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California Decision Defines Scope of Fiduciary Duties Owed by Directors of Insolvent Corporations to Creditors

November 3, 2009

 

Last week, the California Court of Appeal, Sixth Appellate District issued a decision that limits a breach of fiduciary duty action brought by creditors against directors of an insolvent corporation under California law. The decision, Berg & Berg Enterprises, LLC v. Boyle, 2009 Cal. App. LEXIS 1740 (Oct. 29, 2009), raises certain key differences between California’s treatment of director liability and director liability under Delaware law. It also raises important issues for consideration by boards of California corporations.[1]

Some of the practical considerations raised by Berg include:

  • When a California corporation is insolvent, directors owe a fiduciary duty to creditors under the trust fund doctrine not to divert, dissipate, or unduly risk corporate assets. These duties are triggered once a corporation is actually insolvent, not merely in the “zone of insolvency.” Delaware law may continue to recognize derivative actions by creditors when a corporation is in the zone of insolvency.
  • Directors of an insolvent California corporation may be held liable for breaching fiduciary duties to creditors if directors prefer certain creditors over others. However, directors will generally be protected from the business judgment rule assuming that a decision to prefer certain creditors is made in good faith and does not involve a conflict of interest.
  • The decision notes in several places that Berg’s allegations failed to plead that a detailed, pragmatic proposal to invoke the bankruptcy option was submitted to the Pluris board before the assignment to creditors was made. To preserve business judgment rule protection, directors of insolvent corporations should conduct a reasonable inquiry into proposals made by creditors. A reasonable inquiry may or may not require detailed consideration depending on the proposal that is made.
  • Under both Delaware and California law, directors must be especially careful when considering any actions that may benefit insiders or otherwise show a conflict of interest.

1. Background

The Berg case arose out of a dispute between Berg & Berg Enterprises, LLC (“Berg”) a real estate developer, and Pluris, Inc. (“Pluris”), a Silicon Valley startup in the business of developing advanced network routers. Pluris folded in 2002 due to the general downturn in the telecommunications industry and difficulties with the company’s financing efforts and product development. Berg alleged that it became Pluris’s largest creditor when its predecessor-in-interest MWP agreed to build and then lease two office buildings in San Jose, California to Pluris.[3] The relationship became contentious after Pluris allegedly repudiated the lease agreement and subsequently made an assignment of all of its assets for the benefit of its creditors. In response, Berg first attempted to file an involuntary bankruptcy proceeding against Pluris in an effort to take advantage of approximately $50 million in net operating losses. When the involuntary bankruptcy proceeding was dismissed, Berg then commenced litigation in state court against nine of Pluris’s directors for breach of fiduciary duty, alleging that the directors failed to conduct a reasonable investigation into the proposal to pursue the Berg bankruptcy plan for the purpose of preserving the net operating losses.

Berg filed its original complaint solely on its own behalf, alleging that the Pluris directors breached their fiduciary duty to Berg by making the assignment for the benefit of Pluris’s creditors before examining a range of other possible courses of action to maximize the value of the company’s assets and allowing the assignee to waste Pluris’s assets. In particular, Berg alleged that a bankruptcy filing could have made the preservation of the net operating losses possible and led to higher payments to creditors. The trial court determined after early challenges to the complaint that Berg failed to show any individual injury, and Berg then amended the complaint in response to assert a derivative action on behalf of Berg and all other Pluris creditors. After several additional challenges to the pleadings, the trial court finally sustained demurrers to Berg’s third amended complaint without leave to amend for failure to state a cause of action for breach of fiduciary duty, resulting in dismissal of the action and Berg’s subsequent appeal.

The California Court of Appeal upheld the trial court’s dismissal of the action. After extensively examining the law of fiduciary duties of directors of an insolvent corporation or corporations in the “zone of insolvency,” the court announced that in California “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 . . ..” Id. at *43. Rather, the duty owed by corporate directors to an insolvent corporation’s creditors arises under the “trust fund doctrine”[4] and is limited “to the avoidance of actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditors claims.” Id. Moreover, the duty arises only when a corporation is insolvent, and the duty is not so broad as to encompass corporations in the “zone of insolvency.” Even assuming that Pluris was actually insolvent at the time the assignment for the benefit of creditors was made, and that Berg or Pluris could successfully carry forward the net operating losses against future income, the court held that the facts pled by Berg failed to show that there was any diversion, dissipation, or undue risk to corporate assets that would trigger the limited duties to creditors under the trust fund doctrine. Id. at *45.

In addition, even if there were a cognizable claim for breach of fiduciary duty, the court held that the business judgment rule would shield the Pluris directors from liability if the decision to make the assignment for the benefit of its creditors was made in good faith and without the presence of a conflict of interest.[5] While Berg alleged that the Pluris directors had failed to adequately consider the bankruptcy option and the plan to carry forward net operating losses, the court held that Berg failed to plead sufficient facts showing that the bankruptcy option was a practical and reasonable option worthy of detailed consideration by the Pluris board. Id. at *58-*60.

