Do Directors and Officers Owe Fiduciary Duties to Creditors?

By Brian Spector

It is generally understood that a company’s directors and officers owe fiduciary duties to its shareholders. In Arizona, they also owe them to creditors – at least once the company becomes insolvent.

Arizona follows the “Trust Fund Doctrine.” It was first recognized here in A.R. Teeters & Assocs. v. Eastman Kodak Co., 172 Ariz. 324, 836 P.2d 1034. (App. 1992), in which the Arizona Court of Appeals explained:

"The theory of the trust fund doctrine is that all of the assets of a corporation, immediately on its becoming insolvent, exist for the benefit of all of its creditors and that thereafter no liens nor rights can be created either voluntarily or by operation of law whereby one creditor is given an advantage over others."

Teeters, 836 P.2d at 1041 (citation omitted). In Teeters, the court held that an officer, director, and stockholder who loaned money to the company breached a fiduciary duty owed to the company’s other creditors where (i) he caused the transfer of corporate assets to himself (ii) the transfer occurred while the corporation was insolvent; and (iii) the transfer had the effect of preferring him to the disadvantage of other creditors of the same priority.

A few points worth noting:

• The Trust Fund Doctrine is similar to, but in some ways broader than, the concept of a “preference” under the Bankruptcy Code.[1] Liability arises under state law and exists regardless of whether (i) the transfer occurs within certain proximity of a bankruptcy filing or (ii) a bankruptcy case is ever filed. There must be a showing, however, that the company was insolvent at the time of the transfer. E.g., In re Weinberg, 410 B.R. 19, 28-19 (9^th Cir. BAP 2009). There is no fiduciary duty to, or trust fund for, creditors until then.
• Teeters’ language appears to make the Trust Fund Doctrine applicable whenever, as a result of the transfer, “one creditor is given an advantage over others.” Thus far, it has been applied in Arizona only when the transferee is, or is related to, a director, officer, or stockholder. No reported Arizona case has been found applying it to transfers to non-insider, arms-length creditors.
• The source of recovery is a breach of fiduciary claim against the officer or director that caused the company to make the transfer. Liability, if established, is limited to the value of the assets received by the transferee.
• Query whether the doctrine will be applied and/or fiduciary duties extended where the transfer occurs within the “vicinity” or “zone of insolvency” or where it causes the company to become insolvent. This issue has been addressed in other jurisdictions.[2] For now, Teeters’ language suggests that in Arizona, the trust fund does not arise until the company becomes insolvent.

No Arizona cases could be found applying the Trust Fund Doctrine in the context of an Arizona limited liability company. It would seem logical, however, to do so.

The bottom line is that officers, directors, and others in control of a company’s affairs need to be careful about transfers made while the company is insolvent. Such transfers could result in liability to them where none previously existed.

-------------------------------------

[1] The doctrine is similar to the concept of a preferential transfer under the Bankruptcy Code. Under the Bankruptcy Code, a transfer made to a creditor on account of a debt is considered preferential, and therefore recoverable, if (among other things) it was made within a certain time frame -- one year for insider creditors and ninety days for all other creditors -- prior to the bankruptcy filing and enables the creditor to receive more than it would otherwise receive in a bankruptcy liquidation. 11 U.S.C. §547. The doctrine also presumably applies to transfers made for less than reasonably equivalent value, which also may be recoverable under state fraudulent transfer law. See A.R.S. §44-1001 et seq.

[2] See, e.g., Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991)(unpublished opinion by the Delaware Court of Chancery suggesting that the expansion of duties to creditors can occur in the “vicinity of insolvency”); but see RSL Communications PLC v. Bildrici, 649 F. Supp 184, 206 (S.D.N.Y. 2009)(applying New York law and rejecting a “zone of insolvency” theory); North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A. 2d 92, 101 (Del. 2006)(applying Delaware law, the Delaware Supreme Court held that no direct claim for breach of fiduciary duty may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency).