The Delaware Limited Liability Company Act (the LLC Act) authorizes state-law derivative actions for Delaware limited liability companies (LLCs), but also expressly limits such actions to members of the LLC or an assignee of the LLC's interest. Other parties in interest, such as creditors of the LLC, are not vested with authority to bring such actions.1 This stands in contrast to Delaware corporations that do not have a similar standing limitation for derivative actions.
On five separate occasions, the United States Bankruptcy Court for the District of Delaware (the Bankruptcy Court) has either held or suggested that the LLC Act precludes a bankruptcy court from granting an official committee of unsecured creditors standing to pursue an estate cause of action on behalf of the bankrupt LLC.2
In In re Pack Liquidating LLC,3 however, the Bankruptcy Court approved the official committee of unsecured creditors' request to bring derivative breach of fiduciary duty claims against the founders of Packable Holdings LLC, a Delaware LLC, in its Chapter 11 cases. Breaking with prior Delaware bankruptcy court precedent, the Bankruptcy Court held that the LLC Act does not preclude it from granting the committee standing to pursue an estate cause of action against an LLC's members or managers for breach of fiduciary duty, reasoning the restrictions on derivative actions under the LLC Act have no bearing on the Bankruptcy Court's power to authorize the committee to bring an estate cause of action.
Hartford and Cybergenics
The Bankruptcy Court based its decision, in substantial part, on
the Third Circuit's Cybergenics4
decision, which starts where the Supreme Court left off in
Hartford Underwriters Ins. Co. v. Union Planters Bank
N.A.5
In Hartford, the Supreme Court decided whether an
administrative claimant of a Chapter 7 bankruptcy estate has
standing to bring suit under Bankruptcy Code section 506(c), which
allows the trustee to recover costs and expenses of preserving
collateral from the secured creditor. The Supreme Court, noting
that section 506(c) states that only “the trustee may
recover,” considered whether it was a proper inference that
the trustee is the only party that is entitled to invoke that
statutory provision and held that the phrase “the trustee may
recover” means here that only the trustee can use the
recovery power granted in section 506(c).6 The
Supreme Court declined to decide whether its rationale extended to
Bankruptcy Code avoidance provisions, which also contain the same
phrase, “the trustee may [avoid/recover],” and left
open the validity of the practice under which courts grant
creditors or creditors' committees derivative standing to
bring avoidance actions.
The Third Circuit addressed this open issue in
Cybergenics and authorized a creditors' committee to
bring fraudulent transfer suits on behalf of the bankruptcy estate.
Notwithstanding the Supreme Court's Hartford
decision and the language contained in the avoidance provisions of
the Bankruptcy Code, all of which provide that “the trustee
may avoid[/recover] … ” certain
transfers,7 the Third Circuit held that the
Bankruptcy Code implicitly authorizes the bankruptcy court
to grant the committee derivative standing to bring avoidance
actions, provided the creditors' committee demonstrates that
“(i) the debtor-in-possession has unjustifiably refused to
pursue the claim or refused to consent to the moving party's
pursuit of the claim on behalf of the debtor-in-possession; [and]
(ii) the moving party has alleged colorable
claims.”8 Some, but not all, circuit
courts have agreed.9
In reaching its conclusion, the Cybergenics court neither
cited to nor referenced any state law authorizing derivative
standing to bring avoidance actions.10 Instead,
the Cybergenics court gave three reasons for arriving at
its holding: (1) the modest power to grant a committee standing can
be implied from more drastic tools at the court's disposal to
ensure that the debtor is fulfilling its fiduciary duties, e.g.,
the court's power under section 1104 of the Bankruptcy Code
to appoint a Chapter 11 trustee to dispossess the debtor from
possession of its estate;11 (2) the power may
be implied from sections 1109(b), 1103(c)(5), and 503(b)(3)(B) of
the Bankruptcy Code;12 and (3) the power to
confer standing was a traditional pre-Bankruptcy Code practice that
has been implicitly carried forward.13
Judge Goldblatt's Pack Liquidating Decision
Applying the Cybergenics court's reasoning,
Pack Liquidating extended derivative standing to the
