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Bankruptcy Court Opinion Clarifies California Law on Duties of Directors & Officers Upon Insolvency – by Stephen O’Neill, Esq. – Dorsey

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Bankruptcy Court Opinion Clarifies California Law on Duties of Directors & Officers Upon Insolvency

It is not unusual in the lifecycle of a start-up for the company to hit road blocks and have cash flow issues. During these times, the board and its members will ask the company’s professionals what their fiduciary duties are and to whom do they owe these duties?  The Bankruptcy Court for the Central District of California recently addressed this issue in In re AWTR Liquidation, Inc., 2016 Westlaw 1128029 (filed March 11, 2016).  This opinion provides some insight as to a federal bankruptcy court’s views and interpretation of the current state of California law.  Takeaways from the opinion include the following:

  1. Directors (but not officers under California law) are protected by the business judgment rule if they attempt in good faith to follow their overall duty to attempt to preserve and enhance corporate profitability or value; however, the business judgment rule will not apply where actions are taken which lack good faith or inherent fairness, are made with improper motives or result in inherent conflicts of interest;
  2. When the company becomes insolvent, its creditors become bearers of the go forward risk; thus, under California law, directors’ duties to the company’s creditors arise upon the onset of insolvency, and creditors then have standing to sue derivatively;
  3. Directors’ duties to the company’s creditors arising upon insolvency are supplemental and do not supersede or dilute existing duties to shareholders; therefore, directors may have to answer to constituencies favoring conflicting approaches, especially during insolvency;
  4. Exculpatory provisions in a company’s governing documents generally do not excuse directors from their duties of loyalty and good faith.

Bottom line, the board and its members should keep themselves well-informed about the corporation’s affairs and exercise their powers – including conducting reasonable diligence of corporate actions and weighing the potential risks and value to the company of proposed competing courses of action – in good faith and in the best interests of the corporate enterprise as a whole, and should avoid all actions that could be viewed as self-dealing or lacking in fairness.

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