United States: Delaware Supreme Court Affirms That Creditors Of Insolvent LLCs Do Not Have Derivative Standing -September 2011 (No. 2)

In a decision¹ issued late last fall that surely surprised "wizened veterans" of the debate over corporate creditor standing to bring derivative claims, Vice Chancellor Laster of the Delaware Court of Chancery dismissed creditors' derivative claims brought against the board of directors of an insolvent limited liability company. The Court ruled that Section 18-1002 of the Delaware Limited Liability Company Act (the "LLC Act"), 6 Del. C. § 18-1002, expressly limited standing to bring a derivative claim to members of limited liability company (an "LLC") and their assignees. Plaintiff appealed to the Delaware Supreme Court, which affirmed the Court of Chancery decision.

Background

Plaintiff CML V, LLC ("CML") lent funds to JetDirect Aviation Holdings, LLC ("JetDirect"), a private jet management and charter company. Beginning in 2005, JetDirect undertook an expansion program, pursuant to which it acquired other charter and service companies.

In its complaint, CML averred that members of JetDirect's board approved four acquisitions in 2007 in breach of their fiduciary duties. CML contended that, if the JetDirect board possessed accurate financial information, it would have recognized that JetDirect lacked sufficient working capital to finance these acquisitions. CML alleged that in June 2007, JetDirect defaulted on its obligations to CML and, shortly thereafter, filed for bankruptcy. Among other things, CML asserted that the board: (i) breached its duty of care by approving the 2007 acquisitions without informing itself of critical information about JetDirect's financial condition; (ii) acted in bad faith by consciously failing to implement and monitor internal controls; and (iii) benefited from an allegedly self-interested asset sale in violation of the duty of loyalty.

Court of Chancery Ruling

In a corporate setting, Delaware law is well-settled—when a corporation is insolvent, its creditors become the principal constituents injured by any fiduciary breaches that diminish the corporation's value. The creditors therefore have standing to pursue derivative claims against the directors of an insolvent corporation. In the Court of Chancery, CML argued that the same "equitable considerations" should apply in the context of an LLC, and should entitle creditors to sue derivatively in the name of the insolvent entity.

The Court declined to extend the prevailing corporate analysis by analogy to LLCs because such entities are a creature of statute. Vice Chancellor Laster noted that prior decisions and scholarly commentary have either presumed derivative standing for creditors of alternative entities, without directly addressing the issue, or avoided the question entirely. In the absence of precedent, the Court found that the literal terms of the LLC Act control. The LLC Act, similar to other alternative entity statutes, creates both a right to bring a derivative claim and defines a proper plaintiff. Under its plain language, only a member or an assignee may sue derivatively. Vice Chancellor Laster cautioned that it is not the Court's job to go beyond the clear and unambiguous legislative directive stated in the LLC Act and inject into the statute concepts borrowed from corporate common law precedents. CML appealed.

The Supreme Court Decision

On September 2, 2011, the Supreme Court, sitting en banc, affirmed Vice Chancellor Laster's decision.

CML raised two issues on appeal: (i) that 6 Del. C. §§ 18-1001 and 18-1002 do not deprive creditors of standing to bring derivative actions on behalf of insolvent LLCs, but (ii) if they do, those provisions unconstitutionally deprive the Court of Chancery of its equity jurisdiction. The Supreme Court rejected both contentions.

In reviewing the statutory provisions in question, the Supreme Court held them to be unambiguous. It instructed that when "statutory text is unambiguous, [the courts] must apply the plain language without any extraneous contemplation of, or intellectually stimulating musings about, the General Assembly's intent." Indeed, the Court found that sections 18-1001 and 18-1002 serve very different purposes, one creating the right to bring a derivative action on behalf of an LLC and the other conferring derivative standing on members and assignees. In so doing, the legislature was both free and "well suited," the Court found, to make policy choices and impose statutory limitations on derivative standing on entities other than corporations.

The Court then emphasized that in the LLC context specifically, the Delaware legislature had espoused a clear intention to allow interested parties to define the contours of their relationship with each other. Creditors, therefore, have significant contractual flexibility to protect their unique interests and must employ tools already available to them.

With respect to the question of constitutionality, CML argued that the LLC Act impermissibly curtailed the Court of Chancery's jurisdiction to less than that extant in 1792 when Delaware ratified its first constitution. The Court disagreed. It noted that LLCs did not come into existence until 1992, when the LLC Act was signed into law. As such, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, the courts must look to the LLC Act as the only statute that creates those rights, remedies and obligations. In so reasoning, the Court held that sections 18-1001 and 8-1002 embody a valid exercise of legislative authority and the limitation so imposed on derivative standing does not impinge upon the constitutional jurisdiction of the Court of Chancery. Under these circumstances, there was no room for the common law to override the statutory mandate.

This ruling is important to the lending community. It will be critical, in the future, for banks and other lenders to LLCs to protect their rights in the event of a default. As it stands right now, under Delaware law, present creditors of insolvent LLCs have one less avenue to be made whole. A copy of the Chancery Court Opinion can be found here. A copy of the Supreme Court Opinion can be found here.

Footnotes

1. CML V, LLC v. Bax, 6 A.3d 238 (Del Ch. 2010)

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