California: Directors of Insolvent Corporations Owe "Limited" Fiduciary Duties to Creditors

With Bloomberg reporting predictions of up to 40 retail bankruptcies, and the Wall Street Journal describing “retail zombies” teetering on the edge of bankruptcy, I revisited fiduciary duties owed by directors to a corporation as it approaches insolvency.

Under ordinary circumstances, when a corporation is solvent, fiduciary duties are owed to the corporation and shareholders. These are the duties to act in good faith, in the best interest of the corporation and shareholders, and to avoid self-dealing. See, e.g., Cal. Corp. Code § 309(a). A corporation owes no duty to creditors, who are protected by contract rights. But when a corporation is insolvent, shareholders are “out of the money,” while creditors are the parties with a stake in the enterprise. Directors might be incentivized to make “swing for the fences” decisions, gambling for a chance at success. Creditors, on the other hand, will likely be risk-averse and seek to preserve existing value.

In Delaware, upon insolvency, fiduciary duties expand to include creditors. N. Am. Cath. Ed. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101-03 (Del. 2007). This is a change from the 1990s-2000s, when Delaware caselaw suggested there was a “zone of insolvency,” which was a gray area where duties began to shift over time. Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991).

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[.]” Berg & Berg Enterprises, LLC v. Boyle, et al., 178 Cal.App.4th 1020, 1041 (Cal.App. 2009). Instead, California applies a “trust fund doctrine” under which “all of the assets of a corporation, immediately on its becoming insolvent, become a trust fund for the benefit of all of its creditors[.]” Id. at 1040. Under the trust fund doctrine, directors owe a “limited” duty to avoid “actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditors claims.” Id. at 1041.

Berg & Berg Enterprises suggests that directors’ duties in an insolvent corporation are less burdensome in California than Delaware. But a 2016 Bankruptcy Court decision didn’t think so, finding the duties are “essentially, if not exactly, the same[.]” Solution Trust v. 2100 Grand LLC (In re AWTR Liquidation Inc.), 548 B.R. 300, 325 (C.D. Bankr. 2016). (In the absence of a California Supreme Court decision on a state law issue, a federal court will predict how the Supreme Court “would” decide.)

So how do directors discharge fiduciary duties in the face of conflicting interests between shareholders and creditors? The Bankruptcy Court in In re AWTR Liquidation Inc. found there was “[o]nly one rational approach” – for directors “to exercise their business judgment in a good faith attempt to weigh the likely value of each proposed course of action, taking into account both the risks and the potential rewards, and then choose whichever has the best chance to preserve and increase value of the corporation as a whole, for the benefit of all constituent groups.” In re AWTR Liquidation Inc., 548 B.R. at 327-28 (emphasis in original).

Director fiduciary duties in insolvent California corporations remain unsettled, and the actions undertaken by the board in a company that may be insolvent can be the source of significant litigation and, potentially, subject directors to liability.