Fresno Lawyer – Randolf Krbechek

Here is a recent decision that is not a surprise under a traditional agent-principal analysis.  Even so, it has to sting, because the corporation loses twice – first, when it was defrauded by the former president, and second when the corporation was sued by shareholders for the diminished value of their securities.

The fact pattern is straightforward.  “ChinaCast founder and CEO Ron Chan embezzled millions from his corporation and misled investors through omissions and false statements – textbook securities fraud.”  These were not small losses: “From June 2011 through April 2012, Chan ‘transferred’ $120 million of corporate assets to outside accounts that were controlled by him and his allies.”

There’s your background.  The corporation, recognized by law as a separate “person,” lost millions of dollars through embezzlement by the former CEO.  At the same time, the former CEO made false representations on behalf of the corporation, which false representations caused damage to investors in the corporation.

Explained the court, “Throughout 2011, Chan signed SEC filings on behalf of ChinaCast and never disclosed the $120 million in transfers and other fraudulent activities afoot.”  (Of course Chan made false representations – otherwise, he would of been admitting his wrongdoing.)

The corporation brought forth a common-law defense: “The adverse interest doctrine may prevent a court from imputing knowledge of wrongdoing to an employer when the employee has abandoned the employer’s interests, such as by stealing from it or defrauding it.”

“The sole question on appeal is a purely legal one and an issue of first impression in this circuit:  Can Chan’s fraud be imputed to ChinaCast, his corporate employer, even though Chan’s looting of the corporate coffers was adverse to ChinaCast’s interests?”

The Ninth Circuit held that the corporation could be sued by investors based on the false representations, even though the corporation suffered its own separate injuries.  Explained the court, “we conclude that Chan’s fraudulent misrepresentations – and, more specifically, his scienter or intent to defraud – can be imputed to ChinaCast.

“Significantly, imputation is proper because Chan acted with apparent authority on behalf of the corporation, which placed him in a position of trust and confidence and controlled the level of oversight of his handling of the business.”

That’s certainly a difficult result.  Everyone suffered from the wrongful acts of Chan.  In an earlier time, the law probably would have allowed the losses to rest where it found them.  In our increasingly urban society, the law reaches out to protect injured persons, even when the defendant has already “paid once” for the injury.

In re ChinaCast Education Corporation Securities Litigation, __ F.3d __ (9th Cir. Oct. 23, 2015)

The Delaware Supreme Court recently decided William Penn Partnership v. Saliba, a case in which there are no winners.  In the case, one of the members breached his fiduciary obligations, but his conduct caused no damage.  Nonetheless, the court awarded attorneys’ fees as an “equitable remedy.”  In this author’s view, the award distorts the law of equitable remedies, creates uncertainty in the law, and rewards fruitless litigation.

The facts were as follows.  The parties were members of a limited liability company called Del Bay Associates, LLC.  Del Bay built the Beacon Motel in Lewes, Delaware in 1987, with 66 guest units.  Later, some of the members (the Lingos) wanted to “end their business relationship” with the other members.

The Lingos concocted a story about their need to dissolve the limited liability company and sell the motel to fulfill obligations under a section 1031 tax-deferred exchange.  Explained the court, “On June 10, 2003, the Lingos convinced Hoyt to sign the contract immediately so they could present it to the JGT board. The Lingos told Hoyt that if he did not sign the contract, JGT might back off.”

The court found that the representations were not true.  Instead, the Lingos controlled both sides of the transaction – seller and buyer.  For example, “The Lingos manipulated the sales process through misrepresentations and repeated material omissions such as (1) imposing an artificial deadline justified by ‘tax purposes;’ (2) failing to inform Saliba and Ksebe that they were matching their offer by assuming the existing mortgage; [and] (3) failing to inform Saliba and Ksebe that they had already committed to selling the property to JGT, an entity the Lingos controlled.”

