Delaware bans LLC creditor derivative suits

Larry Ribstein —  6 September 2011

On Friday the Delaware Supreme Court decided the important case of CML V, LLC v. Bax (see Francis Pileggi’s helpful summary).

The court, per CJ Steele, held that a creditor lacks standing to sue an insolvent LLC derivatively.  The court reasoned that when the Delaware LLC Act says in §18-1002 that a plaintiff in an LLC derivative suit “must be a member or an assignee of a limited liability company,” it really and unambiguously means that he “must be a member or an assignee of a limited liability company.” Not a creditor.

Plaintiff argued that the Delaware statute refers only to member/assignee suits authorized by §18-1001 and does not preclude all creditor derivative suits.  This argument, draws force from N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007), which said that creditors of an insolvent corporation could sue derivatively under similarly phrased §327 of the DGCL. Plaintiff also insisted that it would be absurd to distinguish between LLCs and corporations.

CJ Steele responded that while the DGCL is limited to a shareholder-instituted derivative suit, Delaware §18-1002 refers to “a derivative suit.”  Also, while §18-1001 says that a a member or assignee “may” bring a derivative suit, §18-1001 says the plaintiff “must” be a member or an assignee, thereby calling attention to mandatory nature of §18-1002.

As to the plaintiff’s absurdity argument, here’s the opinion gets interesting (footnotes omitted):

[T]he 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 standing. The General Assembly is well suited to make that policy choice and we must honor that choice. In this respect, it is hardly absurd for the General Assembly to design a system promoting maximum business entity diversity. Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.

Moreover, in the LLC context specifically, the General Assembly has espoused its clear intent to allow interested parties to define the contours of their relationships with each other to the maximum extent possible. It is, therefore, logical for the General Assembly to limit LLC derivative standing and exclude creditors because the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests. because there’s no difference in this respect between LLCs and corporations.

So this opinion reinforces developing Delaware law highlighting the LLC’s nature as a contractual entity, in contrast to the regulatory nature of the corporation.  Indeed, as I point out in my Rise of the Uncorporation (p. 6):

Uncorporations are characterized by their reliance on contracts. This is an aspect of uncorporations’ partnership heritage, as partnerships are contracts among the owners. * * * In contrast, corporate law is mainly couched in mandatory terms. * * * [T]he corporation’s special regulatory nature emerged from its historical roots. The corporation initially was a vehicle for government enterprises, monopolies, or franchises.

The CML opinion also carefully responded to plaintiff’s argument that this holding strips the Chancery Court of equitable jurisdiction to deal with injustice, in violation of the Delaware constitution. The court reasoned that the constitution freezes equity’s jurisdiction as of 1792, a time when LLCs didn’t exist.  The court went on to explain (footnotes omitted):

[T]he General Assembly passed the LLC Act as a broad enactment in derogation of the common law, and it acknowledged as much. Consequently, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, courts must look to the LLC Act because it is only the statute that creates those rights, remedies, and obligations.

Although the LLC statute provides that equity supplements its express provision, this refers only to rights and remedies the statute doesn’t address. On the other hand,

if the General Assembly has defined a right, remedy, or obligation with respect to an LLC, courts cannot interpret the common law to override the express provisions the General Assembly adopted.

The court points out that the creditor plaintiff’s exclusive redress in this situation is to contract for protection, and notes a variety of contractual terms that could have addressed the problem in this case.

This is a significant opinion because of its bluntness.  The basic point is that the legislature has decreed that LLCs are about contracts, so LLCs, unlike corporations, are freed from the sort of mandatory interference by Chancery that the constitution provides for corporations. In short, LLCs can opt out of litigation; corporations can’t.

This is wholly consistent with the central point of my Uncorporation and Delaware Indeterminacy, which surveys in detail Delaware uncorporation law and contrasts it with Delaware corporate law.

It’s also consistent with CJ Steele’s 2007 article, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies.  There he criticized his predecessor’s opinion in the Gotham case, which suggested that fiduciary duties are unwaivable, noting:

The supreme court apparently found it difficult to abandon the view that judicial oversight of disputes within the governance structure of limited liability unincorporated entities must invariably be from the perspective of a set of freestanding non-waivable equitable principles, drawn from the common law of corporate governance.

The Delaware legislature later fixed the Gotham court’s mistake, and CJ Steele has made clear ever since that the legislature meant what it said.  In this case he settles the potential constitutional impediment.

Interestingly, the Supreme Court’s reasoning in this case eschewed the more elaborate reasoning of VC Laster in this case, analyzed here. Although the Vice Chancellor reached the same result, he included an extensive analysis of how the LLC act differs from the corporate act in protecting creditors, thereby making the creditor derivative suit unnecessary. CJ Steele implies that it doesn’t matter whether the LLC Act includes effective substitute remedies.  It’s enough that the legislature has spoken and left creditors to their contracts.

Finally, it’s worth concluding the same way I did in my earlier post on this case by contrasting the clear and predictable approach in the Delaware courts with the

chaotic and unprincipled case law on LLCs in the supposedly commercially sophisticated New York, which I’ve discussed in several posts, as noted here. Among other sins, New York courts constructed an LLC derivative remedy out of nothing, and then had to make up the rest of LLC derivative suit law out of a whole cloth. In CML, VC Laster combined scholarly analysis and business sophistication in an opinion that gives contracting parties and later courts plenty of guidance.”

CJ Steele makes it even clearer:  There is no derivative remedy for LLCs in Delaware other than that provided for in the statute. Moreover, the parties to LLCs must look to their contracts.  If they want a court to fill in the blanks for them, they should have been a corporation, or an LLC in some other state.

Larry Ribstein

Posts

Professor of Law, University of Illinois College of Law

Trackbacks and Pingbacks:

  1. Delaware Supreme Court Affirms: Creditors Have No Right to Derivative Suit in LLC Context - September 6, 2011

    […] Professor Larry Ribstein, one of the country's foremost experts on LLCs, provides a scholarly and thorough analysis of this important decision here. […]