Recently, in Berg & Berg Enterprises, LLC v. Boyle, 2009 Cal. App. LEXIS 1740 (Oct. 29, 2009), the California 6th District Court of Appeal defined the circumstances under which a director/officer of an insolvent corporation owes fiduciary duties to the corporation's creditors. The court determined that a corporate creditor can sustain a breach of fiduciary duty claim against a corporate director/officer only if: the acts underlying the breach occurred when the corporation was actually insolvent and the directors allegedly diverted, dissipated or unduly risked corporate assets in a manner likely to harm creditors (particularly through self-dealing). The court also reaffirmed the so-called business judgment rule, under which courts defer to the business judgment of directors when making corporate decisions.
Berg & Berg Enterprises, LLC sued several directors of the board of Pluris, Inc., alleging breach of fiduciary duty. The alleged breach was predicated upon the board members' decision (in the face of Pluris' substantial operating losses) to enter into an assignment for the benefit of creditors, rather than a Chapter 11 bankruptcy reorganization plan proposed by Berg & Berg. According to Berg & Berg, this election by the board members deprived it and other creditors of benefits they would have realized from the proposed reorganization. The trial court sustained the directors' demurrer to the complaint and Berg & Berg appealed.
California adheres to the trust fund doctrine establishing a limited fiduciary duty from officers/directors to creditors. The Court of Appeal affirmed, and in doing so specified the parameters of a corporate director's fiduciary duty to corporate creditors.
The court reaffirmed that California follows the "trust fund doctrine," which establishes a limited fiduciary duty owed by officers/directors to corporate creditors. According to this doctrine, when a corporation becomes insolvent, its assets enter into a de facto trust for the benefit of creditors, in order to satisfy these creditors' claims. Nonetheless, the court in Berg & Berg held that in order to state a claim for breach of fiduciary duty under the trust fund doctrine, a mere showing of corporate insolvency is per se insufficient. A claimant must also establish that directors/officers of the insolvent corporation diverted corporate assets for the benefit of insiders or preferred creditors, or dissipated or unduly risked corporate assets.
In the course of its ruling reaffirming a corporate director's limited fiduciary duty to a creditor when a corporation is actually insolvent, the court in Berg & Berg also rejected the "zone of insolvency" theory espoused by certain out-of-state courts. Under this theory, breach of fiduciary duty claims are maintainable by creditors against directors of corporations operating in the "zone" or "vicinity" of insolvency, notwithstanding the corporation's actual solvency at the time the allegedly tortious acts are claimed to have occurred. The Court of Appeal held that such a theory would be contrary to California precedent and unworkable. In particular, the court noted that: California cases applying the trust fund doctrine have been limited to entities which are actually insolvent and a "zone of insolvency" standard would be unduly subjective and therefore difficult to apply in practice. As a result, a creditor's breach of fiduciary duty claim against a corporate director/officer requires the corporation's actual insolvency.
The court in Berg & Berg held that even if Berg & Berg had otherwise pleaded a viable breach of fiduciary duty claim, the demurrers were nonetheless sustainable in light of the so-called business judgment rule (codified, in part, at Section 309 of the California Corporations Code). As a result, the business judgment rule "establishes a presumption that directors' decisions are based on sound business judgment, and....prohibits courts from interfering in business decisions made by the directors in good faith and in the absence of a conflict of interest." The Court of Appeal concluded that the business judgment rule constituted an independent ground upon which to sustain the demurrer.
The court determined that: "The directors did not owe a...duty of loyalty to Berg...above shareholders or other constituencies comprising the collective interests in the corporate enterprise [giving] rise to an obligation to put Berg's interests above these other constituencies...the mere act of the assignment and the failure by the directors to pursue Berg's bankruptcy reorganization plan...do not, as a matter of fact or law, establish abdication of duty; the failure to have exercised judgment with reasonable care, skill, and diligence; or even an unreasonable failure to have investigated so as to rebut or allege exceptions to the business judgment rule."
Officers/directors of a corporation (and by extension, managers of a limited liability company) that are facing financial difficulties must determine when and whether they have a special duty to the creditors of the corporation. If the corporation has become insolvent (liabilities exceed assets), then the corporation's assets are considered to be in trust for the creditors, and the officers and directors must act accordingly. The exercise of sound business judgment in good faith does not violate the directors' and officers' special "trust fund" duties (to both creditors and shareholders), but dissipating or diverting assets, especially when self-dealing is present (for example, if the directors and officers are shareholders to which assets have been diverted), does violate the duty and can give rise to personal liability. Hence, when dealing with a financially distressed corporation, the directors and officers should consult counsel to determine what the limits are on their actions with reference to the claims of creditors.
John T. Hansen is a partner in the San Francisco office of Nossaman LLP and specializes in bankruptcy, corporate reorganization, employment/disability law and civil litigation. He can be reached at jhansen@nossaman.com.
Tamir Damari has more than a decade of litigation experience, successfully representing a wide range of clients in motions, depositions, appeals and trials. He can be reached at tdamari@nossaman.com.