Director Duties to Creditors at Insolvent Businesses

The California Court of Appeal, Sixth Appellate District issued a ruling in Berg & Berg Enterprises, LLC v. Boyle, 2009 Cal. App. LEXIS 1740 (Oct. 29, 2009) that limits a breach of fiduciary duty action brought by creditors against insolvent corporation directors. This case serves as persuasive authority for bankruptcy cases in New York.

Berg came out of a dispute between Berg & Berg Enterprises, LLC (“Berg”) a real estate developer, and Pluris, Inc. (“Pluris”), a business that developed advanced network routers. Pluris closed in 2002 as a result of downturn in the telecommunications industry. Berg claimed it became Pluris’s creditor when MWP, its predecessor-in-interest, agreed to build and lease office buildings in San Jose, California to Pluris.

Pluris allegedly repudiated the lease contract and assigned its assets for the benefit of its creditors. Berg tried to file an involuntary bankruptcy proceeding against Pluris.  The suit was dismissed.  Later, Berg litigated in California court against nine of Pluris’s directors for breach of fiduciary duty.  Berg claimed the Pluris directors breached fiduciary duties to Berg by assigning assets for the benefit of Pluris’s creditors before examining other possible courses of action to maximize the value of the company’s assets and letting the assignee waste Pluris’s assets. For instance, Berg claimed a bankruptcy filing could have preserved the net operating losses with higher payments to creditors. Net operating losses are considered assets when a profitable business decides to buy an insolvent business.

According to the court, 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. . ..”

The duty owed by corporate directors to an insolvent corporation’s creditors stems from the “trust fund doctrine” limited “to the avoidance of actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditors claims.” When a California corporation is insolvent, directors owe a fiduciary duty to creditors under the trust fund doctrine not to dissipate, divert, or unduly risk corporate assets. The duty arises when a corporation is insolvent, not in the “zone of insolvency.” California law may differ from Delaware law, which may recognize derivative actions by creditors when a corporation is in the zone of insolvency.

The court decided the business judgment rule would shield Pluris directors from liability if the decision to make the assignment for the benefit of its creditors was made in good faith and without any conflict of interest.

Contact a New York bankruptcy counsel to learn more on the impact of bankruptcy court decisions on the administration of a bankruptcy estate.