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CML V, LLC v. Bax, C.A. No. 5373-VCL (Del. Ch. Nov. 3, 2010)

November 3, 2010

In this opinion, the Court of Chancery granted the defendants’ motion to dismiss the plaintiff’s derivative claims against the defendants for breach of fiduciary duties, holding that, under Section 18-1002 of the Delaware Limited Liability Company Act (the “LLC Act”), creditors of an insolvent LLC lack standing to sue derivatively.

The plaintiff, CML V, LLC (“CML”), was a creditor of JetDirect Aviation Holdings, LLC (“JetDirect”), a private jet management and charter company.  Through its subsidiaries, JetDirect provided charter services, aircraft management services, and maintenance and fuel services. Before JetDirect received loans from CML, JetDirect’s board of managers (the “Board”) became aware of serious failures in JetDirect’s internal accounting system and internal controls, including the failure to properly collect and account for financial data from JetDirect’s subsidiaries. After JetDirect received loans from CML, the Board approved several major acquisitions (the “Acquisitions”). The Board approved the Acquisitions even though the Board lacked current information about JetDirect’s financial condition. JetDirect defaulted on its loan obligations to CML and, subsequently, became insolvent. While JetDirect was insolvent, the Board approved interested sales of JetDirect’s assets (the “Sales”) without adequately reviewing the Sales for fairness.

In response to these events, CML brought derivative claims, on JetDirect’s behalf, against the defendants for breach of fiduciary duties. Specifically, CML asserted that: (i) the defendants violated their duty of care by approving the Acquisitions, (ii) the defendants acted in bad faith by consciously failing to implement and monitor an adequate system of internal controls, and (iii) the defendants who benefited from the Sales breached their duty of loyalty. In addition to these derivative claims, CML brought a direct claim against JetDirect for breach of its loan agreement. CML contended that, under the clean-up doctrine, the Court of Chancery had jurisdiction to hear the direct claim. Arguing that the plain meaning of Section 18-1002 of the LLC Act precluded derivative standing for creditors of an insolvent LLC, the defendants moved to dismiss the derivative claims. In response, CML argued that the same equitable considerations that allow creditors to pursue derivative claims against the directors of an insolvent corporation entitle creditors to sue derivatively on behalf of an insolvent LLC.

Though acknowledging that some have assumed that creditor derivative standing exists in the LLC context, the Court of Chancery held that the clear and unambiguous terms of Section 18-1002 of the LLC Act bar a creditor of an insolvent LLC from suing derivatively. Section 18-1002 of the LLC Act states that the plaintiff in a derivative action “must be a member or an assignee of a limited liability company interest.” The Court of Chancery noted that while Section 327 of the Delaware General Corporation Law (the “DGCL”) addresses corporate stockholder derivative standing with non-exclusive language, Section 18-1002 of the LLC Act contains exclusive language. Thus, the plain language of Section 18-1002 of the LLC Act denies derivative standing to everyone except members of an LLC and assignees of an LLC interest.

In addition to considering the plain meaning of the statute, the Court of Chancery also relied upon three other considerations in resolving this case.  Since the LLC Act was modeled on the Delaware Revised Uniform Limited Partnership Act (the “LP Act”), the Court of Chancery first looked at how Delaware courts have interpreted the comparable provisions of the LP Act. Though not addressing creditor derivative standing, Delaware courts have historically  interpreted the LP Act’s derivative standing provisions as exclusive. This interpretation of the LP Act’s derivative standing provisions, the Court of Chancery reasoned, strongly supports an exclusive reading of the derivative standing provisions in the LLC Act.

Second, the Court of Chancery found that the statutory origins of the alternative entity derivative standing provisions suggest a conscious decision to make the alternative entity derivative standing provisions exclusive. Looking to the history of the LP Act, including its predecessor statute, the Delaware Uniform Limited Partnership Act (the “Original LP Act”), as well as the model uniform limited partnership acts upon which each were based, the Court of Chancery noted that the derivative standing provision of the Original LP Act contained non-exclusive language that closely paralleled Section 327 of the DGCL. The Court of Chancery found this as persuasive evidence that the drafters of the LP Act knew how to draft non-exclusive language for the LP Act’s derivative standing provisions. The Court of Chancery, therefore, found that the decision to adopt exclusive language in the LP Act’s derivative standing provisions suggests a conscious intent to make statutory standing exclusive.

Last, the Court of Chancery found that applying the plain meaning of the statute to preclude creditor derivative standing did not produce absurd results. CML argued that adopting a plain meaning interpretation of Section 18-1002 of the LLC Act to preclude creditor derivative standing in the LLC context would produce an absurd distinction with insolvent corporations, where creditors have derivative standing. The Court of Chancery, however, found that, since there are different conceptual  underpinnings of Delaware corporate law and Delaware alternative entity law, there is nothing absurd about different legal principles applying to corporations and LLCs. In addition, the Court of Chancery found that limiting creditors to their contractually bargained-for rights fits with the LLC Act’s policy of giving maximum effect to the principle of freedom of contract. The Court of Chancery also noted that the LLC Act contains several statutory provisions that creditors can use to gain enhanced rights and protections. Thus, because creditors of an LLC have broad statutory and contractual protections available, the Court of Chancery found that it does not create an absurd result to deny derivative standing to creditors of an insolvent LLC.

After holding that Section 18-1002 of the LLC Act denied CML standing as a creditor to bring derivative claims for breach of fiduciary duties, the Court of Chancery dismissed CML’s direct claim against JetDirect for breach of its loan agreement. In the absence of the derivative fiduciary duty claims, the Court of Chancery was unable to exercise jurisdiction over the direct claim under the clean-up doctrine.

The full opinion is available here