Chancery Bars Derivative Claim of Creditor Against Insolvent LLC, Based on LLC Act

CML V, LLC v. Bax, C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010), read opinion here. This is an important decision of the Court of Chancery involving the interpretation of the Delaware LLC Act and the rights of creditors to pursue a derivative claim for breach of fiduciary duty.

Issue Decided.

The Delaware Court of Chancery addressed whether a creditor had standing, based on the Delaware LLC Act, to pursue a derivative claim against an insolvent LLC, similar to a creditor’s right to do so against an insolvent corporation. Short Answer: No.

Brief Summary of Decision

CML V, LLC ("CML") lent funds to JetDirect Aviation Holdings LLC. The complaint plausibly plead that JetDirect was insolvent and CML asserted derivative claims against the LLC managers, alleging breach of fiduciary duty and related claims. The Individual Defendants moved to dismiss those claims based on Section 18-1002 of the Delaware LLC Act.

The Court reasoned that: Section 18-1002 "limits standing to bring a derivative claim to holders of membership interests in a limited liability company ("LLC") and their assignees. Section 18-1002 does not grant standing to creditors…. JetDirect is not a corporation. JetDirect is an LLC, and the plain language of the LLC Act controls."

In connection with dismissing the claims, this 30-page opinion provides a paradigmatic analysis of: (i) the statutory history or the LLC Act, including its origin as a uniform statute; (ii) statutory interpretation principles; (iii) comparison of similar provisions in related alternative entity statutes, such as the L.P. statute; (iv) Delaware-based and national treatises that have opined on the issue; (v) law review articles and other academic literature addressing the issue; and (vi) the impact and potential repercussions of reaching a conclusion that may be at odds with what practitioners and scholars (and even some court decisions) seem to have assumed about the right of creditors to file a derivative action in the LLC context, analogous to their right to do so in the corporate context.

Background

JetDirect was a private jet management and charter service. An aggressive growth strategy left it with a highly leveraged balance sheet and volatile cash flows. Internal control deficiencies and poor financial reporting procedures, combined with ill-advised acquisitions led to several subsidiaries filing for bankruptcy and the insolvency of the parent. CML also alleged that while JetDirect was insolvent, some of the board of managers liquidated some assets by transferring them to entities controlled by certain board members at unfair prices.

Legal Analysis

Although the Court did not apply the analogous right of a creditor in the corporate context to file a derivative suit, it began the legal analysis by acknowledging the Delaware Supreme Court’s benchmark decision in this type of litigation: "The creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties". (citing N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007))(emphasis in slip opinion). Moreover the Court recognized the theoretical underpinning of that holding as follows: "When a corporation is insolvent, the creditors become ‘the principal constituency injured by any fiduciary breaches that diminish the firm’s value’". (citing Id. at 102).

The Court also acknowledged that at least some commentary and a few other court decisions appear to have assumed that this reasoning also applied to allow derivative suits by creditors in the context of insolvent alternative entities. However, the Court of Chancery reasoned that the literal terms of the LLC Act barred such a result. Although the Court recognized its power to avoid a literal interpretation of the statute when "such a reading would be so inconsistent with the statutory purpose as to produce an absurd result," this is not such a case.

Statutory Interpretation

The Court reviewed basic statutory interpretation principles that apply when the language of a statute is clear and unambiguous on its face. It then quoted Section 18-1001 of the LLC Act that defines a "proper plaintiff" who has a right to bring a derivative  action under the Act. Next, it quoted the obvious requirement in Section 18-1002 that "only a member or an assignee" qualifies. The only Delaware treatise to comment directly on how the foregoing statutes apply to creditor’s rights, also states based on those statutes, that "an LLC creditor is not a proper plaintiff in a derivative suit." (citing Robert L. Symonds, Jr. and Matthew J. O’Toole, Delaware Limited Liability Companies, Section 9.09, at 9-61 n. 270 (2007)). Later in the opinion, in connection with its observation that there is a paucity of other direct commentary on the specific issue, the Court noted that the foregoing statement [from Delaware's authoritative treatise on LLCs], was "not trumpeted" and appeared at the end of a long footnote without added discussion.

