, Mr. Alber drove to Delaware from his San Jose, Calif., home since, he says, he couldn't afford an airplane ticket. Mr. Haas coached him by phone. At the deposition, "there were attorneys in the back of the room snickering the whole time and telling jokes to each other," Mr. Alber says.

According to the depositions and subsequent court proceedings, Messrs. Traub and Gold began considering forming Asset Disposition Associates in early 2001 -- about the time that eToys was preparing to file for bankruptcy. The idea was for Mr. Traub to find work for the new firm and for Mr. Gold to value and sell inventory, according to court filings.

The two men agreed that Mr. Gold would be paid a monthly salary of $30,000 for four months. Since Asset Disposition Associates hadn't landed any contracts, Mr. Traub's law firm lent the company the money. The firm was formed in April 2001. A month later, Mr. Gold got the eToys job, court documents show. The bankruptcy case continues. Most of eToys assets have been liquidated but a final distribution hasn't been made.


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