In today’s turbulent economic climate, it is vital for creditors and debtors to understand the precise boundaries of their rights and duties when an enterprise becomes insolvent. Directors, officers and managers must acknowledge those to whom they owe fiduciary duties and fulfill those duties at the risk of personal liability, while creditors evaluate their potential remedies against misbehaving insiders to collect on defaulted obligations. The law is settled that creditors of an insolvent Delaware corporation have the right to bring a derivative claim against the corporation’s directors and officers for breach of fiduciary duties.1 Until recently, many courts and legal commentators assumed that creditors of insolvent limited partnerships and limited liability companies are entitled to the same rights and remedies – i.e., the same right to sue – as creditors of corporations. Not true. In its recent decision, CML V, LLC v. Bax, et al and JetDirect Aviation Holdings, LLC, C.A. No. 5373-VCL (Del. Ch., Nov. 3, 2010), the Delaware Chancery Court clarified that creditors of an insolvent limited liability company (LLC) lack standing to bring derivative claims against managers and officers of an LLC, effectively barring the courthouse door to creditors’ breach of fiduciary duty claims against an LLC’s insiders.

The Court in CML decided that the plain language of Section 18-1002 of Delaware’s LLC Act permitted derivative suits, on behalf of the LLC against managers, only by LLC members and their assignees, even though creditors of insolvent corporations could have such derivative standing. In its analysis, the Court highlighted the broad range of other remedies a creditor might have against LLC managers’ misconduct, such as suing for fraud or to avoid and recover fraudulent transfers. The Court also noted that the LLC Act contains several statutory provisions that creditors can use to gain enhanced rights and protections. For example, the Court found that the LLC Act authorized an LLC to include in its operating agreement provisions whereby members or managers could agree to be obligated personally for the LLC’s liabilities. Thus, the Court found that, because creditors of an LLC have broad contractual and statutory protections available, there was no justification to ignore the plain language of the LLC Act and allow derivative standing to creditors of an insolvent LLC.

The holding in CML limits the application of the Delaware Supreme Court’s Gheewalla decision, which established that a creditor of an insolvent corporation may not bring a claim in the creditor’s own right to recover for breach of fiduciary duty to the corporation, and that such a claim may only be brought derivatively on behalf of the debtor. Meanwhile, California courts have determined that a director’s duty to an insolvent corporation’s creditors is limited to “the avoidance of actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditor claims” under the trust fund doctrine2 and have applied the same reasoning to their analysis of the liability of LLC managers and officers.3

Similarly, under Colorado law, the Colorado Supreme Court has ruled that directors of an insolvent corporation owe two specific duties to an insolvent corporation’s creditors: (a) a statutory duty not to vote for distributions to shareholders that would preclude payment of corporate debts, and (b) a common law duty to avoid favoring the director’s own interests over creditors’ claims once the corporation becomes insolvent,4 with such reasoning extended to LLCs.5  

The CML opinion creates complex considerations for creditors to consider in negotiating agreements with their creditors that are Delaware LLCs, as well as for those who organize new business entities, when deciding on the form of an entity and in which jurisdiction it should be organized. It is even more important for directors, officers and managers, when an enterprise is or may become insolvent, to exercise heightened diligence in weighing their options and considering the impact of their decisions and actions on all stakeholders, including creditors. At the point of insolvency, those creditors are the new beneficiaries of managements’ fiduciary duties.  

The lawyers in HRO’s Corporate Department and its Bankruptcy and Restructuring Practice Group are experienced in helping clients navigate their way through the numerous duties and laws relating to insolvency that affect companies and those that they do business with. We welcome the chance to discuss how to manage these risks strategically, provide practical guidance and turn challenges into opportunities.