Four years ago, in N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del.2007), the Delaware Supreme Court held that a creditor of an insolvent Delaware corporation had standing to bring a derivative action. Earlier this month, the court held that this rule does not apply to Delaware LLCs. CML V, LLC v. Bax, No, 735, 2010 2011 WL 3863132 (Del. Sept. 2, 2011).
CML V has far-reaching implications when choosing a business form of organization, debt financing and the limitations that may be imposed on creditors’ rights during insolvency.
The plaintiff, CML V, LLC (“CML”) lent DirectJet Aviation Holdings LLC (“DirectJet”) over $34 million to fund expansions and acquisitions. It became DirectJet’s junior secured creditor. Within a year of closing, DirectJet defaulted and became insolvent.
CML brought suit in the Delaware Court of Chancery, asserting, among other things, derivative claims on behalf of DirectJet against certain DirectJet managers. CML alleged that, due to known deficiencies in DirectJet’s accounting procedures, DirectJet’s management lacked sufficient information to evaluate the suitability of the acquisitions that CML had funded. It also alleged that while liquidating DirectJet’s assets to reduce its debt, certain managers negotiated advantageous asset sales to entities they controlled. The Chancery Court dismissed these claims, concluding that creditors of Delaware LLCs, unlike creditors of corporations, lack standing to assert derivative claims on behalf of their debtors. On appeal, the Supreme Court affirmed.
The distinction turns on a statute. A section of Delaware’s Limited Liability Company Act, 6 Del. C. § 18-1002, affords standing to bring derivative actions “exclusively to ‘members’ or ‘assignees.’” 2011 WL 3863132 at *2. The court held that this language is unambiguous: “the provision dictates that a proper derivative action plaintiff ‘must be a member or an assignee of a limited liability company interest....” Id. (emphasis added). According to its plain meaning, the statute “operates to deny derivative standing to creditors who are not members or assignees of membership interests.” Id. The court rejected the argument that Delaware’s legislature merely intended to rephrase the language of section 327 of the Delaware General Corporate Law, which the court had determined does not bar creditors of insolvent corporations from derivative standing. See Gheewalla, 930 A.2d at 101. It concluded that the legislature intended to limit derivative standing to LLC members and assignees.
The court also rejected CML’s argument that the statutory limitation on derivative standing violated Delaware’s constitution by encroaching on the Chancery Court’s common law equity jurisdiction. The court reasoned that the Chancery Court had no constitutionally guaranteed jurisdiction over LLC derivative actions, since LLCs are a creature of statute and did not exist under the common law. Id. at 5-6.
The decision identifies an important distinction concerning creditors’ rights in the corporate versus LLC context. Creditors of an insolvent Delaware corporation have derivative standing rights, and creditors of an LLC do not. The court acknowledged the concern that, unless the creditors of insolvent business entities have derivative standing, “there will exist no stakeholders with incentive to enforce fiduciary duties through legal action.”Id. at *4. But it reasoned that creditors can choose not to invest, noting that while it “may be correct that in insolvency creditors become the ultimate risk bearers in LLCs….[u]ltimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.” Id. at *4.
The decision establishes a bright line rule prohibiting LLC lenders from enforcing fiduciary obligations owed by management during insolvency. Unresolved by the court’s decision, however, is whether the rule of CML might be remedied through private ordering. In particular, 6 Del. C. § 18-1101 provides: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Further, the Act provides: “To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement….” Id. (emphasis added).
Thus while the General Assembly’s draftsmanship of 6 Del. C. § 18–1002 has, with the court’s ruling in CML, closed the door to LLC creditor protections through derivative actions similar to those afforded in the corporate context during insolvency, 6 Del. C. § 18-1101 may provide an avenue by private contract for alternative protective measures. Perhaps in an appropriate circumstance the operating agreement could provide for a particular creditor or class of creditors to have derivative rights as third-party beneficiaries of the operating agreement or as parties to the operating agreement for that limited purpose.
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This article was originally published by Bingham McCutchen LLP.