It is well settled that creditors of insolvent corporations can obtain derivative standing to prosecute claims that belong to a debtor’s bankruptcy estate. The same principle, however, generally does not apply for Limited Liability Companies (“LLCs”) and Limited Partnerships (“LPs”). Many state statutes expressly limit derivative standing to the members of LLCs and LPs or assignees of such interests.1 This has been an issue in recent bankruptcy cases, where unsecured creditors’ committees, which often seek standing to pursue estate causes of action, have been barred from bringing claims.
In a seminal 2011 case, CML V LLC v. Bax,2 the Delaware Supreme Court held that creditors could not bring derivative claims on behalf of a Delaware LLC, interpreting the language of the Delaware Limited Liability Company Act. Delaware bankruptcy courts have generally followed suit, holding that creditors of LLCs and LPs are prohibited by statute to assert derivative claims and therefore lack standing to prosecute.3 These cases specifically noted that the differing results between corporations and LLCs should not be viewed as an “absurd result,” given an LLC’s inherent flexibility and the freedom of contract the form allows sophisticated parties.4 Most recently, the judge in In re Dura Automotive Systems LLC denied the creditors’ committee standing based on Delaware law and acknowledged that other remedies exist such as appointing a chapter 11 trustee or examiner.5 Some courts have reasoned that bankruptcy trustees are not required to seek standing, like creditors, because the bankruptcy code or state law authorizes the trustee to bring claims on behalf of the estate.6
This topic is now manifesting itself in various aspects of bankruptcy cases. The standing issue often comes into play near the end of a case, when a creditors’ committee seeks to assert claims a debtor does not want, or is unable to, to pursue. Recently, it has also come up at the early stages of a bankruptcy proceeding.
A debtor seeking to obtain consensual debtor-in-possession (DIP) financing or use of cash collateral frequently stipulates that no causes of action exist against its prepetition lenders. The stipulation typically is accompanied by a challenge period (at a minimum of 60 days) within which a creditors’ committee or other parties-in-interest may investigate the lender’s liens and conduct and potentially seek standing to bring suit on behalf of the debtor’s estate. When the debtor is an LLC or LP, however, these challenge periods may be legal fiction, as creditors may later be denied standing to prosecute these claims based on relevant state statutes, leaving no party with standing to do so. In this circumstance, the debtor functionally would have released all lender-related claims at the outset of the case. To avoid this, creditors may have to seek to appoint a chapter 11 trustee (as the Dura judge suggested) or convert the case to chapter 7 prior to the final DIP hearing (or prior to the expiration of the challenge period depending on the DIP/cash collateral order), but these options come with a heavy price, as they will lead to additional significant administrative expense, no reorganization in chapter 7 and possibly none even in a chapter 11 context, and the chance to maximize the value of assets will likely be substantially diminished. Thus, in many cases such options may not provide practical recourse.
The bankruptcy court in In re Rudy’s Barbershop Holdings LLC took a novel approach that provided definitive recourse for the creditors of the debtor LLC in the final DIP/cash collateral order.7 There, the proposed DIP lenders were also the debtor’s majority equity holders and prepetition lenders. The bankruptcy court insisted that the challenge period and any lawsuit or contested matter by the creditors’ committee “not be illusory” and, therefore, the court would not enter the final order unless the lenders would not be allowed to raise a standing defense to any challenge proceeding. To ensure this worked, the court included language in the order that required the parties to amend their LLC agreements to permit such challenges. At the hearing, the judge also suggested the solution of deleting the debtor’s claim stipulations and release provisions from the terms of the DIP financing or cash collateral order as a potential alternative for creditors’ protection, because the debtors would not be prohibited from bringing any claims themselves.
While the Rudy’s court may have been particularly concerned with the identity of interests between the debtors’ lenders and majority equity holders, that court is not alone in seeking to resolve the creditor standing issue for LLC-debtors in the early stages of the bankruptcy proceedings. Recently, the judge in In re Comcar Industries Inc.8 raised concerns over the potentially “illusory” nature of a challenge period in connection with the interim hearing on a DIP financing proposal, also under circumstances where the proposed DIP lender was also the majority equity holder. In order to resolve such concerns, the debtors and the DIP lender agreed that all stipulations were only binding on the debtors, making clear that a chapter 7 or 11 trustee would have the opportunity to assert a challenge if the creditors’ committee did not have standing to do so.9 Additionally, the creditors’ committee in the J. Crew bankruptcy proceedings raised concerns over its ability to seek standing in opposition to DIP financing where certain of the debtors are Delaware LLCs.10 In the final DIP order, the debtors addressed the creditors’ committee’s concerns by providing that releases granted with respect to the LLCs are not binding on entities or their estates, if upon a motion filed by the creditors’ committee, the Court converts the case to a chapter 7 or appoints a chapter 11 trustee – and tolling the challenge period while the creditors’ committee’s motion remains pending.11
While some creditors of LLCs and LPs have been left in precarious positions with respect to prosecuting derivative claims, parties have more frequently been anticipating these challenge issues and attempting to address them in the earlier stages of the bankruptcy proceedings. Courts are also cognizant of this issue and have shown concern and have been flexible in crafting solutions. While this issue continues to percolate and sort itself out, bankruptcy practitioners need to be keenly aware that a debtor’s organizational form and relevant state law, as well any applicable LLC or LP agreements, may yield unexpected outcomes. This remains a grey area in bankruptcy law, but S&K will continue to monitor this situation and provide any relevant updates.