Lending to an LLC? Think Twice and Draft Carefully

The court explained that in a corporate setting, Delaware law is well-settled ' when a corporation is insolvent, its creditors become the principal constituents injured by any fiduciary breaches that diminish the corporation's value. The creditors therefore have standing to pursue derivative claims against the directors of an insolvent corporation. Defendant Jet Direct, however, is a Delaware limited liability company. In the Court of Chancery, CML argued that the same equitable considerations of judicially conferred standing to a party who can bring claims in the name of the entity should apply in the context of an LLC, and should entitle creditors to sue derivatively in the name of the insolvent entity. The court declined this invitation to extend the prevailing corporate analysis by analogy to LLCs because such entities are created by statute. In writing the dismissal, Vice Chancellor J. Travis Laster noted that prior decisions and scholarly commentary have either presumed derivative standing for creditors of alternative entities, without directly addressing the issue, or avoided the question entirely. But, when confronted with the actual fact pattern and in the absence of precedent, the court found that the literal terms of the governing statute ' the Delaware LLC Act ' must control. The LLC Act, similar to other alternative entity statutes (in Delaware and other states), creates both a right to bring a derivative claim and defines a proper plaintiff. Indeed, when dealing with any alternative entity it is not just prudent due diligence to review the formation agreements, but also to review the statute pursuant to which the entity is created.

In this case, under the plain language of the Delaware LLC Act, only a member or an assignee of a member can bring a derivative suit. The lower court cautioned that it is not the court's job to go beyond the clear and unambiguous legislative directive stated in the LLC Act and inject into the statute concepts borrowed from corporate common law precedents. The Supreme Court agreed. Sitting en banc, the court affirmed Vice Chancellor Laster's decision dismissing all claims.

On Appeal

On appeal, CML focused the court's review on two issues: 1) that 6 Del. C. ” 18-1001 and 18-1002 do not deprive creditors of standing to bring derivative actions on behalf of insolvent LLCs, but 2) if they do, those provisions unconstitutionally deprive the Court of Chancery of its equity jurisdiction. The Supreme Court rejected both contentions.

Not surprisingly, the Supreme Court started its inquiry by reviewing the plain language of the statute. It instructed that when “statutory text is unambiguous, [the courts] must apply the plain language without any extraneous contemplation of, or intellectually stimulating musings about, the General Assembly's intent.” Indeed, the court found that ” 18-1001 and 18-1002 serve very different purposes, one creating the right to bring a derivative action on behalf of an LLC and the other conferring derivative standing on members and assignees. In so doing, the legislature was both free and “well suited,” the court found, to make policy choices and impose statutory limitations on derivative standing on entities other than corporations. While the Delaware LLC Act otherwise provides numerous protections to creditors, the legislature did not see fit to confer standing to creditors to sue in the name of the company. For instance, members are precluded from making distributions when the company's liabilities exceed its assets. Here, the court was not inclined to employ judicial activism to expand the legislative boundaries.

Indeed, the court then emphasized that in the LLC context specifically, the Delaware legislature had espoused a clear legislative intention to allow interested parties to define the contours of their relationship with each other. Creditors, therefore, have significant contractual flexibility to protect their unique interests and must employ tools already available to them. And going forward, creditors should draft carefully the provisions they deem appropriate, keeping in mind that they otherwise would have no standing to sue derivatively.

On the question of constitutionality, CML argued that the Delaware LLC Act impermissibly curtailed the Court of Chancery's equitable jurisdiction to less than that extant in 1792 when Delaware ratified its first constitution. The Supreme Court disagreed. It noted that LLCs did not come into existence until 1992, when the LLC Act was signed into law. As such, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, the courts must look to the LLC Act as the only statute that creates those rights, remedies and obligations. In so reasoning, the court held that ” 18-1001 and 18-1002 embody a valid exercise of legislative authority, and the limitation so imposed on derivative standing does not impinge upon the constitutional jurisdiction of the Court of Chancery. Under these circumstances, there was no room for the common law to override the statutory mandate.

Conclusion

This ruling is important to the lending community. It will be critical, in the future, for banks and other lenders to LLCs and other alternative statute-created entities to protect their rights in the event of a default. As it stands right now, under Delaware law, present creditors of insolvent LLCs have one less avenue to be made whole.

Alisa E. Moen is a partner based in Blank Rome LLP's Wilmington, DE, office. Moen focuses her practice in the areas of complex corporate, business and fiduciary disputes. She has successfully tried corporate and commercial cases to conclusion in both federal and state courts, and has focused her practice on matters pending before the Delaware Court of Chancery. She can be reached at [email protected] or 302- 425-6426. Moen represented one of the defendants in the CML case.

Late last fall, the Delaware Court of Chancery issued a decision that surprised many business law observers and practitioners. The Chancery Court dismissed creditors' derivative claims brought against the board of directors of a failed and insolvent limited liability company. The Delaware Supreme Court agreed and affirmed the decision.

