United States: California Court Clarifies Directors' Duties When A Corporation Is Insolvent Or In The Zone Of Insolvency

On October 29, 2009, the California Court of Appeal, Sixth District, in Berg & Berg Enterprises, LLC v. Boyle, et al., unequivocally ruled that, under California law, directors of either an insolvent corporation or a corporation in the more elusively defined "zone of insolvency" do not owe a fiduciary duty of care or loyalty to creditors. In so ruling, California joins Delaware in clarifying directors' duties when the corporation is insolvent or in the zone of insolvency.

Background

Berg & Berg Enterprises LLC was the largest creditor of the failed Pluris, Inc. In July 2002, Pluris's directors elected to enter into an assignment for the benefit of creditors (ABC) under California law. Berg brought a complaint against Pluris's directors alleging that while Pluris was insolvent or in the zone of insolvency, Pluris's directors breached their fiduciary duties to Pluris's creditors by failing to examine a range of possible courses of action to maximize the value of the remaining assets and not merely to take the most expedient step of entering into the ABC. Berg alleged that the directors failed to explore ways to preserve, among other things, the value of $50 million in net operating losses (NOLs) that were lost upon the execution of the ABC. Further, Berg alleged that the directors failed to do the following:

Seek alternative sources of financing

Make any reasonable inquiry into alternative ways to derive additional value for Pluris's creditors

Consider other benefits of a chapter 11 reorganization, such as Berg's purported agreement to reduce its claim and contribute cash for the benefit of Pluris's other creditors

Berg alleged that once the directors determined that Pluris's equity interests had no value, the directors abdicated their duty to Pluris's creditors by entering into the ABC.

The directors moved to dismiss the complaint, and the trial court granted the motion. The trial court based its decision on CarrAmerica Realty Corp. v. nVIDIA Corp., a 2006 case from the U.S. District Court for the Northern District of California. CarrAmerica held that California follows the "trust fund doctrine" with respect to a director's fiduciary duty to creditors. According to the trial court, CarrAmerica held that a director's fiduciary duty to creditors only arises upon a corporation's insolvency. The scope of this fiduciary duty is to avoid self-dealing, preferential treatment of creditors, diversion, dissipation or undue risk to the insolvent corporation's assets. Because Berg could not allege that the directors breached such a duty by entering into the ABC, the trial court granted the motion to dismiss without leave to amend. Berg appealed.

The Appeals Court's Analysis

On appeal, the California Court of Appeal analyzed what, if any, fiduciary duty individual directors owe to creditors. The appeals court first noted that under California statute, "corporate directors owe a fiduciary duty to the corporation and its shareholders . . . and must serve 'in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders.'" Next, the appeals court noted that with respect to a duty to creditors, there is "no analogous statutory authority in California establishing or recognizing that upon a corporation's insolvency, or more vaguely when it enters into a 'zone of insolvency,' directors instead or also owe a duty to the corporation's creditors." The appeals court further noted that it was "easy to see that especially when a corporation is in financial distress, the interests of the shareholders and the corporation itself may inherently collide with those of the creditors, making any respective duties owed by directors to each constituency potentially in conflict and making the scope of each respective duty elusive and difficult to ascertain."

Credit Lyonnais and the Evolution of the Purported Duty of Care and Loyalty to Creditors

The appeals court next considered California and other post–Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp. decisions addressing a director's fiduciary duties of care and loyalty to creditors upon insolvency. The appeals court noted the well-known footnote in Credit Lyonnais in which the Delaware Court of Chancery posited that where a corporation was operating in the vicinity of insolvency, a board of directors is not merely the agent to the shareholders but also to the creditors. The appeals court further noted that a recognition of such expanded fiduciary duties of care and loyalty was thought to minimize the risk to creditors of "opportunistic behavior" such as the sale of corporate property at "fire-sale prices" or unreasonable risk taking with corporate assets for the sole benefit of shareholders.

The appeals court next observed that the establishment of a director's fiduciary duties of care and loyalty to creditors has generated controversy and broad criticism from commentators. The criticism largely focuses on "the difficulty in perceiving insolvency, or worse, the zone of insolvency, which is when such duties arise, and the practical difficulties and inefficiencies inherent in directors managing conflicting duties owed to disparate interests, thereby diluting the continuing and historic duty owed by directors to shareholders." Finally, the appeals court noted that there are no published decisions that rely on, or post-date, Credit Lyonnais that determine that corporate insolvency triggers fiduciary duties of care and loyalty to creditors. However, there are decisions that rely on the trust fund doctrine to satisfy a creditor's claim against an insolvent corporation.

