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Beware of Fiduciary Duties to Creditors - Different for Corporations and LLCs

February 1, 2011

In a recent decision, CML V, LLC v. Bax, et al., C.A. No 5373-VCL (Del. Ch. Nov. 3, 2010), the Delaware Court of Chancery held that, unlike Delaware corporations, creditors of an insolvent Delaware limited liability company cannot bring derivative actions against the members or managers of the company unless they specifically contract for such rights. The decision effectively precludes creditors of insolvent limited liability companies from suing members and managers for breaches of fiduciary duties owed to the company, unless they amend the company's limited liability operating agreement to provide directly that such duties are owed to creditors.

The Chancery Court noted that the ruling contradicts widespread assumptions held by both academics and the Delaware courts themselves. In fact, this ruling runs contrary to common commercial practice, in which the form of an entity, whether a corporation, limited liability company or limited partnership, is most often selected for tax or corporate control reasons, with the expectation that the general tenets of the Delaware corporate law apply.

Background

According to the decision, JetDirect Aviation Holdings, LLC was highly leveraged and had volatile cash flows and internal control deficiencies. In April 2007, CML V, LLC loaned JetDirect approximately $34 million. Subsequently, in late 2007, JetDirect's board of managers undertook four major acquisitions allegedly without the benefit of current information on the company's financial condition. JetDirect defaulted on its loan obligations to CML in June 2007 and was insolvent by January 2008, at which time JetDirect's managers began liquidating some of JetDirect's assets, including selling certain assets to manager controlled entities. CML alleges that such sales were approved by JetDirect's board without an adequate review of the fairness of such transactions and, thus, breached fiduciary duties owed indirectly to CML. Such duties are indirect because at the juncture of insolvency creditors, rather than the company's equity holders, become the residual stakeholders.

Each of JetDirect's operating subsidiaries eventually commenced bankruptcy cases and CML brought claims both directly against JetDirect on account of JetDirect's defaults under the loan and derivatively against JetDirect's mangers for breach of fiduciary duties owed to CML. The derivative claims were based on allegations that JetDirect was either in the zone of insolvency or insolvent by April 2007, thus, the managers owed fiduciary duties to its creditors, including CML, and the managers breached those duties. The alleged fiduciary duties breached by the managers were (i) their duty of care, by approving the 2007 acquisitions while "lacking critical information relating to JetDirect's financial condition," (ii) their duty of loyalty, by acting in bad faith when "failing to implement and monitor an adequate system of internal controls" and (iii) their duty of loyalty by "benefiting from self interested asset sales." JetDirect's mangers moved to dismiss CML's derivative claims against them, arguing that CML lacks standing to bring derivative suits under the LLC Act.

The Chancery Court's Decision

In ruling that the creditors of a limited liability company lack standing to bring an action in right of the limited liability company against its members and managers for breaches of fiduciary duties or otherwise, the Chancery Court held that the plain language of Section 18-1002 of the LLC Act, entitled "Proper Plaintiff," only allows a member or an assignee of an interest in such limited liability company to bring a derivative claim.

The Chancery Court went on to distinguish the rights of creditors of insolvent Delaware corporations from the rights of creditors of insolvent limited liability companies. The Court acknowledged that a combination of Section 327 of the DGCL and case law have provided creditors of insolvent Delaware corporations with standing to bring derivative claims against directors on behalf of the corporations for breaches of fiduciary duties.1 However, in CML, the Court determined that no such right exists for a creditor of a limited liability company given that the language of Section 18-1002 of the LLC Act is exclusive to "a member or assignee of a limited liability company interest," while the language of Section 327 of the DGCL is not exclusive to shareholders of the corporation, but simply dictates the qualifications required to be met by shareholders instituting derivative suits.

In support of its decision, the Chancery Court recognized that the LLC Act provides flexibility so that creditors may negotiate certain rights and protections for themselves. Consistent with other recent cases, the Court notes that "LLCs are creatures of contract, designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved."2 Creditors can protect themselves through the covenants, asset liens, and other negotiated contractual protections customarily contained in a loan agreement and can also bargain for express contractual rights in the borrower's LLC agreement. Such rights may include, among other things, (i) penalties and other consequences for members triggered by the occurrence of specific events, (ii) personal liability of members for the debts of the limited liability company, and (iii) creation or expansion of fiduciary duties of members and managers to preserve assets for creditors, which would be triggered by insolvency.

Take-Aways for Creditors of LLCs

Unlike rights afforded to creditors of Delaware corporations, creditors of Delaware limited liability companies are barred from bringing claims based upon breaches of fiduciary duties by the members or mangers of such companies unless, among other things, they amend the LLC agreement to directly provide for them. Thus, in order to fully protect themselves, creditors of limited liability companies will need to bargain for specific rights in the loan agreement or demand amendments to the borrower's LLC agreement as a pre-condition to extending credit or making a loan.

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1 See CML V, 6 A.3d at 240, citing N. AM. Catholic Educ. Programming Found, Inc. V. Gheewalla, 930 A.2d 92, 101 (Del. 2007); see also § 320 DGCL

2 CML V, 6 A.3d at 249 (quoting Travel Centers of Am., LLC v. Brog, 2008 WL 176987, at *1 (Del.Ch. Apr. 3, 2008) (quoting In re Grupo Dos Chiles, LLC, 2006 WL 668443, at *2 (Del.Ch. Mar. 10, 2006)); see also Kelly v. Blum, 2010 WL 629850 (Del. Ch. Feb. 24, 2010).