November 30, 2010
Because Delaware is the predominant state in which most U.S. businesses choose to incorporate, it is not surprising that Delaware statutory and case law are also the primary authorities governing alternative business entities, such as limited liability companies ("LLCs") and limited partnerships ("LPs"). In early November, the Delaware Court of Chancery issued an important opinion involving the interpretation of the Delaware Limited Liability Company Act ("LLC Act") and the rights of a creditor to assert a derivative claim against members of the board of managers of an insolvent LLC.
In CML V, LLC v. Bax, C.A. No. 5373 VCL, 2010 WL 4517795 (Del. Ch. Nov. 3, 2010), CML V ("CML") loaned large sums of money to JetDirect Aviation Holdings, LLC ("JetDirect"), an LLC. After JetDirect became insolvent, CML filed a derivative claim for breach of fiduciary duty against the various members of JetDirect's board of managers, claiming that the board members had approved four major acquisitions by JetDirect without informing themselves of critical information about the company's financial condition. The individual defendants moved to dismiss on the ground that CML lacked standing as a creditor to sue derivatively under the LLC Act, Del. Code Ann. tit. 6, § 18‑1002. This statute provides that "[i]n a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action[.]" Id.
CML was clearly not a member or an assignee of JetDirect. However, in the context of insolvent corporations, Delaware courts have recognized that creditors have an equitable right to maintain derivative actions against directors on behalf of the corporation for breaches of fiduciary duties. CML V, 2010 WL 4517795, at *2; see N. Am. Catholic Educ. Programming Found. v. Prod. Res. Group, L.L.C., 863 A.2d 772, 776 (Del. Ch. 2004). When a corporation is insolvent, creditors become "the principal constituency injured by any fiduciary breaches that diminish the firm's value." CML V, 2010 WL 4517795, at *2 (internal quotation marks omitted). Hence, creditors may effectively step into the shoes of a stockholder and assert a derivative claim on behalf of the corporation.
CML argued that the court should apply by analogy in the LLC setting a corporate creditor's equitable right to maintain a derivative action when an insolvent corporation is involved. To most observers, CML's argument had a certain intuitive appeal. Indeed, the court acknowledged that "the standing provisions in the alternative entity statutes have not been widely understood as barring derivative claims by creditors of an insolvent entity. To the contrary, many have assumed that creditor standing exists." Id.
Although the court recognized the compelling force of this argument, it nevertheless ruled that "the literal terms of the LLC Act control, and they bar a creditor of an insolvent LLC from suing derivatively." Id. Declining any invitation to depart from a literal reading of the statute, the court ruled that CML lacked standing to pursue its derivative claim for breach of fiduciary duty against JetDirect's former board members. Id.