So, we have a transaction in which one member abused his fiduciary duties to the other members.  More bluntly, “The Lingos here acted in their own self interest by orchestrating the sale of Del Bay’s sole asset, the Beacon Motel, on terms that were favorable to them.  By standing on both sides of the transaction – as the seller, through their interest in and status as managers of Del Bay, and the buyer, through their interest in JGT– they bear the burden of demonstrating the entire fairness of the transaction.”

Such proof of “entire fairness” was a burden the Lingos could not meet.  “The concept of entire fairness consists of two blended elements: fair dealing and fair price.  Fair dealing involves analyzing how the transaction was structured, the timing, disclosures, and approvals.  Fair price relates to the economic and financial considerations of the transaction.  We examine the transaction as a whole and both aspects of the test must be satisfied; a party does not meet the entire fairness standard simply by showing that the price fell within a reasonable range that would be considered fair.”

In fact, the price did fall with “a reasonable range.”  The buyer paid $6,625,000 for the Beacon Motel, while the trial court found that the “retained appraisal valued the property at $5,480,000.”  Thus, the price paid by the buyer was greater than the fair market value for the motel, meaning that the non-controlling members suffered no compensable injury.

The court found that this result was not satisfactory.  “Merely showing that the sale price was in the range of fairness, however, does not necessarily satisfy the entire fairness burden when fiduciaries stand on both sides of a transaction and manipulate the sales process.”

OK, but we have no basis on which to award damages.  “Saliba and Ksebe were left without a typical damage award because the Court’s appraisal of the property came in at a value lower than the sale price.”

What to do?  This court decided to award attorneys’ fees to the non-controlling members.  “The Chancellor concluded it would be unfair and inequitable for Saliba and Ksebe to shoulder the costs of litigation arising out of improper prelitigation conduct attributable to the Lingos that amounted to a violation of their fiduciary duties.”

Although there was no statutory or contractual basis for an award of attorneys’ fees, the Delaware Supreme Court held that “The Chancellor’s decision to award attorneys’ fees and costs was well within his discretion and is supported by Delaware law in order to discourage outright acts of disloyalty by fiduciaries.  Absent this award, Saliba and Ksebe would have been penalized for bringing a successful claim against the Lingos for breach of their fiduciary duty of loyalty.”

Which perhaps would have been the better result.  This litigation was surely driven by the attorneys, not by the injured parties, with substantial attorneys’ fees.  The court’s award of attorneys’ fees on equitable grounds will only foster litigation in the future, which is hardly an optimal result.

William Penn Partnership v. Saliba (Del. Supreme Court Feb. 9, 2011) 2011 Del. LEXIS 91

Another in a recent wave of California cases has hit the nail on the head, holding that the trustee can be held liable for debts, but not the trust itself.  The reason is elementary – a trust is a relationship, not an entity.  This rule has roots that run back hundreds of years.  It explains a number of the seeming paradoxes in trust law.

The second published appellate decision in Greenspan v. LADT, LLC (Dec. 30, 2010) 191 Cal.App.4th 486 concerned efforts to enforce an $8.45 million judgment.  It seems that $47 million in assets that should have been available to satisfy a judgment had dwindled to $13,000.  The judgment creditor looked to other assets to satisfy the judgment.

This is one of the inflection points at which our legal system buckles.  It can be inordinately difficult to enforce a judgment.  Here, the court held that it was proper to amend the judgment to add the trustee as a judgment debtor.  With a twist, because the trustee was the manager of the limited liability companies against which the judgment was entered, such that the liability was based on an alter ego theory.

Let’s consider the court’s analysis.  The court held that Barry Shy could be added as judgment debtor based on “his control of the Shy Trust and its companies to such an extent that his failure to satisfy the judgment would promote injustice.”

The court employed a well-known procedure, stating that “Amendment of a judgment to add an alter ego is an equitable procedure based on the theory that the court is not amending the judgment to add a new defendant but is merely inserting the correct name of the real defendant.”

