Of the. Bankruptcy Rulings Educate on Creditors’ Rights to Sue | Proskauer Rose LLP


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

In these circumstances, creditors might consider sending a letter to the board to convince directors to pivot 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 social form of the borrower. A creditor’s right to sue the directors of the company varies depending on whether the borrower is incorporated 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 breach of fiduciary duty or otherwise pursue derivative claims on behalf of the LLC.

state law

First, we provide a brief refresher on the basics before unpacking the different rules for corporations versus LLCs.

Fiduciary obligations are governed by the state of incorporation. We focus on Delaware law because of the prevalence of corporations formed in Delaware and the fact that other states have laws substantially identical to Delaware law.

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

First, directors have fiduciary duties to the corporation and its shareholders. [2]

Second, when a company is solvent, these obligations can be enforced by the shareholders of the company by bringing a so-called derivative action, distinct from a direct action, where the shareholders sue on behalf of the company because they are the beneficiaries. ultimate growth and added value. [3]

A derivative lawsuit allows a shareholder to sue on behalf of the company for harm caused to the company. [4]

The creditors of a solvent company cannot enforce the obligations of the directors. Instead, creditors are protected by contracts, fraudulent conveyance law, bankruptcy law, general commercial law, and other sources of creditor rights, and those rights do not change when a business enters the insolvency zone. [5]

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

Therefore, creditors of an insolvent corporation also have standing to maintain derivative claims against the directors on behalf of the corporation for breaches of fiduciary duty. The insolvency of the company makes the creditors the main constituency harmed by any fiduciary breach that diminishes the value of the company. [7]

But the form of the legal person is important. While the Gheewalla Court’s analysis is straightforward in the corporate context, its application in the LLC context is more complicated.

The distinction is based on the Delaware Limited Liability Corporations Act. 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 is permitted to bring a derivative action on behalf of the LLC.

In CML V LLC against Bax in 2011, [8] the Delaware Supreme Court squarely 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 the right to bring a derivative action created an absurd distinction between insolvent corporations, where creditors can bring a derivative action, and in the context of insolvent LLCs , where they cannot.[9]

The Delaware Supreme Court flatly denied the creditors’ claim and ruled that the language of the LLC Act was unambiguous. [10] Applying the law, the Delaware Supreme Court held that “only LLC members or assignees of LLC interests have standing to bring a derivative action on behalf of an LLC – creditors do not” . [11]

The court rejected the argument that the Delaware legislature merely intended to restate the wording of Section 327 of the Delaware General Corporations Act, which the court found did not prevent creditors from insolvent corporations to have derivative status. [12]

He concluded that the legislature intended to limit derivative status to members and assignees of the LLC. [13]

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

Accordingly, an LLC’s creditors do not have standing to sue the directors or officers for any breach of fiduciary duty, even when the LLC is insolvent.

Bankruptcy Background

The Bax decision and the LLC Act were applied in the context of Chapter 11 where Delaware bankruptcy courts ruled that individual creditors and committees of unsecured creditors cannot assert derivative claims to pursue claims on behalf of LLC debtors.

In In re: Dura Automotive Systems LLC in 2021, [15] the United States Bankruptcy Court for District of Delaware argued that

the committee is not a member of the LLC Debtors or an assignee of any LLC interest and, therefore, does not have standing to bring any derivative action on behalf of the LLC Debtors under the Delaware Limited Liability Companies Act .

In In re: HH Liquidation LLC in 2018, [16] the Delaware District Bankruptcy Court held that “[c]The committee does not have standing to prosecute breach of fiduciary duty claims on behalf of a debtor that is a limited liability company. »

In In re: PennySaver USA Publishing LLC in 2018, [17] the Delaware District Bankruptcy Court held that “[c]the writers of an LLC do not have standing to bring a derivative action for breach of fiduciary duty against an LLC, even if it is insolvent.”

In In re: Citadel Watford City Disposal Partners LP in 2019, [18] the Delaware District Bankruptcy Court held that “the committee’s derivative claims asserted … on behalf of the [debtor LP] shall be dismissed” under Delaware’s limited partnership law, which contains “permanent provisions virtually identical” to 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 Delaware District Bankruptcy Court held that a Chapter 7 trustee, unlike an individual creditor or a creditors’ committee, is “the sole representative of the estate entitled to sue and be sued” and has standing to defend the interests of the estate, whether the claims are direct or derivative in nature.

Recent Case: Eector County Energy Center LLC

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

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

  • Avoid a $75 million debt allegedly incurred for little value on the eve of bankruptcy when the debtor was insolvent;
  • Recover damages for insider breaches of fiduciary duty; and
  • Avoid insider preferences

Their real objective appeared to be an attempt to derail the debtor’s proposed reorganization plan since it was proposing to grant releases to these parties.

The plaintiff creditor argued that its standing to pursue derivative claims is governed by the Bankruptcy Code and federal common law, and not by the LLC law of the State of Delaware. He argued that LLC law deals with derivative actions in Delaware court on behalf of an LLC.

Here, the creditor argued that he was seeking permission under the equitable powers of the bankruptcy court to act on behalf of the bankruptcy estate and to stand in for the trustee under the Code of bankruptcies and in bankruptcy court.

But in vain. On August 17, 2002, in an unwritten bench decision denying the petition, the bankruptcy court ruled that creditors were barred from asserting derivative claims on behalf of a Delaware LLC under the LLC Act , which only permits the pursuit of such claims by members of the LLC. or their heirs.

The bankruptcy court also rejected the argument that the bankruptcy code and applicable law United States Court of Appeals for the Third Circuit the case superseded Delaware law.

Finally, the bankruptcy court, like the Gheewalla court, determined that creditors had other adequate avenues to seek relief, including the appointment of a Chapter 11 trustee or the conversion of the case from Chapter 11 in a Chapter 7 case.

Convenient to take

Form can trump substance.

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

There may still be other ways for creditors to enforce 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 Rulings Instruct on Creditors’ Rights to Sue » Law360.

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

[2] Identifier. at 99.

[3] Identifier. at 101.

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

[5] Identifier. at 99.

[6] Identifier. at 101-102.

[7] Identifier.

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

[9] Identifier. at 1043.

[10] Identifier.

[11] Identifier.

[12] Identifier. at 1042.

[13] Identifier. at 1042-43.

[14] Identifier. at 1043.

[15] No. 19-12378 (KBO) (Bankr. D. Del. June 9, 2020).

[16] 590 BR 211, 283–85 (Bankr. D. Del. 2018).

[17] 587 BR 445, 467 (Bankr. D. Del. 2018).

[18] 603 BR 897, 903–05 (Bankr. D. Del. 2019).

[19] 548 BR 410, 413 (Bankr. Del. 2015).

[20] Ch. 11 Cases. NOPE. 22-103320(JTD) (D.Del. 2022).

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