Delaware Single Member LLC Opinions (What are they and why do I need one?)

This post was prepared by Steven D. Goldberg, a Delaware attorney who regularly practices in the area of limited liability companies and limited liability company opinions (sgoldberg@stevendgoldberg.com)

A large portion of our practice involves the delivery of Delaware single member LLC opinions and authority to file bankruptcy opinions in connection with CMBS, Freddie Mac and Fannie Mae loans. The single member opinion has a customary form among experienced Delaware attorneys. The opinion generally deals with issues relating to the enforcability of the loan documents against the borrower or and guarantor which is a Delaware entity. The CMBS opinions are more limited than the Freddie Mac and Fannie Mae opinions. Both Freddie mac and Fannie Mae have required forms of opinion which must be delivered in connection with the loan. Most of the opinions and form language cannot be modified by the opinion giver. The opinion giver must get comfortable with the required language, some of which is not commonly used in connection with opinions. Fannie and Freddie will ask that they receive an opinion that the loan documents are “duly executed”. The opinion giver must parce the words. Contrary to the usual conclusion, the opinion does not deal with the physical act of signing and does not require an “authenticity” opinion as to the signature. The opinion only provides that the signer had power and authority to execute the document. Notwithstanding that conclusion, we will seek to take an assumption that all “signatures on the documents are genuine” so as to avoid any later revisionist interpretation in the event of a forgery.

The authority to file bankruptcy opinion is a long, reasoned, opinion dealing with what law will be applied by a bankruptcy court to determine what person or entity has the power to file a petition in bankruptcy on behalf of the borrower. The actual opinion paragraph reads:

  • Based upon the foregoing, and upon our examination of such questions of law and statutes as we have considered necessary or appropriate, and subject to the assumptions, qualifications, limitations and exceptions set forth herein, we are of the opinion that a federal bankruptcy court would hold that Delaware law, and not federal law, governs the determination of what persons or entities have authority to file a voluntary bankruptcy petition on behalf of the Borrower.  Our opinion is based on the assumption that in any case in which this question is considered, the question will be competently briefed and argued.  Our opinion is reasoned and also presumes that any decision rendered will be based on existing legal precedents, including those discussed below.

I say that the opinion is “reasoned” because there is no existing binding law on the subject. The opinion extends to 12 pages.

It is not unusual in our practice to receive a call or email from Borrower’s counsel the week of or several days before closing. The Delaware opinion was on the closing check list from the beginning, but Borrower’s counsel or the Borrower itself hoped that Lender’s counsel would waive the requirement or let Borrower’s counsel to deliver the Delaware opinion. Often the Borrower objects to its counsel spending any more money. For what ever reason it is not unusual to receive the request to deliver the opinion at the last minute.

Traditionally purchasers, lenders and other parties to transaction have requested a legal opinion from the seller/borrower’s counsel that such party exists in good standing under the laws of the jurisdiction in which it is formed and that it has the power and authority to enter into the transaction and perform its obligations under the transaction documents. Other opinions specific to the transaction are often requested. Historically, Delaware attorneys have delivered such opinions respecting Delaware corporations. As the Delaware General Corporation law (DGCL) has become the default “national corporate law” in the US, attorneys not admitted in Delaware have become comfortable with delivering these opinions in certain circumstances and third parties have  also become comfortable with accepting these opinions when delivered by non-Delaware admitted attorneys in certain circumstances. This change has been accelerated by a general belief that the  DGCL as it applies to these opinions is almost completely statutory and that, to the extent that the opinion implicates Delaware Jurisprudence, that information is readily available on electronic services. Delaware corporate opinions given by non-Delaware admitted attorneys are generally limited to Delaware’s DGCL and generally do not implicate contract or other state specific bodies of law.

The trend toward the use of a Delaware limited liability company (DLLC) and particularly the use of a Delaware single member limited liability company (DSMLLC) as the borrower or other vehicle in transactions has changed the opinion landscape. At the present time most rating agencies either require or prefer that the entity serving as the borrower be a DSMLLC. Likewise most lender will require that the borrower be a DSMLLC. The preference or requirement is simple to understand. Delaware has been the leader in the field of limited liability company law; lenders and rating agencies understand their rights under Delaware law and do not necessarily understand or even like their rights under the laws of another jurisdiction. Using a DSMLLC is simpler for the lender and its counsel as it does not have to spend time parcing through another state’s act with which they are not familiar.

As noted earlier in this note, non-Delaware attorneys and their firm’s opinion committees have developed a comfort level in delivering limited Delaware corporate opinions. Opinion committees almost universally deny authority to their firms attorneys to deliver Delaware LLC opinions. An LLC agreement under most state laws is governed by the state’s contract laws. The state LLC act will create a framework of default terms, but the LLC agreement or operating agreement is a specie of contract which is interpreted under state contract law jurisprudence, not just statutory terms. Experienced and responsible attorneys do not deliver legal opinions on contracts subject to the laws of a state in which they are not admitted. That is an invitation to a malpractice case. In some corporate opinions, opinion recipients will permit the opinion giver to assume the laws of the forum state are the same as the laws in the state in which the opinion giver is admitted. However, as the LLC’s agreement or operating agreement are so inextricably tied to Delaware law, few opinion recipients will permit the “same as” assumption and will require that the opinion be delivered by an attorney admitted in Delaware.

The elements of the Delaware Single Member LLC Opinion:

First, the opinion giver will describe the engagement:

We have acted as special Delaware counsel for _______LLC a Delaware limited liability company (the “Company”), solely for the purpose of delivering this opinion in connection with the loan (the “Loan”) made by you to the Company on or about the date hereof. The Loan is secured by the Company’s real property located at ________ (the “Property”).

The term “special Delaware counsel” is understood by the opinion recipient to mean that the engagement is limited as stated in the paragraph. Some judges, however, in jurisdictions where legal opinions are not common have interpreted “special” to be the same as “extremely knowledgeable, of special”

Second, the opinion giver will list the documents which it has reviewed in order to deliver the opinion. Those documents at a minimum include a certified copy of the certificate of formation as filed with the Delaware Secretary of State, Division of Corporations, the limited liability company or operating agreement as in effect as the date of the transaction and a certificate of good standing as issued by the Delaware Secretary of State, Division of Corporations. If the opinion giver is to opine on any documents, such as loan documents, the opinion giver will list the documents reviewed.

Following the list of documents reviewed, the opinion giver will explain that they have not reviewed any other documents or any documents referred to or incorporated into the documents reviewed. The opinion giver will also state whether or not they have conducted any independent factual investigation. Typically the opinion giver will disclaim any responsibility to conduct any such investigation and state that they have relied solely upon such documents in giving the opinion. Delaware counsel is often engaged by the Borrower’s law firm and has not contact whatsoever with the Borrower itself or its principals.

Fourth, the opinion will set out a group of assumption made by the opinion giver in delivering the opinion:

For purposes of this opinion, we have assumed (i) except to the extent provided in paragraph 1 below[ the good standing opinion], that each party to the documents examined by us is duly organized or formed, as the case may be, and validly exists in good standing under the laws of the jurisdiction governing its organization or formation and that each natural person who is a signatory to the documents examined by us have the legal capacity to sign such documents, (ii) except to the extent provided in paragraph 3 below [the opinion that a Delaware Court would conclude that the provisions of the LLC agreement requiring the consent of the Special or Springing Member to the filing of a petition in bankruptcy is enforceable], that each of the parties to the documents examined by us has the power and authority to execute and deliver, and to perform its obligations under, such documents, and (iii) that all of the documents examined by us have been duly authorized, executed and delivered by all parties thereto and that all signatures on such documents are genuine.

