Delaware Supreme Court Affirms Ruling Protecting Managers Of Insolve...

Creditor Derivative Claims Against Fiduciaries Of Insolvent Corporate Entities. In a 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency." 

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation's directors. That led many to wonder whether the same ruling would be extended to managers of Delaware limited liability companies ("LLCs"), the LLC equivalent of a corporation's directors. 

The Chancery Court's Decision. In November 2010, the Delaware Chancery Court answered the question, somewhat surprisingly, with a decisive "no." In CML V, LLC v. Bax, 6 A.3d 238 (Del.Ch. 2010), the Chancery Court held that creditors could not bring derivative actions for breach of fiduciary duty against managers of insolvent LLCs, chiefly because the relevant Delaware LLC Act provision limited standing to bring such suits only to LLC members and their assignees. For a discussion of the Chancery Court decision, follow the link to a November 2010 post on the blog entitled "New Ruling Finds Important Protection For Managers Of Insolvent Delaware LLCs."

The Delaware Supreme Court Decision. The decision was appealed to the Delaware Supreme Court. On September 2, 2011, the Delaware Supreme Court issued an opinion analyzing the Delaware LLC Act and affirming the Chancery Court's decision. A copy of the Delaware Supreme Court's opinion is available through this link.

• The Delaware Supreme Court held that the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, limits standing to bring derivative claims only to LLC members and their assignees because the LLC Act provides that only they are "proper plaintiffs." The Delaware Supreme Court held that this statute was unambiguous and expressly limits standing only to LLC members and their assignees. The creditor plaintiff argued that it was "absurd" for the result to be different as between a corporation and LLC, but the Delaware Supreme Court held that the Delaware General Assembly "was well suited to make that policy choice and we must honor that choice." 
• The plaintiff also claimed that by limiting standing, the statute violated the Delaware Constitution's prohibition against curtailing the Chancery Court's jurisdiction to less than the general equity jurisdiction of the High Court of Chancery of Great Britain as it existed in 1792, when Delaware ratified its first constitution. The Delaware Supreme Court rejected the argument holding that, among other reasons, Delaware limited liability companies, unlike corporations, came into existence only in 1992 and therefore did not exist in 1792. In addition, the LLC statute was properly able to both grant and limit derivative standing.

Creditor Options. Recognizing that this standing provision could limit creditor remedies in the event of insolvency, the Delaware Supreme Court discussed one remedial option available to creditors. In footnote 20 of the opinion, the Court stated:

Admittedly, this approach is not the only option the General Assembly had, and we make no normative comment on the General Assembly's policy choice. Our only purpose here is to explain that limiting derivative standing to members and assignees in a contractual entity like an LLC is not absurd because other interest holders--like creditors--have other options--as, for example, negotiating automatic assignment of membership interests upon insolvency clauses into the credit agreement and requiring the members and governing board to amend the LLC agreement accordingly.

Key Observations. As the Delaware Supreme Court noted, certain creditors may require that the LLC agreement be amended to provide for automatic assignment of membership interests to the creditors upon insolvency. If so, those creditors would then have standing to bring derivative claims. However, absent such provisions, under the Delaware Supreme Court's decision:

• Managers of a Delaware LLC will not be subject to derivative claims by creditors if the entity becomes insolvent, although it is far less certain that the standing statute would preclude a bankruptcy trustee from bringing claims on behalf of the LLC itself;
• An insolvent LLC's creditors will not have derivative standing to bring potential D&O type claims; and
• These creditors will be limited to contractual remedies against the LLC to protect themselves. 

Although Delaware LLCs and corporations share many common features, this new Delaware Supreme Court decision makes clear that the automatic derivative standing of creditors upon insolvency is one important distinction.