Now, I have trouble understanding why equity should intervene, because the claim seeks substantive legal relief.  The cavalier use of this procedure does not promote justice, especially when the defendants were known to the plaintiff during the trial on the merits.  Still, court held that “such a procedure is an appropriate and complete method by which to bind new defendants where it can be demonstrated that in their capacity as alter ego of the corporation they in fact had control of the previous litigation, and thus were virtually represented in the lawsuit.”

The trustee was the manager of the limited liability companies against which judgment was entered.  His liability arose, as a factual matter, from his management of the limited liability companies, not from his acts as trustee (manager) of the trusts.  This then is a leap, albeit a small one.  With our modern statutory schemes for limited liability companies, we have made it difficult to enforce judgments placed against an LLC.

Stated the court, “we conclude the alter ego doctrine may apply to a trustee but not a trust . . . Courts often speak of the alter ego doctrine as if it applied to a trust as an entity.  But a distinction must be made between a trust and a trustee. The general rule that a trust is a relationship is universally recognized by U.S. cases and statutes, and is consistent with the prevailing norms of the entire common-law world. The fundamental nature of this relationship is that one person holds legal title for the benefit of another person.  Thus, in actuality, a trust is not a legal person which can own property or enter into contracts.”

That is a rock-solid statement of the law, correct on all points.  “Because a trust is not an entity, it’s impossible for a trust to be anybody’s alter ego. That’s because alter ego theory, which is simply one of the grounds to ‘pierce the corporate veil,’ is inescapably linked to the notion that one person or entity exercises undue control over another person or entity.  However, a trust’s status as a non-entity logically precludes a trust from being an alter ego.”

The court is still right on the money.  “Unlike a corporation, a trust is not a legal entity. Legal title to property owned by a trust is held by the trustee.  A trust is simply a collection of assets and liabilities. As such, it has no capacity to sue or be sued, or to defend an action.”

But now we enter a hazy area.  Generally, a claim against the trustee must be connected to a claim connected with the management and operation of trust assets.  Stated differently, the personal liability of a trustee for his wrongdoing does not enable a judgment creditor to reach trust assets.  Such protection of trust assets is tied to the fundamental notion that a trust is a relationship, whereby the trustee holds title to the trust assets for benefit of the cestui que trust.

The court’s next step is not on such firm grounding.  “The proper procedure for one who wishes to ensure that trust property will be available to satisfy a judgment is to sue the trustee in his or her representative capacity.”  True, but the court seeks to hold the trustee liable for debts owed by a trust asset.  How do we cross this bridge?

In a single leap.  “In the present case, Greenspan properly sought to add Moti Shai, the trustee of the Shy Trust, as a judgment debtor.  If Moti Shai is the alter ego of Barry Shy, then Barry may be considered the owner of the Shy Trust’s assets for purposes of satisfying the judgment.”

This result means that the court is disregarding two layers – the limited liability company (on alter ego grounds) and the trust.  I propose that the trust should be disregarded on a more fundamental basis – an estate planning trust has no legal effect until the death of the settlor.  If the trust is revocable by the trustor, it should always be ignored by the court.  If the trust is irrevocable, then we enter the familiar area of the fraudulent transfer.  In other words, the court reached the right result, but there’s an easier way to connect the dots.

Greenspan v. LADT, LLC (Dec. 30, 2010) 191 Cal.App.4th 486

In Ahcom, Ltd. v. Smeding, 2010 DJDAR 16125 (9th Cir. Oct. 21, 2010), the Ninth Circuit Court of Appeal considered when alter ego liability could be imposed on corporate shareholders.  Applying California law in a bankruptcy context, the court provided contours to alter ego liability.

