Recently while involved in a pre-bankruptcy planning session with corporate counsel for the debtor entity, concerns were raised over liability in the “zone of insolvency”.  This concept of liability was first developed in Delaware involving a leverage buyout of MGM where the court theorized that individual directors of a financially distressed corporation operating at or near insolvency owed a duty of due care to its creditors.  Credit Lyonnais Bank Nederland N.V. vs. Pathe Communications Corp., 1991 WL 277613, 1991 Del. Ch. Lexis 215, Footnote No. 55 (Del. Ch. Dec. 30, 1991).  This case marked the beginning of nightmares for insolvency lawyers throughout the country involved with financially distressed businesses since the timing of the zone was unclear and the resulting scope of duties ill-defined. 

However, here in California there was and still is no zone of insolvency liability.  California courts instead adhere to the “trust fund doctrine” which generally requires the prohibition of self-dealing and preferential treatment of creditors regarding an insolvent corporation’s assets.  Berg & Berg Enterprises, LLC vs. Boyle, 178 Cal.App 4th 1020, 1032 (2009).  In Berg, the corporation had entered into an assignment for the benefit of creditors.  One of the company’s creditors claimed that the directors had failed to properly preserved the corporation’s alleged $50,000,000 of net operating losses which would have benefited creditors.  The complaint asserted that the directors had breached their duties owed to creditors in the zone of insolvency.

The trial court sustained the defendant directors’ demurrer without leave to amend, and the court of appeals confirmed, holding that no duty was owed by the directors of the corporation to its creditors.  The court reasoned:

We accordingly hold that the scope of any extra- contractual duty owed by corporate directors to the insolvent corporation’s creditors is limited in California, consistently with the trust fund doctrine, to the avoidance of actions that divert, dissipate or unduly risk corporate assets that might otherwise be used to pay creditors’ claims.  This would include acts that involve self-dealing or the preferential treatment of creditors.  Further, because all the California cases apply the trust fund doctrine that appear to have dealt with actual insolvent entities, and because the existence of a zone or vicinity of insolvency is even less objectively determined than actual insolvency, we hold that there is no fiduciary duty proscribed under California law that is owed to creditors by directors of a corporation solely by the virtue of its operating in the “zone” or “vicinity” of insolvency.  Id at p. 1041.

Although recent Delaware case law appears to be moving away from the zone of insolvency-type of claims,  California does not use this approach.  Thus, California law clearly is more advantageous to directors in the pre-bankruptcy environment[1] and simplifies insolvency planning and reviewing of potential insider claims for both debtors and creditors.

[1]See, “Corporate Fiduciary Liability to Creditors and Interested/Director Transactions:  Two Key Distinctions Between California and Delaware Fiduciary Duty Law That Come Under Scrutiny During Insolvency”, Peter M. Gilhuly, Ted A. Dillman, 31 Cal. Bankr. J. 827 (2012), for an article that discusses the difference between California and Delaware law regarding potential insider liability at or near insolvency.

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