California Appellate Court Reaffirms Limits on Directors’ Fiduciary Duties to Creditors and Rejects Duties in Zone of Insolvency

December 7, 2009

A California appellate court recently reaffirmed long-standing California law that limits the fiduciary duties directors owe to creditors and rejected extending fiduciary duties to creditors during the corporation’s vague zone of insolvency.  The opinion should allow directors to rest a little easier.

Plaintiff Berg & Berg Enterprises, LLC, a creditor of Pluris, Inc., sued individual directors of Pluris claiming that directors breached their fiduciary duties to Berg and other creditors when they executed an assignment for the benefit of creditors without exploring other options first.  Berg asserted that because Pluris was insolvent or in the “zone of insolvency,” the directors of Pluris owed Berg and other creditors fiduciary duties of care and loyalty.  Berg claimed the directors had breached those duties by failing to explore ways to maximize Pluris’ value and the value of its net operating losses.  After a successful demurrer by the directors, Berg appealed to the Court of Appeal of California.

The court in Berg & Berg Enterprises, LLC v. Boyle 178 Cal. App. 4th 1020 (2009) tackled two major issues.  First, do directors owe fiduciary duties of care and loyalty to creditors of a corporation?  Second, if directors owe fiduciary duties to creditors, at what point do such a duties arise?  Namely, do they arise when the corporation is in the amorphous zone of insolvency or when the corporation is actually insolvent?

Generally directors of a solvent company only owe fiduciary duties to the residual stakeholders of a corporation, which are the shareholders.  When the corporation becomes insolvent, shareholder value is essentially worthless, and shareholders no longer occupy the position of residual claimants.  Under California law, once a corporation becomes insolvent, the “trust fund doctrine” applies and “all of the assets of a corporation…become a trust fund for the benefit of all of its creditors.”  Berg at 1040.  Under the trust fund doctrine, recovery for breaches of fiduciary duties “generally pertain[s] to cases where the directors or officers of an insolvent corporation have diverted assets of the corporation ‘for the benefit of insiders or preferred creditors.'”  Berg at 1040 – 1041.  No California cases “expressly limit the fiduciary duty under the trust fund doctrine to the prohibition of self-dealing or the preferential treatment of creditors, [but] the scope of the trust fund doctrine in California is reasonably limited to cases where directors or officers have diverted, dissipated, or unduly risked the insolvent corporation’s assets.”  Berg at 1041.  In sum, for creditors to recover under the trust fund doctrine for breaches of fiduciary duties, directors must have engaged in self-dealing, favored certain creditors, or engaged in conduct that has diverted, dissipated, or unduly risked the insolvent corporation’s assets.  Thus, California law does not impose duties to creditors solely due to a state of corporate insolvency; before liability will be imposed under California law, directors must have engaged in some type of misconduct.

While Delaware has pulled back from a vastly expansive view of fiduciary duties to creditors, it is still not as director-friendly as California.  In 1991, Credit Lyonnais Bank Nederland v. MGM Pathe Communications, Civ. Ac. No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. 1991) paved the way for expanding fiduciary duties owed by directors to creditors when the corporation becomes insolvent or even comes within the ambiguous “zone of insolvency.”  Subsequent cases have provided that once a corporation becomes insolvent or even reaches the “zone of insolvency,” directors have a duty to consider the best interests of the whole corporate enterprise, encompassing all its constituent groups, without preference to any.  This duty, therefore, under Delaware law, requires directors to take creditor interest into account, but not necessarily to give those interests priority.  Although Credit Lyonnais took an expansive view of directors’ duties to creditors, the Delaware Supreme Court in National American Catholic Education Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) retreated from Credit Lyonnais and rejected the breach-of-fiduciary-duty liability when the corporation is in the “zone of insolvency” and only allowed liability when the corporation is actually insolvent.

The Berg court took California even further than Delaware in limiting director duties to holding that the duty owed by the directors to an insolvent corporation’s creditors is limited to the duty provided by the trust fund doctrine.  In declining to create a new duty owed to creditors, the court reasoned that such a duty would conflict with and dilute the statutory and common law duties that directors already owe to shareholders and the corporation.  The court also noted the practical problems with creating such a duty, including a director’s inability to determine when the state of insolvency that triggers the duty to creditors actually exists.

Berg further held that there is no fiduciary duty under California law that is owed to creditors solely by virtue of its operating in the “zone of insolvency.”  The duty created in the trust fund doctrine only arises when the entity is actually insolvent.  Reaching this holding, the court reasoned that all the California cases applying the trust fund doctrine appear to have dealt with actually insolvent entities, and the existence of a zone or vicinity of insolvency is even more difficult to determine than actual insolvency.

The court’s decision in Berg is a victory for directors as California rejected an expansion of director duties and reaffirmed California’s long-standing limited trust fund doctrine duties.  The Berg court dismissed the creditor’s claim, affirming the demurrer of the lower court stating that the creditor had not even made out a cause of action as a matter of law.

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn attorney with whom you work or any of the following:

Business Restructuring and Reorganization Group
Michael A. Rosenthal – Co-Chair, New York (212-351-3969, [email protected])
Craig H. Millet – Co-Chair, Orange County (949-451-3986, [email protected])
David M. Feldman – Co-Chair, New York (212-351-2366, [email protected])
Oscar Garza – Orange County (949-451-3849, [email protected])
Janet M. Weiss – New York (212-351-3988, [email protected])
Matthew J. Williams – New York (212-351-2322, [email protected])
J. Eric Wise – New York (212-351-2620, [email protected])
Samuel A. Newman – Los Angeles (213-229-7644, [email protected])

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