The moment a corporation becomes insolvent, a lot can change, and fast.  If the officers and directors of the company are unaware of how insolvency can transform the landscape of corporate responsibilities and duties, they run the risk of exposing themselves to liability for the corporation’s debts, even if there was no personal guaranty.  For purposes of this blog article, we look at how insolvency changes (or doesn’t change) the scope of a director’s fiduciary duties to creditors.

The Business Judgment Rule

First, a little background information.  The decisions of a company’s Board are scrutinized under what is known as the business judgment rule (the “BJR”).  The BJR provides broad latitude to the decision makers of a business, and courts will not review (i.e. second guess) directors’ business decisions or hold directors liable for errors or mistakes in judgment, so long as they satisfy the following: 

1. Disinterested and independent; 
2. Acting in good faith; and
3. Reasonably diligent in informing themselves of the facts.  

When a company becomes insolvent the protections of the BJR remain largely intact.  However, the duties owed by the directors of the company become slightly larger.

Fiduciary Responsibilities

It is well established that corporate directors owe a fiduciary duty to the corporation and its shareholders and must serve in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders.  Corporations Code § 309.  Notably, this fiduciary duty is not owed to a corporations’ creditors. 

In California, only upon a company becoming insolvent does any such duty become owed to creditors.  Even with such duty, however, the duty is limited in scope and is not synonymous with the fiduciary duty directors owe to the corporation and its shareholders.  Unlike the fiduciary duty owed to the corporation and its shareholders (above), there is no statutory authority in California establishing that, upon a corporation’s insolvency, or otherwise, directors also owe a duty to the corporation’s creditors.  In fact, under current California law, 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.  Berg & Berg Enterprises, LLC v. Boyle (2009) 178 Cal.App.4th 1020, 1041. 

Rather, the duty owed by directors to creditors is an extension of the contractual relationship that already exists between the creditor and the company in question, and stems from what is known as the “trust fund doctrine. 

The Trust Fund Doctrine

The trust fund doctrine dictates that all of the assets of a corporation, immediately upon becoming insolvent, become a trust fund for the benefit of all creditors in order to satisfy their claims.  Berg & Berg Enterprises, LLC v. Boyle (2009) 178 Cal.App.4th 1020, 1040.  The scope of violations of the trust fund doctrine are limited to instances where directors or officers have “diverted, dissipated, or unduly risked the insolvent corporation’s assets.”  Id.  As such, by relying on the trust fund doctrine, California courts hold that the scope of the duty owed by corporate directors to the insolvent corporation’s creditors is limited in California only to the avoidance of actions that divert, dissipate, or unduly risk corporate assetsthat might otherwise be used to pay creditors claims. This would include acts that involve self-dealing or the preferential treatment of creditors (i.e. directors diverting assets of the corporation for benefit of insiders or preferred creditors). 

Defining Insolvency

With the existence of such a duty owed to creditors upon “insolvency,” the next question, naturally, becomes, “What is the definition of insolvency?”  Unfortunately, there are multiple definitions and, ultimately, will be an issue of fact.  California Corporations Code section 501 provides, for example, that a corporation is insolvent, if, as a result of a prohibited distribution, it would “likely be unable to meet its liabilities … as they mature.”  In the Ninth Circuit Court of Appeals, a finding of insolvency by the standard of a debtor not paying debts when they become due requires more than merely establishing the existence of a few unpaid debts. See In re Dill, 731 F.2d 629, 632 (9th Cir.1984).  There is also insolvency in the balance sheet sense in which the value of liabilities exceeds the value of assets. See In re Kallmeyer, 242 B.R. 492, 496–497 (9th Cir.BAP1999). 

Fortunately, because the trust-fund doctrine only deals with entities that are actually insolvent, California courts hold that there is no fiduciary duty 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 Enterprises, LLC v. Boyle (2009) 178 Cal.App.4th 1020, 1041.  While insolvency is a grey area in and of itself (above), the existence of a zone or vicinity of insolvency is even less objectively determinable than actual insolvency, which is further reason why California courts do not prescribe a duty owed to creditors when an entity operates in the “zone of insolvency.”  Accordingly, when a solvent corporation is navigating in the zone of insolvency, the focus for directors does not change: directors must discharge their duty to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of the shareholder owners.

Based on the foregoing, and in conjunction wit the BJR, it follows that in order for a creditor to hold a director liable for operational decisions of the business based on allegations of breach of fiduciary duty, the creditor would need to establish the following: (1) the company was insolvent; (2) the conduct in which the director engaged amounted to self-dealing, preferential treatment of creditors, and diversion, dissipation or undue risk of corporate assets; and (3) directors were not personally disinterested and their acts were not performed in good faith and without following reasonable investigation (i.e. a rebut of the presumption afforded by the BJR).   

The challenge for a director is that the definition of insolvency is not clear under California law, as described above.  As a result, when a corporation approaches a point where it cannot pay its creditors or when a dissolution is reasonably foreseeable, it is important to understand the potential obligations to the corporation’s creditors.  The failure to recognize such obligations will expose you personally for liabilities that were once held exclusively by the corporation.  Such personal liability can come in the form of fraud or breach of fiduciary duty, which also may become non-dischargeable in a bankruptcy under 11 USC 523(a).  As such, at a minimum, you should consult with counsel to make sure your bases are covered.