Delaware Court Rules that Trustee Acting for Creditors of an LLC or LP Cannot Assert Breach of Duty Claims

It is a well-settled principle of Delaware corporate law that creditors of an insolvent corporation can pursue derivative (but not direct) actions for breach of fiduciary duty against directors of the corporation. An unresolved issue is whether creditor derivative actions can likewise be brought against the managers or governors of other insolvent legal entities, such as limited liability companies (LLCs) or limited partnerships (LPs). A Delaware bankruptcy judge recently ruled on this issue, holding that a liquidation trustee acting on behalf of creditors of an LLC and an LP lacks standing to pursue derivative breach of fiduciary duty claims. Gavin/Solmonese LLC v. Citadel Energy Partners LLC (In re Citadel Watford City Disposal Partners), 2019 Bankr. LEXIS 1375 (Bankr. D. Del. May 2, 2019)(Carey, J.).

The Citadel Debtors were formed under the laws of three different states: Delaware, North Dakota and Wyoming. During the pendency of their bankruptcy proceedings, a committee of unsecured creditors (the Committee) commenced a breach of fiduciary duty adversary proceeding against certain principals of the Debtors. Thereafter, a chapter 11 plan was confirmed. The plan created a liquidation trust and provided for the appointment of a liquidation trustee (Trustee) to act on behalf of the Debtors' creditors. The Trustee succeeded to the Committee as plaintiff in the breach of fiduciary duty case.

Certain defendants in the adversary proceeding filed a motion to dismiss the derivative claims that were being prosecuted by the Trustee. Their motion to dismiss was predicated on an argument that creditors do not have standing to assert derivative claims against the principals of an LLC or an LP and as a result the Trustee also lacks standing. The Bankruptcy Court agreed and granted the motion to dismiss.

In the Citadel opinion, Judge Carey explained that the issue of whether creditors have derivative standing to bring breach of fiduciary claims against managers or other principals of insolvent LLCs and LPs was an issue of state law. He therefore examined Delaware, Wyoming and North Dakota state law and found that each limits LP and LLC derivative standing to partners of such entities, their members, or individuals to whom such rights have been assigned. See In re Citadel Watford City Disposal Partners, 2019 Bankr. LEXIS 1375, at *9-10 ("Authority for derivative standing by creditors who are not partners or assignees of partnership interests is plainly missing from the statutory language. Under Delaware law, then, creditors of limited partnerships lack standing to sue derivatively on behalf of an LP"); Id. at *11 ("The Delaware Limited Liability Company ('LLC') Act contains virtually identical standing provisions as the LP Act, except for substituting terms relevant to the entity, such as 'member' for 'partner' and 'limited liability company' for 'limited partnership'"); Id. at *15 ("[t]he Wyoming and North Dakota derivative statutes are substantially similar to that of Delaware, have been interpreted consistently with the Delaware decisions and limit derivative actions authorized by statute to members at the time an action is commenced.").

Because creditors of an LP or an LLC lack standing to bring a derivative claim for breach of fiduciary duty against the LP's or LLC's managers or other principals, Judge Carey held that the Trustee, which was acting on behalf of the Debtors' creditors, likewise lacks such standing. Accordingly, the Court dismissed those claims. In rendering his decision, Judge Carey was untroubled by the fact that he was "distinguishing between insolvent corporations, where creditors can sue derivatively, and insolvent LLCs [and LPs], where they cannot." Id. at *11. He noted that unlike corporations, LLCs are "creatures of maximum flexibility, and creditors are presumed to be capable of protecting themselves through the contractual agreements that govern their relationships." Id. (quoting In re HH Liquidation, LLC, 590 B.R. 211, 283-85 (Bankr. D. Del. 2018).

The Citadel decision is important for those representing LLC or LP debtors, their managers or other principals, and their creditors—especially because breach of fiduciary duty claims have become a common way for out-of-the-money creditors to try to generate some recovery. It may also provide an avenue for a corporate entity – particularly a closely held one—to limit the liability of its directors with respect to potential derivative lawsuits—by converting to an LLC or an LP. Of course, there would be other considerations in pursuing such a strategy.

© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.