Chancery Court Denies Creditors’ Derivative Standing Under Delaware LLC Act

November 17, 2010

In a case that may limit the rights of lenders and other creditors against managers of Delaware LLCs, and provides added protections for insiders of Delaware LLCs, the Delaware Court of Chancery this month held that a creditor of an insolvent LLC lacked standing to bring derivative claims under the Delaware Limited Liability Company Act. In re CML V v. Bax points out an important difference between available remedies for creditors of Delaware corporations and Delaware LLCs. While this case may be subject to appeal, no appeal has yet been filed.

CML made loans to JetDirect Aviation Holdings, LLC (“JetDirect”). With JetDirect’s operating subsidiaries in bankruptcy, the lender sought to bring derivative claims of the parent against 12 individual defendants for breach of fiduciary duties in a manner alleged to have harmed JetDirect.

The individual defendants moved to dismiss, asserting, in part, that the lender lacked standing as a creditor to sue derivatively under Section 18-1002 of the LLC Act, which states that to bring a derivative suit against an LLC, a plaintiff “must be a member or an assignee.” CML argued that it is well-established that a creditor may bring a derivative suit against an insolvent corporation, and the same equitable considerations apply concerning insolvent LLCs. The Court held that “[a]lthough this Court may depart from the literal reading of a statute where such a reading is so inconsistent with the statutory purpose as to produce an absurd result, this is not such a case.”

The Court noted, however, that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.” In fact, the only existing authority for doing so consisted of a single line in a footnote of a Delaware treatise and abbreviated treatment in an unreported district court decision. On the contrary, multiple commentators and two past decisions of the Court implicitly assumed that a creditor of an insolvent alternative entity could sue derivatively for breach of fiduciary duty. The Court nevertheless read the plain language of the LLC Act, by contrast to the non-exclusive language in the Delaware General Corporation Law, to deny derivative standing to creditors of an insolvent LLC.

The Court buttressed its view by analyzing the development of parallel provisions in the Delaware Limited Partnership Act, which has a derivative standing provision largely identical to 18-1002. The Court also reasoned that this construction is consistent with a core purpose of the LLC Act to enable the maximum amount of freedom of contract. The Court found that creditors of LLCs are generally capable of protecting themselves through contractual agreements and that “[t]o limit creditors to their bargained-for rights and deny them the additional right to sue derivatively on behalf of an insolvent entity comports with the contractarian environment created by the LLC Act." In fact, the court identified a few provisions that might be added to LLC agreements to protect creditors from breaches of fiduciary duty by managers.

In an environment where lenders to Delaware LLCs need to seek protection in the absence of derivative standing, we suggest that in structuring loans to Delaware LLCs, lenders consider, in appropriate circumstances, such options as “bad boy” guarantees from members/managers, or requiring that the LLC agreement include specific contractual duties of members/managers to protect the assets/value of the LLC, with specific penalties in favor of the LLC or required capital contributions in the case of breach, as such obligations may be enforced by a creditor. Pledges of membership interests as collateral for obligations to the lenders may also provide protection. Creditors might exercise a default remedy to foreclose on the membership interest, and thereby acquire derivative standing as assignee of the member.

This article was originally published by Bingham McCutchen LLP.