Next the Court contrasted the above statutory provisions with Section 327 of the DGCL which is the only Delaware corporate statute that addresses derivative actions. Section 327 houses the contemporaneous ownership requirement, but does not create the right to sue derivatively and does not limit derivative suits to stockholders exclusively. By comparison, read literally, Section 18-1002 does deny creditors the right to sue an insolvent LLC derivatively.

A Dog That Has Not Barked

The above sub-title in the Court’s opinion begins a section that has the following opening sentence: "As compelling as a literal reading of Section 18-1002 may seem, it encounters an awkward fact: Despite the ostensibly obvious implications of the statute, virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit."

Instead of the literature on this topic addressing the question directly, most commentators have focused on the right to limit fiduciary duties that creditors can invoke, but as the Court observes: "That question never arises if creditors lack standing to sue under Section 18-1002". See extensive commentary cited at n. 2.

Additional Analysis

The importance of this decision presents a challenge to reduce the essential parts of the 30-page decision to a length befitting a short blog post, but the next section of the opinion can be broken down into three categories that the interested reader can turn to the full opinion to read. Due to the fact that the Delaware LLC Act is based on a uniform act, and is also related to similar alternative entity statutes, the Court reasoned that: "A context-free reading of those provisions risks a content-skewed result." Thus, the Court considered the following inquiries: "(i) how parallel provisions of other alternative entity statutes have been interpreted; (ii) the source and development of the alternative entity derivative standing provisions; and (iii) whether enforcing the plain meaning of Section 18-1002 would create an absurd result at odds with the overarching purpose and framework of the LLC Act.

Each of the above lines of inquiry, resulted in support for interpreting Section 18-1002 as an exclusive provision that limits derivative suits to LLC members and assignees. This part of the Court’s opinion provides a history lesson that cites to court decisions and commentary as far back as the 1800s, and cites as well to modern learned commentary from the leading experts in the field of alternative entities, including our "blog friend", Professor Larry Ribstein.

Footnote 9 stores a treasure trove of citations to reference manuals on grammar and writing styles supporting the active voice, as compared to passive, as a preferred method to avoid ambiguity in both statutory drafting and other writing contexts.

As part of its statutory analysis, the Court rejected CML’s argument that the corporate analogy should be used, and emphasized that: "As a threshold matter, there is nothing absurd about different legal principles applying to corporations and LLCs."

Multiple references to sections of the LLC Act that appear designed to specifically protect the interests of creditors, bolstered the Court’s reasoning that its conclusion did not leave creditors without protection. Indeed, a substantial portion of the Court’s opinion was devoted to a recitation of the many opportunities and legal rights that the law provides in general to creditors to protect their interests, both through private ordering and many other direct causes of action available to them. See generally Ross Hldg. &  Mgmnt. Co.. v. Advance Realty Gp., Inc., 2010 WL 3448227, at *6 (Del. Ch. Sept. 2, 2010)(referring to Chancery’s "general equity powers" as a basis to have a receiver appointed for an LLC)

Conclusion

In addition to the foregoing reasons, the Court concluded the justification for its holding by noting that the result  "fulfills the contractarian spirit" of the LLC Act. Based on the dismissal of the derivative claims, CML was left with a claim for money damages only, which the Court of Chancery does not have jurisdiction over. Thus, the plaintiff needed to transfer the case to Delaware’s trial court of general jurisdiction, the Superior Court, pursuant to Section 1901 of Title 10 of the Delaware Code.

SUPPLEMENTProfessor Larry Ribstein, the country’s leading scholar on alternative entities, whose scholarship was cited many times by the Court in this case, provides an insightful analysis of the opinion here.