The Delaware Bankruptcy Court Divided: Whether Creditors’ Committees of Bankrupt Delaware Limited Liability Companies May Bring Derivative Claims

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.

© Arnold & Porter Kaye Scholer LLP 2024 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.