CML V, LLC v. Bax,
C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010), read opinion here.
This is an important decision of the Court of Chancery involving the
interpretation of the Delaware LLC Act and the rights of creditors to pursue a
derivative claim for breach of fiduciary duty.
Issue Decided.
The Delaware Court of Chancery addressed whether a
creditor had standing, based on the Delaware LLC Act, to pursue a derivative
claim against an insolvent LLC, similar to a creditor's right to do so against
an insolvent corporation. Short Answer: No.
Brief Summary of Decision
CML V, LLC ("CML") lent funds to JetDirect
Aviation Holdings LLC. The complaint plausibly plead that JetDirect was
insolvent and CML asserted derivative claims against the LLC managers, alleging
breach of fiduciary duty and related claims. The Individual Defendants moved to
dismiss those claims based on Section 18-1002 of the Delaware LLC Act.
The Court reasoned that: Section 18-1002 "limits
standing to bring a derivative claim to holders of membership interests in a
limited liability company ("LLC") and their assignees. Section 18-1002
does not grant standing to creditors.... JetDirect is not a corporation.
JetDirect is an LLC, and the plain language of the LLC Act controls."
In connection with dismissing the claims, this 30-page
opinion provides a paradigmatic analysis of: (i) the statutory history or the
LLC Act, including its origin as a uniform statute; (ii) statutory
interpretation principles; (iii) comparison of similar provisions in related
alternative entity statutes, such as the L.P. statute; (iv) Delaware-based and national
treatises that have opined on the issue; (v) law review articles and other
academic literature addressing the issue; and (vi) the impact and potential
repercussions of reaching a conclusion that may be at odds with what
practitioners and scholars (and even some court decisions) seem to have assumed
about the right of creditors to file a derivative action in the LLC context,
analogous to their right to do so in the corporate context.
Background
JetDirect was a private jet management and charter
service. An aggressive growth strategy left it with a highly leveraged balance
sheet and volatile cash flows. Internal control deficiencies and poor financial
reporting procedures, combined with ill-advised acquisitions led to several
subsidiaries filing for bankruptcy and the insolvency of the parent.
CML also alleged that while JetDirect was insolvent, some of the board of
managers liquidated some assets by transferring them to entities controlled by
certain board members at unfair prices.
Legal Analysis
Although the Court did not apply the analogous right of a
creditor in the corporate context to file a derivative suit, it began the legal
analysis by acknowledging the Delaware Supreme Court's benchmark decision in
this type of litigation: "The directors of an insolvent corporation
have standing to maintain derivative claims against directors on behalf of the
corporation for breaches of fiduciary duties". (citing N. Am.
Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101
(Del. 2007))(emphasis in slip opinion). Moreover the Court recognized the
theoretical underpinning of that holding as follows: "When a
corporation is insolvent, the creditors become 'the principal constituency
injured by any fiduciary breaches that diminish the firm's value'". (citing
Id. at 102).
The Court also acknowledged that at least some commentary
and a few other court decisions appear to have assumed that this reasoning also
applied to allow derivative suits by creditors in the context of insolvent
alternative entities. However, the Court of Chancery reasoned that the literal
terms of the LLC Act barred such a result. Although the Court recognized
its power to avoid a literal interpretation of the statute when "such a
reading would be so inconsistent with the statutory purpose as to produce an
absurd result," this is not such a case.
Statutory Interpretation
The Court reviewed basic statutory interpretation
principles that apply when the language of a statute is clear and unambiguous
on its face. It then quoted Section 18-1001 of the LLC Act that defines a
"proper plaintiff" who has a right to bring a derivative action
under the Act. Next, it quoted the obvious requirement in Section 18-1002 that
"only a member or an assignee" qualifies. The only Delaware treatise
to comment directly on how the foregoing statutes apply to creditor's rights,
also states based on those statutes, that "an LLC creditor is not a
proper plaintiff in a derivative suit." (citing Robert L. Symonds, Jr. and
Matthew J. O'Toole, Delaware Limited Liability Companies, Section 9.09,
at 9-61 n. 270 (2007)). Later in the opinion, in connection with its
observation that there is a paucity of other direct commentary on the specific
issue, the Court noted that the foregoing statement [from Delaware's
authoritative treatise on LLCs], was "not trumpeted" and appeared at
the end of a long footnote without added discussion.
