Several years ago Prof. Ann Conaway (Widener Law) asked me to give my views on fiduciary duties to creditors of insolvent entities in a conference focusing on the then-new Production Resources Group case.  After giving the usual, “that’s easy, as I know nothing about the topic” response, I spent a bit of time thinking about the issues.  Ultimately, my slightly more refined thoughts were presented at a University of Md. Law School conference and published in a Journal of Business and Technology Law symposium issue.  I commend all the other articles in the issue to those who care about this stuff.  It has been an interesting area, both before the Delaware and Maryland symposia and after.

 On September 2, 2011 the Delaware Supreme Court added another interesting wrinkle when it unanimously affirmed Chancery’s decision in CML V, LLC v. Bax, and held that LLC creditors lack standing to pursue derivative claims on the LLC’s behalf.  The court held that the “plain meaning” of the Delaware LLC Act requires that the plaintiff “in a derivative action . . . must be a member or an assignee of a limited liability company interest at the time of bringing the action.”  Therefore, creditors need not apply.

 Before discussing the CML V, LLC case further, it may be useful to provide an attenuated, stylized outline of prior Delaware fiduciary-duty-to-creditor cases:

 1.         Credit Lyonnais, 1991 WL 277613 (Del. Ch. 1991) – shareholders may not be able to succeed in asserting that corporate directors acting “in the vicinity of insolvency” did not consider only shareholder interests in reaching their decisions; consideration of creditor interests permissible.

 2.         Geyer v. Ingersoll Publications, 621 A.2d 784 (Del. Ch. 1992) – corporate insolvency in fact causes director fiduciary duties to shift from shareholders to creditors; parties did not contest existence of shift, and court did not develop a theory.

3.         Production Resources Group, 863 A.2d 772 (Del. Ch. 2004) – when corporation reaches point of insolvency, directors owe fiduciary duty to creditors; creditors are placed in the shoes normally occupied by shareholders.  Creditor can allege claims of harm to the corporation, but, as with shareholders, these claims are derivative in nature and are subject to §102(b)(7) defenses that directors would have in shareholder derivative action.

 4.         North American Catholic Educational Programming Foundation v. Gheewalla, 930 A.2d 92 (Del. 2006) – Del. Supreme Court holds that creditor claims against directors of insolvent corporations are derivative, rather than direct, in nature.  Fundamentally, insolvency changes who may bring a fiduciary claim but not the nature of the claim.

 Then came CML V, LLC in which the Delaware Supreme Court held:

 1.         As noted above, the plaintiff in a LLC derivative action must be a member or assignee of an LLC interest at the time the action commences.  Presumably a similar rule would apply to limited partnerships, in which the statute contains similar language, and not to corporations, in which it does not.

 2.         In response to the creditor’s argument that the statutory exclusivity language applies only to member derivative suits, and not to creditor derivative suits in which Gheewalla provided standing to creditors, the court held that the legislature created an independent restriction on all derivative actions on behalf of LLCs – not just on the member derivative suits authorized by the statute.

 3.         The court ruled that its application of the exclusivity language did not produce an unreasonable or absurd result by irrationally creating one set of rules for corporations (in which creditors can bring derivative suits) and LLCs (in which they cannot).  The court held that even if in insolvent LLCs no stockholders will enforce fiduciary duties, the General Assembly is vested with the power to make the policy choice, and the courts must honor that choice.  The court also noted that “it is logical for the General Assembly to limit LLC derivative standing and exclude creditors because the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests.”

 4.         In a very interesing (perhaps the most interesting) portion of its opinion, the court ruled that its holding did not strip Delaware courts of their equitable jurisdiction, in violation of the Delaware Constitution.  The court held (originalists take note!) that the Constitution froze equity jurisdiction as of 1792, and that (surprise!) LLCs did not exist in 1792.  The court stated:

The General Assembly passed the LLC Act in derogation of the common law, and it acknowledged as much.  Consequently, when adjudicating the rights, remedies, and obligations associated with Delaware LLCs, courts must look to the LLC Act because it is the only statute that creates those rights, remedies and obligations.

Actually, the statute says that “the rule that statutes in derogation of the common law are to be strictly construed shall have no application to this chapter” – I think this may be a bit different from saying that the LLC Act itself is in derogation of common law, but I leave that to others to discern.

The court noted that the Delaware LLC Act provides that equity supplements the Acts’ provisions, but ruled that this relates only to rights and remedies the statute does not address.  The LLC statute addressing derivative claims, there is no role for equity/common law in addressing those claims.

 I have several comments:

1.         In my prior article, Why a Fiduciary Duty Shift to Creditors of Insolvent Business Entities is Incorrect as a Matter of Theory and Practice, 1 J. Bus. & Tech. L. 431 (2007), I argued that fiduciary duties should not be owed to creditors of any entity type.  The “creditor shift” creates unacceptable ambiguity and uncertainty since (a) it is difficult or impossible to determine when shifts occur, deepen, end, etc., (b) creditors are not homogeneous and those creditors that are in the best position to bring derivative claimes can contract “to protect their unique, distinct interests;” (c) there is no clarity to the duties owed and whether defenses, such as the business judgment rule, apply; and (d) the whole area becomes a huge mess when dealing with contract-based entities, such as LLCs, in which fiduciary duties are capable of modification or elimination by contract.  The CML V, LLC court moved, in dictum, toward a conclusion that creditors can protect themselves if they see fit to do so – it would have been a very nice result if the whole concept of the creditor shift were ratcheted back, instead of merely dealing with standing.  There is no reason to distinguish LLCs and corporations in this regard.  I think CML V adds unnecessarily to the chaos.

2.         By dealing only with creditor standing, the court left “rights without remedies.”  Fiduciary duties are owed, but they are derivative and unenforceable.  I have stated a view that the law is like a slinky – when one end is pushed too far forward there is a flop-over where the law shifts to favor the other end.  In my view, it would have been a better result if the court had simply (and logically) ruled that the statutory member-exclusivity language predated the evolution of the creditor shift, and therefore that it does not apply to creditor fiduciary derivative actions unless the legislature acts to make it apply.  I think this better recognizes both history and the difficulty (at least in Delaware) of subsequent legislative action that is not in the interests of firm management.  I may be wrong, but no way is the Delaware bar going to change the LLC Act to overrule the case.

 As it is, decisions like CML V will put pressure on other courts (which act in equity and do not have Delaware’s contract superiority perspective) to find other ways to provide remedies, such as by creating direct rights for creditors in insolvency settings.  I think this is already the rule in Colorado, and such a rule could inappropriately eliminate entity-based defenses available to managers in derivative cases and procedural protections such as special litigation committees.  CML V also likely will draw closer attention to differences in state derivative action statutes, and cause statutory hair splitting to occur (a great job for us experts).  A very quick review of several state LLC acts reveals that different states have different (or no) formulations for derivative claims.  ULLCA seems close to the Delaware model; Re-ULLCA seems to differ in pertinent regards (and I do not think any attention was paid to this issue in the drafting process).

3.         As noted above, it is the court’s treatment of common law and equitable jurisdiction that may be most interesting over time.  I am glad I do not live in a colony.  For example, the Delaware LLC Act does not set forth fiduciary duties, and Steele, C.J. has stated a view that these duties are to be found in the parties’ contract if they are to exist at all (oversimplification noted).  Steele, C.J. wrote the CML V decision.  Although under CML V the legislature spoke on derivative actions, one might watch for a contractarian expansion of the originalist position in the case of LLC fiduciary duties.  This would move Delaware further to the pro-management fringe.

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