The issue in Ahcom was whether “a creditor of a corporation in bankruptcy has standing to assert a claim against the corporation’s sole shareholders on an alter ego theory or whether that claim belongs solely to the corporation’s bankruptcy trustee.”  The district court held that the claim belonged to the trustee, who must likely was unwilling to pursue litigation against the shareholders.

On appeal, the Ninth Circuit held that the creditor could pursue the claim, because it was an injury specific to the creditor, not a generalized injury that affected all shareholders.  Thus, “Ahcom’s first amended complaint asserted two substantive claims, one related to the foreign arbitration award and one related to a breach of contract.”

[According to its website, Ahcom is “one of the largest traders and distributors of tree nuts, including almonds and cashews in the world.]

“Ahcom also alleged an alter ego claim whereby they sought to pierce the corporate veil to hold the Smedings responsible for [the corporation’s] actions.  Crucially, both of Ahcom’s substantive claims to recover the arbitration award and the contract-related damages, by their terms, depend on the success of Ahcom’s alter ego allegations. Without those allegations, Ahcom has no claim against the Smedings.”

Explained the court, “The issue is not so much whether, for all purposes, the corporation is the ‘alter ego’ of its stockholders or officers, or whether the very purpose of the organization of the corporation was to defraud the individual who is now in court complaining, as it is an issue of whether in the particular case presented and for the purposes of such case justice and equity can best be accomplished and fraud and unfairness defeated by a disregard of the distinct entity of the corporate form.”

Now comes a profound statement, based on prior published California case law.  “In fact, there is no such thing as a substantive alter ego claim at all:  A claim against a defendant, based on the alter ego theory, is not itself a claim for substantive relief, e.g., breach of contract or to set aside a fraudulent conveyance, but rather, procedural.”

This author would posit that many lawyers would view an alter ego claim as a substantive claim against the shareholders, not a mere matter of procedure.

The court continued.  “This reading is unavoidable when we consider that no California court has recognized a freestanding general alter ego claim that would require a shareholder to be liable for all of a company’s debts and, in fact, the California Supreme Court stated that such a cause of action does not exist.”

As a result, the creditor could pursue its claim against the shareholders.  “We conclude that California law does not recognize an alter ego claim or cause of action that will allow a corporation and its shareholders to be treated as alter egos for purposes of all the corporation’s debts.  Just because [the corporation’s bankruptcy] trustee could not bring such a claim against the [shareholders] under California law, there is no reason why Ahcom’s claims against the [shareholders] cannot proceed.”

A pithy yet profound decision.

Ahcom, Ltd. v. Smeding, 2010 DJDAR 16125 (9th Cir. Oct. 21, 2010)

A recent article by attorney Thomas M. Madden compares the fiduciary obligations applicable to limited liability companies under the laws of five different states – Delaware, Massachusetts, New York, California, and Illinois.

Mr. Madden concludes that, “A look at the five major states’ codes will quickly dispel any presumption that all states treat limited liability companies alike.  Each state has a distinct approach to fiduciary duties – ignoring them entirely, recognizing them in some fashion, setting them out extensively in black letter, or some variation on the foregoing.”

The author provides further analysis.  “While the express, statutory duties of members and managers of limited liability companies range from the practically nonexistent in Delaware to the substantial and detailed in Illinois, well established statutory and common law duties between majority stockholders of close corporations and minority holders exist in the five major states.”

Of course, the question is, To what extent will a court draw from a different body of law?  The author finds strong links.  “The range, or continuum, from the lacking to the pronounced, holds consistently in both corporate and limited liability company law from least strict in establishing and enforcing fiduciary duties in Delaware to most strict in Illinois . . .

“This body of statutory and common law on fiduciary duties tied to limited liability companies, though not as developed into enduring doctrines as with the corporate common law, is growing, and indicates a strong link to the predecessor parallel law on close corporations.”

