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By Gerald P. Burleson, Member of the California Bar, and

Emily Bishop, 3rd year law student, University of San Diego Law School,

and a candidate for the July, 2017 California Bar Exam

© 2017 by Gerald P. Burleson, all rights reserved

The California Corporation Code imposes statutory restrictions on the ability of corporations to make loans and guaranties to their directors and officers. In the event there is an unlawful loan or guaranty, a minority shareholder who has not consented to the corporate action may bring suit against any director or officer liable for approving the prohibited loan or guaranty.

California closely held corporations are prohibited from loaning money or property to, or guaranteeing the obligation of, any corporate director or officer unless the transaction (or employee benefit plan) is approved by a majority of the shareholders entitled to act on the matter.i In this context, the term “approval by a majority entitled to act” means either: (1) the written consent of a majority of the outstanding shares, exclusive of shares owned by interested officers or directors, (2) the affirmative vote of a majority of the shares present and voting at a meeting at which a quorum is present, exclusive of shares owned by interested officers or directors, or (3) the unanimous vote or written consent of the shareholders.ii Without the requisite shareholder approval, directors and officers authorizing the loan or guaranty are jointly and severally liable to the corporation for the benefit of its shareholders.

The purpose of this prohibition is to “prevent directors from taking advantage of their position to grant themselves or their colleagues unwarranted loans, and thus dissipate corporate funds in violation of their trust.”i In applying the statute with regard to its intent, California courts have construed the statutory prohibition as extending to any situation where a director derives a financial benefit from the use of corporate funds and the corporation itself receives no consideration, regardless of how the transaction is disguised.

For example, in a California case interpreting the predecessor statute to Section 315, Wulfjen v. Dolton, the California Supreme Court looked to the true nature of the transaction, finding the statutory prohibition applicable despite the fact that the transaction on its surface did not appear to be a loan. In Wulfjen, the corporation received the full amount of a promissory note executed by it and the directors as co-makers, and the directors applied the majority of the proceeds to repay funds advanced by them to the corporation—despite their agreement to be repaid only out of the corporation’s net earnings—a contingency which had yet to materialize. Since the contingency establishing the corporation’s legal obligation to repay the directors had not materialized, the Court held the directors’ payment of corporate funds was essentially a prohibited advance or loan. The Court’s analysis turned on the potential for directors and officers to skirt the statute merely by re-characterizing the transaction as other than a loan or guaranty: “To construe section [315] otherwise than as comprehending this financial manipulation of corporate funds would place in the hands of unscrupulous directors the power to deplete the assets of a corporation which they direct in violation of the statute and then defend with complete immunity against recovery because the transaction on its face did not appear to be a loan.”

Ruling on a similarly disguised loan transaction, the Ninth Circuit Court of Appeal in In re Globe Drug Co. Inc., found an unlawful loan or guaranty where a director borrowed money from a bank to purchase the company’s stock from other shareholders and made payments on the loan with corporate funds. After several years, with the approval of the board of directors, the corporation took out a bank loan to pay off the director’s remaining balance on the note. The court found that the execution of the note by the corporation to the bank was in essence a loan to the director or guaranty of his obligation, either “directly or indirectly.” Under California’s predecessor statute to Section 316, the directors were held jointly and severally liable to the corporation for approving the prohibited transaction.

As the foregoing examples indicate, courts are ready and willing to hold directors and officers liable for violating §315 regardless of the disguised form of the transaction. But the icing on the cake: a single minority shareholder may institute an action against approving directors and officers for unlawful loans or guaranties.

I Compliance with the normal requirements for shareholder derivative suits is unnecessary. Cal. Corp. Code § 316(c).

II Cal. Corp. Code § 315(a). This general restriction, however, is subject to certain exceptions:Approval by disinterested board: In a corporation with 100 or more shareholders with a bylaw authorizing the board alone to approve such a loan or guarantee to an officer, the loan or guarantee may be approved by the board alone if the board determines that such loan or guarantee may reasonably be expected to benefit the corporation.

(2) Advancement of expenses: A corporation may advance money to a director or officer of the corporation (or of its parent) for any expenses reasonably anticipated to be incurred in the performance of corporate duties, provided that the expenses would have been reimbursable absent the advance.

(3) Payment of life insurance premiums: A corporation may pay premiums on life insurance covering a director or officer provided repayment is secured by the proceeds of the policy and its cash surrender value.

III If the corporation has more than one class or series of shares outstanding, the “shareholders entitled to act” include only those shareholders entitled under the articles to vote on all matters or on loans or guaranties to directors and officers. Cal. Corp. Code § 315(g).

IV Wulfjen v. Dolton, 24 Cal.2d 878, 888 (1944).