Del. Bankruptcy Rulings Instruct on Creditors' Rights to Sue

Creditors of distressed businesses are often frustrated by shareholder- controlled boards when directors pursue strategies that appear to be designed to benefit shareholders at the creditors' expense.

In these circumstances, creditors might consider sending a letter to the board to convince the directors to pivot and adopt alternative strategies or face risk of liability for breaching fiduciary duties.

The efficacy of this approach depends on many factors, including the company's financial condition, the board's composition and the underlying transactions at issue.

But, to the surprise of many, the approach is also dependent on the corporate form of the borrower. A creditor's right to sue the company's directors depends on whether a borrower is formed as a corporation or a limited liability company.

As explained below, creditors of an LLC, even an insolvent one, cannot sue directors — known in the LLC context as managers — for breaching fiduciary obligations or otherwise pursue derivative claims on the LLC's behalf.

State Law

First, we provide a quick refresher on basic principles before we unpack the different rules for corporations versus LLCs.

Fiduciary duties are governed by the state of formation. We focus on Delaware law because of the prevalence of companies formed in Delaware and the fact that other states have adopted laws that are substantively identical to Delaware law.

Here are three critical takeaways from the Delaware Supreme Court's landmark decision in North American Catholic Educational Programming Foundation Inc. v. Gheewalla in 2007: [1]

First, directors owe fiduciary obligations to the corporation and its shareholders. [2]

Second, when a corporation is solvent, those obligations may be enforced by the corporation's shareholders by bringing a so-called derivative action, as distinct from a direct action, where the shareholders sue on the corporation's behalf because they are the ultimate beneficiaries of the corporation's growth and increased value. [3]

A derivative suit enables a shareholder to bring a suit on behalf of the corporation for harm done to the corporation. [4]

Creditors of a solvent corporation cannot enforce the directors' duties. Instead, creditors are protected by contracts, fraudulent transfer law, bankruptcy law, general commercial law and other sources of creditor rights, and these rights do not change when a company enters the zone of insolvency. [5]

Third, when a corporation is insolvent, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value. [6]

Consequently, the creditors of an insolvent corporation also have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation's insolvency makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value. [7]

But the form of corporate entity matters. While the Gheewalla court's analysis is straightforward in the context of corporations, applying it in the LLC context is more complicated.

The distinction turns on the Delaware Limited Liability Company Act. Section 18-1001 creates a statutory right for LLC members and their assignees to bring a derivative action on behalf of an LLC.

Section 18-1002 provides further that no party other than a member or assignee is permitted to bring a derivative action on behalf of the LLC.

In CML V LLC v. Bax in 2011, [8] the Delaware Supreme Court squarely addressed the differences between corporations and LLCs when a creditor of an insolvent LLC brought derivative action against the LLC's directors.

The court also argued that denying an LLC creditor standing to sue derivatively created an absurd distinction between insolvent corporations, where creditors can sue derivatively, and in the context of insolvent LLCs, where they cannot.[9]

The Delaware Supreme Court squarely rejected the creditors' claim and held that the language of the LLC Act is unambiguous. [10] Applying the statute, the Delaware Supreme Court held that "only LLC members or assignees of LLC interest have derivative standing to sue on behalf of an LLC — creditors do not." [11]

The court rejected the argument that the Delaware Legislature merely intended to rephrase the language of Section 327 of the Delaware General Corporate Law, which the court had determined does not bar creditors of insolvent corporations from derivative standing. [12]

It concluded that the legislature intended to limit derivative standing to LLC members and assignees. [13]

The court rejected the argument that this rule created an absurd distinction between corporations and LLCs on the grounds that an LLC is inherently designed to be more flexible than a corporation and to reflect the freedom of contract between sophisticated parties. [14]

As a result, creditors of an LLC lack standing to sue directors, or managers, for any breach of any fiduciary duties even where the LLC is insolvent.

Bankruptcy Context

The Bax decision and LLC Act have been applied in the Chapter 11 context where Delaware bankruptcy courts have held that individual creditors and unsecured creditors' committees cannot assert derivative claims to prosecute claims on behalf of LLC debtors.

