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.
In reaching this conclusion, the court emphasized that the "exclusive language of [LLC Act] Section 18‑1002 contrasts with the non‑exclusive language of the Delaware General Corporation Law (the "DGCL"), 8 Del. C. § 327." Id. at *4. Section 327 of the DGCLC—the only Delaware Code provision that addresses derivative actions—"does not create the right to sue derivatively and, by its terms, does not say that only stockholders can sue derivatively." Id. Instead, the DGCL requires only that a stockholder plaintiff satisfy a contemporaneous ownership requirement. This open‑ended statutory language does not expressly preclude a derivative action brought by someone other than a stockholder.
According to the CML V court, the open nature of DGCL § 327 "demonstrates that the General Assembly can readily adopt a non-exclusive limitation on derivative standing." Id. Whereas DGCL § 327 is nonexclusive in nature, LLC Act § 18‑1002 "uses exclusive language." Id. The exclusive terms employed by LLC Act § 18‑1002 literally "den[y] derivative standing to creditors of an insolvent LLC." Id.
Although the court found that this conclusion was compelled by the clear language of the LLC Act, it conceded the "awkward fact" that the result causes LLC derivative actions "to differ markedly from their corporate cousins." Id. Even so, "any apparent tension between the plain language of the LLC Act and the commonly held understanding of the provisions" had to be resolved in favor of the statutory language. Id. at *6. Moreover, the court found there was nothing inherently absurd "about different legal principles applying to corporations and LLCs." Id. at *10. Rather, because the "conceptual underpinnings" of Delaware corporations law differed from that of Delaware's alternative entity law, "courts should be wary of uncritically importing requirements from the DGCL" into the LLC context. Id. (internal quotation marks omitted).
Unlike the DGCL, the "overarching policy" of the LLC Act is to "give maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements." Del. Code Ann. tit. 6, § 18‑1101(b). Creditors generally may be presumed to be entities capable of protecting themselves in a bargained‑for contract. CML V, 2010 WL 4517795, at *10. Accordingly, the court concluded that limiting "creditors to their bargained‑for rights and deny[ing] them the additional right to sue derivatively on behalf of an insolvent entity comports with the contractarian spirit created by the LLC Act." Id. Further, the LLC Act provides "expansive contractual and statutory remedies" to creditors. Id. at *14. As a result, it was neither absurd nor unreasonable for the court to interpret the LLC Act as denying derivative standing to creditors of an insolvent LLC. Id.As the CML V court itself acknowledges, the conclusion that the LLC Act does not grant standing to creditors of an insolvent LLC "might surprise wizened veterans of debates over corporate creditor standing." Id. at *1. The mere fact that a specific practice or remedy has been approved under established precepts of Delaware corporations law is no guarantee that the same practice or remedy will be available in the context of newer, alternative forms of business entities, such as LLCs and LPs.