Fifth, the opinion giver will define the laws under which the opinion is delivered and what is excluded:

This opinion is limited to the laws of the State of Delaware (excluding the securities and blue sky laws of the State of Delaware), and we have not considered and express no opinion on the laws of any other jurisdiction, including federal laws (including federal bankruptcy law) and rules and regulations relating thereto.  Our opinions are rendered only with respect to Delaware laws and rules, regulations and orders there under that are currently in effect.  In rendering the opinions set forth herein, we express no opinion concerning (i) except as provided in Opinion 4 below [the UCC opinion], the creation, attachment, perfection or priority of any security interest, lien or other encumbrance, or (ii) the nature or validity of title to any property.

The first opinion is generally the “good standing ” opinion. Contrary to general belief, in Delaware, the concept of good standing is not derived from a legal analysis similar to the analysis of fact and law necessary to reach the other opinions delivered. The only way in which a person may determine whether the LLC or any other Delaware registered entity is in good standing is to receive a certificate from the Secretary of State. Good standing means with respect to a LLC that the certificate of formation has been filed and accepted by the Secretary, that no certificate of cancellation has been filed, that no certificate of merger has been filed whereby the LLC is merged out of existence and the LLC tax has been paid in full. With respect to a corporation good standing also includes the filling and paying the fee to file the annual report required of corporations but not LLC’s.

The opinion is in two parts, first: The Company is duly formed as a limited liability company. To give this opinion the opinion giver must review all documents which have been filed with the Division of Corporations. The opinion giver must confirm that the LLC has adopted a LLC agreement. Under Delaware law the LLC agreement may be written, oral or implied. Oral or implied agreements present particular challenges to opinion givers. We will not give an opinion on an oral or implied agreement.

The second part of the first opinion is :

  • Based solely on the Good Standing, the Company exists in good standing as a limited liability company under the laws of the State of Delaware.

Some opinion givers use the phrase “validly exists”, however the Good Standing certificate only states that the LLC “is duly formed under the laws of the State of Delaware and is in good standing and has a legal existence [emphasis added] so far as the records of this office show, as of [the date of the certificate]. “Validly exists” with respect to a Delaware LLC is a meaningless term.

The second opinion is short, however it requires the greatest legal analysis of the LLC agreement. The opinion giver must analyze the entire LLC agreement under both Delaware LLC law and Delaware contract law, to determine that the agreement is valid, binding and enforceable against the member and any special or springing member. Opinion givers do not want to see LLC agreements that contain economic terms such a buy/sell, put/call, employment provisions, etc., as such terms, depending on circumstances and terms may not be “entirely” valid or enforceable and may be subject to various exceptions which the opinion recipient will not want to see in an otherwise “clean” opinion:

  • The LLC Agreement constitutes a legal, valid and binding agreement of the Member, and is enforceable against the Member and the Springing Member, in accordance with its terms.

In most loans today in excess of five million dollars the lender will require that the LLC agreement include a “special member” or “springing member” or “an independent manager or director”. The function of this person is first to avoid the problem under the Delaware Act that he LLC automatically dissolves when it no longer has a member and second this person acts as a second set of eyes with special, enumerated duties in the case of the filing of bankruptcy. There are carve outs from default fiduciary duties. The agreement will require that prior the filing of a petition in bankruptcy the company must receive the unanimous consent of all members, including the special or springing member or the independent manager or director. The opinion recipient will want an opinion that the section of the agreement requiring the consent of the springing member, special member, independent manager or independent director will be enforceable.

  • If properly presented to a Delaware court, a Delaware court applying Delaware law would conclude that (i) for so long as a mortgage lien exists on the Property, in order for a Person to file a voluntary bankruptcy petition on behalf of the Company, the prior written consent of the Springing Member or Special Member, as provided for in Section  __ of the LLC Agreement, is required, and (ii) such provision, contained in Section __ of the LLC Agreement, that requires, for so long as a mortgage lien exists on the Property, the prior written consent of the Springing Member or Special Member in order for a Person to file a voluntary bankruptcy petition on behalf of the Company, constitutes a legal, valid and binding agreement of the Member, and is enforceable against the Member, in accordance with its terms. 

The fourth opinion deals with the issue of charging orders. Charging orders are the traditional manner in which the creditor of a partner in a partnership could charge the interest of the partner in the partnership and receive any distribution to which the debtor would otherwise be entitled under the partnership agreement. Traditionally the judgment creditor could “foreclose” on the charging order so as to sell the interest at sale. This concept has been brought over into section 18-703 of the Delaware Act. The lender is concerned that the creditor may have some right to receive specified property owned by the LLC in discharge of the member’s debt or have the right to foreclose on the LLC interest and to have the LLC interest sold under a judicial or quasi-judicial sale. To resolve those concerns Delaware has created 18-703 (d) and (e):

(d) The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest and attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor, whether the limited liability company has 1 member or more than 1 member.

(e) No creditor of a member or of a member’s assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.

The fourth opinion reads as follows:

  • While under the LLC Act, on application to a court of competent jurisdiction, a judgment creditor of the Member may be able to charge a Member’s share of any profits and losses of the Company and the Member’s right to receive distributions of the Company’s assets (a “Member’s Interest”), to the extent so charged, the judgment creditor has only the right to receive any distribution or distributions to which a Member would otherwise have been entitled in respect of such Member’s Interest.  Under the LLC Act, no creditor of a Member shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the Company.  Thus, under the LLC Act, a judgment creditor of a Member may not satisfy its claims against a Member by asserting a claim against the assets of the Company.

The fifth opinion is generally included, but not in all opinions. The fifth opinion deals with the enforceable of a UCC security interest granted to the secured party. The opinion does not opine on “priority”. If the secured party seeks a priority opinion the will not receive that opinion from a knowledgeable attorney and will be told to purchase a UCC policy from a title insurance company which commonly will insure priority. Some opinion recipients will accept the UCC opinion from the Borrower’s counsel.

  • A valid and enforceable security interest in favor of Lender has been granted by Borrower in the personal property collateral referred to in the Security Instrument (the “Collateral”) to the extent a security interest can be created therein under the Uniform Commercial Code as enacted in the State of Delaware (the “UCC”).  The Delaware Financing Statement is in proper form so as to comply with the filing requirements of the U.C.C.  Upon filing of the Delaware Financing Statement with the Secretary of State, Lender’s security interest in the Collateral will be perfected to the extent a security interest in such Collateral can be perfected by filing in the State of Delaware of UCC-1 financing statements under the UCC.

The sixth opinion implicates  an analysis of Section 18-201(b):

(b) A limited liability company is formed at the time of the filing of the initial certificate of formation in the office of the Secretary of State or at any later date or time specified in the certificate of formation if, in either case, there has been substantial compliance with the requirements of this section. A limited liability company formed under this chapter shall be a separate legal entity, the existence of which as a separate legal entity shall continue until cancellation of the limited liability company’s certificate of formation.

