Recently, three different Delaware bankruptcy judges all ruled that the Delaware Limited Liability Company Act, or DLLCA, precludes bankruptcy courts from granting derivative standing for creditors’ committees to pursue lawsuits belonging to the estates of limited liability companies.
Based on the Third Circuit’s en banc decision in Official Comm. of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003), Bankruptcy Judge Craig T. Goldblatt of Delaware found himself in the uncomfortable position of dissenting from his brethren.
In 52 pages on February 2, Judge Goldblatt explained why, in his view, Cybergenics required him to decide that “the restrictions on derivative actions imposed by the [DLLCA] . . . have no bearing on a bankruptcy court’s ability to authorize a committee to bring an estate cause of action.”
The Lawsuit and the Delaware Statutes
The debtor was a Delaware LLC in chapter 11. The official creditors’ committee believed the estate had causes of action against members and officers of the LLC for breach of fiduciary duty. So, the committee filed a motion seeking derivative standing to bring the actions in bankruptcy court on behalf of the debtor.
Opposing the motion for standing, the debtor and its officers and members relied on In re HH Liquidation, LLC, 590 B.R. 211 (Bankr. D. Del. 2018); In re PennySaver USA Publishing, LLC, 587 B.R. 445 (Bankr. D. Del. 2018); and In re Citadel Watford City Disposal Partners, L.P., 603 B.R. 897 (Bankr. D. Del. 2019). To read ABI’s report on Watford and its summaries of HH and PennySaver, click here.
In HH, for instance, the Delaware bankruptcy court ruled in 2018 that an unsecured creditors’ committee of an LLC had no standing to sue for breach of fiduciary duty because none of the creditors was a member of the LLC. Given the absence of a “proper plaintiff,” the court found no subject matter jurisdiction. HH, supra, 590 B.R. at 283-85.
When it comes to derivative actions, Delaware law treats corporations and LLCs differently. While 36 states have adopted the Model Business Corporation Law’s approach to derivative suits, the law in Delaware regarding corporations is governed by common law, modified by Section 327 of the Delaware General Corporation Law.
As Judge Goldblatt said, Section 327 “limit[s] the right to bring a derivative action to a shareholder who held shares at the time of the challenged transaction.” However, he went on to say that “Delaware law also recognizes that in the event of insolvency, creditors replace shareholders as the residual beneficiaries of an increase in corporate value.” As a result, “the Delaware Supreme Court has authorized creditors to sue derivatively to enforce the obligations that an insolvent company’s directors owe to the corporation.”
For Delaware corporations, there is thus no bar to giving standing to a committee for pursuit of claims belonging to the debtor. With regard to LLCs, Delaware law is different, because LLCs are considered “creatures of contract.”
The DLLCA permits LLCs to grant exculpation for violation of fiduciary duties or to eliminate monetary liability, Judge Goldblatt said. Delaware law goes on to say that the plaintiff in a derivative action must be either a member of the LLC or an assignee of the LLC.
Judge Goldblatt explained that the DLLCA thus “function[s] to bar creditors from bringing the kind of [suits based on] derivative standing that creditors of a corporation may bring.” As the three Delaware bankruptcy judges found in HH, PennySaver and Watford, the Delaware DLLCA deprives creditors’ committees of derivative standing to prosecute estate claims.
The Implications of Cybergenics
But is the Delaware DLLCA the end of the story? Judge Goldblatt responded, saying, “Any fair reading of the Third Circuit’s landmark decision in Cybergenics reveals that the answer to that question is no.”
Explicating Cybergenics in pages of detail, Judge Goldblatt said that the en banc opinion “did not rely in any way on the existence of a state-law authority for a shareholder or creditor to assert a derivative action.” Rather, he said, “the Cybergenics court viewed an order authorizing committee standing as a tool, provided by federal bankruptcy law, that does not depend at all upon state law.”
