Alert > Securities Litigation / Financial Institutions Litigation
California Court of Appeal Clarifies Fiduciary Duties Owed by Directors to Creditors of Insolvent Corporation
In Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020 (2009), the California Court of Appeal for the Sixth Appellate District addressed previously unsettled questions regarding the fiduciary duties owed by directors of nearly insolvent or insolvent corporations to corporate creditors. In affirming the trial court’s dismissal of creditor claims for breach of fiduciary duty, the Court held that a corporate director has no fiduciary duty to corporate creditors when the corporation is in the so-called “zone of insolvency,” and that the creditors may bring such claims only when the corporation is actually insolvent and the director has diverted, dissipated or unduly risked corporate assets that might otherwise be used to pay creditors claims.
The Trial Court Dismisses the Creditors’ Claims on Demurrer
Berg & Berg Enterprises LLC (“Berg”) was the largest creditor of failed Pluris, Inc., a California corporation (“Pluris”). While Pluris was experiencing financial difficulties it entered into an assignment for the benefit of creditors, an alternative to liquidation in bankruptcy under the California Code of Civil Procedure. Berg filed a lawsuit against several individual members of the board of directors of Pluris, alleging that the directors breached their fiduciary duties by electing to make the assignment in lieu of a Chapter 11 bankruptcy reorganization plan proposed by Berg.
Berg alleged that the directors owed Berg a fiduciary duty because Pluris was at the time of the assignment operating in that “ill-defined sphere known as the ‘zone of insolvency.’” Berg claimed that the directors breached that duty by failing to conduct a reasonable investigation into the reorganization plan before proceeding with the assignment. The trial court sustained the directors’ demurrer to the complaint and dismissed the case without leave to amend. Berg appealed the trial court’s decision.
The Court of Appeal Affirms
In affirming the trial court’s decision, the Court rejected the “zone of insolvency” theory on which Berg based its claim. Although that theory has been embraced by courts in several other states, the Court held that California law recognizes no fiduciary duty owed by directors to corporate creditors when the corporation operates in the “zone” or “vicinity” of insolvency. The Court further held that even when a corporation is actually insolvent, there is no “broad, paramount fiduciary duty of due care or loyalty” that directors owe the corporation’s creditors solely because of the “state of insolvency.” Rather, the Court reasoned that California courts follow the “trust fund doctrine,” which establishes a limited fiduciary duty owed by corporate directors to corporate creditors of an insolvent corporation.
The Court ultimately held that “the scope of any extra-contractual duty owed by corporate directors to the insolvent corporation’s directors is limited in California, consistent 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 creditor claims.” This would include acts that involve self-dealing or the preferential treatment of creditors.
Conclusion
The “zone of insolvency” theory creates significant uncertainties for corporate directors as to precisely when fiduciary duties arise in favor of corporate creditors. The trust fund doctrine employed by the Court of Appeal in Berg eliminates such uncertainties and significantly limits the scope of corporate directors’ duties to creditors of an insolvent or financially distressed California corporation.
This alert was authored by Bingham securities litigation partners Dale Barnes and Peter Villar and associate Craig Taggart. For more information on this alert, please contact any of the lawyers listed below:
Dale E. Barnes, Co-chair, Securities Litigation
dale.barnes@bingham.com, 415.393.2522
Jordan D. Hershman, Co-chair, Securities Litigation
jordan.hershman@bingham.com, 617.951.8455
Peter N. Villar, Partner
peter.villar@bingham.com714.830.0640
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