Creditors Of An Insolvent Delaware LLC Do Not Have Derivative Rights

Steven D. Goldberg, Esq.
Wilmington, DE
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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.

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