The opinion provides:

  • Under the LLC Act, (i) the Company is a separate legal entity, and (ii) the existence of the Company as a separate legal entity shall continue until the cancellation of the LLC Certificate.

The final opinion generally delivered provides that under the Act and the Agreement, the bankruptcy of the member will not cause the company to dissolve and wind up its affairs.    Section  18-304 deals with the bankruptcy of a member. The section provides that “Unless otherwise provided in a limited liability agreement…” the bankruptcy of a member causes the member to ceases to be a member of the company and then has the status of an “assignee”. The typical agreement for a loan transaction contains savings language which provides generally:

  • Notwithstanding any other provision of this Agreement, no Bankruptcy Action with respect to the Member or a Special Member shall cause the Member or Special Member, respectively, to cease to be a member of the Company and upon the occurrence of such an event, the Company shall continue without dissolution.
  • Notwithstanding any other provision of this Agreement, each of the Member and each Special Member waives any right it might have to agree in writing to dissolve the Company upon a Bankruptcy Action of the Member or a Special Member or the occurrence of an event that causes the Member or a Special Member to cease to be a member of the Company.

The opinion reads:

  • Under the LLC Act and the LLC Agreement, the Bankruptcy or dissolution of the Member will not, by itself, cause the Company to be dissolved or its affairs to be wound up.

While these are the most common opinions, the following are also often given particularly in Freddie Mac and Fannie Mae guaranteed transactions where they are required conditions of their loan commitments:

  • Borrower has the authority under its Operating Agreement to execute, deliver and perform its obligations under the Loan Documents.
  • The execution and delivery of the Loan Documents by or on behalf of Borrower, and the consummation by Borrower of the transactions contemplated thereby, and the performance by Borrower of its obligations there under, have been duly and validly authorized by or on behalf of Borrower.
  • The execution and delivery of, and the performance of the obligations under, the Loan Documents, will not violate the Organizational Documents of Borrower.
  • Based solely upon (a) our knowledge and (b) the Borrower’s Certificate, the execution and delivery of the Assumption Documents will not (i) cause Borrower to be in violation of, or constitute a material default under the provisions of any agreement to which Borrower is a party or by which Borrower is bound, (ii) conflict with, or result in the breach of, any court judgment, decree or order of any governmental body to which Borrower is subject, and (iii) result in the creation or imposition of any lien, charge or encumbrance of any nature whatsoever upon any of the property or assets of Borrower, except as specifically contemplated by the Loan Documents.
  • Based solely upon (a) our knowledge and (b) the Borrower’s Certificate, there is no litigation or other claim pending before any court or administrative or other governmental body or threatened against Borrower, the Mortgaged Property, or any other properties of Borrower, Guarantor or Key Principal, except as identified on Exhibit __. [In all transactions where we deliver an opinion we require that each party upon which we opine delivers to us a General Certificate on our firm’s form which makes factual representations about the party upon which we may rely in delivering the opinion.]
  • Based solely on (a) our knowledge and (b) the Borrower’s Certificate, no authorization, consent, approval, or other action by, or filing with, the State of Delaware or federal court or governmental authority is required in connection with the execution and delivery by Borrower of the Assumption Documents.

 

2014 Delaware LLC Act Amendments

The 2014 Amendments to the Delaware Limited Liability Company Act were adopted by the Delaware General Assembly and became effective August 1, 2014. 2014 LLC Act Amendments The 2014 Delaware LLC Act Amendments are not extensive.

Section 1, amends 18-104(g). Section 18-104(g) requires that each company provide to its registered agent the name, address and business telephone number of a natural person who is either a member, manager, officer, employee or designated agent of the company who is authorized to receive communications on behalf of the registered agent. Since the adoption of 18-104(g) pressure has mounted by governmental agencies, both in the US and abroad for the disclosure of the beneficial owners of LLC’s. The amendment to 18-104(g) now provides that when a request is received by the company from the communications contact, that it shall provide the communications contact with the name, business address and business telephone number of a natural person who has access to the record required to be maintained by 18-305(h), which includes a list of members. While this does not provide the names of the beneficial owners, it does provide law enforcement a natural person to deal with on behalf of the company and a person who has access to the member list. The amendment further defines what is an “electronic transmission” for the purpose of the subsection to avoid arguments that the form of request does not meet the requirements of the statute.

Section 2, amends 18-302(d). This amendment specifically provides that a consent may be given by a member which will have a future effective date.

Section 3, amends 18-305. The amendment to 18-305(a) clarifies that a member, in making a demand for books and records, may do so in person, by an attorney or other agent. Subsection(e) is amended to delete a reference which implied  that only an attorney may make a demand on behalf of the member.  The amendment adds additional language to subsection (e) that a demand made by an attorney or agent must be accompanied by a power of attorney or “such other writing which authorizes the attorney or other agent to so act on behalf of the member.” The amendment adds a new subsection (h) which provides that “A limited liability company shall maintain a current record that identifies the name and last known business, residence or mailing address of each member and manager”. It was subsumed in other sections of the Act that the company must maintain these records, this amendment clarifies that requirement.

Section 4, amends 18-404(d). Like with 18-302(d), 18-404(d) now provides that a manager may give a consent with a future effective date.

Section 5, amends 18-806. This section deals with the revocation of a dissolution. As previously written the consent of all remaining members was required to revoke a dissolution, though the determination to dissolve did not require the unanimous consent of all members. As amended, the revocation of dissolution, prior to the filing of a certificate of cancellation, requires the affirmative vote, or written consent of the members in accordance with the requirements in the company agreement for electing to dissolve.

Delaware LLC and LP Opinions

A large part of our legal practice is the delivery of legal opinions in connection with loans being made to Delaware LLC’s and LP’s. Generally the underlying transaction involves the financing or re-financing of real estate owned by the LLC or LP, however some opinions are delivered in connection with business transactions not involving real estate. Lenders insist that the borrowing entity be a single member LLC or a LP with only one limited partner. The LLC or LP agreement for the borrower will contain “SPE” or “Special Purpose Entity” language which limits the powers of the borrower to the operation and protection of the property and provides specific language in the case of a bankruptcy filing. Each lender has its own SPE language which they require to be included in the Operating Agreement or LP Agreement of the borrower. The operating agreement of the Manager of the borrower or its General Partner will contain SPE language and an obligation on the part of the the Manager or General Partner to ensure the observation of the borrower to these limitations. Most lender language is similar, but not exactly the same. Most transactions are divided into three entity levels. The first level is the borrower, the second level is the member or limited partner of the borrower and the third level is the manager of the LLC or the general partner of the LP. The single member and the limited partner are generally LLC’s. The single member’s operating agreement or the limited partner’s operating agreement are generally the entity agreement which contains the investors and the agreement contains the business deal among the investors and the promoter. Most rating agencies and lenders prefer for the borrower and any manager or general partner to be Delaware entities. The preference is pragmatic. Both they and their counsel understand the rights of the lender under both the Delaware LLC and Limited Partnership acts. They do not have to learn or understand the laws of an additional state. Additionally, as both Delaware acts specifically provide that a third party which is not a member or partner may be given rights under the agreement, the agreement typically provide rights to the lender such that the agreement may not be amended without the consent of the lender which the loan is outstanding.

