Creditors of insolvent Delaware corporations have recourse against corporate directors and officers whose disloyal or self-dealing conduct reduces the corporation’s assets available for distribution. Delaware courts have held that directors and officers of insolvent corporations owe fiduciary duties to creditors as the principal stakeholders in the remaining corporate assets. Where those duties are breached, creditors have standing to bring actions derivatively on behalf of the corporation for damages to the corporation. However, in a recent decision by Vice Chancellor J. Travis Laster, the Delaware Court of Chancery held that creditors of insolvent limited liability companies (LLCs) do not have the same standing to act as derivative plaintiffs and do not have the same recourse against disloyal fiduciaries.
In CML V, LLC v. Bax, Civil Action No. 5373-VCL (Nov. 3, 2010), the court rejected the assumption that senior managers and board members of insolvent LLCs owe the same fiduciary duties to creditors as do officers and directors of insolvent corporations. The plaintiff, CML, loaned approximately $34 million to JetDirect, a limited liability company. After JetDirect defaulted, CML brought suit against Bax, who was JetDirect’s CFO, and 11 other individuals who served in senior management or as members of JetDirect’s board of managers. The complaint alleged that the individual defendants breached their fiduciary duties by approving and effecting four major acquisitions without current data or accurate information on JetDirect’s own financial condition. The complaint also alleged that the defendants lacked information because they consciously failed to maintain adequate financial controls, that senior management withheld adverse information from the board, and that assets were sold off to insiders at low prices.
CML claimed standing as a creditor to sue the individual defendants derivatively on behalf of JetDirect. The court found, however, that the law of limited liability companies differs in a crucial way from that of corporations. While the Delaware General Corporation Law sets requirements for stockholders of corporations who would bring derivative suits, its language is non-exclusive, leaving open the possibility that constituencies other than stockholders could have derivative standing. The courts have interpreted that opening to allow creditors of insolvent corporations to sue and impose personal liability on corporate fiduciaries; creditors lack such recourse under the law of contracts.
By contrast, the Delaware Limited Liability Company Act provides that the plaintiff in a derivative action against an LLC must be a member of the LLC (or an assignee of a membership interest in the LLC). The Court of Chancery found that the exclusive language in the LLC Act bars creditors from bringing actions derivatively.
The court recognized that, under its ruling, lenders will have rights as creditors of insolvent LLCs inferior to the rights they have as creditors of insolvent corporations. The court noted, however, that limited liability companies are “creatures of contract.” Under the LLC Act, their governing agreements can include provisions to protect creditors by imposing penalties on members of defaulting LLCs, by allowing removal of managers, expanding fiduciary duties or personal liabilities, establishing special duties with respect to designated “series” of assets, or by conditioning certain amendments or actions on creditor approval or bond ratings. In addition, the court noted that the LLC Act gives creditors certain express statutory rights, not granted to creditors of corporations, including the right to seek appointment of a receiver and the power to enforce members’ contribution obligations.
The court’s ruling shifts the respective legal positions of creditors and managers of insolvent LLCs. It remains to be seen how lenders and managers of LLCs will react, and whether, and to what extent, they will adjust their negotiating positions at the outset.