Creditors of a Delaware LLC Do Not Have Standing to Sue Derivatively and Must Rely on Contractual Remedies
The Delaware Supreme Court recently affirmed the Delaware Chancery Court’s opinion in CML V, LLC v. Bax, 6 A.3d 238 (Del. Ch. 2010), holding that the Delaware Limited Liability Company Act (the “Act”) does not confer derivative standing on creditors to sue for breaches of fiduciary duties. CML V, LLC v. Bax, C.A. No. 5373, 2011 WL 3863132 (Del. Sept. 2, 2011).
Specifically, the Delaware Supreme Court determined that the Act plainly and unambiguously limits derivative standing to “members” of, and “assignees” of, a limited liability company interest in a Delaware limited liability company (a “LLC”).1 The Delaware Supreme Court explained that it “may be correct that in insolvency creditors become the ultimate risk earers in LLCs,” but nevertheless concluded that “the General Assembly is free to elect a statutory limitation on derivative standing for LLCs that is different than that for corporations, and thereby preclude creditors from attaining [derivative] standing,” given the distinction between corporations and LLCs, and the fact that “the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests.” Unless the Delaware General Assembly acts to amend the Act to expressly confer derivative standing on creditors of a Delaware LLC, therefore, such creditors must resort to contractual remedies to protect their interests. According to the Delaware Supreme Court, a creditor may: (i) "negotiat[e] [an] automatic assignment of membership interests upon insolvency” of the LLC and “requir[e] the members and governing board to amend the LLC agreement accordingly”; (ii) “negotiate for a provision that would convert its interests to that of an ‘assignee’ in the event of insolvency”; and (iii) “negotiate for a term that would give [the creditor] control of the LLC’s governing body in [the] event [of insolvency]….”
Although not expressly affirmed by the Delaware Supreme Court, the Delaware Court of Chancery further suggested that: (i) “creditors [may] bargain for penalties and consequences for members upon the occurrence of specific events or if creditors’ rights are breached”; (ii) creditors may become parties to the LLC’s limited liability company agreement and cause such agreement to “provide for duties triggered by insolvency that would include an obligation to preserve assets for creditors”; and (iii) creditors may negotiate for a provision of the limited liability company agreement of the LLC or another agreement whereby the managers or members agree to be “obligated personally for any or all of the debts of, obligations and liability” of the LLC as permitted by Section 18-303(b) of the Act.2
Because the Act is based on the Delaware Revised Uniform Limited Partnership Act, which similarly confers derivative standing solely upon “partner[s]” and “assignee[s] of a partnership interest,” it can be inferred from the Delaware Supreme Court’s decision that creditors of a limited partnership similarly lack standing to pursue derivative actions on behalf of the limited partnership.
1The Delaware Supreme Court also rejected plaintiff’s argument that Section 18-1002 of the Act unconstitutionally restricts the Delaware Court of Chancery’s equitable jurisdiction and stated that “[a]lthough the Delaware Constitution prohibits the General Assembly from limiting the Court of Chancery’s jurisdiction over the extension of corporate derivative standing in the interests of justice, this case deals not with a corporation but with a statutorily created LLC — a business entity that did not exist in 1792 [when the Delaware Constitution was adopted]. Therefore, nothing in the Delaware Constitution precludes the General Assembly from limiting the scope of LLC derivative standing in 6 Del. C. § 18-1002 to LLC ‘member[s]’ or assignees.”
2The Court of Chancery suggested that such “provision[s] c[an] be used in lieu of or to supplement personal guarantees for a particular debt.”