There are three types of opinions which we deliver, based upon the type of financing. Fannie Mae and Freddie Mac have their own forms of opinion which they insist to be used. While each permit some minor deviation from the form in the provisions and assumptions, other than the actual opinions, they permit few deviations in the actual opinion paragraphs.

The third type of opinion is given in connection with loans which will be sold into CMBS pools. While there is not a CMBS opinion form, per se, Delaware attorneys have by consensus adopted somewhat of a standard form of opinion for such loans.

While the three opinions differ in their format all three opinions will contain a recitation of the organizational documents which were reviewed as well as the loan documents which were reviewed and sets forth certain limitations and assumptions. The first opinion opines that the borrower is “duly formed” and that it validly exists in good standing under the laws of the State of Delaware. The second opinion general is that the LLC or LP agreement is a valid and binding obligation of the member or partners and that the agreement is enforceable against the member or the partners. The opinion also opines as to the power and authority of the borrower to operate and conduct its business; that the execution and delivery of the loan documents have been authorized by all necessary company action; that a valid and enforceable security interest has been created by the UCC-1 financing statement; that the company is a separate legal entity; that the bankruptcy or dissolution of the member or partner will not cause the borrower to dissolve; and that upon the occurrence of an event which causes the last remaining member or partner to cease to be a member or partner, that the springing member will automatically be admitted and that the company will not dissolve. An additional opinion that is included relates to charging orders. The opinion provides that the sole remedy of the creditor is the charging order and that the judgment creditor may not satisfy its claim against the assets of the Company.

In addition to the three opinions discussed above, with some larger loans the lender will seek an opinion that in the event that the company file a petition in bankruptcy, that the Federal Bankruptcy Court would recognize the terms of the operating agreement or LP agreement in determining who has authority to file bankruptcy on behalf of the company. In these loans the lender will require that the company has one or two “special members”, sometimes called “independent managers” or “independent directors” depending upon the structure of the company. In each case the operating agreement or the LP agreement will contain extensive language limiting the actions which the company may take. One of these limitation is who has the authority to file a petition and the process upon which the action may be approved. These companies are referred to as special purpose entities or SPE’s. Each lender has a variation of the language. The language dealing with bankruptcy generally looks like the following:

Special Member

As long as any Obligation is outstanding, the Member shall cause the Company at all times to have at least [**one/two**] Special Member[**s**] who will be appointed by the Member.  To the fullest extent permitted by law, including Section 18‑1101(c) of the Act, each Special Member shall consider only the interests of the Company, including its respective creditors, in acting or otherwise voting on a Bankruptcy Action.  No resignation or removal of a Special Member, and no appointment of a successor Special Member, shall be effective until such successor shall have executed a counterpart to this Agreement.  In the event of a vacancy in the position of Special Member, the Member shall, as soon as practicable, appoint a successor Special Member.  All right, power and authority of each Special Member shall be limited to the extent necessary to exercise those rights and perform those duties specifically set forth in this Agreement and no Special Member shall have any authority to bind the Company.  Except as provided in the second sentence of this Section __, in exercising their rights and performing their duties under this Agreement, any Special Member shall have a fiduciary duty of loyalty and care similar to that of a director of a business corporation organized under the General Corporation Law of the State of Delaware.  No Special Member shall at any time serve as trustee in bankruptcy for any Affiliate of the Company.  The Special Member is a “manager” within the meaning of the Act.

While I have not been involved in a loan where the SPE language prohibits the filing of bankruptcy, I understand that some lender have included such language. The general wisdom is that such language would be considered to be against public policy and unenforceable as the right to file bankruptcy is a constitutional right.

The question presented in the opinion is:

You have requested our opinion as to whether a federal bankruptcy court would hold that Delaware law, and not federal law, would govern the determination of what persons or entities have authority to file a voluntary bankruptcy petition on behalf of the Borrower.

The opinion itself is a 13-14 page reasoned opinion, as no appellate court has ruled on the question. The opinion given is:

Based upon the foregoing, and upon our examination of such questions of law and statutes as we have considered necessary or appropriate, and subject to the assumptions, qualifications, limitations and exceptions set forth herein, we are of the opinion that a federal bankruptcy court would hold that Delaware law, and not federal law, governs the determination of what persons or entities have authority to file a voluntary bankruptcy petition on behalf of the Borrower.  Our opinion is based on the assumption that in any case in which this question is considered, the question will be competently briefed and argued.  Our opinion is reasoned and also presumes that any decision rendered will be based on existing legal precedents, including those discussed below.

In connection with the delivery of any of the opinions, a careful review of the operating agreement of LP agreement is necessary so as to determine whether the agreement supports the opinions which are to be delivered. We require that the company delivers to us a general certificate setting out certain factual matters upon which we will rely, additionally the general certificate set out matters required under the USA Patriot Act.

We can be reached at sgoldberg@stevendgoldberg.com. our telephone number is 302.351.4490

Unilateral Mistake Coupled With the Counter Party’s Knowing Silence Permits Reformation

Chief Justice Steele, writing for the Court En Banc, has clarified Delaware’s law on unilateral mistake. The Court held that in cases of unilateral mistake, where the counter party has knowledge of the mistake yet remains silent, a Delaware Court may reform the contract. The Court specifically adopted Restatement (Second) of Contacts, § 157 (1981). Neither exceptional circumstances, fraud nor trickery are required to reform a contract.

Scion Breckenridge Managing Member LLC v. ASB Allegiance Real Estate Fund, No. 437, 2012 (Del.)Scion v ASB is a case involving multiple real estate investments. Scion was the sponsor of the investments, it found and managed the properties, and ASB was the promoter which provided 99% of the capital. In their first transaction the joint venture agreement properly reflected the waterfall of funds from the project. In the second and subsequent investment the attorney who drafted the agreement, who admittedly lacked experience in such matters, copied the first agreement, made deal specific changes, but revered a significant term in the waterfall so that Scion would receive its “promote” return before ASB had received back its negotiated return and capital investment. The Court below found that Scion was aware of the mistake, but remained silent. In one of the transactions the parties amended their joint venture agreement and the amendment contained standard ratification language. Notwithstanding the ratification language the Court below found that Scion was not aware of the drafting mistake and ASB again remained silent.

Scion sought reformation. ASB defended on various grounds. ASB argued that Scion had not read the second and subsequent agreements, and was barred by its negligence in seeking reformation. Second they argued that the ratification barred reformation.

This case caused the Supreme Court to review, clarify and in some instances overrule existing Delaware precedent. The Court clarified its ruling in Cerberus International, Ltd. v. Apollo Management, L.P. 794 A.2d 1141 (Del. 2002) wherein it had taken “no position upon whether, under certain circumstances, a party’s misconduct could bar a reformation claim.” The Court went on to state “[i]t is unclear whether “misconduct” mean simple negligence, gross negligence, or something more. To resolve the confusion surrounding our use of the word ‘misconduct’ we now adopt the standard in Restatement (Second) of Contracts §157: for purposes of a reformation claim ‘[a] mistaken party’s fault in failing to know or discover the facts before making the contract’ does not bar a reformation claim ‘unless his fault amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.’ To the extent existing Delaware case law is inconsistent with this standard, we expressly overrule it.”