The author does not hesitate in his analysis.  “While we can draw the obvious and tiresome conclusion that fiduciary duties in corporations – specifically close corporations – are more pronounced and more enforceable in the five major states generally than fiduciary duties in limited liability companies, I believe the cited case law, if not the statutory law of the five major states as well, supports a real connection between the treatment of fiduciary duties associated with close corporations and the treatment of fiduciary duties associated with limited liability companies – a connection that is increasing with the age and growth of the body of law on LLCs.”

“The real question, then, is the normative one: should duties like those owed by majority shareholders of close corporations to minority shareholders exist regarding limited liability company members and managers, strengthened by statute and/or enforced at common law, and be treated increasingly similarly?”

“Our look at the five major states gives us no consensus answer to the normative question.  On the treatment of duties in limited liability companies becoming increasingly similar to those in close corporations, there is a clear consensus from the five major states as a group that this is occurring (whether or not it ought} – albeit in a manner and to a degree inconsistent among those five major states.”

There are substantial differences between the various states, “from the Delaware pro-contractarian model to which Massachusetts statutory law, if not common law, seems to be following (each allowing the near elimination of all fiduciary duties in the name of freedom of contract particularly applied to operating agreements) to the Illinois codified duties of loyalty and due care.”

Here then is the question: “Should the [expansive] sort of duty enforced in Van Gorkom apply to members and managers of private limited liability companies?  Rather, should those duties be stripped to the near bare version of UCC-like good faith and fair dealing in contract?  The best solution is probably something in between.

According to Mr. Madden, “Putting aside the economic based arguments of the contractarians, it would seem that [ ] a majority with no duties to a minority would wield power so great as to enable the facile pursuit of pure self-interest over the interest of the entity and/or its minority owners.”

I fully endorse this position.  The notion that the parties, at the inception, could agree to bargain away remedies for wrongs as yet uncommitted seems a folly.  Even more, “it is simply hard to believe that any parties with some equality of bargaining power would rationally contract away some fiduciary duty of the majority to the minority and the entity itself.  This would be tantamount to investment without recourse.  Doesn’t any investor – public or private – have some bottom line expectation of fair treatment?  Shouldn’t the law recognize and enforce that expectation?”

“Would it not make more sense to keep in place some level of fiduciary duty beyond the basic UCC contractual obligation of good faith and fair dealing while making goals and rights explicit in operating agreements?  For instance, provide a call right upon certain major decision triggers where a minority member’s interests might diverge from the majority.  Adept drafting of an operating agreement at the formation of the venture would go a long way toward preventing situations where minority members were likely to assert different interests from the majority, while allowing the existence of fiduciary obligations of the majority to the entity and to the minority to maintain the adequate protection of them from the pure self-interest of those in control.”

Agreed.  The needs to help limit unbridled self-interest.  From my view, the duties established in the corporate model are much to be commended, and should generally be made part of an operating agreement for a limited liability company.

Thomas M. Madden, Do Fiduciary Duties of Managers and Members of Limited Liability Companies Exist as with Majority Shareholders of Closely Held Corporations?, in 12 Dusquesne Bus. Law Rev. 211 (Summer 2010)

Attorneys Jim Weller and Alan Ytterberg published a recent article discussing an odd hybrid entity – the “private trust company.”  As the authors explain, “Similar to a regulated trust company, an unregulated trust company is an entity formed under state law for the limited purpose of providing trust services to a single family.”

A private trust company is first an entity established under state law.  “Most states that authorize private trust companies allow them to be formed as a corporation or a limited liability company.”  However, “there is no information available to ascertain the number of unregulated trust companies that have been formed in the U.S.”

By way of history, “U.S. Trust Company (est. 1853), Northern Trust (est. 1889), and Bessemer Trust (est. 1907) were originally formed as private trust companies, but today they are known and respected as public trust companies that provide a wide range of fiduciary and trust services.”

A private trust company is a state-chartered institution that is formed to manage assets for wealthy families into the future.  Thus, “it is a state chartered entity that is formed for the express purpose of providing trust and fiduciary services to a single family” and is tied to one or more irrevocable trusts established by the family.

