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CML V, LLC v. Bax: The Delaware Court of Chancery Discusses Creditors' Standing to Bring Derivative Claims Under the LLC Act and Confirms Creditors' Protective Options Under the LLC Act

November 17, 2010

In a recent opinion, the Delaware Court of Chancery considered whether creditors of an insolvent limited liability company (“LLC”) have standing to assert derivative claims under the Delaware Limited Liability Company Act (the “LLC Act”). The Court held that the default rules of the LLC Act deny creditors standing to bring derivative actions on behalf of an LLC.
 
The Court also discussed the many unique provisions of the LLC Act that creditors, including lenders, may utilize to protect their interests when extending credit to an LLC. The case highlights the Delaware courts’ respect for the principle of freedom of contract and the importance of provisions of an LLC agreement in creating rights, powers and duties of various interested parties. As is always the case, practitioners should carefully review provisions of an LLC agreement to ensure such interested parties’ interests are protected.

In this case, CML V, LLC (the “Plaintiff”) lent funds to JetDirect Aviation Holdings, LLC (“JetDirect”), a Delaware limited liability company that was engaged in the private jet management and charter business. JetDirect subsequently became insolvent and defaulted on its loan obligations owed to the Plaintiff. The Plaintiff brought this action asserting derivative claims for breach of fiduciary duties against several individual managers of JetDirect (the “Defendants”). The Defendants moved to dismiss the Plaintiff’s claims on various grounds, including that the Plaintiff lacked standing as a creditor to sue derivatively under Section 18-1002 of the LLC Act.

The Court agreed with the Defendants’ interpretation of Section 18-1002 of the LLC Act and held that Section 18-1002 of the LLC Act (i) limits standing to bring a derivative claim to holders of limited liability company interests in an LLC and their assignees, and (ii) does not grant standing to creditors. Interestingly, prior to the decision in CML and as noted therein by the Court, a few Delaware decisions had implied, and many commentators and practitioners had assumed, that creditors of an insolvent LLC may sue derivatively.

The Court held that the default rules of the LLC Act deny standing to creditors of an LLC to sue derivatively. The Court reviewed and contrasted the exclusive language found in the derivative standing provision of Section 18-1002 of the LLC Act and the non-exclusive language found in the derivative standing provision of Section 327 of the General Corporation Law of the State of Delaware (the “DGCL”). Unlike the language contained in Section 327 of the DGCL, which has been interpreted by both the Delaware Supreme Court and the Delaware Court of Chancery as not requiring derivative claims to be brought only by stockholders, the Court concluded that (i) “[u]nder the plain language of Section 18-1002, standing to bring a derivative action is limited to ‘a member or an assignee’” and (ii) “[r]ead literally, Section 18-1002 denies derivative standing to creditors of an insolvent LLC.”

In reaching its conclusion, the Court explained that “‘[b]ecause the conceptual underpinnings of the corporation law and Delaware’s [alternative entity] law are different, courts should be wary of uncritically importing requirements from the DGCL into the [alternative entity] context.’” Furthermore, the Court emphasized that LLCs are creatures of contract designed to afford the maximum amount of freedom of contract to parties, and that “creditors generally are presumed to be ‘capable of protecting themselves through the contractual agreements that govern their relationships.’”

Nevertheless, the Court highlighted the following statutory features of the LLC Act “that appear designed (at least in part) with creditors in mind,” and that creditors may use to obtain additional rights and protections to enhance their dealings with an LLC: (i) Sections 18-101(7) and 18-306 of the LLC Act enable a creditor to bargain for express contractual rights in an LLC agreement while remaining a non-party (including the right to bargain for penalties and consequences upon the occurrence of specific events or if a creditor’s rights are breached); (ii) Section 18-1101(c) of the LLC Act permits the duties of a member or manager of an LLC to be expanded in an LLC agreement and may be used to expand the duties owed to a creditor if a creditor is willing to become a party to the LLC agreement; (iii) Section 18-302(e) of the LLC Act enables a creditor to include a provision in an LLC agreement that requires the creditor’s consent to amend an LLC agreement; (iv) Section 18-303(b) of the LLC Act provides that, notwithstanding the general protection of limited liability provided by the LLC Act, a member or manager of an LLC may agree to be personally liable for the obligations of an LLC in an LLC agreement or under another agreement; (v) Section 18-805 of the LLC Act permits a creditor in certain circumstances to seek the appointment of a receiver; and (vi) Section 18-502(b) of the LLC Act provides creditors with a statutory right to enforce a member’s obligation to make a contribution despite the lack of derivative standing.

The Court’s emphasis on freedom of contract should provide assurance to those involved in the negotiation of LLC agreements that there is considerable flexibility in delineating the rights, powers and duties of those interested in the operation of an LLC.