committee to bring breach of fiduciary duty claims, holding that
“[a] federal bankruptcy court's ability to authorize a
Cybergenics action [is a federal remedy] … [that]
is not affected by the Delaware Limited Liability Company
Act.”14 Indeed, Pack Liquidating
interpreted Cybergenics to confer broad authority on
bankruptcy courts to grant creditors' committees with
derivative standing to pursue avoidance actions, state-law breach
of fiduciary duty claims, or any other claims for the benefit of
the estate.15 Alternatively, the Bankruptcy
Court held that even if the LLC Act purported to preclude it from
conferring standing on the committee to pursue estate causes of
action, it would be preempted by and give way to the federal
Bankruptcy Code.16
The “strongest argument” in favor of the application
of the LLC Act, according to the Bankruptcy Court, was that
“even though the authority to grant committee standing is
federal in nature, being derived from the Bankruptcy Code, the
Bankruptcy Code should be understood to incorporate applicable
state law,” such as the LLC Act.17
However, the Bankruptcy Court rejected this argument and ultimately
held that the breach of fiduciary duty claims the committee seeks
to assert should be viewed as a “direct (though implicit)
federal remedy that [does] not involve ‘borrowing' of
any law … [and] to the extent one views the question as a
choice between ‘borrowing' a state law rule or
‘devising' a federal common law of derivative actions,
the type of derivative action contemplated by Cybergenics
would not ‘borrow' the provisions of the Delaware
Limited Liability Company Act that would operate to defeat the very
cause of action it contemplated.”18
In reaching its decision, Pack Liquidating hesitantly
departed from prior Delaware Bankruptcy Court precedent, despite
acknowledging the “imperative to adhere to this Court's
precedent,”19 citing its obligation to
apply Cybergenics.
Implications
In view of the emerging split in Delaware, it will be worth
watching whether the issue is squarely addressed by the Third
Circuit Court of Appeals (or the Supreme Court). For now, there
will be uncertainty in the practice which may depend on the judge
handling the case. In those situations where the company is
refusing to bring a material, colorable action against the members
and the court is unwilling to grant derivative standing to the
committee, the court may instead appoint a trustee to bring the
actions. That of course has broader ramifications as it will
displace the debtor-in-possession from all control and
decision-making. In contrast, the granting of derivative standing
to a committee allows the action to be pursued and the
debtor-in-possession to remain in place.
Pack Liquidating does not hold that the Bankruptcy Court
has an unqualified right to confer standing on creditors'
committees to bring causes of action on behalf of the estate.
Committees must, among other things, allege colorable claims. The
LLC Act authorizes LLCs, through their operating agreements, to
restrict or eliminate the fiduciary duties owed by, among others,
“a member, manager or other person to a limited liability
company or to another member or manager or to another person that
is a party to, or otherwise bound by, a limited liability company
agreement; provided, that a limited liability company agreement may
not limit or eliminate liability for any act or omission that
constitutes a bad faith violation of the implied contractual
covenant of good faith and fair dealing.”20 LLCs should consider reviewing
the exculpation provisions in their governing operating agreements
to ensure the provisions provide for exculpation in an appropriate
scope. Making any necessary changes to broaden the scope of the
exculpation provisions may render claims against the LLC's
managers, members, and other persons for breach of their fiduciary
duties not colorable, thwarting a committee's attempt to gain
standing to pursue such claims.
Finally, we note that debtor-in-possession financing and cash
collateral orders often contain, at the insistence of the
creditors' committee, an agreement by the Delaware LLC debtor
and the applicable lender to waive any challenge to the ability of
the creditors' committee to file derivative actions
notwithstanding the LLC Act. We would expect that this practice
would continue until this issue is further settled.
Footnotes
1. CML V LLC v. Bax, 28 A.3d 1037 (Del. 2011) (Bax) (interpreting the LLC Act and holding that a creditor of an insolvent Delaware LLC does not have standing to bring a derivative action).
