On September 2, the Delaware Supreme Court affirmed a holding by the Court of Chancery that creditors of insolvent Delaware limited liability companies do not have standing to sue derivatively. This contrasts with Delaware corporations: the Delaware courts have recognized that when a corporation becomes insolvent, creditors become the residual risk-bearers and are permitted to sue derivatively on behalf of a corporation to the same extent as stockholders.
The Delaware Supreme Court, like the Court of Chancery, held that the plain language of the Delaware Limited Liability Company Act (“LLC Act”) limits an action to sue derivatively to an LLC’s members or their assignees. Unlike the Delaware General Corporation Law (the “DGCL”), the LLC Act leaves no room for the court to imply a right of action to sue derivatively because the LLC Act 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 . . ..” The court found that use of the word must in the LLC Act unequivocally was meant to exclude other potential plaintiffs. The DGCL has a comparable provision. The DGCL provision (Section 327) only allows derivative suits “instituted by a stockholder” to be brought if the stockholder was a stockholder when the alleged fiduciary violation occurred. The court construed these provisions quite differently. Section 327 imposes a contemporaneous stock ownership requirement in stockholder-initiated derivative suits; it does not exclude other potential plaintiffs. The LLC Act, however, not only requires contemporaneous membership, but also expressly limits derivative actions to members (or their assignees). The court held that, given this unambiguous statutory language, only the legislature could imply a right of creditors to bring derivative actions.
The Supreme Court noted that “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.” In the case of LLCs, Delaware’s legislature “has espoused its clear intent to allow interested parties to define the contours of their relationships with each other to the maximum extent possible.”
Lenders to Delaware LLCs should keep these principles in mind when making financing decisions and consider seeking protections to compensate for the lack of derivative standing. As the Supreme Court and Court of Chancery observed, creditors can obtain derivative standing by negotiating for the automatic assignment of membership interests upon insolvency. Credit agreements, or the LLC’s operating agreement itself, can also explicitly provide for expanded legal duties to creditors, include personal guarantees, a duty to preserve assets upon insolvency or stiff penalties if creditor rights are violated.