Next the Court contrasted the above statutory provisions
with Section 327 of the DGCL which is the only Delaware corporate statute that
addresses derivative actions. Section 327 houses the contemporaneous ownership
requirement, but does not create the right to sue derivatively and does not
limit derivative suits to stockholders exclusively. By comparison, read
literally, Section 18-1002 does deny creditors the right to sue an insolvent
LLC derivatively.
A Dog That Has Not Barked
The above sub-title in the Court's opinion begins a
section that has the following opening sentence: "As compelling as a
literal reading of Section 18-1002 may 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."
Instead of the literature on this topic addressing the
question directly, most commentators have focused on the right to limit
fiduciary duties that creditors can invoke, but as the Court
observes: "That question never arises if creditors lack standing to
sue under Section 18-1002". See extensive commentary cited at n. 2.
Additional Analysis
The importance of this decision presents a challenge to
reduce the essential parts of the 30-page decision to a length befitting a
short blog post, but the next section of the opinion can be broken down into
three categories that the interested reader can turn to the full opinion to
read. Due to the fact that the Delaware LLC Act is based on a uniform act, and
is also related to similar alternative entity statutes, the Court reasoned
that: "A context-free reading of those provisions risks a
content-skewed result." Thus, the Court considered the following
inquiries: "(i) how parallel provisions of other alternative entity
statutes have been interpreted; (ii) the source and development of the
alternative entity derivative standing provisions; and (iii) whether enforcing
the plain meaning of Section 18-1002 would create an absurd result at odds with
the overarching purpose and framework of the LLC Act.
Each of the above lines of inquiry, resulted in support
for interpreting Section 18-1002 as an exclusive provision that limits
derivative suits to LLC members and assignees. This part of the Court's
opinion provides a history lesson that cites to court decisions and commentary
as far back as the 1800s, and cites as well to modern learned commentary from
the leading experts in the field of alternative entities, including our
"blog friend", Professor Larry Ribstein.
Footnote 9 stores a treasure trove of citations to
reference manuals on grammar and writing styles supporting the active voice, as
compared to passive, as a preferred method to avoid ambiguity in both statutory
drafting and other writing contexts.
As part of its statutory analysis, the Court rejected
CML's argument that the corporate analogy should be used, and emphasized
that: "As a threshold matter, there is nothing absurd about different
legal principles applying to corporations and LLCs."
Multiple references to sections of the LLC Act that
appear designed to specifically protect the interests of creditors, bolstered the
Court's reasoning that its conclusion did not leave creditors without
protection. Indeed, a substantial portion of the Court's opinion was devoted to
a recitation of the many opportunities and legal rights that the law provides
in general to creditors to protect their interests, both through private
ordering and many other direct causes of action available to them. See
generally Ross Hldg. & Mgmnt. Co.. v. Advance Realty Gp.,
Inc., 2010 WL 3448227, at *6 (Del. Ch. Sept. 2, 2010)(referring to
Chancery's "general equity powers" as a basis to have a receiver
appointed for an LLC)
Conclusion
In addition to the foregoing reasons, the Court concluded
the justification for its holding by noting that the result
"fulfills the contractarian spirit" of the LLC Act. Based on the
dismissal of the derivative claims, CML was left with a claim for money damages
only, which the Court of Chancery does not have jurisdiction over. Thus, the
plaintiff needed to transfer the case to Delaware's trial court of general
jurisdiction, the Superior Court, pursuant to Section 1901 of Title 10 of the
Delaware Code.
SUPPLEMENT: Professor
Larry Ribstein, the country's leading scholar on alternative entities, whose
scholarship was cited many times by the Court in this case, provides an insightful
analysis of the opinion here.
Read more Delaware business
litigation case summaries and commentary on Delaware
Corporate and Commercial Litigation Blog, a blog hosted by Francis G.X.
Pileggi, of Fox Rothschild LLP.