Prosecuting the Directors of a Troubled Company: When Form Trumps Substance – Insolvency/Bankruptcy

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Creditors of distressed companies are often frustrated with shareholder-controlled boards when directors pursue strategies that appear to be designed to benefit shareholders at the expense of creditors. In these circumstances, creditors might consider sending a letter to the board to convince directors to pivot and adopt alternative strategies or face the risk of liability for breach of fiduciary duties. The effectiveness of this approach depends on many factors, including the financial condition of the company, the composition of the board of directors and the underlying transactions involved. But, to the surprise of many, the approach is also addicted on the social form of the borrower. A creditor’s right to sue the company’s directors varies depending on whether the borrower is incorporated or a limited liability company (“LLC”). As explained below, creditors of an LLC (even insolvent) cannot sue directors (known as “managers”) for breach of fiduciary duty or otherwise pursue derivative claims on behalf of the LLC.

A. State Law

First, we provide a brief refresher on the basics before unpacking the different rules for corporations versus LLCs. Fiduciary obligations are governed by the state of incorporation. We focus on Delaware law due to the prevalence of Delaware-formed corporations.

Here are three key takeaways from the Delaware Supreme Court’s landmark decision in North American Catholic Educational Programming Foundation, Inc. v. Gheewala930 A.2d 92 (Del. 2007) (“Ghiwalla“):

1. Directors have fiduciary duties to the society.

2. When a company is solvent, these obligations can be enforced by the shareholders of the company by bringing a “derivative action” (as opposed to a direct action) where the shareholders bring an action on behalf of the company because they are the ultimate beneficiaries of the growth and the increased value of the company. Derivative claims do not arise from particular harm that is personal to the plaintiff, but rather arise secondarily from harm caused directly to the company. The creditors of a solvent the company cannot enforce the duties of directors. Instead, creditors are protected by contracts, fraudulent conveyance law, bankruptcy law, general commercial law, and other sources of creditor rights, and those rights do not change when a business enters the “zone of insolvency”.

3. But, when a company is insolvent, its creditors replace the shareholders as residual beneficiaries of any increase in value. Therefore, the creditors of a insolvent society
too
have standing to maintain derivative claims against the directors on behalf of the company for breaches of fiduciary duty. The insolvency of the company makes the creditors the main constituency harmed by any fiduciary breach that diminishes the value of the company.

But the form of the legal entity matters! While the Ghiwalla the court’s analysis is straightforward in the corporate context, its application in the LLC context is more complicated. The distinction is based on the Delaware Limited Liability Companies Act (“LLC Act”). Section 18-1001 creates a legal right for LLC members and their assigns to bring a derivative action on behalf of an LLC. Article 18-1002 further provides that no party other than a member or assignee is permitted to bring a derivative action on behalf of the LLC. In CML V, LLC c. bax, 28 A. 3d 1037 (Del. 2011) (“Bax”), the Delaware Supreme Court squarely addressed the differences between corporations and LLCs when a creditor of an insolvent LLC brought a derivative action against the directors of the LLC and argued that an LLC creditor’s refusal to sue derivatively created an “absurd distinction between insolvent corporations, where creditors can sue derivatively, and insolvent LLCs, where they cannot can’t”. The Delaware Supreme Court flatly denied the creditors’ claim and ruled that the language of the LLC Act was unambiguous. Applying the law, the Delaware Supreme Court held that “only LLC members or assignees of LLC interests have standing to bring a derivative action on behalf of an LLC – creditors do not” . The court rejected the argument that the Delaware legislature merely intended to restate the wording of Section 327 of the Delaware General Corporations Act, which the court found did not prevent creditors from insolvent corporations to avail themselves of derivative status. He concluded that the legislature intended to limit derivative status to members and assignees of the LLC. Accordingly, creditors of an LLC do not have standing to sue the directors (managers) for any breach of any fiduciary duty, even when the LLC is insolvent.

B. Context of the bankruptcy

The bax The decision and the LLC Act have been applied in Chapter 11 contexts where Delaware bankruptcy courts have repeatedly held that individual creditors and unsecured creditor committees (as opposed to a Chapter 7 trustee) cannot not assert derivative claims to pursue claims on behalf of LLC Debtors. example, in the case of chapter 11 of In re Dura Automotive Systems, LLCNo. 19-12378 (KBO) (Bankr. D. Del. June 9, 2020) the bankruptcy court held that “the committee is not a member of LLC debtors or an assignee of an LLC interest and, therefore , does not have standing to act under the [LLC Act] bring a derivative costume [for state law claims, preference under section
547, equitable subordination and recharacterization claims] on behalf of the debtors of the LLC. “). This limitation on standing does not apply to a Chapter 7 trustee, who, unlike an individual creditor or a creditors’ committee, is the sole estate representative with the power to sue and sue. ‘wanted.

C. Recent case

Creditors in a recent bankruptcy case tried a different tactic to circumvent the state law’s limitation on the quality of creditor derivatives to sue on behalf of a Delaware LLC. In Ector County Energy Center, LLC Chapter 11 case pending in Delaware, the debtor’s largest unsecured creditor has sought standing to pursue derivative claims on behalf of the debtor’s LLC estate to (a) avoid a $75 million debt allegedly incurred for little value on the eve of bankruptcy while the debtor was insolvent, (b) recover damages for insider breaches of fiduciary duty and (c) avoid insider preferences. (Their real objective appeared to be an attempt to derail the debtor’s proposed reorganization plan since it was proposing to grant releases to these parties).

The plaintiff creditor argued that its standing to pursue derivative claims is governed by the Bankruptcy Code and federal common law, not LLC Law of the State of Delaware. He argued that the LLC statute deals with “derivative actions” in “Delaware court” in “the name of an LLC.” Here the creditor argued that he was seeking permission from the bankruptcy court fair powers act on behalf of the bankruptcy estate and stand in for the trustee under the Bankruptcy Code and before the bankruptcy court.

But in vain. In an unwritten bench decision denying the petition, the bankruptcy court ruled that creditors were barred from asserting derivative claims on behalf of a Delaware LLC under the LLC Act, which only permits the pursuit of such claims by members of the LLC or their assignees. The bankruptcy court also rejected the argument that the bankruptcy code and applicable Third Circuit case prevailed over Delaware law. Finally, the bankruptcy court, like the court of Ghiwalladetermined that creditors had other adequate avenues to seek relief, including the appointment of a Chapter 11 trustee or conversion of the case to Chapter 7.

Convenient to take: The form can prevail over the substance. Creditors of a Delaware LLC cannot assert derivative claims on behalf of an LLC, including claims against officers for breach of fiduciary duty and, after a bankruptcy filing, fraudulent conveyance claims. There may still be other ways for creditors to enforce these claims on behalf of the LLC, but doing so derivatively is not one of them! Of course, blunting that sword in many cases can benefit secured lenders.

Suing Directors of a Troubled Company: When Form Trumps Substance

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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