2. The three published decisions are In re HH Liquidation LLC, 590 B.R. 211 (Bankr. D. Del. 2018) (Gross, J. (ret.)); In re PennySaver USA Publishing LLC, 587 B.R. 445 (Bankr. D. Del. 2018) (Sontchi, J. (ret.)); and In re Citadel Watford City Disposal Partners L.P., 603 B.R. 897 (Bankr. D. Del. 2019) (Carey, J. (ret.)). The two unpublished decisions are In re Dura Automotive Systems, Bankr. D. Del. No. 19-12378 (Owens, J.), June 9, 2020 Hr'g Tr. at 45-48 and In re Ector County Energy Center LLC, Bankr. D. Del. No. 22-10320 (Dorsey, J.), Aug. 17, 2022 Hr'g Tr. at 59-61 (Ector County). It bears noting, however, that Judge Dorsey's ruling in Ector County emphasized that the standing motion was brought by an individual creditor rather than an official committee of unsecured creditors.
3. Case No. 22-10797, ECF No. 1231 (Bankr. D. Del. Feb. 2, 2024) (Pack Liquidating).
4. Official Comm. of Unsecured Creditors of Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003) (en banc) (Cybergenics).
5. 530 U.S. 1 (2000) (Hartford).
6. Id. at 6.
7. 11 U.S.C. §§ 544(b)(1), 545, 547(b), 548(a)(1), 549, 550 (providing “trustee may recover” any transfers avoided pursuant to, among other sections, sections 544, 545, 547, 548, and 549).
8. Pack Liquidating at 44 (quoting In re Optim Energy LLC, No. 14-10262-BLS, 2014 WL 1924908, at *6 (Bankr. D. Del. May 13, 2014).
9. Term Loan Holder Comm. v. Ozer Group LLC (In re Caldor Corp.), 303 F.3d 161, 166 (2d Cir. 2002) (holding, after the Supreme Court issued the Hartford decision, that sections 1103(c)(5) and 1109(b) “impl[y] a qualified right for creditors' committees to initiate adversary proceedings where the trustee or debtor in possession unjustifiably failed to bring suit”); In re The Gibson Group Inc., 66 F.3d 1436, 1446 (6th Cir. 1995) (“a creditor or creditors' committee may have derivative standing to initiate an avoidance action where: 1) a demand has been made upon the statutorily authorized party to take action; 2) the demand is declined; 3) a colorable claim that would benefit the estate if successful exists, based on a cost-benefit analysis performed by the court; and 4) the inaction is an abuse of discretion (“unjustified”) in light of the debtor-in-possession's duties in a Chapter 11 case”). Other circuits have precluded creditor derivative standing in bankruptcy because there is no explicit authority in the Bankruptcy Code to allow for such a practice. See In re Fox, 305 B.R. 912, 914 (B.A.P. 10th Cir. 2004) (considering the issue of creditor derivative standing and holding that “the Bankruptcy Code does not allow such suits”); see also Surf N Sun Apartments Inc. v. Dempsey, 253 B.R. 490, 491-95 (M.D. Fla. 1999) (holding that the Bankruptcy “Code does not vest bankruptcy courts with the power to grant standing to individual creditors to prosecute such actions,” that the bankruptcy courts cannot unilaterally confer standing upon the creditor to pursue the claim itself, and that “[i]f such authority is to be granted it must come from Congress and not the courts”). The Fourth Circuit refused to decide the issue of whether creditors' committees could gain standing to sue in bankruptcy cases when faced with the issue in 2005, but the court noted that “[w]e have never decided whether creditor derivative suits are permitted in the bankruptcy courts of this circuit” and that “[i]t is far from self-evident that the Bankruptcy Code permits creditor derivative standing.” In re Balt. Emergency Servs. II Corp., 432 F.3d 557, 560-61 (4th Cir. 2005).
10. “The painstaking Cybergenics opinion … did not rely in any way on the existence of state-law authority for a shareholder or creditor to assert a derivative action.” Pack Liquidating at 15.
11. Cybergenics, 330 F.3d at 572-74.
12. Id. at 560-66.
13. Id. at 569-572.
14. Pack Liquidating at 15, 41.
15. Id. at 19-20 (holding the power to grant derivative standing is implied from sections 1109(b), 1103(c)(5), and 503(b)(3)(B) of the Bankruptcy Code and is broad enough to include any claims for the benefit of the estate).
16. Id. at 27-30.
17. Id. at 34.
18. Id. at 38, 39.
19. Id. at 39.
20. 6 Del. Code § 18-1101(e).
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