Putting the “Limited Liability” into “Limited Liability Company”: Delaware Supreme Court Affirms Limited Scope of Derivative Standing to Pursue Claims on Behalf of LLCs

Contributed by Doron P. Kenter.
We previously wrote about a decision in CML V, LLC v. Bax et al., 6 A.3d 238 (Del. Ch. 2010) (“JetDirect), pursuant to which the Delaware Court of Chancery found that the plain language of the Delaware Limited Liability Company Act denies derivative standing to creditors of insolvent Delaware limited liability companies.  In contrast, creditors of a “regular” insolvent corporation have standing to assert derivative claims on behalf of the corporation.  Recognizing that it is indeed strange that creditors of insolvent corporations have derivative standing while creditors of insolvent LLCs do not (simply because one is a corporation and the other an LLC), the Chancery Court noted in its decision 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.”  Regardless of the limited attention given to this principle thus far, the JetDirect case has now called attention to this surprising principle.
In JetDirect, the creditor plaintiff brought a derivative suit on behalf of JetDirect against certain of JetDirect’s current and former managers, alleging breaches of the duties of care, loyalty, and good faith.  The plaintiff alleged that JetDirect had not employed adequate internal controls and that its board and management had carelessly pursued major acquisitions, which JetDirect lacked the working capital to finance.  JetDirect subsequently failed.
The Delaware Supreme Court, sitting en banc, unequivocally affirmed the Chancery Court’s decision and further expanded on the constitutional underpinnings of this wrinkle in the statutory authority depriving creditors of insolvent limited liability companies from asserting derivative actions on the LLC’s behalf.
Reviewing the Chancery Court’s decision, the Delaware Supreme Court first considered the plain language of the Delaware Limited Liability Company Act, concluding that such language is plain and unambiguous in limiting derivative standing exclusively to “member[s]” or “assignee[s]” of LLCs.  “In as many words,” the court noted (in far less detail than the Chancery Court’s decision), “the provision [of the LLC Act] dictates that a proper derivative action plaintiff ‘must be a member or an assignee of a limited liability company interest . . . .’” (emphasis in original).
Rejecting the plaintiff’s argument that this understanding of the LLC Act would create a regime in which insolvent LLCs will have no stakeholders with an incentive to enforce fiduciary duties through legal action, the court noted that the Delaware General Assembly is entitled to make its own policy choices in creating corporate structures and instituting rights and responsibilities with respect thereto.  The court stated that the General Assembly is entitled to “design a system promoting maximum business entity diversity.” Though it may seem strange that creditors of corporations and creditors of LLCs hold different legal rights against the different types of corporations, creditors (particularly investors such as lenders and noteholders) are free to choose the entities with which they do business – in other words, if creditors don’t like the LLC regime, they can take their toys to a different sandbox.
Notably, the plaintiff in JetDirect asserted that if the LLC Act does limit derivative standing to members and assignees of LLCs, then it impermissibly strips the Chancery Court of equitable jurisdiction to extend derivative standing to creditors where such standing is necessary to prevent a complete failure of justice.  Pursuant to the Delaware Constitution, the General Assembly is prohibited from limiting the Chancery Court’s equitable jurisdiction to less than the general equity jurisdiction of the High Court of Chancery of Great Britain “at the time of our separation from the Mother Country.”  The Delaware Supreme Court accordingly acknowledged that the Chancery Court could not be deprived of the ability to confer standing to creditors of a corporation if such an extension of standing were in the interests of justice.  The court noted that the LLC Act does not deal with corporations, but instead deals with statutorily created LLCs.  The court concluded that, because the corporate form of an LLC did not exist in the High Court of Chancery of Great Britain three hundred years ago, the General Assembly was not precluded from limiting the scope of derivative standing with respect to creditors of LLCs.
Moreover, the court noted that even if the Chancery Court had the common law equitable jurisdiction to extend derivative standing outside the corporate context – which it does not – this equitable power cannot override the express provisions of the LLC Act.  Because the General Assembly expressly created the corporate form of the LLC and the right to sue derivatively on behalf of an LLC, the General Assembly was consequently entitled to expressly limit that right to the LLC’s members and assignees.
Finally, the court noted that the statutorily-created corporate form of the LLC brings with it a bundle of rights and that noteholders and other lenders are free to invest in LLCs on such terms as they deem to be acceptable.  In this case, the plaintiff could have negotiated for contractual protections, but it did not.  It hardly threatens the “interests of justice,” the court reasoned, to impose a statutory framework within which sophisticated parties are entitled to make informed choices.