Creditor derivative suits in Delaware LLCs

Cite this Article
Larry Ribstein, Creditor derivative suits in Delaware LLCs, Truth on the Market (November 07, 2010),

The ever-helpful Francis Pileggi thoroughly discusses an interesting and important recent Delaware opinion by VC Laster, CML V, LLC v. Bax, C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010) which holds a creditor lacks standing under the Delaware LLC act to sue an insolvent LLC derivatively.  The following builds on Mr. Pileggi’s excellent analysis.

The court interpreted Section 18-1002 of the Delaware LLC Act, which provides:

In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and: (1) At the time of the transaction of which the plaintiff complains; or (2) The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction.

Seems simple doesn’t it?  The section says “the plaintiff must be a member or an assignee. . . ”

But almost nothing’s simple in the world of litigation. Plaintiff creditor, neither a member nor an assignee, argued that the court should borrow principles from Delaware corporate law.  That law lets creditors sue derivatively (see N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007)) under statutory language (Section 327 of the DGCL) which applies to a “derivative suit instituted by a stockholder. . . ” This language technically leaves open whether a derivative suit may be brought other than by a stockholder subject to different rules.

The court noted that the Delaware LLC statute borrowed wording from the LP statute and that a “leading treatise” interpreted that statute as giving exclusive standing to limited partners, citing, of course, Bromberg & Ribstein.  

The plaintiff mainly argued the court should ignore the plain language because it “generates an absurd distinction between insolvent corporations, where creditors can sue derivatively, and insolvent LLCs, where they cannot.”  But the court wisely responded:

“Because the conceptual underpinnings of the corporation law and Delaware’s [alternative entity] law are different, courts should be wary of uncritically importing requirements from the DGCL into the [alternative entity] context.” Twin Bridges Ltd. P’ship v. Draper, 2007 WL 2744609, at *19 (Del. Ch. Sept. 14, 2007). 

More importantly, the court went on to show why the LLC act should be interpreted differently: because of its policy of leaving parties to the protection of their contracts.  As Kelli Alces and I have noted, this policy is particularly applicable to creditors, who

The most defensible distinction between debt and equity interests is that, given the open-endedness of the residual claim, it is inherently more difficult for equity holders to contractually specify duties than for debt holders. Although shareholders have contracting options, such as terms that specify the firm’s obligations to pay dividends, standard-form credit and equity contracts differ regarding specificity of duties. This matters for fiduciary duties because a strong duty of loyalty is appropriate only when the agent delegates open-ended discretion to the principal. The creditors are better left to flexible enforcement of specific contract terms than broad fiduciary remedies.

Ribstein & Alces, Directors’ Duties in Failing Firms, 1 J. Bus. & Tech. L. 529, 536 (2007) (SSRN).

VC Laster pointed out various ways the LLC act facilitates contractual protection of creditors, including by a provision in the operating agreement and by using the series LLC provisions to supplement security interests in specific assets.  He also observed that Section 502(b) of the LLC act lets an LLC creditor enforce a member’s contribution obligation.  The court said this creditor right gave rise to the trust fund doctrine, and in turn to the creditor derivative action.  Thus, says the court, “[b]y addressing the germ from which the analogous corporate creditor derivative action grew, the LLC Act removes the impetus for a similar experiment with LLCs.” 

The most striking thing about this scholarly opinion is its clear contrast 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.