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Creditors’ rights continue to evolve in Delaware courts.

New areas of the law usually undergo an evolutionary process, and that is clearly the case with regard to the rights of creditors and the duties owed by the management of companies to which they lend money.

In 1991, in Credit Lyonnais Bank v. Pathe Comm. Corp., the Delaware Court of Chancery held that directors did not breach their fiduciary duties by considering the interests of creditors (as opposed to just stockholders) when making decisions.

For 15 years thereafter, federal bankruptcy courts, supposedly applying Delaware law and citing Credit Lyonnais, held that directors actually owe fiduciary duties  to creditors when making decisions while the corporation is insolvent or in the zone of insolvency. In 2007, the Delaware Supreme Court put an end to these holdings in North American Catholic Educational Programming, Inc. v. Gheewallathough some bankruptcy courts now misinterpret Gheewalla.

In Gheewalla, the court held that directors of a corporation do not owe any fiduciary duties to creditors because a creditor’s relationship is purely contractual and any claim must be grounded in the loan documents. However, the court went on to hold that once a corporation is actually insolvent, creditors, as the residual beneficiaries of the corporation, step into the shoes of the stockholders and can pursue derivative claims so long as those claims are that management breached a duty owed to the corporate enterprise and not that management’s actions disregarded some duty owed to creditors.

After Gheewalla, most practitioners assumed the standing afforded to creditors would be extended to limited liability companies, but in an en banc decision issued on Sept. 6, 2011, in CML V, LLC v. John Bax, et al., the Delaware Supreme Court ruled that creditors of insolvent LLCs have no standing to pursue derivative claims. The reason for this because the LLC relationship is governed solely by contract and such rights must be found in Delaware’s Limited Liability Company Act (LLC Act) or the applicable LLC operating agreement.

Section 18-1002 of the LLC Act states that “[i]n a derivative action, the plaintiff must be a member or an assignee” of an LLC. The court held that “the plain language of 6 Del. C. § 18-1002 is unambiguous and limits derivative standing in LLCs exclusively to ‘member[s]’ or ‘assignee[s].’”

The analysis in CML makes perfect sense, but Section 327 of the Delaware General Corporation Law (DGCL), which governs derivative standing for general corporations, states that “[i]n any derivative suit…it shall be averred in the complaint that the plaintiff was a stockholder…” A creditor cannot make  such an averment, so why didn’t the c ourt in Gheewalla hold that Section 327 limits derivative standing exclusively to stockholders?

The rationale is that the right to pursue a derivative action was created hundreds of years ago by courts of equity and the DGCL is a codification of the common law of corporations, whereas LLCs are new and the LLC Act is in derogation of the common law (a debate for another day). The CML court held that the Delaware Court of Chancery has the power to extend judicially created equitable      doctrines to prevent failure of justice, but it has no such power when the Legislature has clearly spoken on a matter exclusively within its realm (i.e., the LLC world).

This separation of power between Delaware’s equity court and the legislature also makes perfect sense, but the CML court went on to state that even if it had the power to extend derivative standing to creditors of LLCs, it was unnecessary because creditors can negotiate for many different types of contractual remedies and their failure to do so does not threaten the “interests of justice.”

If that is so, creditors of general corporations can negotiate for the exact same remedies. In fairness to the Delaware Supreme Court, the issue they were confronting in Gheewalla was whether creditors were owed direct fiduciary claims; derivative claims were not being considered and derivative standing was not the central issue. Perhaps this aspect (dicta) of Gheewalla needs to be revisited.

The next step in this evolving area is to extend to Section 327 of the DGCL, the conclusion in CML that creditors can protect themselves and do not need the protection of judicially created equitable doctrines. The extension of derivative standing to creditors in Gheewalla, and the subsequent, well-reasoned approach taken in CML, should not exist in the same analytical space.

Contributing Author

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John Reed

John Reed is a partner the Delaware office of DLA Piper, where he concentrates his practice on corporate litigation and counseling. He can be contacted...

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