Plaintiff CML V, LLC (“CML”) lent funds to JetDirect Aviation Holdings, LLC (“JetDirect”), a private jet management and charter company. Beginning in 2005, JetDirect undertook an expansion program pursuant to which it acquired other charter and service companies. It was this acquisition campaign that the plaintiff blamed upon the company's eventual demise into bankruptcy. The Complaint alleged, among other claims, that the directors failed to adequately supervise the acquisition efforts and failed to educate themselves on the true financial condition before approving further expansions. Such claims for breaches of fiduciary duties to the company and its ownership would be readily available in the corporate context when the enterprise is insolvent. Not so, when the company is formed as an alternative business entity, such as a limited liability company or a limited partnership. To some, until recently, this was a distinction without a difference. Now ' lender beware.

The Plain Language of the Delaware LLC Act

The court explained that in a corporate setting, Delaware law is well-settled ' when a corporation is insolvent, its creditors become the principal constituents injured by any fiduciary breaches that diminish the corporation's value. The creditors therefore have standing to pursue derivative claims against the directors of an insolvent corporation. Defendant Jet Direct, however, is a Delaware limited liability company. In the Court of Chancery, CML argued that the same equitable considerations of judicially conferred standing to a party who can bring claims in the name of the entity should apply in the context of an LLC, and should entitle creditors to sue derivatively in the name of the insolvent entity. The court declined this invitation to extend the prevailing corporate analysis by analogy to LLCs because such entities are created by statute. In writing the dismissal, Vice Chancellor J. Travis Laster noted that prior decisions and scholarly commentary have either presumed derivative standing for creditors of alternative entities, without directly addressing the issue, or avoided the question entirely. But, when confronted with the actual fact pattern and in the absence of precedent, the court found that the literal terms of the governing statute ' the Delaware LLC Act ' must control. The LLC Act, similar to other alternative entity statutes (in Delaware and other states), creates both a right to bring a derivative claim and defines a proper plaintiff. Indeed, when dealing with any alternative entity it is not just prudent due diligence to review the formation agreements, but also to review the statute pursuant to which the entity is created.

In this case, under the plain language of the Delaware LLC Act, only a member or an assignee of a member can bring a derivative suit. The lower court cautioned that it is not the court's job to go beyond the clear and unambiguous legislative directive stated in the LLC Act and inject into the statute concepts borrowed from corporate common law precedents. The Supreme Court agreed. Sitting en banc, the court affirmed Vice Chancellor Laster's decision dismissing all claims.

On Appeal

On appeal, CML focused the court's review on two issues: 1) that 6 Del. C. ” 18-1001 and 18-1002 do not deprive creditors of standing to bring derivative actions on behalf of insolvent LLCs, but 2) if they do, those provisions unconstitutionally deprive the Court of Chancery of its equity jurisdiction. The Supreme Court rejected both contentions.

Not surprisingly, the Supreme Court started its inquiry by reviewing the plain language of the statute. It instructed that when “statutory text is unambiguous, [the courts] must apply the plain language without any extraneous contemplation of, or intellectually stimulating musings about, the General Assembly's intent.” Indeed, the court found that ” 18-1001 and 18-1002 serve very different purposes, one creating the right to bring a derivative action on behalf of an LLC and the other conferring derivative standing on members and assignees. In so doing, the legislature was both free and “well suited,” the court found, to make policy choices and impose statutory limitations on derivative standing on entities other than corporations. While the Delaware LLC Act otherwise provides numerous protections to creditors, the legislature did not see fit to confer standing to creditors to sue in the name of the company. For instance, members are precluded from making distributions when the company's liabilities exceed its assets. Here, the court was not inclined to employ judicial activism to expand the legislative boundaries.

Indeed, the court then emphasized that in the LLC context specifically, the Delaware legislature had espoused a clear legislative intention to allow interested parties to define the contours of their relationship with each other. Creditors, therefore, have significant contractual flexibility to protect their unique interests and must employ tools already available to them. And going forward, creditors should draft carefully the provisions they deem appropriate, keeping in mind that they otherwise would have no standing to sue derivatively.

On the question of constitutionality, CML argued that the Delaware LLC Act impermissibly curtailed the Court of Chancery's equitable jurisdiction to less than that extant in 1792 when Delaware ratified its first constitution. The Supreme Court disagreed. It noted that LLCs did not come into existence until 1992, when the LLC Act was signed into law. As such, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, the courts must look to the LLC Act as the only statute that creates those rights, remedies and obligations. In so reasoning, the court held that ” 18-1001 and 18-1002 embody a valid exercise of legislative authority, and the limitation so imposed on derivative standing does not impinge upon the constitutional jurisdiction of the Court of Chancery. Under these circumstances, there was no room for the common law to override the statutory mandate.

Conclusion

This ruling is important to the lending community. It will be critical, in the future, for banks and other lenders to LLCs and other alternative statute-created entities to protect their rights in the event of a default. As it stands right now, under Delaware law, present creditors of insolvent LLCs have one less avenue to be made whole.

Alisa E. Moen is a partner based in Blank Rome LLP's Wilmington, DE, office. Moen focuses her practice in the areas of complex corporate, business and fiduciary disputes. She has successfully tried corporate and commercial cases to conclusion in both federal and state courts, and has focused her practice on matters pending before the Delaware Court of Chancery. She can be reached at [email protected] or 302- 425-6426. Moen represented one of the defendants in the CML case.