Later in the decision the Court held: “We hold that Cerberus accurately states Delaware law: reformation based on unilateral mistake is available where a party can ‘show that it was mistaken and that the other party knew of the mistake but remained silent.’ To the extent our case law otherwise or imposes additional requirements, we expressly overrule them.”

The Court went on to clarify the distinction between reformation and rescission. “This standard is limited to reformation claims and does not affect our existing rule in cases that a failure to read bars a party from seeking to avoid or rescind a contract. Avoidance and reformation are fundamentally different remedies. Avoiding or rescinding a contract essentially ‘results in [the] abrogation or ‘unmaking’ of an agreement, and attempts to return the parties to the status quo [ante].’ In contrast, reformation does not ‘unmake’ an agreement’ it corrects an enforceable agreement’s written embodiment to ‘reflect the parties’ true agreement.’ We adhere to our case law holding that a party cannot seek avoidance of a contract he never read. In contrast, we will permit a party to seek reformation of a written agreement that incorrectly transcribes the parties’ agreement, so long as the party’s conduct does not amount to a failure to act in good faith and in accordance with reasonable standards of fair dealing.”

Upon the issue of ratification the Court Stated:

“The Vice Chancellor appropriately noted that ‘[r]atification requires ‘[k]knowledge, actual or imputed, of all material facts’ and knowledge ‘may be implied from conduct, as well as expressed by words.’ He also correctly concluded that ratification of a document subject to reformation requires actual knowledge of the mistake. As we commented in Cerberus, a party seeking reformation by definition admits that had he read the document more carefully, he would have noticed and corrected the mistake. The Vice Chancellor reasoned that requiring actual knowledge ‘recognizes that a party otherwise entitled to equitable reformation based upon mistake nearly always could have discovered the erroneous provisions. The problem in these cases arise because ‘[t]he mistaken party unwillingly believes, however, that the provision is accurate. That is the point of the mistake. Accordingly, ratification does not preclude reformation unless the ratifying party actually knew of the error.'”

The Joint venture agreement contained a cost shifting provision with respect to attorneys’ fees. The provision used the term “incurred” in connection with reimbursement of attorney fees. In this case counsel for Scion was prosecuting the case with outcost to Scion based upon a malpractice claim. Consequently Scion had not “incurred” any attorneys fees. The Court did remand the case to determine whether under the Court of Chancery’s equitable powers Scion was entitled to an award of counsel fees.

sgoldberg@stevendgoldberg.com

stevendgoldberg.com

 

 

Delaware 2013 Amendments to the Limited Liability Company Act Confirm That Single Member LLC’s are Entitled to the Same Protections as Multi-Member LLC’s and that Default Fiduciary Duties Exist Under the Delaware Act

The 2013 Amendments to the Delaware Limited Liability Company Act have not yet been introduced in the General Assembly. The Delaware Bar Association traditionally proposes annual amendments to Delaware laws. This article is a preview of what is likely to be introduced. The amendments being proposed are modest, dealing primarily with single member LLC’s and confirming the existence of default fiduciary duties.

Sections 1-5 of the Act are technical. They provide that in the case of a merger, consolidation, transfer, domestication or conversion of a limited liability company or the conversion of another entity to a limited liability company, the interests may remain outstanding or may be cancelled. The “remain outstanding” concept was added to the Act. Many people believe that this could have been accomplished before the amendment, however in certain EU and cross border transaction this has become important. In order to give clean opinions the “remain outstanding” language was added.

Some commentators who have written on asset protection have expressed the opinion that Section 18-703(d), which deals with charging orders, and which states that the charging order “is the exclusive remedy by which a judgment creditor of a member or a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest.” does not foreclose all other remedies where the company is a single member company, notwithstanding the fact that the Section uses the word “exclusive”. In response to the criticism Section 6 of the Act adds at the end of the Section 18-703(d) the phrase “and attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor, whether the limited liability company has 1 member or more than 1 member.”

The Act further focuses on the single member company in Section 7. There are few cases in the US, outside of the Bankruptcy Courts where corporations with a single stockholder are treated differently from corporations with multiple stockholders in the absence of the traditional basis of veil piercing, such as active fraud. In the LLC area, however, some courts have expressed the proposition that single member LLC’s are not entitled to the same protections. No Delaware court has ever expressed such a proposition, however Delaware LLC’s often find themselves in court rooms outside of the State of Delaware where the judges may not be entirely conversant with the Delaware Act. To clarify that a single member LLC is entitled to the same protections, the Act amends Section 18-1101 to add a new Subsection (j) which reads: “The provisions of this chapter shall apply whether the limited liability company has 1 member or more than 1 member.” This amendment should put the question to rest.

Within the Delaware Supreme Court, the Delaware Court of Chancery and the Delaware Bar the question as to whether there exist default fiduciary duties under the Delaware LLC Act has been an open question. The LP Act, through its integration with the GP Act provides for default fiduciary duties. The LLC Act does not contain a provision dealing with default fiduciary duties. That absence caused some commentators, including Delaware’s Chief Justice, to argue that as a contractual entity the duties of the members and managers should only be those contained in the company agreement and that the Act does not contain default fiduciary duties. The other side argued that the similarity between the LLC and LP acts and the fact that Section 18-1101(c) provides that “[t]o the extent that, at law or in equity, a member or manager … has duties (including fiduciary duties)… [those duties]… may be expanded or restricted or eliminated by provisions in the limited liability company agreement…”. Some have argued, including this commentator, that in order for these fiduciary duties to be expanded, restricted or eliminated, they must first exist within the Act.  In a recent Per Curium decision by the Delaware Supreme Court in the case of Gatz Properties, LLC v. Aruga Capital Corp., 2012 WL 5425227 (Del. Nov. 7, 2012), the Court invited the Delaware Bar to suggest legislation to the Delaware General Assembly if it believed that default fiduciary duties exist under the Delaware Act. Section 8 is the result of that invitation. Section 8 confirms that default traditional fiduciary duties exist within the Act by amending Section 18-1104 to add the highlighted language: In any case not provided for in this chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.”

If adopted by the Delaware General Assembly the amendment will become effective on August 1, 2013, and as is traditional with all Delaware amendments, unless otherwise provided in the legislation, the amendment are applicable to all Delaware limited liability company irrespective of when created.

I can be reached at sgoldberg@stevendgoldberg.com

 

Delay in Seeking Expedition Causes Court to Deny Motion to Expedite

Steven D. Goldberg, Esq. Wilmington, DE sgoldberg@stevendgoldberg.com http://www.stevendgoldberg.com Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law including Delaware Law opinions. Delaware Forms and Publications are available at http://www.delawarellclaw.com

The Delaware Court of Chancery almost routinely expedites cases where there is proof that a party will be prejudiced in the absence of expedition. The Delaware Courts are in fact renowned for their willingness to expedite complex and complicated cases. In Icahn Partners LP v. Amylin Pharm., Inc., 212 WL 1526814, (Del. Ch. Apr. 20, 2012) the Court stated:  “A plaintiff may earn expedited proceedings when she ‘has articulated a sufficiently colorable claim and shown a sufficient possibility of a threatened irreparable injury, as would justify imposing on the defendants and the public the extra (and sometimes substantial) cost of an expedited preliminary injunction proceeding.” The Court may however refuse to expedite a proceeding where the plaintiff’s delay “imposes additional burdens on the [C]ourt and could prejudice the [C]ourt’s ability to adjudicate the matter fairly.” Oliver Press Partners v. Decker 2005 WL 3441364 (Del. Ch. Dec 6, 2005).

