New Twist in LLC Law in Delaware: LLCs May Provide Greater Protection Against Creditors Than Corporations

by Jonathan T. Rubens

The limited liability company has been the entity of choice for many small businesses, investment partnerships, holding companies, and others in most US states for many years. For several years, more LLCs have been formed in the US each year than corporations and partnerships combined. The reason: maximum flexibility in profit sharing (LLCs allow corporate-type liquidation preferences or partnership-type profits interests), pass-through taxation (as in partnerships and S corporations), and the potential to reduce fiduciary duties or even to eliminate them (as has been suggested for some time in the context of Delaware LLCs). Now the LLC's already surging popularity may have a further boost. The important opinion of the Delaware Chancery court in CML V LLC v. JetDirect Aviation, Case no. 5373-VCL (Nov. 3, 2010) somewhat surprisingly provides the LLC a potentially greater shield from creditors than a corporation.

The issues in CML turned on whether a creditor plaintiff can file a derivative lawsuit against the holders of membership interests in a limited liability company. A derivative action is one brought in the name of a corporation to recover judgments in its favor when current management has failed or refused to do so and when making a demand of them to comply would be futile. Litigants may also pursue derivative lawsuits in the context of an LLC, as is allowed by Section 18-1001 of the Delaware LLC Act, which provides that an LLC member or an assignee of a member "may bring an action in the Court of Chancery in the right of a limited liability company to recover a judgment in its favor if managers or members with authority to do so have refused to bring an action," or if it would be futile to make such a demand. However, Section 18-1002 of the Delaware Act appears to limit derivative actions to a plaintiff (i) who is a member or an assignee of a member at the time of bringing the action; or (ii) who became a member or an assignee by operation of law or pursuant to the terms of an LLC agreement from a person who was a member or assignee at the time of the transaction.

The plaintiff in CML lent funds to JetDirect Aviation Holdings, LLC and then, after the borrower's operating subsidiaries became insolvent, the plaintiff sought to recover from the borrower for breach of its loan agreement. The plaintiff also named the individual members of the LLC as defendants in a derivative claim, seeking to recover damages from them individually for breach of their fiduciary duties as managers of the LLC.

It is clear that, under Delaware law, equitable considerations have given standing to an insolvent corporation's creditors to maintain derivative claims against directors on behalf of the corporation, and there is no clear corporate counterpart to the standing limitation of 18-2002 for LLCs. The result: third party creditors can have standing to bring derivative claims against Delaware corporate directors but not against Delaware LLC managers. Although Section 327 of the Delaware Corporations imposes a contemporaneous ownership requirement on shareholders seeking to maintain derivative actions, the court points out that this restriction does not apply to non-shareholder plaintiffs. In other words, non-shareholder plaintiffs are not barred. Non-owner creditor plaintiffs pursuing defaulting LLC debtors, by contrast, are barred from derivative actions altogether.

What is the result of this strange distinction? Perhaps the ever-popular LLC form will now be even more popular as the entity of first choice for new business founders in Delaware, as it can provide an extra shield from creditors who might otherwise be able to pursue derivative claims against them if they had chosen the corporate form. At the same time, this decision may cause sources of commercial debt financing to become even more wary of non-corporate structures than they already may be.

Bullivant Houser Bailey PC is an Oregon Professional Corporation. These materials, prepared by Bullivant attorneys, are for general informational purposes only and are not for the purpose of providing legal advice or legal opinions on specific facts or circumstances. Internet subscribers and online readers should not act upon this information without seeking professional advice.

Copyright

All copyrightable text and graphics, the selection, arrangement, and presentation of all materials are copyright © 1996-2010, Bullivant Houser Bailey PC. All rights reserved.