The Third Circuit is not alone. Judge Goldblatt pointed to the Second, Sixth and Seventh Circuits for holding that “the authority to grant committee standing [is] a federal law power that [does] not turn on any provision of state law.” Likewise, he cited Bankruptcy Judge Michael E. Wiles of New York for “[r]ejecting the argument that the Delaware Limited Liability Company Act precluded him from authorizing a committee to pursue an estate cause of action.” See In re McClatchy Co., 20-10418 (Bankr. S.D.N.Y. July 6, 2020), Hr’g Tr. at 30.
Judge Goldblatt held:
[T]he bankruptcy court authority described by the Cybergenics court, to grant a committee standing to pursue an estate cause of action when a debtor in possession refuses to bring a potentially valuable claim, is a power that derives from federal law. It does not rely or depend on the law of the state in which the debtor is incorporated. As such, limitations on state-law derivative actions have no application to a Cybergenics action. For that reason, the restrictions on derivative actions imposed by the [DLLCA] . . . have no bearing on a bankruptcy court’s ability to authorize a committee to bring an estate cause of action.
Preemption
Even if the DLLCA could be read to deprive a committee of derivative standing, Judge Goldblatt went on to hold that Delaware law “would conflict with the Bankruptcy Code and thus be preempted.”
Judge Goldblatt said that preemption can be express or implied. If implied, preemption comes in two forms: field or conflict preemption. He decided that the case presented “implied rather than express” preemption.
Judge Goldblatt saw “no objective of chapter 11 . . . more critical than ensuring that the debtor in possession operate as a faithful trustee.” He found preemption because “[a]ny state law that would operate to preclude a bankruptcy court from granting a committee standing to pursue an estate cause of action . . . would frustrate that congressional purpose and thus be preempted by the Bankruptcy Code.”
The Contrary Delaware Decisions
Judge Goldblatt recognized that “three judges of this Court have issued published opinions reaching the opposite conclusion.” He added, “That is certainly reason to pause.”
Of course, the three decisions were not binding on Judge Goldblatt, but he said there were “sound prudential reasons to strive for consensus.”
Of most significance in deciding whether to follow precedents from his own courthouse, Judge Goldblatt observed that “the prior decisions did not address how the Cybergenics opinion affected the proper resolution of the question at issue.”
“Despite the Court’s strong reluctance to break with a uniform position adopted by other judges of this Court,” Judge Goldblatt concluded “that in the circumstances presented here, it is required to do so” because “Third Circuit precedent is formally binding on this Court.” He therefore “respectfully disagree[d] with the three published opinions in favor of adhering to the reasoning set out by the en banc Third Circuit decision.”
Finding that the committee had met the “traditional standards” for standing, Judge Goldblatt granted “the Committee’s motion for derivative standing to pursue the breach of fiduciary duty claims.”
Observation
Judge Goldblatt’s opinion harkens to a decision by Bankruptcy Judge Christopher M. Lopez of Houston in December, In re Envision Healthcare Corp., 655 B.R. 701 (Bankr. S.D. Tex. Dec. 12, 2023).
Contrary to holdings by the Delaware Chancery Court, Judge Lopez held that Delaware law cannot strip away a member’s managerial and voting rights in a limited liability company when the member files a chapter 11 petition. To read ABI’s report on Envision, click here.
With regard to preemption, Judge Goldblatt relied on Envision in his footnote 87.
Recently, three different Delaware bankruptcy judges all ruled that the Delaware Limited Liability Company Act, or DLLCA, precludes bankruptcy courts from granting derivative standing for creditors’ committees to pursue lawsuits belonging to the estates of limited liability companies.
Based on the Third Circuit’s en banc decision in Official Comm. of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003), Bankruptcy Judge Craig T. Goldblatt of Delaware found himself in the uncomfortable position of dissenting from his brethren.
In 52 pages on February 2, Judge Goldblatt explained why, in his view, Cybergenics required him to decide that “the restrictions on derivative actions imposed by the [DLLCA] . . . have no bearing on a bankruptcy court’s ability to authorize a committee to bring an estate cause of action.”