In a recent decision by VC Noble, Brookstone Partners Acquisition XVI, LLC v. Tanus, CA No. 7533-VCN (Del. Ch. Aug. 10, 2012) the Court was faced with an action filed by the plaintiff on May  5, 2012, but did not seed to expedite the action until August 3, 2012 the Plaintiff sought to have the court enter a preliminary injunction before October 15, 2012 and a trial in January, 2013. Plaintiff knew when it filed the action that it faced an October 15, deadline to obtain a preliniary injunction as a contract was expiring on that date.

The Court held tha “Had Brookstone moved for expedition when the case was filed (or shortly thereafter), this case might well be nearing a hearing on a preliniary injunction with a 2012 trial date. But Brookstone let this action … proceed on a normal basis for months, knowing that it wanted relief before October 15, 2012.” The Court finally stating “[E]quity aids the vigilant, not those who slumber on their rights” refused to expedite the proceedings.

Dlaware Court of Chancery Finds Personal Jurisdiction Over Party Acting As Manager Under 18-109

Steven D. Goldberg, Esq. Wilmington, DE sgoldberg@stevendgoldberg.com http://www.stevendgoldberg.com Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law including Delaware Law opinions. Delaware Forms and Publications are available at http://www.delawarellclaw.com

Feeley, et al. v. NHAOCG, LLC, et al. Vice Chancellor Laster

Ak-Feel, LLC was the sole “managing member” of Oculus Capital Group, LLC (“Oculus”) an a 50% member in Oculus. Feeley was the managing member of Ak-Feely and an employee of Oculus. NHAOCG, LLC (“NHA”), a NY LLC was the remaining 50% member in Oculus.

Under the LLC agreement of Ak-Feel the managing member had complete authority to act for the LLC and no member who was not acting as the managing member had any authority to act for the LLC.

The Oculus LLC agreement similarly gave the managing member complete authority. The managing member could only be removed with the consent of both members or by NAH if Feeley is no longer an employee of Oculus, if Andrea Aikel has been terminated for “Good Cause” or if Ak-Feel has defaulted un its obligation under the Oculus LLC agreement and has failed to cure the default.

After a dispute arose, NAH purported to act for Oculus and notified Feeley that Oculus would not renew his contract (an action which could only be taken by the managing member) but stated that his employment would continue after the termination of the contract. Later it gave Feeley notice that Oculus was terminating the employment contract of Feeley. NAH purported to remove Ak-Feely as the managing member and named itself as the managing member. Feeley promptly filed the subject action and sought a TRO against his removal as the managing member of Oculus and asserted 9 claims against NAH, the individual beneficial owners of NAH as well as Aikel, claims which involved the breach of the LLC agreement, the implied covenant of good faith and fair dealing, breach of fiduciary duties, tortious interference as well as other minor claims.

The Oculus LLC agreement did not contain a consent to jurisdiction provision and the defendants do not have any jurisdictional ties to Delaware other than their action with respect to Oculus in connection to the control dispute.

Section 18-110 of the Delaware LLC Act (the “Act”) gives the Delaware Court of Chancery in rem jurisdiction to determine who validly holds office as a manager of a Delaware LLC. The Court stated that “[b]ecause a Section 18-110 proceeding affects the Delaware LLC and the office of managing member, it is not necessary for all claimants to the office to be subject to the Court’s in personam jurisdiction in order for the court to make an authoritative determination.” The Court thus found that it had in rem jurisdiction over NAH.

Section 18-109(a) of the Act is an implied consent statute which grants the court personal jurisdiction over persons who serve as managers of a LLC for  the purpose of adjudicating claims for breach of duty in the capacity as manager involving or relating to the business of the LLC. The complaint alleges that NAH “participated materially in the management of Oculus by taking actions that fell within the exclusive authority of the Managing Member under the Oculus LLC Agreement.” The Court found that NAH had indeed participated beyond merely exercising a claimed right to remove Feeley and Ak-Feel.

The individual defendants moved to dismiss, the Court deferred decision on the motion to dismiss them pending further discovery and the scheduled one day hearing. The Court considered whether it had jurisdiction over the individuals by looking though the entities in a manner authorized in the USACafes case discussed in an earlier Blog. This case involves another layer of entities between the individuals and NAH which further caused the Court to defer a ruling.

The Court found pendent jurisdiction under 18-109 based in large measure by applying law developed under the DGCL and its application to corporate directors. “Once a defendant is subject to personal jurisdiction under Section 18-109 as to certain claims, the Court may over the defendant with respect to other sufficiently related claims. Asssist, 753 A.2d at 981; see Infinity Investors 2000 WL 130622, at *6 (‘[O]nce jurisdiction is properly obtained over a non-resident director defendant pursuant to Sec. 3114, such non-resident director is properly before the Court for any claims that are sufficiently related to the cause of action asserted against such directors in their capacity as directors.’)”.

I can be reached at sgoldberg@stevendgoldberg.com, my direct dial number is 302.351.4490

Delaware Chancery Court Rules On Default Fiduciary Duties Of The Manager Of A Delaware LLC

Steven D. Goldberg, Esq. Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law. Delaware Forms and Publications are available at http://www.delawarellclaw.com

The issue of whether a manager of a Delaware LLC has default fiduciary duties akin to a corporate director has been an unsettled area of Delaware law. Several members of the Delaware Court of Chancery have touched on the issue in written opinions, generally finding default duties to exist. The Delaware Supreme Court has not, however, ruled on the issue. Chief Justice Steele has written and spoken extensively on the issue positing that the Act does not create such duties and as the LLC is a creature of contract, the Court should not create duties where no such duties exist legislatively.

Many practitioners have expressed the belief that in the “public deal” where the structure is corporate in nature, there should be default duties as it would be against public policy in such cases that the manager’s conduct was not circumscribed by fiduciary duties. Section 18-1101(c) of the Delaware LLC Act provides:

To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.