In In re: Dura Automotive Systems LLC in 2021, [15] the U.S. Bankruptcy Court for the District of Delaware held that

the committee is not a member of the LLC debtors or an assignee of an LLC interest and, thus, lacks standing under the Delaware Limited Liability Company Act to bring a derivative suit on behalf of the LLC debtors.

In In re: HH Liquidation LLC in 2018, [16] the District of Delaware bankruptcy court held that the "[c]ommittee does not have standing to pursue the breach of fiduciary duty claims on behalf of any Debtor that is a limited liability company."

In In re: PennySaver USA Publishing LLC in 2018, [17] the District of Delaware bankruptcy court held that "[c]reditors of an LLC have no standing to bring a derivative breach of fiduciary duty claim against an LLC even if it is insolvent."

In In re: Citadel Watford City Disposal Partners LP in 2019, [18] the District of Delaware bankruptcy court held that "the Committee's derivative claims asserted ... on behalf of the [debtor LP] must be dismissed" under Delaware limited partnership law, which contains "virtually identical standing provisions" as the LLC Act.

At least one decision has distinguished creditors and committees from a Chapter 7 trustee.

In In re: Golden Guernsey Dairy LLC in 2015, [19] the District of Delaware bankruptcy court held that a Chapter 7 trustee, unlike an individual creditor or creditors' committee is "the sole representative of the estate with the authority to sue and be sued" and has standing to pursue the estate's interest whether the claims are direct or derivative in nature.

Recent Case: Ector County Energy Center LLC

Creditors in a recent bankruptcy case [20] tried a different tactic to skirt the state law limitation on creditor derivative standing to sue on behalf of a Delaware LLC.

In Ector's Chapter 11 case pending in Delaware, the debtor's largest unsecured creditor sought standing to pursue derivative claims on behalf of the LLC debtor's estate to:

Avoid $75 million in debt allegedly incurred for little value on the eve of bankruptcy while the debtor was insolvent;
Recover damages for insider breaches of fiduciary obligations; and
Avoid insider preferences

Their real aim appeared to be an attempt to derail the debtor's proposed plan of reorganization as it proposed to grant releases to these parties.

The plaintiff creditor argued that its standing to prosecute derivative claims is governed by the Bankruptcy Code and federal common law, not Delaware state LLC law. It argued that the LLC statute addressed derivative actions in the Delaware court on behalf of an LLC.

Here, the creditor argued it was seeking authority under the bankruptcy court's equitable powers to act on behalf of the bankruptcy estate and to stand in the shoes of the trustee under the Bankruptcy Code and in the bankruptcy court.

But to no avail. On Aug. 17, 2002, in an unwritten bench decision denying the motion, the Bankruptcy Court held that creditors are prohibited from asserting derivative claims on behalf of a Delaware LLC under the LLC Act, which only allows such claims to be pursued by LLC members or their assignees.

The bankruptcy court also rejected the argument that the Bankruptcy Code and the applicable U.S. Court of Appeals for the Third Circuit case overrode the Delaware statute.

Finally, the bankruptcy court, like the court in Gheewalla, determined that the creditors had other adequate means of seeking legal redress, including seeking the appointment of a Chapter 11 trustee or having the Chapter 11 case converted to a case under Chapter 7.

Practical Takeaway

Form can trump substance.

Creditors of a Delaware LLC cannot assert derivative claims on behalf of an LLC, including claims against managers for breach of fiduciary obligations and, after a bankruptcy filing, fraudulent transfer claims.

There may yet be other ways for creditors to assert these claims on the LLC's behalf, but doing it derivatively is not one of them.

Reproduced with permission. Originally Published September 2022, "Del. Bankruptcy Rulings Instruct on Creditors' Rights to Sue" Law360.

[1] 930 A.2d 92 (Del. 2007).

[2] Id. at 99.

[3] Id. at 101.

[4] Tooley v. Donaldson, Lufkin & Jennette, Inc., 845 A. 2d. 1031, 1036 (Del. 2004).

[5] Id. at 99.

[6] Id. at 101-102.

[7] Id.

[8] 28 A. 3d 1037 (Del. 2011).

[9] Id. at 1043.

[10] Id.