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The Trust Fund Doctrine - Choose Your State of Incorporation or Formation Wisely

In the excitement of starting a new business, many California small business owners give little thought to the state they choose for incorporation or the formation of a LLC. As a result, they opt for California as the logical choice. But with the majority of small businesses failing shortly after they open their doors, a basic understanding of California's trust fund doctrine should cause a business person to pause before incorporating or forming a LLC in California, since the ramifications down the road can be profound.

While most attorneys and some business people are aware of the trust fund doctrine, most do not understand the significance a corporation's or LLC's state of incorporation or formation has on an owner should his or her business run into financial difficulty. Under California law, once a corporation or LLC becomes insolvent (debts exceed assets), the "trust fund doctrine" applies and the assets of the corporation or LLC become a trust fund for the benefit of their creditors. Under the trust fund doctrine, corporate directors and officers and LLC managers owe a fiduciary duty to creditors not to "divert, dissipate or unduly risk" the insolvent corporation's or LLC's assets. See Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020 (2009). Vague language that should concern any owner of a struggling California business. Even more frightening is that failure to abide by this duty can render the violator personally liable to creditors.

Contrast this with Delaware, a popular choice of incorporation or formation of a LLC. Unlike California, Delaware expressly rejects the trust fund doctrine and does not impose any fiduciary duty on directors or officers of an insolvent corporation or managers of a LLC. See North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007). Therefore, if Delaware law applies, officers and directors of an insolvent corporation and managers of an insolvent LLC are immune from any claims of a violation of the trust fund doctrine.

Unfortunately, choice of law principles are inconsistently applied in California, meaning even if a California business incorporates or forms a LLC under Delaware law, a California court may nevertheless conclude public policy dictates that because the company is doing business in California with California creditors, California law should be applied to protect those creditors. In California, the "internal affairs" of a corporation will generally be governed by the law of the state in which the corporation or LLC is incorporated. The question then becomes whether a creditor's breach of fiduciary duty claim against a corporate officer or director or a LLC manager is an "internal affair." As of today, this question remains unanswered.

So what is a business person to do to avoid California's trust fund doctrine? Incorporating or forming an LLC under Delaware law is an obvious first step. However, a savvy businessperson will go beyond this and insert a Delaware choice-of-law provision in its contracts to make it clear obligations to creditors should be governed by Delaware law.

By: Gary A. Pemberton and Heather B. Dillion

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