State the authors, “there are a variety of states which promote private trust companies. Most of these states have favorable tax laws, and they have modernized their trust laws.  In that regard, Wyoming, Nevada, South Dakota, and Texas are some of the more popular states where wealthy families are chartering private trust companies.”

States have different requirements for physical presence in the jurisdiction, but the requirements are not difficult to satisfy.  For example, “Licensed family trust companies in Nevada must have at least one officer who is a Nevada resident, a physical office in Nevada, and “a bank account with a state chartered or national bank having a principal or branch offices in Nevada.”

The authors further explain that, “State banking commissioners have less incentive to subject a private trust company to the same regulatory oversight that a public trust company has because there is no public interest to protect.  This distinction is formally recognized in states which permit private trust companies to seek exemption from certain regulatory provisions that apply to trust companies transacting business with the public.”

So, the state sanctions the formation of an entity, accords it the privileges of conducting business and of limited liability, but provides for little if any public or regulatory oversight.  “A private trust company must meet minimum capital requirements in order to exercise the fiduciary powers granted to it by the chartering state.  These capital requirements vary from state to state.  South Dakota has the lowest capital requirement at $200,000.”

The authors add that, “a private trust company must apply for and obtain a charter from the state where it is to be located.  Once the charter is granted, the private trust company is subject to the laws and regulations of that state.  The lone exception is an unregulated trust company which can be formed in Massachusetts, Nevada, Pennsylvania, Virginia, and Wyoming.”

That’s private justice for the very wealthy in America, which is a distressing topic.

The issue this week concerns the appropriate remedy when controlling shareholder(s) breach the fiduciary duties they owe to the other shareholders.  An article by attorney William S. Monnin-Browder discusses whether courts should apply a minority interest discount in a forced sale.

Background

As explained in many published opinions, “stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another . . . They may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation.”  Donahue v. Rodd Electrotype Co., 328 N.E.2d 505, 515 (Mass. 1975)

Wrongful Conduct by the Controlling Shareholder

Mr. Monnin-Browder explains that, “There are a number of ways that majority shareholders can usurp the interest of the minority.  For instance, the terms ‘freeze-out’ and ‘squeezeout’ are often used, synonymously, to describe a situation where the majority uses its controlling position to exclude a minority shareholder from participation in the business.”

By the wrongful acts of the majority, “minority shareholders can be prevented from gaining a return if they are fired, which a majority-controlled board can freely do . . . One common form of the squeeze-out occurs when a majority shareholder prevents a minority from receiving a return on her investment, and then attempts to buy the minority’s shares when the value of the stock is compromised . . . The lack of a ready market for shares in a close corporation prevents a minority shareholder from selling shares as a means of escape.”

The Remedy

“Once a court determines that majority shareholders have breached their fiduciary duty, the court is forced to find an appropriate remedy.  Remedies for breach of fiduciary duty are equitable in nature . . . Common remedies for breach of fiduciary duty in a close corporation include dissolution, reversal of an offending decision, or buyout of the minority shareholder’s shares by the corporation.”

However, “the most common remedy employed by courts today [ ] is buyout . . . Courts view buyout as a less harsh remedy than dissolution because it compensates the aggrieved shareholder, while allowing the corporate entity to survive.  It is also often the most practical remedy.  A court order to rehire or return the shares sold, for example, may not be a viable option.”

Marketability Discount

But to do so, the court must establish the value of the victim’s interest in the entity.  “Valuing a share in a close corporation usually begins with an analysis of the value of the corporation as a whole.  To do this, courts often look to three major approaches: market value, net asset value, and earnings value.  These factors are weighed differently, according to the specific factual circumstances.”