Here the legislature expressed an intent that if a member or manager has duties, at law or in equity, including fiduciary duties, those duties may be “expanded, restricted or eliminated”. The “implied contractual covenant of good faith and fair dealing” may not be eliminated. The implied covenant, however, only comes into play where the parties have not addressed an issue which could not have been reasonably anticipated when the agreement was drafted and is not an opportunity for the court to “fix a wrong”. The question then is whether the legislature intended, without expressing, that there are default duties or was the legislature expressing the thought that there are not necessarily duties, but to the extent that they may exist, then they may be modified as provided. In the case of Auriga Capital Corporation, et al v. Gatz Properties, LLC, et al, CA 4390-CS Decided January 27, 2012 Auriga Capital Chancellor Strine held that the manager of this LLC had an equitable duty of care and loyalty to the LLC and its members which was not restricted or eliminated in the LLC company agreement. Generally when courts consider fiduciary duties in the corporate context they include a somewhat amorphous duty of “good faith”. In this case the Court inexplicably did not address good faith. The LLC which was the subject of this litigation was established as a blind investment where the investors put up their money and the manager created the investment from the funds raised. The Court found that the manager manipulated the LLC for the benefit of the manager and its affiliated family members to the detriment of the non-family members. [The manager was an entity with an individual as the sole member, in this context the Court ascribed the actions of the entity to its member and referred to the member as the “manager” of the subject LLC.] This is a case of very bad facts where the manager who took advantage of the minrity investors argued that there were no fiduciary duties owed to the members, and if any existed the exculpation provisions of the agreement absolved the manager from liability. In the manager’s defense it asserted that it had the voting power to cause a sale of the LLC’s property to itself, a matter at the core of the complaint, and the right to “exploit the minority”. The Court stated at p.5,

“The manager was free not to vote his membership interest for the sale. But he was not free to create a situation of distress by failing to cause the LLC to explore its market alternatives and then to buy the LLC for a nominal price. The purpose of the duty of loyalty is in large measure to prevent the exploitation by a fiduciary of his self-interest to the disadvantage of the minority.”

The Chancellor first concludes that fiduciary duties exist under the Act and then goes on to analyze their foundation.

The Delaware LLC Act starts with the explicit premise that “equity” governs any case not explicitly covered by the Act. [18-1104] But the Act lets contracting parties modify or even eliminate any equitable fiduciary duties, a more expansive constriction than is allowed in the case of corporations. For that reason, in the LLC context, it is typically the case that the evaluation of fiduciary duty claims cannot occur without a close examination of the LLC agreement itself, which often tailors the traditional fiduciary duties to address the specific relationship of the contracting parties.

. . . .

The Delaware LLC Act does not plainly state that the traditional fiduciary duties of loyalty and care apply by default as to managers or members of a limited liability company. In that respect, of course, the LLC Act is not different than the DGCL, which does not do that either. In fact, the absence of explicitness in the DGCL inspired the case of Schnell v. Chris-Craft. Arguing that the then newly-revised DGCL was a domain unto itself, and that compliance with its terms was sufficient to discharge any obligation owed by the directors to the stockholders, the defendant corporation in that case won on that theory at the Court of Chancery level. But our Supreme Court reversed and made emphatic that the new DGCL was to be read in concert with equitable fiduciary duties just as had always been the case, stating famously that “inequitable action does not become legally permissible simply because it is legally possible.”

The LLC Act is more explicit than the DGCL in making the equitable overlay mandatory. Specifically, § 18-1104 of the LLC Act provides that “[i]n any case not  provided for in this chapter, the rules of law and equityshall govern.” In this way, the LLC Act provides for a construct similar to that which is used in the corporate context. But unlike in the corporate context, the rules of equity apply in the LLC context by statutory mandate, creating an even stronger justification for application of fiduciary duties grounded in equity to managers of LLCs to the extent that such duties have not been altered or eliminated under the relevant LLC agreement.

It seems obvious that, under traditional principles of equity, a manager of an LLC would qualify as a fiduciary of that LLC and its members. Under Delaware law, “[a] fiduciary relationship is a situation where one person reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.”  Corporate directors, general partners and trustees are  analogous examples of those who Delaware law has determined owe a “special duty.” Equity distinguishes fiduciary relationships from straightforward commercial arrangements where there is no expectation that one party will act in the interests of the other.

The manager of an LLC – which is in plain words a limited liability “company” having many of the features of a corporation – easily fits the definition of a fiduciary. The manager of an LLC has more than an arms-length, contractual relationship with the members of the LLC. Rather, the manager is vested with discretionary power to manage the business of the LLC.

Thus, because the LLC Act provides for principles of equity to apply, because LLC managers are clearly fiduciaries, and because fiduciaries owe the fiduciary duties of loyalty and care, the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties. [Citations omitted]

Looking for a legislative basis the Chancellor discussed the 2004 amendment to the LLC Act which added the “elimination” of duties in 18-1101(c). He concluded that if the duties he discussed did not apply to LLCs the legislation “would have been logically done differently.” He analyzes the use in the amendment of the term “eliminate” rather than the legislature stating that the manager and members “shall owe no duties of any kind to the LLC…” It is my opinion that this is a weak construct to bootstrap fiduciary duties. If indeed the legislature had believed there should be default fiduciary duties, the legislature knows how to say that and this reverse logic is inappropriate.

The DGCL and corporate laws generally can trace their history back to English Common Law which existed prior to separation. The LLC Act to the contrary has no counterpart at Common Law and is wholly a legislative construct, notwithstanding the fact that much of the LLC Act is based on the Delaware Revised Uniform Limited Partnership Act, which did have a counterpart at Common Law. It is true that the DGCL does not specifically provide for default fiduciary duties, however there is a clear Common Law and historical basis for implying such duties. It is dangerous to apply corporate constructs to LLCs notwithstanding the fact that the LLC may have a corporate structure by agreement and may have been called by the legislature a limited liability “company”. The courts have made it clear that the LLC agreement is a matter of “private ordering” and based upon “…rules of law and equity, including the law merchant,…” (18-1104). This concept should not cause the Court to incorporate wholesale the corporate rules of governance. The parties in this case were very litigious, therefore there is the possibility that an appeal will be taken and the Supreme Court will have the opportunity to speak definatively on the issue.

I can be reached at sgoldberg@stevendgoldberg.com, my direct dial number is 302.351.4490

 

Creditors Of An Insolvent Delaware LLC Do Not Have Derivative Rights

Steven D. Goldberg, Esq.
Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law.
Delaware Forms and Publications are available at http://www.delawarellclaw.com

Previously decided Delaware cases had assumed, but did not analyze the Delaware LLC Act in reaching the assumption,  that the creditors of an insolvent Delaware LLC had the right to sue derivatively under §18-1002 of the Delaware Act. Only one treatise on the Delaware Act indicates that there is no derivative right for creditors.

In the context of the Delaware General corporation Law (DGCL), in Am. Catholic Educ. Program Found, Inc. v. Gheewalla, 930 A.2d, 101 (Del. 2007) the Delaware Supreme Court found that §327 of the DGCL does not limit the subset of parties which can sue derivatively to stockholders and that when a corporation is either insolvent or in “the zone of insolvency” the director’s constituencies shifts from the stockholders to the corporation’s creditors who then have the right to sue the directors derivatively for any breach of duty.  Section 327 creates a non-exclusive limitation on derivative standing.

In the November 3, 2010 decision in CML V, LLC v. Bax, C M L V LLC vs John Bax Vice Chancellor Laster concluded that in a derivative suit against the managers of an insolvent LLC, the Delaware Act only permits members and assignees to sue derivatively under §18-1002 and that creditors do not have standing to sue. “Under the plain meaning of Section 18-1002, standing to bring a derivative action is limited to ‘a member or an assignee.’ Read literally, Section 18-1002 denies derivative standing to creditors of an insolvent LLC.” (Slip at 7).

The Court observes  “As compelling as a literal reading of Section 18-1002 might seem, it encounters an awkward fact: Despite the ostensibly obvious implications of the statute, virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.” (Slip 8). The Court then makes an in depth analysis of the LLC Act, the LP Act and the DGCL to buttress its conclusion that there are no derivative rights for a creditor of an insolvent LLC or LP.

