Clarifying D&O Fiduciary Duty To Creditors In Calif.

Published on Law360.com

The Sixth District Court of Appeal, resolving a previously unanswered question in California, has drawn a bright line shielding company directors and officers from personal liability arising from creditor claims of breach of fiduciary duty. Berg & Berg Enterprises LLC v. Boyle, --- Cal. App. 4th ---, 2009 WL 3470631, 09 Cal. Daily Op. Serv. 13, 305 (Oct. 29, 2009).

California has now joined Delaware in holding that directors do not owe creditors a fiduciary duty, even when the corporation is operating in the so-called "zone of insolvency."

Berg & Berg Enterprises LLC, was the largest creditor of Pluris Inc. when Pluris did an assignment for the benefit of creditors under California law and closed its doors.

Berg subsequently brought an action against several of Pluris' directors, challenging decisions the directors made as breaches of the fiduciary duties the directors owed to all creditors when the company was operating in the "zone of insolvency."

The legal theory was not novel, but no California court had ever resolved the question of whether directors and officers owe creditors - as opposed to the company and its shareholders - a duty of care when insolvent or near insolvency.

The theory originated from a footnote in a Delaware case, Credit Lyonnais Bank Nederland NV v. Pathe Communications Corp., 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991), which, although finding no breach of fiduciary duty, posited that "where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the [shareholders], but owes its duty to the corporate enterprise" as a whole, including its creditors. Id. at *108, n.55.

Cases and legal commentary following Credit Lyonnais have suggested that when a corporation is actually or nearly insolvent, the directors may owe a duty of care that is paramount to the common law and statutory fiduciary duties owed to shareholders.

Berg & Berg soundly rejected that theory. The court held that no duty of directors to creditors is created "solely due to a state of corporate insolvency."

Rather, the court held that, even where a corporation is actually insolvent, the duty of care directors owe to the corporation's creditors is limited to avoiding actions that would harm the corporation itself, such as acts that involve self-dealing or the preferential treatment of creditors.

Although never previously decided by a California court, this holding of Berg & Berg is consistent with federal cases applying California law, which have held that upon actual insolvency, a corporation's assets become subject to a constructive trust for the benefit of corporate creditors - the so-called "trust fund doctrine."

The Berg & Berg court found that the "trust fund doctrine" is applicable in California to corporations that are legally insolvent, but that it is limited to cases where directors or officers have diverted corporate assets to insiders or preferential creditors, or have otherwise "dissipated or unduly risked the insolvent corporation's assets."

The Berg & Berg court had even more antipathy toward finding that directors owed a heightened duty to creditors in the impossible-to-define "zone of insolvency."

Recognizing that as long as the corporation remains solvent, the corporation is able to satisfy its contractual obligations to creditors and the directors' primary duties are to exercise their business judgment in an effort to maximize the corporation's overall financial health for the benefit of its shareholder owners.

The court, therefore, concluded that "because the existence of a zone or vicinity of insolvency is even less objectively determinable than actual insolvency, we hold that 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."

Berg & Berg essentially adopted the holding in the seminal Delaware case on the issue, North American Catholic Educ. Programming Found. Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).

Gheewalla held that creditors have no direct cause of action against individual directors or officers for breach of their fiduciary duties either when actually insolvent or when operating in the "zone of insolvency," and may only bring a derivative action against the directors for such a breach if the corporation is actually insolvent.

With California joining Delaware in concluding that directors' primary obligations are to offer effective, good faith leadership to their corporations for the benefit of the company and its shareholders, creditors' attempts to hold directors and officers personally liable for their business decisions will be severely hampered.