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: Law at the End of the Day

Stakeholder Versus Shareholder Maximization Models of Corporate Duty and American Courts

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There has been an increasing interest in the value of extending corporate responsibility to a broad range of stakeholders beyond shareholders and sometimes creditors. Much of that interest and activity originates within elements of global civil society, academia and international organizations. A consensus appears to be developing within these transnational actors of the need for the application of strong stakeholder welfare maximization models as a basic framework for corporate behavior.

A recent case interpreting California Corporate law, however, suggests the strength of the shareholder welfare maximization model in American corporate jurisprudence. It also suggest the difficulties of moving from that model to a more stakeholder friendly alternative. The Business Law Section of the California Bar recently described a case in which these issues were central.

In Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020 (2009), the California Court of Appeal delimited for the first time the scope of the duties owed by directors of a financially distressed California corporation to the corporation?s creditors. Rejecting Delaware precedent, the court held that directors owe no special duties to creditors, beyond those imposed by the traditional trust fund doctrine.

Berg & Berg Enterprises, LLC was a creditor of Pluris, Inc. when Pluris found itself in financial distress. After learning of the trouble at Pluris, Berg proposed that Pluris maximize the value of its net operating losses, if Pluris could not obtain financing to continue operations. When Pluris failed to secure the needed financing, Pluris chose not to follow Berg?s suggestion but made an assignment for the benefit of creditors instead. In its complaint, Berg alleged that by making the assignment the Pluris directors had breached their fiduciary duties to creditors, which arose when the company entered the ?zone of insolvency.?

The Court of Appeal held that a director?s fiduciary duties of care and loyalty are owed only to the corporation and its shareholders, not to the corporation?s creditors. Instead, a director?s only duty to an insolvent company?s creditors is to avoid diverting, dissipating, or unduly risking assets that might otherwise be used to pay creditors. This rule is known as the ?trust fund doctrine.?

Applying the trust fund doctrine, the court found that the decision by the Pluris directors not to maximize the net operating loss value did not involve self-dealing, the preferential treatment of creditors or the diversion of assets otherwise available to pay creditors. Moreover, the court noted that even if a fiduciary duty did exist, the directors? decision would have fallen within the protection of the business judgment rule.

The Berg court declined to follow Delaware cases holding that directors of a company in the zone of insolvency have a fiduciary duty to creditors beyond that required under the trust fund doctrine. However, the court did not fully describe the scope of a director?s duty under the doctrine in California, or the remedies for its breach, leaving it to future cases to reveal the details and illuminate other differences, if any, between California and Delaware law on this point. Ultimately, although Berg may have shifted the balance slightly in favor of directors in California, directors still owe a duty to their companies? creditors under the trust fund doctrine and are still prohibited from engaging in self dealing or diverting company assets.

Business Law Section of the California Bar, Corporations Committee E-Bulletin, California Rejects Delaware?s ?Zone of Insolvency? Rule, March 5, 2010.

The holding of the case is not remarkable. Courts all over the United States have held that where an entity (like an individual) holds funds for the benefit of another, then the duty of the holder with respect to those funds is elevated. Delaware has chosen to speak of that obligation in fiduciary duty terms. That makes sense within a jurisprudential framework founded on notions of principal-agent relations. New Jersey famously extended the fiduciary duty of care (in its form as a duty to monitor corporate activities) to creditors whose funds were held in a trust relationship with the corporation, at leats in the context of insolvency. Francis v. United Jersey Bank, 87 N.J. 15, 432 A.2d 814 (N.J. 1981). California has chosen to apply this principal-agent foundation differently. The focus is not so much on the general duties of corporate officers, that include monitoring and activity obligations to creditors with respect to whom funds are held in trust, but on the quality of the relationship between the corporation and the creditor. In an insolvency context, the corporation's relationship with its creditors change, and a quasi trust relationship is created--the corporation is now responsible for managing its activities to protect the interests of the creditors in its funds pending resolution through insolvency proceedings overseen by the state.

The case is an important reminder, though, that at least as far as th American judiciary is concerned, absent an additional special relationship of trust (as in solvency, perhaps bailment) the primal and supreme relationship that is recognized is that between director and shareholder. The corporation remains a vehicle for the maximization of aggregate shareholder value (understood as shareholder or corporate welfare maximization). Within this conceptual universe, the concept of stakeholder value, or even stakeholder responsibility is incomprehensible. The reason is simple--in the absence of a special or trust relationship between a stakeholder class and the corporation, there is no possibility of extending a duty grounded in "trust" to those stakeholders. This does not mean that such an extension of duty is impossible. It only reminds that in the absence of a (statutorily) created relationship (agent-principal; trust; bailment or the like), it is unlikely that courts will move beyond the current shareholder maximization framework. For people advocating regimes of corporate responsibility grounded in obligation to actors other than shareholders (or sometimes creditors and other actor sin similar relationships) this suggests the difficulty of such a project within the domestic legal order of states.

Full post as published by Law at the End of the Day on March 10, 2010 (boomark / email).