Delaware Supreme Court Upholds Bar on Derivative Suits by Creditors of Insolvent LLCs
During the past two months I have been on an extended vacation – very nice. Thanks to my colleagues Janet Jacobs and John Laney for guest-authoring posts, here and here.
Last week the Delaware Supreme Court ruled on the appeal of CML V, LLC v. Bax, in which the Court of Chancery held last year 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. I wrote about that surprising result here – surprising because it is inconsistent with the corporate rule.
Delaware’s Supreme Court affirmed the Court of Chancery decision, holding that “Section 18-1002 of the LLC Act, by its plain language, limits LLC derivative standing to ‘member[s]’ or ‘assignee[s],’ and thereby denies derivative standing to LLC creditors.” CML V, LLC v. Bax, No. 735,2010, 2011 Del. LEXIS 480, at *24 (Del. Sept. 2, 2011) (brackets in the original).
The 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.
The Court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as requiring that the plaintiff be an LLC member or an assignee of a member. The Court emphasized the mandatory language in Section 18-1002: “must be a member or assignee,” and found Sections 18-1002 and 18-1002 to be unambiguous. CML, 2011 Del. LEXIS 480, at *11.
CML argued that (i) Section 18-1001 authorizes derivative standing to members or assignees but is not by its language exclusive, (ii) Section 18-1002 addresses only the chronology of such a member’s or assignee’s status, and (iii) when the two sections are read together they are similar in their effect to the comparable provisions of the Delaware General Corporation Law, Del. Code Ann. tit. 8, § 327, which has long been interpreted as allowing derivative standing for creditors of insolvent corporations.
CML’s position is buttressed by what the Court of Chancery characterized as an awkward fact:
[V]irtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit. Particularly in light of Production Resources and Gheewalla, an exclusive reading of Section 18-1002 would cause LLC derivative actions to differ markedly from their corporate cousins. If practitioners widely understood the derivative standing provisions to have this effect, one would expect treatises, articles, and commentaries to call attention to that fact. … [O]ne also would expect courts to have encountered parties raising the statutory provisions as a defense. Yet the universe of authorities favoring the no-standing position consists of (i) a single sentence at the end of a footnote in one Delaware treatise, see Symonds & O’Toole, supra, § 9.09, at 9-61 n.270, and (ii) abbreviated treatment in an unreported district court decision, see Magten, 2007 WL 129003, at *3.
Many commentators, by contrast, have assumed that creditors of an insolvent LLC can sue derivatively. In light of this assumption, they have debated vigorously whether an LLC agreement can limit the fiduciary duties that the creditors would invoke. That question never arises if creditors lack standing to sue under Section 18-1002.
CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220, at *12-13 (Del. Ch. Nov. 3, 2010) (footnote omitted).
This widespread reading of Sections 18-1001 and 18-1002 significantly undercuts the Court’s assertion that these two sections are unambiguous.
Nonetheless, the Court has spoken and the rule is now clear, at least until changed by legislative action. Given the gulf between the Court’s reading of the statute and the widespread past interpretations by commentators and practicing lawyers, it would not be surprising to see legislative action on this point. As the Court said, “The General Assembly is well suited to make that policy choice and we must honor that choice.” CML, 2011 Del. LEXIS 480, at *13.
Delaware Court Interprets LLC Act to Bar Derivative Suit by Creditor of Insolvent LLC
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.
Time Is Running Out to Defer Income Recognition from Debt-Equity Exchanges
Restructures of financially distressed firms often involve debt-equity exchanges. The concept is straightforward: the company issues equity to its lenders in exchange for their cancellation of some of the company’s debt. The company’s debt burden and interest payment expenses are reduced and its balance sheet is strengthened.
On the downside, the company’s equity holders are diluted, often substantially. The alternative to the restructure, of course, may be a chapter 7 bankruptcy in which the equity owners are wiped out. Lenders don’t usually want to take equity in their debtors, but depending on its security position, a lender may view a debt-equity exchange as a preferable alternative to liquidation or as a necessary component of a chapter 11 case. The exchange will provide the lender with upside on the equity it receives, assuming the company survives and ultimately prospers.
The details of a debt-equity exchange are complex. Multiple classes of debt and equity may be involved. The company and the debtors will need to agree on valuations of different classes of debt and equity, on how much debt and how much equity to exchange, and on the classes and amounts of equity to be exchanged. And as with any major corporate transaction, the tax consequences have to be considered.
If the amount of debt that is cancelled exceeds the fair value of the equity issued in exchange for the debt, the company will recognize cancellation of debt (COD) income in the amount of the excess. I.R.C. § 61(a)(12), § 108(e)(8). If the debtor is an LLC, the equity may consist of either a capital or a profits interest in the LLC.
The Code provides several exceptions to recognition of COD income, including an insolvency exception. If the company issuing the equity is insolvent or in a title 11 bankruptcy case immediately before discharge of its debt, it will not recognize COD income. I.R.C. § 108(a). The tax obligation is deferred and not completely eliminated, because what would otherwise be COD income is applied to reduce several of the company’s tax attributes, beginning with its net operating loss carryovers. I.R.C. § 108(b).
The tax rules on debt-equity exchanges apply to corporations and to LLCs in the same way, with one significant exception. LLCs are taxed as partnerships and LLC income is passed through to the members. COD income of an insolvent LLC will therefore be allocated to the members, but they cannot use the § 108 insolvency exception based solely on the LLC’s insolvency. The members have the income, but the LLC has the insolvency. Not unless the member itself is insolvent can it claim the insolvency exception.
In many cases the member will not be insolvent, in which case the LLC’s COD income will be included in the member’s income unless any of several other exceptions apply to that member. And if the LLC is insolvent, there won’t be any cash distributions to the members to cover their tax bill from the COD income.
LLC members caught in this situation may be able to defer COD income from a debt-equity exchange, if the exchange occurs before the end of this year. The American Recovery and Reinvestment Act of 2009 added a new Code § 108(i), which allows taxpayers incurring COD income as a result of debt-equity exchanges occurring during 2009 or 2010 to elect to defer that income.
The deferred income will be included in the taxpayer’s income ratably over five years, starting in 2014 and ending in 2018. The deferral election is made by attaching a statement to the taxpayer’s return for the taxable year in which the debt-equity exchange takes place. The deferral is accelerated into any year in which the taxpayer’s death, sale of the LLC interest, or cessation of doing business occurs.
The deferral will be attractive for most LLC members receiving COD income. Whether it’s the right choice will depend on the taxpayer’s individual situation, and on what happens to income tax rates during 2014 through 2018.
But the clock is running down on this deferral opportunity. If an LLC restructures with a debt-equity exchange that closes after December 31, 2010, its members will no longer be able to elect the deferral. As the end of 2010 approaches, LLCs contemplating debt-equity exchanges should consider timing the transaction to ensure closing before the year end, in order to preserve the members’ ability to elect the deferral.
