United States: Restructuring And Insolvency Update - March 2024

Potential Resurrection of Creditor Derivative Suits on Behalf of Debtor LLCs

In early February, a Delaware bankruptcy judge broke ranks with several of his fellow Delaware bankruptcy judges who have held that creditors' committees and/or individual creditors cannot obtain derivative standing to prosecute breach of fiduciary duty claims on behalf of the bankruptcy estate of a Delaware limited liability company.

On February 2, 2024, Judge Craig T. Goldblatt issued a 52-page "Memorandum Opinion" in In re Pack Liquidating, LLC, No. 22-10797 (CTG), 2024 WL 409830 (Bankr. D. Del. Feb. 2, 2024) holding that the Delaware Limited Liability Company Act does did not preclude the bankruptcy court from granting the official creditors' committee standing to pursue estate causes of action (assuming it otherwise met the established standards for granting that relief).

Prior to this ruling, Delaware bankruptcy judges had issued three published opinions—In re HH Liquidation, LLC, 590 B.R. 211 (Bankr. D. Del. 2018) (Ret. J. Gross), In re PennySaver USA Publishing, LLC, 587 B.R. 445 (Bankr. D. Del. 2018) (Ret. J. Sontchi), and In re Citadel Waterford City Disposal Partners, L.P., 603 B.R. 897 (Bankr. D. Del. 2019) (J. Carey)—and at least two bench rulings—In re Dura Automotive Systems, LLC, No. 19-12378 (J. Owens) and In re Ector County Energy Center LLC, No. 22-10320 (J. Dorsey)—holding that creditors, including official committees of unsecured creditors, cannot derivatively prosecute claims on behalf of a Delaware LLC (Citadel involved a Delaware limited partnership, which is governed by similar state law). Other than Dura Automotive, the judges who have denied creditor standing to sue derivatively on behalf of a Delaware LLC's estate have focused their rulings on breach of fiduciary duty claims. This makes sense, particularly in the context of fraudulent transfer claims, which under state law are creditor claims.

A member of a Delaware LLC (like a shareholder of a corporation) may sue derivatively for breach of fiduciary duties. Delaware LLC Act § 18-001. The Delaware LLC Act limits who can be a plaintiff in such an action to members or certain assignees of an LLC interest. Id. § 18-002. The Delaware Chancery Court examined the plain meaning of these statutes in 2010 in CML V, LLC v. Bax, 6 A.3d 238 (Del. Ch. 2010) and held that only members or assignees of LLC interests have standing to bring derivative actions. Thus, the court concluded, creditors of an LLC never have standing to bring derivative actions on behalf of an LLC. In reaching its conclusion, the Bax court noted that the LLC Act's guiding policy is to promote freedom of contracts. And creditors of an LLC, the court noted, generally have the ability to protect themselves, both through their agreements with the LLC and through their insistence on the inclusion of creditor protections in the LLC agreement. Moreover, creditors of an insolvent LLC are protected by state fraudulent transfer laws, as well as the avoidance provisions of the Bankruptcy Code in the event the LLC files for bankruptcy.

Judge Goldblatt's fellow judges focused their opinions on state law (i.e., the Delaware LLC Act and the Bax decision) not on the Bankruptcy Code or the Third Circuit Court of Appeals' ruling in Cybergenics. In this seminal case—which is binding precedent for Delaware Bankruptcy Courts—the Third Circuit held that the bankruptcy court could authorize the committee to pursue certain estate claims and that such authority was implicit in the Bankruptcy Code. Official Comm. of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003).

In contrast, Judge Goldblatt's ruling is based on the premise that, "[w]hile an order granting a committee standing...can fairly be described as authorizing a 'derivative' lawsuit, it is a federal rather than state-law derivative action, and thus not the subject of the Delaware Limited Liability Company Act." Pack Liquidating, 2024 WL 409830 at *2.He therefore determined that Cybergenics and Bax were not in conflict, and that Cybergenics controlled in the bankruptcy context. But even if they were in conflict, the outcome would be the same, as the U.S. Constitution's Supremacy Clause would require the authority that the Third Circuit found implicit in the Bankruptcy Code to preempt any contrary state law.

Judge Goldblatt noted that in the federal court's "hierarchal system of precedent" he was not "formally" bound to follow the rulings of his fellow judges, but recognized that there are "sound prudential reasons to strive for consensus" in multi-judge trial/bankruptcy courts. Consensus and clarity are important to the rule of law, and predictability is especially important in areas of commercial law (such as bankruptcy) where "parties can be expected to rely on consistent application of settled law in their commercial dealings." Id. at *2, 16. Thus, he was "loath to break with the only three written opinions by judges of this Court to have addressed the topic." Id. at *2.

Nevertheless, the Pack Liquidating decision—which itself is not binding on other Delaware bankruptcy judges—gives rise to significant uncertainty. As a result, until a higher court decides the issue, creditors may be well-advised to negotiate for provisions in financing, cash collateral, or similar orders, or other so-ordered stipulations, prospectively granting standing to pursue claims on behalf of debtors notwithstanding any issue regarding whether creditors have the ability to file derivative suits on behalf of any debtor that is a Delaware LLC or LP.

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