2. Comparing Duties Under California and Delaware Law

The Berg decision thoroughly discusses Delaware law on the fiduciary duties of directors of insolvent corporations, highlighting important differences and similarities between California and Delaware law on this issue. In its often-cited footnote 55, the Delaware Chancery Court noted in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., 199 Del. Ch. LEXIS 215 (Dec. 30, 1991), that once a corporation becomes insolvent, a director’s duty to the corporate enterprise also protects creditors of the corporation. In a more recent decision, NACEPF v. Gheewalla, 930 A.2d 92, 103 (2007), the Delaware Supreme Court clarified the bounds of the Credit Lyonnais decision and held that creditors cannot bring direct claims for breaches of fiduciary duties against directors of corporations that are insolvent or in the zone of insolvency.

Berg recognizes that a corporation must actually be insolvent for any duty to apply, 2009 Cal. App. LEXIS 1740, at *44-*45 n.22, while Gheewalla leaves open the possibility that derivative claims may be brought by creditors of a corporation in the zone of insolvency. Berg also notes that the only extra-contractual duty that directors owe to creditors arises from the trust fund doctrine, meaning that under California law creditors can only sue directors when they divert, dissipate or unduly risk corporate assets that could otherwise be paid to creditors. Id. at *43. Gheewalla makes clear that creditors have standing to bring any derivative action for harm to the corporation once the corporation is insolvent. Gheewalla, 930 A.2d at 101. At the same time, Berg does not expressly require that creditors of insolvent corporations bring only derivative actions, as is required in Delaware.[6]

Both California and Delaware courts recognize the trust fund doctrine. However, the Berg decision may support applying the doctrine in a way that Delaware does not. Berg does not clarify whether any preferential payment to certain creditors (and not just to insiders) may potentially give rise to a breach of fiduciary duty under California law,[7] although decisions to prefer certain creditors would be protected by the business judgment rule if the decisions were made in good faith and free of any conflict of interest. Id. at *53. Application of the trust fund doctrine in Delaware is not as certain,[8] but those Delaware decisions that have applied the trust fund doctrine generally apply the doctrine only when there has been a preference to an insider.[9]


[1] Note that the Berg decision only addresses fiduciary duties of insolvent corporations and not duties applied to other business associations, such as the duties of members of LLCs. The duties of members of other insolvent business associations may be different from those duties held by corporate directors.

[2] O’Melveny & Myers LLP represented a majority of the Defendants and Respondents in Berg.

[3] MWP allegedly subsequently transferred its rights and interests related to Pluris to Berg.

[4] Once a corporation becomes insolvent and creditors become the true residual risk-bearers, the “trust fund doctrine” as applied by courts in California is a basis for a breach of fiduciary duty action “where the directors or officers of an insolvent corporation have diverted assets of the corporation for the benefit of insiders or preferred creditors,” allowing courts in equity to impose a trust on a corporation’s assets for the benefit of all creditors. CarrAmerica Realty Corp. v. nVIDIA Corp., 2006 U.S. Dist. LEXIS 75399, at *6 (N.D. Cal. Sept. 29, 2006).

[5] See, e.g., Katz v. Chevron Corp. (1994) 22 Cal.App.4th 1352, 1366.

[6] The facts of Berg indicate that the original complaint alleging direct harm was sustained with leave to amend by the trial court on the basis that only harm to the corporation was alleged. In amending the complaint, Berg chose to assert the action on behalf of all creditors, and therefore the Court of Appeal did not have to decide whether an individual action could be pled under the creditor trust doctrine theory for breach of fiduciary duty.

[7] See Saracco Tank & Welding Co. v. Platz (1944) 65 Cal.App.2d 306, 313-18 (applying the trust fund doctrine to find breach of fiduciary duty from preferential payments to creditors, even though preferred creditors were not insiders). However, Saracco appears to be the exception, with most California cases finding a breach of fiduciary duty only where the preferences were made to insiders or otherwise showed conflicts of interest. See, e.g., Commons v. Schine (1973) 35 Cal.App.3d 141, 145 (controlling partner liable for payment of insolvent partnership’s debt to the partner’s own corporation); In re Jacks, 266 B.R. 728, 736 (Bankr. C.D. Cal. 2001) (director liable for using corporate assets to guarantee director’s personal debt).

[8] The Delaware Supreme Court has not ruled on the application of the trust fund doctrine, and more recent Chancery Court decisions question whether the doctrine would still be applied today. See, e.g., Prod. Res. Group LLC v. NCT Group, Inc., 863 A.2d 772, 791 (Del. Ch. 2004) (noting that “[a] strand of authority (by no means universally praised) . . . describes an insolvent corporation as becoming akin to a trust for the benefit of the creditors.”); see also In re JTS Corp., 305 B.R. 529, 538 (Bankr. N.D. Cal. 2003) (noting that “Delaware law has not followed an uncompromising trust fund doctrine,” and that recent decisions from lower courts in Delaware “have generally turned away from describing directors of an insolvent corporation as guardians of a trust fund for the benefit of creditors.”).

[9] One early case considering the trust fund doctrine declined to apply the doctrine where only a mere preference, and not a preference creating a conflict of interest (such as a preference payment to insiders), was at issue. Asmussen v.Quaker City Corp., 156 A. 180 (Del. Ch. 1931). Delaware courts have applied the trust fund doctrine to void payments to insider parties. Penn. Co. for Insur. on Lives & Granting Annuities v. S. Broad St. Theatre Co., 174 A. 112 (Del. Ch. 1934).