The Bankruptcy Court of the Central District of California ruled recently that officers and directors of an insolvent company owe a fiduciary duty to the company’s creditors and that exculpatory provisions in a company’s governing documents do not excuse them from that duty.
The case — In re AWTR Liquidation, Inc. — involved the bankruptcy of Rhythm & Hues Studios Inc., the graphic effects studio that produced the Academy Award-winning film Life of Pi and others. The studio filed bankruptcy after its three primary directors made a series of poor business investments and allegedly enriched themselves at the expense of the company.
The court found that under California law, directors are protected by the business judgment rule to the extent that they act in good faith and uphold their duty to preserve and enhance the value of the corporation. However, when directors’ actions breach that duty, the business judgment rule will not apply.
In addition, the court found that directors’ duties to a company’s creditors begin at the onset of insolvency since it is at that time that creditors become “risk bearers” with their claims affected by the decisions of company directors and officers. The court also said that directors’ duties to creditors are supplemental to their existing duties to shareholders, which the court recognized might cause a conflict when creditors and shareholders have different approaches to risk. Shareholders may favor business decisions with more risk since there is more reward for them, while creditors typically opt for strategies that minimize risk so their claims are protected.
This recent decision clarifies that in California, once a corporation becomes insolvent, its creditors have standing to enforce claims not only against the corporation but also its officers and directors.
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