Century City Bar Association Newsletter

California Court Erects Barrier To Creditor Claims Against Directors

By Louis R. Dienes

In Berg & Berg Enterprises, LLC v. Boyle, 2009 Cal. App. LEXIS 1740 (Oct. 29, 2009), the California Court of Appeal, Sixth Appellate District, recently issued a decision that materially limits the scope of director duties to creditors of insolvent corporations under California law. Dealing with the issue for the first time, the Court distinguished California's treatment of director liability from the treatment of director liability under Delaware law and declined to impose on directors any special duties to creditors. The decision raises important issues for directors of California corporations.

The Berg Decision

In Berg, Berg & Berg Enterprises, LLC, the largest creditor of Pluris, Inc., a failed Silicon Valley start up, filed a complaint against Pluris' directors after Pluris' business became financially distressed in 2002 and Pluris made an assignment for the benefit of its creditors and alleged, after amended pleadings, that Pluris' directors had breached their fiduciary duty to Pluris' creditors at the point Pluris entered the "zone of insolvency."

In its pleadings Berg alleged that Pluris had been involved in a lease dispute with a Berg-related entity in 2002. Berg agreed to settle that dispute when the financially-distressed Pluris told Berg that it was seeking outside financing to fund its continuing operations and that settlement of the Berg lease dispute was a condition to obtaining financing. Berg further alleged that it had informed Pluris that, if Pluris' efforts to find outside financing failed, Berg wanted to find ways for Berg to derive value from approximately $50 million in net operating losses Pluris had accumulated.

Pluris was unable to obtain the outside financing and entered into an assignment for the benefit of its creditors. Berg claimed that Pluris' directors owed a fiduciary duty to Pluris' creditors because the company was insolvent, or nearly-insolvent, and that Pluris' directors breached their fiduciary duty to Berg and other Pluris creditors by failing to follow, or even consider, Berg's proposal with respect to Pluris' net operating losses or other proposals.

The trial court dismissed Berg's complaint without leave to amend, holding that Berg's complaint failed to state a viable claim for breach of fiduciary duty against Pluris' directors and the appellate court upheld the trial court's dismissal. 1 2009 DJDAR 15513 (2009).

The Berg's Decision and Directors' Duties Under California and Delaware Law

The Berg decision discusses at length Delaware and California law with respect to the fiduciary duties of directors of insolvent corporations. The Delaware Chancery Court found in Credit Lyonnais v. Pathe Communications, 199 Del. Ch. LEXIS 215 (Dec. 30, 1991), that once a corporation becomes insolvent, its directors' duties to the corporate enterprise also protect the corporation's creditors. More recently, in NACEPF v. Gheewalla, 930 A.2d 92, 103 (2007), the Delaware Supreme Court clarified its holding in Credit Lyonnais, finding that creditors cannot bring direct claims for breaches of fiduciary duties against directors of corporations that are insolvent, or in the zone of insolvency.

The Berg decision addresses the issue squarely under California law by holding that a corporation must actually be insolvent for any duty to apply, 2009 Cal. App. LEXIS 1740, at *44-*45 n.22, in contrast to the Delaware Gheewalla decision which left open the possibility that derivative claims could be brought by creditors if the distressed corporation was in "the zone of insolvency".

The Berg decision holds that the only extra-contractual duty that directors owe to creditors arises from the "trust fund doctrine" adopted by California courts in accordance with Pepper v. Litton 308 U.S. 295, 306 (1939), in which the U.S. Supreme Court held that "all of the assets of a corporation, immediately upon becoming insolvent, become a trust fund for the benefit of all creditors."

This means that under California law creditors can only sue corporate directors when they divert, dissipate or unduly risk corporate assets that could otherwise have been paid to the corporation's creditors. Id. at *43. In contrast, Gheewalla holds that creditors have standing to bring a derivative action for harm to the corporation from the moment that the corporation is insolvent. Gheewalla, 930 A.2d at 101. Interestingly, however, Berg does not require that creditors of insolvent corporations limit themselves to derivative actions as required by Delaware law.

The application of the trust fund doctrine under Delaware law is uncertain, and the Delaware decisions that apply the doctrine generally only apply it in instances in which there has been a preference to a corporate insider. While both California and Delaware law recognize the trust fund doctrine, the Berg decision does not make clear whether a preferential payment to any portion of the creditors (as opposed to the insiders specifically) will support a claim for breach of fiduciary duty under California law, although the business judgment rule generally offers protection from such claims, provided the directors' acted in good faith and without a conflict of interest. Id. at *53.

Berg's Lessons for Directors of Insolvent California Corporations

The directors of insolvent California corporations owe fiduciary duties to creditors under the trust fund doctrine not to divert, dissipate, or unduly risk corporate assets. These duties arise when a corporation is actually insolvent, not merely in the "zone of insolvency." This is in contrast to Delaware law, which may recognize derivative actions brought by creditors even when a corporation is in the zone of insolvency.
The directors of insolvent California corporations can be held liable for breaches of fiduciary duties to creditors if they prefer some creditors over other creditors. However, the business judgment rule generally offers protection from such claims, provided the directors' acted in good faith and without a conflict of interest.
The Berg decision calls attention to Berg's failure to make a detailed proposal to Pluris's board before the assignment to creditors was executed. Directors of insolvent California corporations may be well advised to exercise special care where detailed proposals are made to the board of directors by creditors.
Under California and Delaware law, directors may be well advised to exercise special care when considering actions that might benefit insiders or result in a conflict of interest.

_{Louis R. Dienes is a member of the Corporate Department of TroyGould PC in Century City. He has been a trusted legal advisor to boards, senior management, investment banks and investors in mergers, acquisitions and divestitures, equity and debt financings, and business operations in more than $10 billion of consummated transactions. He is currently the President-Elect of the Century City Bar Association. He received his law degree from Stanford University in 1994.

LOS ANGELES MAGAZINE SOUTHERN CALIFORNIA SUPER LAWYER IN MERGERS & ACQUISITIONS FOR 2009 AND 2010}

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