Creditor Barred from Bringing a Derivative Action Against an Insolvent Delaware Limited Liability Company

In a recent ruling, Trusa v. Nepo (Del. Ch. April 13, 2017), consistent with prior case law, Vice Chancellor Montgomery-Reeves of the Delaware Chancery Court held that a creditor cannot bring a derivative action against a Delaware limited liability company, even where the company is clearly insolvent. The ruling is interesting, because in the well-known case of North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that a derivative action was available to creditors of an insolvent Delaware corporation. The Delaware Legislature may have to step in to harmonize this inconsistency.

Background

In 2010, plaintiff Stephen Trusa had made a loan in the amount of $200,000 to XION Management LLC, a Delaware limited liability company. Allegedly, he extended the loan on the basis of misleading representations of XION’s managing members, including the defendant Norman Nepo and two others. Two years later, the loan matured and XION defaulted. Trusa commenced an action against XION, which failed to answer the complaint and did not respond to discovery requests. The Delaware Superior Court in that case entered a default judgment against XION. Clearly, however, Trusa was unlikely to receive satisfaction from XION, which by all indications was insolvent and lacked the wherewithal to make good on the judgment.

Trusa then sued the managing members of XION in Delaware Chancery Court, alleging a plethora of claims for relief. Among the claims were several brought on a derivative basis, for the alleged breaches of fiduciary duties of the managing members owed to XION. The plaintiff argued that he was entitled to pursue the derivative claims as a creditor of the company.¹

The Court’s Analysis

The court dismissed Trusa’s derivative claims based upon a plain reading of the Delaware Limited Liability Company Act. Section 18-1001 of the Act, titled “Right To Bring Action,” states:

Moreover, in § 18-1002, titled “Proper Plaintiff,” the Act provides that in a derivative action, the plaintiff must be a member or an assignee of a member at the time of bringing the action, and the plaintiff or its predecessor in interest must also have been a member at the time the relevant transaction occurred. 

According to the court, the plain language of the Act limits derivative claims on behalf of a limited liability company to members and their assignees. The court cited a prior Delaware Chancery case, CML V, LLC v. Bax, 6 A.3d 238 (Del. Ch. 2010), which dismissed derivative claims brought by creditors of an insolvent limited liability company, saying that they did not have standing to bring derivative actions under the express terms of the Act. This decision was affirmed by the Delaware Supreme Court. CML V, LLC v. Bax, 28 A.3d 1037 (Del. 2011).

Gheewalla

In Gheewalla, the Delaware Supreme Court held that creditors cannot bring any claims in the nature of a corporate action against directors and officers of a Delaware corporation when the corporation is merely in the “zone of insolvency.” Even after such time as a corporation is actually insolvent, creditors may not bring direct claims against the officers and directors of the corporation. However, the court stated, “the creditors of an insolvent corporation have standing to maintain derivative claims against directors on the behalf of the corporation for breaches of fiduciary duties.” The court explained, “The corporation’s insolvency ‘makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value’” (citing Production Resources Group, L.L.C. v. NZT Group, Inc., 868 A.2d 772 (Del. Ch. 2004)). 

Interestingly, the Delaware Supreme Court in Gheewalla reached its conclusion notwithstanding § 327 of the Delaware General Corporation Law (DGCL), titled “Stockholder’s derivative action; allegation of stock ownership,” which states:

In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law. (emphasis supplied)

While the language of DGCL § 327 can be distinguished from the corresponding language in the Delaware Limited Liability Company Act, both statutes refer to derivative suits by stockholders.

Observations

The Delaware Supreme Court’s ruling in Gheewalla that creditors of insolvent corporations have standing to bring a derivative action is based upon a compelling rationale. Once the corporation enters insolvency, the interests of the equity owners are extinguished, and the only parties for whom the corporation’s fortunes are relevant are its creditors. Conceptually, the same should be true with respect to an insolvent limited liability company, and it is incongruous for the courts to recognize the rights of creditors to bring a derivative action in one instance and not the other. This inconsistency may well need to be addressed by the Delaware Legislature. In any case, it is possible that the last word has not been heard on this issue.

¹ Trusa also argued that he had standing to pursue his derivative claims by virtue of a power of attorney granted to him by the company pursuant to his loan documentation. The court ruled against him on this basis as well, finding that the power of attorney by its terms was limited to effectuating his remedies as a creditor. The court also dismissed a variety of other claims brought by Trusa against the managing members.