Contributed by Sara Coelho
In a decision that likely will surprise many, the Delaware Court of Chancery found in CMV V, LLC v. Bax et al., 6 A.3d 238 (Del. Ch. 2010) (JetDirect) that the plain language of the Delaware Limited Liability Company Act denies derivative standing to creditors of Delaware limited liability companies. The extent and nature of fiduciary duties under Delaware law to creditors of insolvent entities, and the standing of creditors to enforce such rights, has been written about and debated extensively, without substantial commentary on how the plain language of the LLC Act’s standing provisions affect creditor rights to sue on behalf of LLCs. Acknowledging this strange absence in the context of an otherwise robust debate, under the headline of “The Dog That Has Not Barked,” the court stated that “[i]f practitioners widely understood the derivative standing provisions to have this effect, one would expect treatises, articles and commentaries to call attention to that fact.” Although the court rested its decision on plain meaning alone, it also reviewed the history of the LLC Act’s standing provisions because they “are not uniquely Delawarean” and are “part of widely adopted uniform acts where consistent interpretation and stable commercial expectations have particular salience.”
In JetDirect, the creditor plaintiff brought a derivative suit on behalf of the corporation against certain individuals alleging breaches of the duties of care, loyalty and good faith. Among other things, the plaintiff alleged that JetDirect’s internal controls had broken down and that, notwithstanding the resulting lack of information about the company’s financial situation, the board and management pursued major acquisitions that they should have known, had their controls worked, they lacked the working capital to finance. The company failed. Notwithstanding these allegations and the apparent insolvency of the company, the court dismissed the action based on the plain language of the LLC Act, which holds that in a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest. The insolvency of the LLC was not a factor in the decision. In finding that LLC creditors have no derivative standing, the court did not comment on whether there are fiduciary duties to creditors of a Delaware LLC.
Beyond the statutory text, the sparse authority on the question mainly consists of insinuations of such standing in dicta from two Delaware opinions, a single line in the footnote of a treatise, and an unpublished federal court decision interpreting a similar Montana statute. The court found strong support, however, in the history of the LLC Act and the Delaware Limited Partnership Act from which the LLC Act was modeled and from which it took its derivative standing provisions. Although Delaware originally adopted an expansive standing provision under its partnership law, when it adopted the Revised Uniform Partnership Act (“RULPA”), Delaware chose to enact the restrictive standing provision that was then included in the uniform act, even though the legislature included other “uniquely Delawarean sections.” The court, thus, concluded that the implementation of the RULPA statutory standing provisions that were ultimately adopted under the LLC Act as well “suggests a conscious intent to make statutory standing exclusive.” Moreover, Delaware courts narrowly interpreted derivative standing provisions in the Limited Partnership Act to bar suits by assignees of limited partners until the statute was amended to allow such suits. Given this history, the court rejected arguments from the plaintiff that a plain reading of the statute leads to unreasonable or absurd results and could therefore be disregarded. To the contrary, the court found that a plain reading, in limiting creditors to their contractual rights, is consistent with the “contractarian environment created by the LLC Act.”
Speaking of the “contractarian” characteristics of Delaware LLCs, however, the opinion examines the numerous rights and remedies available to creditors under the LLC Act, including allowing for the following in LLC Agreements:
- granting rights to non-parties to the LLC agreement, including creditors (6 Del. C. § 18-101(7));
- providing for penalties or other consequences for members upon occurrence of certain events (contrary to contract law, which generally bans penalty provisions), (6 Del. C. § 18-306);
- providing for the ouster of LLC managers upon specified events (6 Del. C. § 18-402);
- expansion or restriction of fiduciary duties (6 Del. C. §18-1101(c));
- personal guarantees of debts and obligations of the LLC by members or managers (6 Del. C. § 18-303(b));
- provision for separate rights or duties regarding certain property or obligations, which rights may supplement rights under security agreements (6 Del. C. § 18-215); and
- cementing bargained-for creditor rights into the LLC agreement by requiring creditor approval to amend the LLC agreement (6 Del. C. § 18-302(e)).
It will have to be seen whether creditors negotiate successfully for such rights, and what sorts of terms evolve. For example, could an LLC agreement provide that membership interests devolve to a creditor upon certain events, providing a creditor with derivative standing in times of distress? Practitioners should consider that some creditor rights may be embedded in an LLC agreement.
The court offered several additional valuable insights for practitioners. First, the Delaware LP Act’s standing provisions are identical to those in the LLC Act (but for references to type of entity), and the court stated that the LP Act “facially bars” parties other than limited partners or their assignees from suing derivatively. Second, the court noted that some states did not adopt the restrictive standing provisions of the RULPA. It follows that they may be amenable to permitting derivative standing for creditors of LLCs. Finally, in its astonishment at the lack of attention to the LLC Act itself, the court’s analysis underscores that the laws governing alternative entities in Delaware vary from the laws governing corporations.