Two general forms of discount are commonly applied in valuing interests in a closely-held corporation.  The first is a marketability discount.  As explained, “The marketability discount compensates for the absence of a market for shares of a close corporation.  Investors will pay less for these shares, compared to more liquid shares, because they prefer shares that are easily sold and/or transferred.  Marketability discounts can be substantial, averaging from approximately 35 to 50% of the value of the stock. “

Minority Interest Discount

The second principal discount is the minority interest discount.  “The minority discount compensates for the fact that the shares constitute a minority interest in the corporation that is not controlling, so long as there is no shareholder agreement to the contrary.  Investors prefer stock that has the accompanying voting power to influence the operations of the corporation.  Therefore, investors will pay less for those shares than shares in the majority interest.  Like marketability discounts, minority discounts can have a substantial impact on the value of the shares, reducing the price as much as 33%.”

Thus, the combined discount based on minority interest and lack of marketability can exceed 50% of the value of the stock.  Such discounts are commonly used in the estate planning context.

Should a Court Apply the Discount?

The judicial trend is not to apply the discount in the context of a forced buyout of a minority interest.  “Some courts state that the context and purpose of the legislation suggest that no discount should apply.  In Swope v. Siegel Robert, Inc., for example, the Eighth Circuit Court of Appeals applied Missouri law to reject the application of both a marketability and minority discount.”

In this way, “The typical freeze-out situation arises when a minority shareholder has no other choice but to sell their shares to the majority shareholder at less than their fair value.  From a policy standpoint, it would be illogical to discount the value of the shares because doing so would reward an oppressive majority shareholder and injure the party who is relatively blameless.”

That analysis is sound, because the “buyout does not occur on an open market.  Therefore, courts argue that they should not apply discounts that account for irrelevant market conditions.  As Professor Moll writes, ‘the forced-sale nature of buyout proceeding and the identity of the purchasers involved weigh heavily against the application of discounts.’”

An Extreme Result

One court went the opposite direction.  “Rather than force the oppressor shareholder to purchase the oppressed shareholder’s stock, the trial court chose a different remedy, holding that the oppressed shareholder was entitled to buyout the shares of the oppressor.  The court [then] applied discounts.”  Balsamides v. Protameen Chemicals, Inc., 734 A.2d 721, 734 (N.J. 1999).

We could certainly ask – Isn’t sauce for the goose also sauce for the gander?  The court put a real hurt to the wrongdoer by forcing a sale and also applying  a judicially-created discount.

A Point of Dispute

Mr. Monnin-Browder posits that “a heightened fiduciary duty exists among shareholders of a close corporation,” explaining that, “In the wake of the Massachusetts ruling, courts in many other states adopted the fiduciary duty rationale of Donahue, thereby recognizing heightened fiduciary duties among shareholders in close corporations and creating a common-law cause of action.”

That is not a careful use of terms.  Fiduciary duties are, by definition, “heightened duties,” filling gaps in the relationship between the parties.  It does not make a great deal of sense to speak in terms of a “heightened fiduciary duty.”

William S. Monnin-Browder, Are Discounts Appropriate?: Valuing Shares in Close Corporations for the Purpose of Remedying Breach of Fiduciary Duty under Massachusetts Law, in 40 Suffolk Univ. Law Review, Vol. 3 (2007) page 723.

A growing body of case law during the past 20 years has addressed the issue of whether and when corporate directors owe fiduciary duties to creditors.  A California appellate court has finally weighed in on this issue, and provided clear guidance on the question.  (We can only hope that the California Supreme Court will not to take the case up for review, because they are sure to muddy the waters.)

In Berg & Berg Enterprises, LLC v. Boyle (Oct. 29, 2009) 2009 DJDAR 15513, the court of appeal explained that “Berg & Berg Enterprises, LLC is the largest creditor of the failed Pluris, Inc. . . . The thrust of Berg’s claim, as finally pleaded, was that the individual directors owed a fiduciary duty to Berg and other Pluris creditors on whose behalf Berg is purportedly proceeding.”

