Derivative Claims Against Directors Of An Insolvent Delaware Corporation. With its 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. To read that decision, click on the case name in the prior sentence. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency."

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation’s directors, but a question remained: Would that same ruling extend to managers of Delaware limited liability companies, the LLC equivalent of a corporation’s directors. Although a number of commentators and some court decisions assumed that it would, a recent Delaware Chancery Court decision has answered the question, somewhat surprisingly, with a decisive "no."

New Chancery Court Ruling. In the new decision, CML V, LLC v. Bax, C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010), the Delaware Chancery Court undertook an extensive analysis of the Delaware LLC Act and also examined the issue more broadly.

  • The Court held that under the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, only LLC members and their assignees have standing to bring derivative claims because the LLC Act provides that only they are "proper plaintiffs." The LLC Act does not give an insolvent LLC’s creditors standing to bring derivative claims. The situation is different for creditors of insolvent corporations because the governing Delaware corporation statutes do not impose exclusive derivative standing provisions.
  • Although the Chancery Court acknowledged that arguments could be made for allowing creditors to bring derivative actions against managers of an insolvent LLC, the Court saw no reason to set aside the literal reading of the LLC Act’s standing provision. The Court also noted that the Delaware Limited Partnership Act has a similar exclusive standing provision.

For a full discussion of the decision, including a link to the opinion itself, be sure to read Francis G.X. Pileggi’s excellent post entitled "Chancery Bars Derivative Claim of Creditor Against Insolvent LLC, Based on LLC Act."  

Impact On An Insolvent LLC’s Creditors. So where does this new decision leave creditors of an insolvent Delaware LLC?

  • Under the Chancery Court decision, unlike directors of a Delaware corporation, managers of a Delaware LLC are not be subject to derivative claims by creditors if the entity becomes insolvent. 
  • If the decision is followed by other courts – specifically including bankruptcy courts where claims involving managers of bankrupt LLCs may more often be litigated — then an insolvent LLC’s creditors will not have access to potential D&O type claims. Instead, those creditors will have to rely on contractual remedies against the LLC to protect themselves. 

Stay Tuned. As noted, the bankruptcy court is often the forum where insolvency-related matters are litigated. Should these claims be pursued outside of the Chancery Court, it will be interesting to see how other courts interpret the Delaware LLC Act’s provisions.