The Court observes that the creditor is not without a remedy. “Creditors generally are presumed to be ‘capable of protecting themselves through contractual agreements that govern their relationships with firms. .. Creditors are often protected by strong covenants, liens on assets, and other negotiated contractual provisions.'” (Slip at 22). The court again observed that under §18-101(7) the creditor may require the LLC to include in its company agreement protective provisions that could require creditor consent for specified actions by the LLC or include consequences or penalties for members upon the occurrence of specific events if a creditor’s rights are breached.”

Under §18-1101(c) the duties of a member or manager to creditors may be  expanded. “Although typically cited for authorizing the restriction or elimination of legal duties, this section likewise authorizes the expansion of legal duties. An LLC agreement conceivably could provide for duties triggered by insolvency that would include an obligation to preserve assets for creditors. If a creditor is willing to become a party to the LLC agreement, then it might be able to make creative use of Section 18-1101(c) of the LLC Act.”

“Third, Section 18-303(b) provides that notwithstanding the general protection of limited liability provided by the LLC Act, a member or manager may agree in the LLC agreement ‘or under another agreement’ to be ‘obligated personally for any or all of the debts, obligations and liability of the limited liability company.’ This provision could be used in lieu of or to supplement personal guarantees for a particular debt. The use of the series provisions under 18-215 could give the creditor an interest in specific property in lieu of or to supplement a security interest in the asset or assets.”

The court noted that “In each of these cases, a creditor can protect its enhanced rights through a provision conditioning the approval of any amendment to the LLC agreement on creditor consent or the satisfaction of conditions.

“Fourth,  a creditor of an LLC can protect itself by seeking the appointment of a receiver to enforce a member’s obligation to make a contribution to the LLC.  See §18-805.”

“Fifth, despite the lack of derivative standing, a creditor possesses a statutory right to enforce a member’s obligation to make a contribution to the LLC. Subject to statutory limitations, if a creditor extends credit to an LLC in reliance on a member’s obligation to make a contribution to the LLC or to return a distribution in violation of the LLC Act, then the creditor may enforce the obligation to the extent of the creditor’s reasonable reliance.”

“Thus, in proper circumstances, [an LLC] creditor in effect may be placed in a position similar to that of the company itself in enforcing rights against members for contributions and returns. The right to enforce a contribution agreement under Section 18-502 has particular relevance to creditor derivative standing.”

The Delaware LLC Act is a contractual based Act. Given the freedom of contract which underpins the entire Act, creditors are able to protect themselves in the many ways indicated in the Court’s decision and this decision does not in any way interfere with the creditor’s rights.

Delaware Court of Chancery Confirms That The Implied Covenant of Good Faith and Fair Dealing is Not a Substitute For Fiduciary Duties

Steven D. Goldberg, Esq.
Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law.
Delaware Forms and Publications are available at http:www.delawarellclaw.com

On October 11, 2010, Vice Chancellor Laster of the Delaware Court of Chancery handed down an important case dealing with the Implied Covenant of Good Faith and Fair Dealing. Lonergan v. EPR Holdings LLC, et al.Opinion ].  The case involved a LP agreement which eliminated all fiduciary duties as permitted under 17-1101 of the Delaware Revised Uniform Limited Partnership Act (DRULPA).  Section 17-1101 is identical to 18-1101 of the Delaware Limited Liability Company Act so that this decision will have equal application for LLC’s. The Plaintiff recognizing that they had no claim for violating fiduciary duties attempted to characterize the claim as a breach if the implied covenant. The Court held that the implied covenant is not a substitute for fiduciary duties and declined to substitute the Court’s judgment for the parties to create a basis for a breach of implied duty claim.

The limited partnership is a publicly traded master limited partnership (mlp). Two sections of the agreement eliminate fiduciary duties (not just reduce or modify the duties).

Section 7.9(e) provides: 
Except as expressly set forth in this Agreement, neither [Holdings GP] nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Partnership or any Limited Partner and the provisions of this Agreement, to the extent that they restrict or otherwise modify the duties and liabilities, including fiduciary duties, of [Holdings GP] or any other Indemnitee otherwise existing at law or in equity, are agreed by the Partners to replace such other duties and liabilities of [Holdings GP] or such other Indemnitee
Section 7.10(d) provides:
Any standard of care and duty imposed by this Agreement or under the Delaware Act or any applicable law, rule or regulation shall be modified, waived or limited, to the extent permitted by law, as required to permit [Holdings GP] to act under this Agreement and to make any decision pursuant to the authority prescribed in this Agreement, so long as such action is reasonably believed by [Holdings GP] to be in, or not inconsistent with, the best interests of [Holdings].

When Section 17-1101(d) [which is identical to 18-1101(d)] was drafted the drafting committee was careful to make sure that Delaware law was not subverted in a way that removed all protections from member but also in a way that does not create an alternative form of fiduciary duty. The drafting committee included in the section the phrase “provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.” The use of the terms “contractual covenant” were carefully selected to differentiate the concept of good faith and fair dealing from any equitable concept of fiduciary duties. At the time that 1101(d) was being drafted the Court of Chancery was using corporate concepts to interpret LP and LLC law. The drafters wanted to clearly differentiate contractual terms from equitable concepts of fiduciary duties.

In defining the implied covenant the Court stated:

The implied covenant is not a substitute for fiduciary duty analysis. “The covenant is ‘best understood as a way of implying terms in the agreement’ . . . . Existing contract terms control, however, such that implied good faith cannot be used to circumvent the parties’ bargain, or to create a free-floating duty unattached to the underlying legal documents.”…The Court must focus on “what the parties likely would have done if they had considered the issues involved.” … It must be “clear from what was expressly agreed upon that the parties who negotiated the express
terms of the contract would have agreed to proscribe the act later complained of . . . had they thought to negotiate with respect to that matter.” “The doctrine thus operates only in that narrow
band of cases where the contract as a whole speaks sufficiently to suggest an obligation and point to a result, but does not speak directly enough to provide an explicit answer.” [Citations omitted].

The Court further stated:
Respecting the elimination of fiduciary duties requires that courts not bend an alternative and less powerful tool into a fiduciary substitute. The nature of the implied covenant of good faith and fair dealing is “quite different from the congeries of duties that are assumed by a fiduciary.” … “Delaware’s implied duty of good faith and fair dealing is not an equitable remedy for rebalancing economic
interests after events that could have been anticipated, but were not . . . .”…To use the implied covenant to replicate fiduciary review “would vitiate the limited reach of the concept of the implied duty of good faith and fair dealing.” … To the extent the complaint seeks to re-introduce fiduciary review through the backdoor
of the implied covenant, it fails to state a colorable claim.

The Court declined to substitute its own analysis for the missing term thereby giving full effect to the elimination of fiduciary duties. This case has well defined the difference between fiduciary duties and the implied covenant. The result of this case is to provide additional certainty to the drafters of Delaware LLC and LP agreements. This certainty of outcome is a keystone of Delaware entity law.

In his decision Vice Chancellor Laster also reviewed the duties that a corporate officer has to the stockholders in a merger transaction. This case will also serve as a starting point for future analysis of corporate duties.