The National Conference of Commissioners on Uniform State Laws (NCCUSL) was formed in 1892 to promote uniformity in state laws by providing states with proposed legislation. NCCUSL’s record has been mixed, but it has had notable successes in the area of commercial and business law. Examples include the Uniform Commercial Code (in cooperation with the American Law Institute), the Uniform Partnership Act, and the Uniform Trade Secrets Act.
LLC law has not been one of NCCUSL’s shining successes. NCCUSL released its first Uniform LLC Act (ULLCA) in 1995, after almost all the states had already adopted LLC statutes. ULLCA has since been adopted by only eight states.
In 2006 NCCUSL released a revised version, the Revised Uniform Limited Liability Company Act (RULLCA). In 2008 RULLCA was enacted by Idaho and Iowa.
Earlier this year Nebraska and Wyoming enacted RULLCA, doubling the number of RULLCA states from two to four. Nebraska’s new law was signed by the governor on April 1, 2010. It becomes effective January 1, 2011 and has a two-year transition period. The new Wyoming Act was signed by the governor on March 8, 2010 and became effective July 1, 2010, with a four-year transition period.
There is significant variation among the current state LLC laws, other than those of the eight states that enacted ULLCA, and the four states that have now adopted RULLCA. Many were originally modified versions of the states’ limited partnership laws, while some were copied in part from other states’ laws, from ULLCA, and from the ABA’s 1992 Prototype Limited Liability Company Act.
RULLCA has been criticized. Larry E. Ribstein, An Analysis of the Revised Uniform Limited Liability Company Act, 3 Va. L. & Bus. Rev. 35 (2008). Professor Ribstein has referred to it as “the incredibly misguided Revised Uniform Limited Liability Company Act,” here. His view is that RULLCA “threaten[s] to impose substantial risks and costs on limited liability companies … that there is little reason for states to adopt the Act, and that practitioners should be wary about advising clients to form under it.” Id.
The major criticisms of RULLCA include the following issues. Ribstein, supra, at 78-79.
- Unworkable provisions on shelf registration, i.e., creating an LLC with no initial members
- No provisions for series LLCs
- An overly broad definition of the elements of the operating agreement
- Unclear rules on the agency power of members and managers
- Broader fiduciary duties than the traditional duties of loyalty and care, with uncertain boundaries, and intricate restrictions on operating agreement waivers of fiduciary duties
RULLCA is a valuable resource for states looking to review and revise their LLC statutes, but its prognosis for becoming widely adopted looks bleak.
Given the relatively recent appearance of LLCs on the legal stage, a variety of state approaches may not be such a bad thing. Over time, case law will play out against the statutory backdrops, LLC statutes will be revised based on business needs and the results of litigation, and lawyers and business people can in effect vote with their feet by forming LLCs using whatever states’ laws best fit their needs.
The Delaware Court of Chancery decided earlier this month that a creditor of an insolvent LLC does not have standing to maintain a derivative suit in the name of the LLC against its managers. CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220 (Del. Ch. Nov. 3, 2010). The court’s lengthy opinion is nicely summarized by Francis Pileggi, here.
This blog post focuses on only one aspect of the opinion – its treatment of the interplay between the LLC Act’s statutory provisions and the judicially-created, derivative-suit remedy available to the courts under their general equity jurisdiction. My thesis is that the court gave unduly short shrift to the equitable underpinnings of the derivative suit.
The CML ruling is in contrast to the rule for corporations. Creditors of an insolvent corporation do have standing in Delaware to bring derivative claims. N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).
The CML conclusion surprised many practitioners. The court itself admitted the “awkward fact” that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing [a derivative] suit.” CML, 2010 Del. Ch. LEXIS 220, at *12.
The result is surprising because it is inconsistent with the corporate rule and with the policy behind that rule. The policy of the corporate rule was noted by the court: “When a corporation is insolvent, the creditors become ‘the principal constituency injured by any fiduciary breaches that diminish the firm’s value.’” Id. at *6 (quoting Gheewalla, 930 A.2d at 102).
That policy applies as much to an insolvent LLC as it does to an insolvent corporation. If the entity is insolvent, the members’ or shareholders’ economic interest in the LLC or corporation has been wiped out. The creditors then in effect stand in the shoes of the members or shareholders.
The CML court’s conclusion turned on its analysis of Sections 18-1001 and 18-1002 of the Delaware LLC Act:
§ 18-1001. Right to bring action.
A member or an assignee of a limited liability company interest may bring an action in the Court of Chancery in the right of a limited liability company to recover a judgment in its favor if managers or members with authority to do so have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed.
§ 18-1002. Proper plaintiff.
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.
(Emphasis added.) The court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as mandating that the plaintiff must be a member or an assignee of a member. CML, 2010 Del. Ch. LEXIS 220, at *7-8.
The court did not discuss Section 18-1002’s references to “a member or an assignee.” Creditors of an insolvent LLC, like assignees of member interests in a solvent LLC, hold the economic interest in the LLC and become the principal constituency injured by fiduciary breaches. It’s hard to see why such a creditor should not be treated like an assignee of the members’ interests. And assignees are explicitly granted standing in Section 18-1001 to initiate a derivative suit.
