548 B.R. 300
Bankr. C.D. Cal.2016Background
- Rhythm & Hues, Inc. (Debtor) filed chapter 11 on Feb. 13, 2013; the liquidating trustee sued former directors/officers (the "Directors") for diverting, dissipating, or unduly risking corporate assets while the company was insolvent.
- Alleged wrongful conduct included: insider financing to CCC Diagnostics (notes totaling $1.89M, later sold to Hughes for $1), transfer of valuable software rights to an affiliate owned by primary directors for no consideration, and non-recourse advances enabling directors to acquire real estate then leased back to Debtor (2100 Grand) that drained corporate cash.
- Complaint also alleges operational mismanagement (low-margin contracts, cost overruns, excessive PTO/sabbatical liabilities), loss of tax refunds by electing NOL carryforward, and specific acts involving Weinberg (CFO) and other directors.
- Plaintiff pleads insolvency under balance-sheet, cash-flow, and inadequate-capitalization tests across much of the relevant period and seeks derivative remedies for creditors and avoidance/recovery under fraud/transfer statutes.
- Defendants moved to dismiss (and for more definite statement) arguing (inter alia) no duty to creditors, insufficient allegations of insolvency, business judgment rule protection, ratification, and statute-of-limitations defenses.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Do directors owe duties to creditors when corporation is insolvent and who may sue? | Creditors, like stockholders, may bring derivative claims when the corporation is insolvent for breaches that divert, dissipate, or unduly risk assets. | Directors assert duties run only to shareholders and not to creditors; creditors lack standing. | Court rejects defendants: upon insolvency creditors join shareholders in derivative suits for conduct that diverts/dissipates/unduly risks assets. |
| What fiduciary standard governs directors/officers near insolvency and does it change at insolvency? | Directors must exercise informed, good-faith business judgment to preserve and grow corporate value; this duty remains essentially the same in insolvency but the constituency expands to include creditors. | Defendants argue insolvency should trigger a different or paramount duty to creditors or require liquidation. | Court holds duties do not materially change; directors should maximize enterprise value for all constituencies without undue preference; insolvency mainly affects standing, not the substance of the duty. |
| Does the business judgment rule and corporate exculpation bar the complaint? | Alleged facts (self-dealing, lack of oversight, repeated unapproved insider transactions) overcome the business judgment presumption and fall within exculpation exceptions (self-dealing, bad faith, reckless disregard, abdication). | Defendants claim the business judgment rule and an articles-of-incorporation exculpation provision shield them as a matter of law. | Court finds business judgment/exculpation do not defeat the complaint at pleading stage (except some operational claims): factual issues on Caremark/oversight and conflicts preclude dismissal. |
| Are insolvency allegations and statute-of-limitations adequate? | Complaint pleads balance-sheet, cash-flow, and inadequate-capitalization insolvency (plus supporting operational/financial allegations); tolling/discovery doctrines apply. | Defendants contend insolvency is not adequately pled and some transfer claims are time-barred. | Court finds insolvency pled sufficiently (all three tests or at least inadequate capitalization + supporting facts); some transfer claims outside limitations (Original Transfers) are dismissed. |
Key Cases Cited
- Ashcroft v. Iqbal, 556 U.S. 662 (2009) (pleading standard: plausibility requirement governs Rule 12(b)(6))
- Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007) (pleading must contain factual content permitting reasonable inference of liability)
- In re Caremark Int’l Derivative Litig., 698 A.2d 959 (Del. Ch. 1996) (directors’ duty to implement and monitor information/reporting systems; sustained failure can establish lack of good faith)
- Stone v. Ritter, 911 A.2d 362 (Del. 2006) (Caremark standard approved; conscious failure to monitor supports liability)
- Berg & Berg Enterprises, LLC v. Boyle, 178 Cal.App.4th 1020 (2009) (California: upon insolvency duty limited to avoiding diversion, dissipation, or undue risk of assets that would pay creditors)
- N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) (directors of insolvent firm must attempt to maximize value for benefit of all interested parties; creditors gain derivative standing)
- Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1990) (directors’ duty to enhance corporate profitability/value)
- Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (business judgment rule and gross negligence standard)
- In re Bridgeport Holdings, Inc., 388 B.R. 548 (Bankr. D. Del. 2008) (failure to inform oneself can defeat business judgment rule)