California rejects “zone of insolvency” theory of director liability

The general rule is that directors of a corporation owe no duty to creditors because it is the shareholders who own a corporation. From an economic perspective, when a corporation is solvent, it is the shareholders who are the residual claimants of the corporation’s assets and who are the residual risk bearers. As long as the corporation remains solvent, the business decisions made by the board of directors directly affect the shareholders’ assets; management accordingly owes fiduciary duties to the shareholders as well as to the corporation. The corporation’s creditors, on the other hand, are free to protect their interests by contract. As long as the corporation is solvent, no matter how badly managed it might be, it is able to satisfy its contractual obligations to creditors who are therefore unaffected by management’s business decisions.

But when insolvency arises, the value of creditors’ contract claims may be affected by management’s business decisions in a way it was not before insolvency. At the same time, as long as insolvency persists, shareholder value is essentially worthless and shareholders no longer occupy the position of residual claimants. Because insolvency shifts the residual risk of management decisions from shareholders to creditors, under the corporate law of some states, at least some of the duties formerly owed by directors only to shareholders are owed also to creditors upon that circumstance, or so it goes in Delaware and some other states. Thus, in Delaware, for example, directors of a corporation operating in the “zone” or “vicinity” of insolvency owe a fiduciary duty to the creditors of the corporation.

In a significant deviation from this aspect of Delaware corporate law, the court in Berg & Berg Enterprises, LLC  v. Boyle (2009) 178 Cal. App. 4th 1020, held that directors of a corporation owe no fiduciary duty to creditors of the corporation by solely by virtue of its operating in the “zone” or “vicinity” of insolvency.

The court held further that that the scope of any extra-contractual duty owed by corporate directors to the insolvent corporation’s creditors is limited 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.


So much for the conventional wisdom that the Delaware judiciary is superior to all others in matters of corporate law.  In fact, the notion of director liability to creditors when the corporation is in the zone of insolvency is decidedly unwise. For one thing, it can be difficult to determine when a corporation is in the “zone” of insolvency. What are the boundary lines for this “zone”? For another, it imposes a conflict of interest on directors.  One day, they owe their fiduciary duty to the shareholders, and the next, they owe it to the creditors instead. What if the corporation then veers out of the zone of insolvency?  Their duty then reverts to the shareholders!

The possibility that the corporation will recover from near insolvency should mean that the directors owe undivided duty to the shareholders, and creditors should be remitted to their contractual remedies, court remedies, and, when appropriate, bankruptcy proceedings.

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