The court also did not discuss in any detail the equity-court origins of the derivative-suit remedy. The court’s disregard of the history of the derivative suit led it to conclude that Sections 18-1001 and 18-1002 are the sole source of authority for an LLC derivative suit. CML, 2010 Del. Ch. LEXIS 220, at *8-9.
That analysis contrasts with the court’s view of Section 327 of the Delaware General Corporation Law (DGCL). Section 327 states: “In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law.” The CML court characterized Section 327 as not creating the right to sue derivatively and as not saying that only stockholders can sue derivatively. CML, 2010 Del. Ch. LEXIS 220, at *10 (citing Schoon v. Smith, 953 A.2d 196, 204 (Del. 2008)).
The reason why Section 327 does not create the right to sue is that the derivative-suit remedy was a judicial creation. Schoon describes at length how the right of shareholders to sue derivatively originated in the equity courts in order to prevent a failure of justice, and how the shareholder derivative suit was later restricted by Section 327 to prevent strike suits. Schoon, 953 A.2d at 201-03.
Delaware courts have applied equitable remedies to LLCs even when the remedy is not set forth in the LLC Act, pursuant to the courts’ general equity powers. E.g., Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. 4113-VCN, 2010 Del. Ch. LEXIS 184 (Del. Ch. Sept. 2, 2010) (appointment of a receiver). Consistent with those cases, Delaware presumably would have applied the derivative-suit remedy to LLCs even if Delaware’s LLC Act made no mention of derivative suits.
The long history of the derivative-suit remedy and the courts’ willingness in general to assert equitable remedies imply that the LLC Act should not be viewed as the sole authority for LLC member derivative suits. And if so, one should read Sections 18-1001 and 18-1002 together, interpreting them much as DGCL Section 372 has been interpreted. Under that reading, the “must” in Section 18-1002 is seen as applying the contemporaneous ownership requirement to the subset of derivative suits instituted by an LLC member, and Section 18-1002 does not close the courthouse doors to a creditor bringing a derivative suit in the name of an insolvent LLC.
The CML court was troubled by the fact that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.” CML, 2010 Del. Ch. LEXIS 220, at *12. The court never answered the obvious question – why is that? The answer is that the court’s perfunctory treatment of the history of the derivative-suit remedy and its disregard of its own general equity jurisdiction resulted in an outré and anomalous conclusion.
LLCs are legal entities and can sue and be sued. But a recent case from Connecticut shows that if an LLC does not properly authorize the filing of a suit, the defendant can defend on the ground that the LLC lacked standing to bring the lawsuit. 418 Meadow Street Assocs. LLC v. Clean Air Partners, LLC, 123 Conn. App. 416, 2010 Conn. App. LEXIS 369 (Aug. 24, 2010).
Wynnick and Weinshel owned 50% of 418 Meadow Street Associates LLC. Levine owned the other 50%. Wynnick and Weinshel brought suit in the name of the LLC to enforce a lease agreement against Clean Air Partners. Levine’s husband owned 20% of Clean Air Partners, and Levine was not a party to the decision to commence the lawsuit.
Clean Air Partners contended that Meadow Street did not have standing to pursue the action because Wynnick and Weinshel failed to secure the necessary LLC approval. Meadow Street, 2010 Conn. App. LEXIS at **4.
Wynnick and Weinshel conceded that the LLC’s operating agreement required a majority vote to launch a lawsuit and that only a 50% vote approved the suit. They argued, however, that Levine had an interest in the outcome of the suit that was adverse to the LLC, and that therefore under Conn. Gen. Stat. § 34-187(b) her vote could be excluded from the votes required to approve the suit. They asserted that Levine’s interest was adverse both because of her husband’s 20% ownership interest in the defendant and because, in a separate lawsuit by Levine to dissolve Meadow Street, Wynnick and Weinshel had counterclaimed against her for mismanagement and breach of fiduciary duty. Meadow Street, 2010 Conn. App. LEXIS at **5.
The court didn’t see it that way. The court’s view was that her husband’s ownership interest in the defendant was not owned by her, and that the dissolution lawsuit was separate and not sufficiently connected to the lease claim against Clean Air Partners. Id. at **9-11. The court therefore affirmed the trial court and ordered dismissal of the action.
An interesting aspect of Meadow Street is the Connecticut statute, Section 34‑187(b). This statute allows an LLC to exclude from the approval process the vote of a member or manager who has an adverse interest in the outcome of a proposed lawsuit. Neither the Delaware nor the Washington LLC Act has a similar provision. In a state without such a rule, if an LLC agreement requires a majority vote to initiate a lawsuit, a 50% member would be able to block a suit even if it was a part owner of the defendant. It’s possible, though, that in such a case the members trying to start the lawsuit might be able to maintain a claim of breach of fiduciary duty against the blocking member, especially if it was voting as a manager or as a managing member.
In Washington or in any of the other community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Wisconsin), the outcome in Meadow Street would likely have been different. In those states, property owned by one spouse is presumed to be owned by the community, which means that each spouse has a one-half undivided ownership interest in their community property. In a community property state, Levine’s husband’s 20% interest in the defendant likely would have been treated as her property, through the community. In that event, her vote would not have been included because of her adverse interest, and the lawsuit would have been duly approved and could have proceeded.