Creditors of distressed businesses are often frustrated by shareholder-controlled boards when directors pursue strategies that appear designed to benefit shareholders at creditors’ expense.
In these circumstances, creditors might consider sending a letter to the board to convince the directors to change and adopt alternative strategies or face the risk of liability for breach of fiduciary duties.
The effectiveness of this approach depends on many factors, including the financial condition of the company, the composition of the board of directors and the underlying transactions involved.
But, to the surprise of many, the approach also depends on the corporate form of the borrower. The right of a creditor to sue the directors of the company depends on whether the borrower is incorporated as a corporation or as a limited liability company.
As explained below, creditors of an LLC, even if it is insolvent, cannot sue the directors, known in the LLC context as managers, for breach of fiduciary duties or otherwise bring derivative claims on behalf of the LLC. the LLC.
First, we provide a quick refresher on the basics before breaking down 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 substantially 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: 
First, the directors have fiduciary duties to the corporation and its shareholders. 
Second, when a corporation is solvent, those obligations can be enforced by the corporation’s shareholders by bringing a derivative action, as opposed to a direct action, where the shareholders sue on behalf of the corporation because they are the beneficial owners of the corporation. corporation. growth and higher value. 
A derivative lawsuit allows a shareholder to bring a lawsuit on behalf of the corporation for damages caused to the corporation. 
The creditors of a solvent corporation cannot enforce the duties of the directors. 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. 
Third, when a corporation is insolvent, its creditors take the place of shareholders as residual beneficiaries of any increase in value. 
Accordingly, creditors of an insolvent corporation are also entitled to maintain derivative claims against the directors on behalf of the corporation for breach of fiduciary duties. The insolvency of the corporation makes creditors the main group harmed by any fiduciary default that diminishes the value of the company. 
But the form of corporate entity matters. While the Gheewalla court’s analysis is straightforward in the context of corporations, applying it in the context of LLCs is more complicated.
The distinction revolves around the Delaware Limited Liability Company Law. Section 18-1001 creates a legal right for LLC members and their assigns to bring a derivative action on behalf of an LLC.
Section 18-1002 further provides that no party other than a member or assignee may bring a derivative action on behalf of the LLC.
In CML V LLC v. Bax in 2011,  The Delaware Supreme Court directly addressed the differences between corporations and LLCs when a creditor of an insolvent LLC brought a derivative action against the directors of the LLC.
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.
The Delaware Supreme Court flatly rejected the creditors’ claim, holding that the language of the LLC Act is unambiguous.  In applying the statute, the Delaware Supreme Court held that “only LLC members or assignees of LLC interests have a derivative right to sue on behalf of an LLC; creditors do not.” 
The court rejected the argument that the Delaware Legislature merely intended to rephrase the language of Section 327 of the Delaware General Corporation Law, which the court had determined does not prevent creditors of insolvent companies from having derivative rights. 
It concluded that the legislature intended to limit the derivative position to members and assignees of the LLC. 
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 sophisticated freedom of contract between parties. 
As a result, creditors of an LLC do not have the right to sue the directors or managers for any breach of fiduciary duties, even when the LLC is insolvent.
The Bax decision and the LLC Act have been applied in the context of Chapter 11, where Delaware bankruptcy courts have held that individual creditors and committees of unsecured creditors cannot assert derivative claims to prosecute claims on behalf of the debtors of the LLC.
In In re: Dura Automotive Systems LLC in 2021,  the US 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, therefore, lacks standing under the Delaware Limited Liability Company Law to bring a derivative claim on behalf of the LLC debtors. the LLC.
In In re: HH Liquidation LLC in 2018,  The bankruptcy court for the District of Delaware held that “[c]The committee has no standing to pursue 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,  The bankruptcy court for the District of Delaware held that “[c]The drafters of an LLC do not have the right to bring a claim arising from a breach of fiduciary duty against an LLC, even if it is insolvent.”
In In re: Citadel Watford City Disposal Partners LP in 2019,  the bankruptcy court for the District of Delaware held that “the claims arising from the Committee asserted … on behalf of the [debtor LP] must be dismissed” under Delaware’s limited partnership law, which contains “practically identical provisions in effect” to the LLC Law.
At least one decision has distinguished creditors and committees from a Chapter 7 trustee.
In In re: Golden Guernsey Dairy LLC in 2015,  The bankruptcy court for the District of Delaware held that a Chapter 7 trustee, unlike an individual creditor or committee of creditors, is “the sole representative of the estate with the authority to sue and be sued” and has the ability to defend the assets. estate interests, whether the claims are direct or derivative in nature.
Recent Case: Ector County Energy Center LLC
Creditors in a recent bankruptcy case  tried a different tactic to get around the state law limitation on a creditor’s derivative ability to sue on behalf of a Delaware LLC.
In the Ector Chapter 11 case pending in Delaware, the debtor’s largest unsecured creditor applied for standing to bring 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 internal breaches of fiduciary duties; Y
- Avoid internal preferences
Its real objective seemed to be an attempt to derail the debtor’s proposed reorganization plan, 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. He argued that the LLC statute addressed derivative actions in Delaware court on behalf of an LLC.
Here, the creditor argued that he was seeking authority under the equitable powers of the bankruptcy court to act on behalf of the bankruptcy estate and to put himself in the place of the trustee under the Bankruptcy Code and in the bankruptcy court.
But it was in vain. On August 17, 2002, in an unwritten court 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 are pursued by LLC members. or their successors.
The bankruptcy court also rejected the argument that the Bankruptcy Code and the applicable US Court of Appeals for the Third Circuit case invalidated the Delaware statute.
Ultimately, the bankruptcy court, like the Gheewalla court, found that the creditors had other adequate means of obtaining legal relief, including the appointment of a Chapter 11 trustee or the conversion of the Chapter 11 case to a case under Chapter 7.
Form can triumph over substance.
Creditors of a Delaware LLC cannot assert derivative claims on behalf of an LLC, including claims against managers for breach of fiduciary duties and, after bankruptcy, fraudulent transfer claims.
There may still be other ways for creditors to assert these claims on behalf of the LLC, but doing so derivatively is not one of them.
Reproduced with permission. Originally published September 2022, “Del. Bankruptcy Resolutions Instruct Creditors’ Rights to Sue” Law360.
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