The trial court sustained demurrers to the complaint without leave to amend, which ruling was affirmed.  The appellate court gave a good, clear analysis of the issue, explaining that, “it is without dispute that in California, corporate directors owe a fiduciary duty to the corporation and its shareholders and now [ ] must serve ‘in good faith, in a manner as such director believes to be in the best interests of the corporation and its shareholders.’”

The court explained that the potential fiduciary obligations owed by corporate directors to creditors arose from an unpublished 1991 Delaware decision involving the leveraged buyout of MGM, “which laid the ground for the insolvency exception to the general rule that directors owe exclusive duties to the corporation and its shareholders, but not to shareholders.”

The question involves what duties are owed by corporate directors to unpaid creditors when the corporation is insolvent.

The Berg & Berg court squarely held that, “under the current state of 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 [ ].  And we decline to create any such duties, which would conflict with and dilute the statutory and common-law duties that directors already owe to shareholders and the corporation . . .

“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, consistent 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 action that involves self-dealing or the preferential treatment of creditors.”

The court further held that a finding of actual insolvency is needed to trigger these duties, rather then the amorphous “zone or vicinity of insolvency.”  Thus, the court held that “there is no fiduciary duty prescribed under California law that is owed to creditors by directors of a corporation solely by virtue of its operating in the ‘zone’ or ‘vicinity’ of insolvency.”

(Note that the court also observed that “there are multiple definitions of insolvency,” adding that “a finding of insolvency by the standard of the debtor not paying debts when they become due requires more than merely establishing the existence of a few unpaid debts.”)

Thus, the court held that, “under the trust-fund doctrine, upon actual insolvency, directors continue to owe fiduciary duties to shareholders and to the corporation but also owe creditors the duty to avoid diversion, dissipation, or undue risk to assets that might be used to satisfy creditors’ claims.”

Even more, the court held that decisions of the directors are presumptively entitled to protection under the business judgment rule.  “The rule establishes a presumption that directors’ decisions are based on sound business judgment, and it prohibits courts from interfering in business decisions made by the directors in good faith and in the absence of a conflict of interest.”

Explained the court, “in most cases, the presumption created by the business judgment rule can be rebutted only by affirmative allegations of fact which, if proven, would establish fraud, bad faith, overreaching or an unreasonable failure to investigate material facts . . . The failure to sufficiently plead facts to rebut the business judgment rule or establish its exception may be raised on demurrer, as whether sufficient facts have been so pleaded is a question of law.”

I for one do not support the expanding toward “tortification” of business law.  The decision in Berg & Berg is a step in the right direction.  The court gives clear guidance, holding that the fiduciary obligations of directors to creditors arise only when the corporation is actually insolvent, and then only when the creditors can plead facts showing that the actions of the directors were in violation of the business judgment rule.  The court also held that it will not intervene in the “ill-defined sphere known as the zone of insolvency.”

This case marks the second published appellate opinion driven by the unpaid creditor.  (The prior opinion is Berg & Berg Enterprises, LLC v.  Sherwood Partners (2005) 131 Cal.App.4th 802.)   Considering that legal counsel included O’Melveny & Myers and Winston & Strawn, it is almost certain that the legal fees to date in this dispute exceed $1 million.

Here’s a point that seems somewhat unfair.  The trial judge based his decision on an unpublished 2006 trial court decision from the federal district court for the Northern District of California.

The problem for trial attorneys is that we cannot cite unpublished opinions as authority in our briefs.  It seems incongruous to have a trial court make a decision based on an unpublished federal court ruling, then have that unpublished ruling cited with approval by the California appellate court.

This problem arises because the two major legal publishers – Lexis and West – continue to make unpublished decisions available via their websites.  When these unpublished decisions become part of the database, it becomes very tempting to cite them, notwithstanding the California Rules of Court.  In this case, the trial court and the appellate court found the temptation to great to resist.