The Trust Fund Doctrine

The appeals court next analyzed the trust fund doctrine, which numerous courts have relied on since it was first espoused in the 1939 seminal decision by the Supreme Court of the United States in Pepper v. Litton. Under the trust fund doctrine, "all of the assets of a corporation, immediately upon becoming insolvent, become a trust fund for the benefit of all creditors" in order to satisfy their claims. In California, application of the trust fund doctrine requires a showing "that directors have engaged in conduct that diverted, dissipated, or unduly risked corporate assets that might otherwise have been used to satisfy creditor claims."

The Appeals Court's Decision

No Fiduciary Duty of Care or Loyalty to Creditors

Relying on its analysis of California statutory and common law, Credit Lyonnais and subsequent decisions, and on the application of the trust fund doctrine, the appeals court concluded that "under the current state of California law, there is no broad paramount fiduciary duty of due care or loyalty that directors of an insolvent corporation owe the corporation's creditors solely because of a state of insolvency, whether derived from Credit Lyonnais or otherwise." The appeals court "decline[ed] to create such a duty, which would conflict with and dilute the statutory and common law duties that directors already owe to shareholders and the corporation. We also perceive practical problems with creating such a duty, among them a director's ability to objectively and concretely determine when a state of insolvency actually exists such that his or her duties to creditors have been triggered."

The appeals court held that "the scope of any extra-contractual duty owed by directors to the insolvent corporation's creditors is limited in California, consistently with the trust fund doctrine, to the avoidance of actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditors [sic] claims . . . [including] acts that involve self-dealing or the preferential treatment of creditors." Further, the appeals court held that because all California cases applying the trust fund doctrine have done so solely with respect to insolvent entities "and because the existence of a zone or vicinity of insolvency is even less objectively determinable than actual insolvency, . . . there is no fiduciary duty prescribed under California law that is owed to creditors by directors of a corporation solely by virtue of its operating in the 'zone' or 'vicinity' of insolvency."

Applying the scope of a director's fiduciary duty under California law, the appeals court affirmed the trial court's decision that Berg's complaint failed to plead adequate facts to support a claim that the Pluris directors breached their fiduciary duties under the trust fund doctrine. The appeals court agreed with the trial court that Berg's complaint did not plead that Pluris's directors had diverted, dissipated or unduly risked corporate assets. Instead, Berg merely asserted that the Pluris directors had not done enough (i.e., had not investigated or explored whether a chapter 11 reorganization would have maximized the value of Pluris's NOLs). The facts as alleged did not involve self-dealing or prohibited preferential treatment of creditors and did not constitute any diversion, dissipation or undue risking of the corporate assets that otherwise could have been used to satisfy creditors' claims. Accordingly, the appeals court concluded that "no matter how Berg . . . characterizes or packages the basic factual underpinnings of its claim," as a matter of law, Berg's claim was inadequate to sustain a cause of action that the Pluris directors breached their fiduciary duties under the trust fund doctrine in California.

Business Judgment Rule

Further, the appeals court addressed the protection offered to directors under the business judgment rule. The business judgment rule, which is well-settled statutory and common law in California, "immunizes directors from personal liability if they act in accordance with" California law. The business judgment rule establishes a presumption that "directors' decisions are based on sound business judgment and it prohibits courts from interfering in business decisions made by directors in good faith and in the absence of a conflict of interest." The appeals court concluded that Berg's allegations did not rebut the presumption afforded by the business judgment rule. Accordingly, even if Berg had otherwise stated a claim for which relief could be granted, its claim would still be barred by the business judgment rule.

Conclusion

The appeals court's clear holding in Berg will aid directors and officers in the performance of their well-established statutory and common law duties to shareholders and the corporation. The Berg decision makes clear that, in California, directors owe no fiduciary duty of care or loyalty to creditors, whether the corporation is insolvent or otherwise. However, liabilities may arise under the trust fund doctrine where self-dealing, preferential treatment of creditors, and diversion, dissipation or undue risk of corporate assets is proved.

As the appeals court noted in Berg, the Credit Lyonnais decision has generated substantial controversy and commentary over the last 19 years regarding a director's fiduciary duties to creditors. The Berg decision joins the Delaware Supreme Court's 2007 decision in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, et al., in clarifying a director's duties when a corporation is insolvent or in the zone of insolvency. The Gheewalla decision held that "the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against a corporation's directors." The Delaware court held that "[w]hen a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must discharge their duty to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of the shareholder owners." However, when a corporation is insolvent, a creditor has standing to maintain derivative claims against directors for breach of their fiduciary duties of care and loyalty. Together, the Berg and the Gheewalla decisions form what is expected to be a growing body of case law clarifying a director's fiduciary duties to a corporation's constituents when the corporation is insolvent or in the zone of insolvency.

See Berg & Berg Enterprises, LLC v. Boyle, et al., 178 Cal.App.4th 1020 (Cal.App. 2009).

The author would like to thank Jeffrey L. Rothschild for his contributions to this article.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions