Delaware bankruptcy court breaks with sister courts and grants derivative standing to creditors of a Delaware LLC to sue its members and officers
Judge Craig T. Goldblatt recently expanded the rights of creditors to sue the members and officers of a bankrupt Delaware limited liability company (LLC) in In re Pack Liquidating, LLC, Case No. 22-10797 (CTG) (Bankr. D. Del. Feb. 2, 2024).
Judge Goldblatt found that the Bankruptcy Code creates a federal right for creditor derivative standing that exists even though Delaware law does not allow creditors of debtor LLCs to sue LLC members and officers for breach of fiduciary duty. Moreover, to the extent that federal right given by the Bankruptcy Code conflicts with state law, Judge Goldblatt also held that the federal Bankruptcy Code preempted Delaware state law. In so holding, Judge Goldblatt broke with a distinguished and well-established line of Delaware bankruptcy cases that applied Delaware state law to deny such derivative standing to creditor representatives.
As a result, creditors’ committees may now have a new tool to pursue fiduciary duty claims against members and officers of a bankrupt Delaware LLC.
The Delaware Limited Liability Company Act (DLLCA)[1] precludes creditors of an LLC from asserting derivative claims for breach of fiduciary duty
The DLLCA prohibits creditors from asserting derivative claims against an LLC’s members and officers outside of a bankruptcy case, even if the applicable LLC is insolvent. Under the plain terms of the DLLCA, only members or an assignee of an LLC can obtain derivative standing to pursue actions on behalf of the LLC.[2] In the seminal case of CML V, LLC v. Bax, 28 A.3d 1037 (Del. 2011), the Delaware Supreme Court applied these express statutory terms and held (i) the DLLCA means what it says – namely that the DLLCA expressly limited standing for derivative actions to members or assignees of the applicable LLC, and (ii) notwithstanding the Court’s decision in Gheewalla[3] that creditors of an insolvent corporation have standing to pursue such derivative claims against the corporation’s officers and directors, the Delaware legislature did not intend the holding in Gheewalla to apply in the context of an insolvent LLC to create standing for creditors to pursue such derivative claims.
Three published Delaware bankruptcy cases previously applied the DLLCA and Bax to limit derivative standing to members and assignees only
Three prior Delaware Bankruptcy Court decisions applied the plain language of the DLLCA and followed the Delaware Supreme Court’s holding in Bax to prevent creditors (or even trustees) from pursuing derivative claims on behalf of Delaware LLC debtors. See In re Citadel Watford City Disposal Partners, L.P., 603 B.R. 897 (Bankr. D. Del. 2019) (where a post-confirmation trust was given authority to pursue all estate causes of action, citing Bax as grounds for dismissing claims for breach of fiduciary duties); In re HH Liquidation, LLC, 590 B.R. 211 (Bankr. D. Del. 2018) (where the creditors’ committee sought breach of fiduciary duty claims against LLC managers, holding that the DLLCA and Bax do not permit creditors to pursue such state law derivative actions); and In re PennySaver USA Publishing, LLC, 587 B.R. 445 (Bankr. D. Del. 2018) (where the court treated a chapter 7 trustee’s complaint as a derivative claim, finding that the DLLCA and Bax barred the trustee from proceeding on the claim).
Pack breaks with other Delaware bankruptcy cases and holds that a creditors’ committee may pursue derivative claims against members and officers of an LLC
Background of Pack
The Pack debtors were organized as Delaware limited liability companies, engaging in e-commerce as third-party sellers of health, beauty, and consumer products. During the pendency of the chapter 11 cases, the Official Committee of Unsecured Creditors (the Pack Committee) filed an adversary proceeding asserting breach of fiduciary duty claims against the LLC’s members and officers (who were the same people serving in both capacities), as well as other claims for equitable subordination, avoidance, and recovery of fraudulent transfers and disallowance of claims.
Certain defendants filed an objection to the Pack Committee’s motion for an order confirming its standing to commence an action for breach of fiduciary claims. They argued DLLCA mandates that only LLC members or their assignees can obtain derivative standing to prosecute the LLC’s breach of fiduciary duties claims. The defendants’ objection cited to Bax and the three Delaware bankruptcy court decisions, discussed above.[4]
In granting the Pack Committee standing, Judge Goldblatt applied the Third Circuit’s Cybergenics[5] decision and held that the question relating to the Pack Committee’s standing involved a right created under the federal Bankruptcy Code and not Delaware state law; therefore, Judge Goldblatt said that the DLLCA does not preclude granting the Pack Committee standing to pursue an estate cause of action if the relief is otherwise warranted.
The Third Circuit Cybergenics decision
In Cybergenics, an unsecured creditors’ committee sought derivative standing to pursue certain fraudulent conveyance claims (avoidance claims) on the debtors’ behalf.[6] The Delaware bankruptcy court concluded that the fraudulent transfer claims were colorable and that the debtors’ refusal to prosecute them was unreasonable.[7] It therefore granted the committee standing to bring the fraudulent conveyance actions under section 544(b) of the Bankruptcy Code.[8]
On appeal, the Delaware district court affirmed the bankruptcy court’s granting of the debtors’ motion to dismiss, holding that the committee could not bring suit under section 544(b) of the Bankruptcy Code because only the debtor or trustee had standing to pursue fraudulent transfer claims.[9]
The Third Circuit Court of Appeals reversed, holding that the bankruptcy court could, in the exercise of its federally created equitable power under the Bankruptcy Code, authorize a creditors’ committee to bring derivative fraudulent conveyance claims when the debtor or trustee improperly refused to do so.[10] In so ruling, Cybergenics did not cite to or rely on state law; its analysis focused exclusively on rights created under federal bankruptcy law.
Holding in Pack
Judge Goldblatt applied Cybergenics and concluded that the Pack Committee’s standing to assert a derivative action is grounded in federal bankruptcy law, and is not dependent on any underlying state law.[11] As such, the Pack Court held that such standing cannot be limited by state law: “[I]t necessarily follows that the authority is not affected by acts of a state legislature to limit the availability of state-law derivative actions.”[12] According to Judge Goldblatt, Cybergenics and the DLLCA “operate in separate spheres . . . [where the DLLCA] governs suits filed in the [Delaware] Court of Chancery, the authority to bring a Cybergenics action is a federal authority.”[13]
Judge Goldblatt also rejected the defendants’ argument that Cybergenics applied only to committee standing to bring an avoidance action (such as the fraudulent transfer claims) rather than breach of fiduciary duty claims.[14] Instead, “the Bankruptcy Code effectively codified the established pre-Code practice of permitting bankruptcy courts to authorize derivative standing when the trustee or debtor-in-possession refused to act in the best interests of the estate . . . [and t]here is no suggestion that the pre-Code practice was limited to avoidance actions.”[15] In addition to Cybergenics, Judge Goldblatt relied upon caselaw from other circuits similarly holding that committee standing in a bankruptcy case derives from federal bankruptcy power – not state law.[16]
Judge Goldblatt also held, in the alternative, that to the extent the DLLCA restricted the power of a bankruptcy court to authorize a Cybergenics action, such restriction would be barred and preempted by the Bankruptcy Code.[17] Even if the DLLCA did “[seek] to restrict the authority of a bankruptcy court to authorize a Cybergenics action, such efforts would be unsuccessful because it would conflict with the Bankruptcy Code and thus be preempted” by federal law.[18]
Judge Goldblatt breaks with other Delaware bankruptcy court decisions
Judge Goldblatt noted that his decision is at odds with the three published opinions of Delaware bankruptcy courts cited above, each following the Delaware Supreme Court’s decision in Bax to deny standing to a non-member or assignee of an LLC to pursue a derivative claim.[19] Judge Goldblatt noted that in each of these three cases, the opinions did not consider Cybergenics or explain how their decisions (based on Bax and the DLLCA) “can be reconciled with Cybergenics.” Though Judge Goldblatt paused at breaking with other trial courts’ decisions,[20] he “respectfully disagreed with the three published opinions in favor of adhering to the reasoning set out by the en banc Third Circuit.”[21]
Judge Goldblatt applied the DLLCA to uphold fiduciary duty waivers
Under the DLLCA, an LLC operating agreement is a creature of state law.[22] It is well-established that the DLLCA authorizes members of an LLC to disclaim all fiduciary duties in the applicable operating agreement. By its terms, the Pack decision would not impact the efficacy of such a waiver – which would operate to bar a creditors committee from pursuing derivative claims for breach of fiduciary duty. According to Judge Goldblatt, the waiver is a state law substantive right which the court would respect:
Unlike the provisions addressed to who may maintain a derivative lawsuit, which are procedural in nature, the disclaimer of fiduciary duties affects the substance of the rights that the debtor would have had as of the time of the bankruptcy filing. Accordingly, to the extent state law permits the disclaimer of fiduciary duties, that is fully respected and controlling in bankruptcy, as the bankruptcy estate obtains under [Bankruptcy Code Section] 541 only those rights that the debtor held as of the time of the bankruptcy filing.[23]
In Pack, the complaint alleged that the debtors’ managers also served as officers.[24] The LLC operating agreement waived the managers’ personal liability for breach of fiduciary duties in their capacity as managers.[25] However, the operating agreement did not waive any officer’s fiduciary duties, even if those officers also served as managers.[26] Accordingly, Judge Goldblatt applied the fiduciary duty waiver in the LLC and held that the Pack Committee (a) could not pursue derivative claims for breach of fiduciary against managers in their capacity as such, but (b) could bring derivative claims for breach of fiduciary against Pack’s officers in their capacity as officers.[27]
Post-Pack future
The Pack decision is an important change in Delaware bankruptcy case law that gives creditors’ committees another tool to pursue claims against members and officers of an LLC. However, there are important limitations and other key takeaways to consider:
- Pack upheld the DLLCA’s enforcement of well-drafted waivers of fiduciary duty liabilities in the LLC operating agreement. Therefore, courts applying Pack’s reasoning may grant standing to creditors’ committees to sue members and officers for breach of fiduciary duty, but only to the extent the relevant LLC operating agreement does not contain those waivers.
- The Pack ruling is not binding authority on other courts in Delaware or in other jurisdictions. Members and officers of financially stressed Delaware LLCs are advised to review their operating agreements to make sure they contain appropriate waivers. If they do not contain the appropriate waivers, they are advised to consider revising them and/or ensuring that the LLC has sufficient insurance to cover the defense of its members and officers.
- Members and board members of an insolvent LLC that do not benefit from fiduciary duty waivers in the relevant LLC operating agreement should make sure to meet, deliberate, and take into account the interests of creditors when making decisions for the LLC.
- While Pack represents a new and expansive application of Cybergenics with respect to derivative standing in Delaware bankruptcy court, the result builds upon workarounds by certain bankruptcy judges to provide creditors’ committees standing to pursue claims against members and officers of a debtor LLC. For example, in connection with the establishment of a “challenge period” to assert claims in connection with post-petition financing (eg, deadlines by which a creditors’ committee must bring any claims against the lender), bankruptcy judges in Delaware at times require debtors to stipulate to waivers of objections to derivative standing for a creditors’ committee.[28]
DLA Piper’s Global Restructuring practice is highly experienced in developing solutions for distressed companies and their stakeholders in all manner of in- and out-of-court restructurings, liability management strategies, finance, and litigation matters.
If you have any questions about this ruling or any restructuring-related matter, please reach out to the authors or your usual DLA Piper contact.
[1] 6 Del. C. § 18-101, et. seq.
[2] Id. § 18-1002. Moreover, Section 18-1002 expressly provides that “the plaintiff [in such action] must be a member or an assignee of a limited liability company.”
[3] N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).
[4] See, e.g., D.I. 1027, 1050, 1067.
[5] In re Cybergenics Corp., 226 F.3d 237, 245 (3d Cir. 2000).
[6] Id.
[7] Id.
[8] Id.
[9] Id.
[10] Id. at 568.
[11] Op. at 38.
[12] Id. at 15-16.
[13] Id. at 27.
[14] Id. at 32.
[15] Id.
[16] Id. at 22 (citing In re Commodore Intl’l Ltd., 262 F. 3d 96 (2d. Cir., 2001); In re STN Enterprises, 779 F.2d 901 (2d. Circ. 198); In re Gibson Group, Inc., 66 F.3d 1436 (6th Cir. 1995); Louisiana World Exposition v. Federal Ins. Co., 858 F.2d 233 (5th Cir. 1988); Fogel v. Zell, 221 F.3d 955 (7th Cir. 2001); In re McClatchy Co., Bankr. S.D.N.Y. No. 20-10418, July 6, 2020 Hr’g Tr. at 30).
[17] Id. at 27.
[18] Id.
[19] See HH Liquidation, 590 B.R. 211; In re PennySaver USA Publishing, 587 B.R. 445; Citadel Watford, 603 B.R. 897.
[20] The Pack Court also noted that other unreported Delaware bankruptcy court decisions reached the same conclusion. See, e.g, In re Dura Automotive Systems, Bankr. D. Del. No 19-12378, June 9, 2020, Hr’g Tr. at 45.
[21] Op. at 43.
[22] “In view of the internal affairs doctrine … matters of corporate law are governed by the law of the state of incorporation.” Id. at 34.
[23] Id. at 45.
[24] Id. at 47.
[25] Id.
[26] Id. at 47-48.
[27] Id.
[28] For example, the interim cash collateral order entered in Pack stated, “Notwithstanding anything to the contrary in this Interim Order, any issue regarding whether creditors have the ability to file derivative suits on behalf of any Debtor that is a limited liability company is expressly reserved pending entry of the Final Order.” In re Pack Liquidating, LLC, et al., Case No. 22-10797 (CTG) (Bankr. D. Del. Aug. 28, 2022) [Docket No. 53] (Interim Cash Collateral Order); see also In re Uphealth Holdings, Inc., Case No. 23-11476 (LSS) (Bankr. D. Del. Dec. 12, 2023) [Docket No. 61] (Interim Cash Collateral Order), [Docket No. 229] (Final Cash Collateral Order).
