In 2007, the Delaware Supreme Court issued an important ruling for creditors of insolvent corporations. It held that such creditors had standing to assert derivative claims for breaches of fiduciary duties against directors of an insolvent corporation.1 But, as the Delaware Court of Chancery recently made clear, there is a big difference between Delaware limited liability companies (LLCs) and their corporate cousins.

On November 3, 2010, the Delaware Chancery Court issued an opinion that should cause lenders and other creditors of Delaware LLCs to sit up and take notice. The opinion challenges popular beliefs and assumptions regarding creditor derivative standing in the context of Delaware LLCs and highlights what was, perhaps, a legislative blunder. From the creditor’s perspective, the opinion is disruptive to say the least, and possibly game changing if upheld on appeal.

The Facts and Issues

The case is CML V, LLC v. Bax et al., Case No. 5373-VCL, and the relevant facts are simple enough. A lender asserted a direct claim against its borrower (a Delaware LLC) for breaching certain of its loan obligations and derivative breach of fiduciary duty and similar claims against certain individual members and managers of the borrower. The individual defendants moved to dismiss the derivative claims against them on various grounds, including that the lender lacked standing as a creditor to sue derivatively under section 18-1002 of the Delaware Limited Liability Company Act (LLC Act). The lender countered that, just as with insolvent corporations, creditors are the principal constituency injured by any fiduciary breaches that diminish the value of the insolvent LLC. As such, the holding of the Delaware Supreme Court in the Gheewalla case should extend to creditors of an insolvent LLC so as to confer derivative standing upon them.

The Statutory Language Controls

The Chancery Court agreed with the defendants, however, explaining that “the literal terms of the LLC Act control, and they bar a creditor of an insolvent LLC from suing derivatively. Although 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.”2

Section 18-1002 of the LLC Act, entitled “Proper Plaintiff,” provides as follows:

In 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 and: (1) at the time of the transaction of which the plaintiff complains; or (2) the plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction. 6 Del. C. § 18-1002 (emphasis added)

Referring to this language as “exclusive language,” the court contrasted it with an example of “non-exclusive language” appearing in the section of the Delaware General Corporation Law that addresses derivative actions.3 “Section 327 demonstrates that the General Assembly can readily adopt a non-exclusive limitation on derivative standing. Section 18-1002, by contrast, uses exclusive language.”4

Because the plain language of the statute appears to be exceedingly clear and dispositive of the issue, the Chancery Court took note of the “awkward fact” that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.5 … If practitioners widely understood the derivative standing provisions to have this effect, one would expect treatises, articles, and commentaries to call attention to that fact.”6 And yet, that has not been the case. Indeed, at the very outset of the opinion, the Chancery Court acknowledged that its ruling might “surprise wizened veterans of the debates over corporate creditor standing…[.]”7 Many commentators have simply assumed that creditors of an insolvent LLC can sue derivatively.8 Nonetheless, constrained by what it perceives to be clear statutory language, the Chancery Court held fast to its conclusions.

Further Support for Its Conclusions

The Chancery Court further supported its conclusions by considering “(i) how parallel provisions of other alternative entity statutes have been interpreted, (ii) the source and development of the alternative entity derivative standing provisions, and (iii) whether enforcing the plain meaning of Section 18-1002 would create an absurd result at odds with the overarching purpose and framework of the LLC Act.”9 The court noted that the LLC Act was modeled on the Delaware Limited Partnership Act (LP Act) which contains nearly identical derivative standing provisions as the LLC Act. “Like the derivative standing provisions in the LLC Act, the comparable derivative standing provisions in the LP Act facially bar any party other than a limited partner or assignee from suing derivatively. Read literally, the provisions prevent creditors from suing, and the Delaware courts historically have interpreted them as exclusive. This treatment strongly supports a similarly exclusive reading of the LLC Act.”10

The court then engaged in a thorough historical review of the adoption of both the LLC Act and the current version of the LP Act. Following the development of various statutory schemes, the court noted that the drafters of the current LP Act had had a “clear choice” in deciding whether to adopt a new uniform statutory scheme known as the “Revised Uniform Limited Partnership Act of 1976,” which contained facially exclusive language in its derivative action standing provisions, or to retain the non-exclusive language contained in the existing LP Act. The drafters chose the former, which suggests “a conscious intent to make statutory standing exclusive.”11

On What Basis Would LLCs Differ from Corporations?

Finally, the court considered whether its adhering to the plain meaning of section 18-1002 of the LLC Act would result in “an absurd distinction between insolvent corporations, where creditors can sue derivatively, and insolvent LLCs, where they cannot.”12 In other words, the court turned to the question “why?” Why would the Delaware legislature permit derivative standing for creditors of insolvent corporations, but not for insolvent LLCs? What about the “equitable considerations” articulated in the Gheewalla case that would seem to apply equally to creditors of LLCs?

While the answer may very well be that such a distinction was not intended by the drafters of the LLC Act – i.e., it was a legislative blunder – the Chancery Court saw a clear basis for making such a distinction. “[T]here is nothing absurd about different legal principles applying to corporations and LLCs.”13 By their very nature, LLCs are “creatures of contract, ‘designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved.’ Creditors generally are presumed to be ‘capable of protecting themselves through the contractual agreements that govern their relationships with firms.’ ‘Creditors are often protected by strong covenants, liens on assets, and other negotiated contractual protections.’ To 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.”14

In addition, the court notes that the LLC Act provides creditors with various forms of statutory protections that further obviate the need for derivative standing. Such protections include, among others, the ability of an LLC agreement to provide express contractual rights to creditors (e.g., provisions requiring prior lender consent before certain acts may be taken or provisions subjecting members to specific penalties or consequences for breaching the LLC agreement or upon the occurrence of specific events) (see 6 Del. C. §§ 18-101(7) and 18-306). It would also include the ability to expand fiduciary duties owed by members to the LLC in the LLC agreement (see 6 Del. C. § 18-1101).15

In sum, “[i]n light of the expansive contractual and statutory remedies that creditors of an LLC possess, it does not create an absurd or unreasonable result to deny derivative standing to creditors of an insolvent LLC. The outcome does not frustrate any legislative purpose of the LLC Act; it rather fulfills the statute’s contractarian spirit.”16

Practical Effects

In neutralizing the threat of derivative actions by creditors, the Chancery Court has greatly expanded the protections afforded to members and managers of Delaware LLCs. If affirmed on appeal, and absent legislative intervention, the popularity of Delaware LLCs as business vehicles may very well increase. As such, lenders transacting with Delaware LLCs must be cognizant of their inability to assert derivative claims and seek greater contractual protections for themselves at the outset of the lending relationship.

The opinion was appealed on November 30, 2010 to the Delaware Supreme Court, Case No. 735,2010. The matter has been fully briefed, and the court is scheduled to hear oral arguments on June 22, 2011. In the meantime, the lending and legal communities are waiting with bated breath.