The Delaware Supreme Court in CML V, LLC v. Bax (Del. September 2, 2011) has held that creditors of a Delaware LLC have no right to bring a derivative suit on behalf of the LLC, regardless of whether the LLC is insolvent. The Court’s ruling was based on the language of Section 18-1002, which states: In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:

(1) At the time of the transaction of which the plaintiff complains; or

(2) The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction.

The Court found this language to be “unambiguous [and] susceptible of only one reasonable interpretation…”, leading the Court to apply the plain language of that section.  And the plain language of that section states that a plaintiff suing derivatively “must be a member or an assignee of a limited liability company.”  The Court did not agree with the plaintiff’s argument that 18-1002 is not clear or that it was intended to cover creditors.  In fact, even though the plaintiff argued to the Court that by reading 18-1002 in a way that does not cover creditors, it would be very possible that creditors would be the ultimate risk bearers of an insolvent LLC since there would be no stakeholder to enforce the fiduciary duties through legal action.  The Court was not simpathic and said that if the legislature would like to change the LLC laws they are free to do so, but until such time, the Court would honor the law as it was written.  

The Plaintiff then argued that the 18-1002 was not constitutional, but the Court again disagreed — predominately because the Court held that 18-1002 was constitution as to this case (note the qualifier) because the “Delaware Constitution only guarantees the Court of Chancery the equity jurisdiction to extend derivative standing to prevent failures of justice involving corporations.” 

This case has important implications to lenders, private equity funds (“PEF”), and members, managers and creditors of Delaware LLCs.  A lender must now make sure the loan documents provide a contractual remedy the would not require equitable extension of derivative standing.  A few possibilities are that a lender could convert its interests to that of an “assignee” in the event of involvency or include a provision in the loan documents that would give it control of the LLC’s governing body in the event of default or insolvency. 

As to PEFs, there is now an even stronger reason to form an LLC under the laws of the State of Delaware (rather than NY which gives creditors derivative standing to sue).  To the extent a PEF portfolio company is a DE LLC-borrower, it should carefully review any loan documents to understand the remedies that may be baked into the loan agreements because of this ruling. 

Furthermore, DE LLCs now clearly provide additional protection to their managers that LLCs of other states do not necessarily provide, and consideration to the state of formation is even more important today after this ruling. 

The law is now clear in Delaware that creditors of a Delaware LLC have no right to bring a derivative suit on behalf of the LLC, and that those creditors may be the ultimate risk bearers in an insovlency situation.  Stakeholders of Delaware LLCs, and their professionals and advisors, must be aware of the Supreme Court’s ruling in CML V, LLC v. Bax so that they can protect themselves and their investments. 

Click here to read the full opinion.