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Unlike their corporate counterparts, executives of insolvent limited liability companies (LLCs) aren’t subject to breach of fiduciary duty lawsuits fled by creditors, according to a recent Delaware Court of Chancery ruling. The ruling came as a jolt to the lending industry, which now must decide whether to continue financing LLCs. The court’s Nov. 3 ruling in CML V LLC v. Bax held that, under the Delaware Limited Liability Company Act, only individuals with a membership interest in the LLC and their assignees have standing to bring derivative claims. Derivative claims are brought on behalf of the company, often by public company shareholders against directors and executives for actions that allegedly harmed the company. According to the ruling, CML lent money to JetDirect Aviation Holdings LLC, a private jet management and charter company whose operating subsidiaries are currently in bankruptcy. CML sued two former executives and 10 directors for breach of fiduciary duties. CML also sued JetDirect for breach of its loan agreement. The first named defendant is John Bax, JetDirect’s former chief financial officer. JetDirect launched an aggressive acquisition campaign in 2005, according to court papers. CML loaned JetDirect $25.7 million in April 2007, then increased its loan to $34.2 million. CML claims that JetDirect’s board approved four major acquisitions in late 2007 without current information about the companies’ financial status. CML also claims that JetDirect’s senior managers failed to share adverse information with the board. JetDirect defaulted on its loan payments to CML in June 2007 and was insolvent by January 2008. JetDirect’s managers started liquidating the company’s holdings in late 2008. CML claims that JetDirect’s board failed to conduct the proper oversight of asset sales that some managers negotiated with entities they controlled. “Although this limitation might surprise wizened veterans of the debates over corporate creditor standing, JetDirect is not a corporation,” Vice Chancellor J. Travis Laster wrote. “JetDirect is an LLC, and the plain language of the LLC Act controls.” Laster’s ruling upheld the lower court’s motion to dismiss the claims against the individual defendants. The parties earlier agreed that if the Chancery court dismissed those claims, then it lacked jurisdiction over the claim against JetDirect itself. The decision comes as a shock to CML and the lending industry, said Michael Friedman, a New York litigation partner at Chicago’s Winston & Strawn, who is one of CML’s lawyers on the Chancery case. Friedman said his client intends to appeal, but for now, lenders must decide whether to finance LLCs knowing they will not have the same remedies available if the investment goes bad as they would with a corporation, Friedman said. “Under Vice Chancellor Laster’s ruling, managers of insolvent LLC’s answer to nobody after insolvency, and can breach their fiduciary duties with impunity,” Friedman said. He also called Laster’s suggestion that lenders can “bargain for express contractual rights in the LLC agreement” unrealistic. “Few managers will agree to voluntarily increase their own exposure, and even if some do, the sudden injection of this issue into standard loan negotiations will greatly increase transactional costs and complexity, and may end up limiting LLCs’ access to capital generally,” Friedman said. The decision is “a pretty fundamental ruling that is going to affect the rights of creditors going forward,” said Alisa Moen, a Wilmington, Del., litigation partner at Philadelphia’s Blank Rome. Moen represented JetDirect and one of its directors, Robert Pinkas. “Litigators have always assumed that creditors would have derivative standing to bring fiduciary duty claims on behalf of an entity that’s insolvent. [This ruling says] if it’s not a corporation, it’s a limited liability company.” Brian O’Connor, a litigation partner at New York’s Willkie Farr & Gallagher and a defense lawyer on the case, said the ruling “very carefully analyzed the statute and differences between the LLC Act and the Delaware General Corporation Law.” O’Connor represented JetDirect’s former chief executive officer, Steven Hankin, and Bax in the case. O’Connor believes the ruling may affect decisions about company formation. “Certainly people may decide to use an LLC if there is not derivative standing for creditors like there is in the form of a corporation,” O’Connor said. Gilchrist Sparks III, of counsel to Wilmington, Del.-based Morris, Nichols, Arsht & Tunnell who represented nine JetDirect directors, declined to comment. The ruling overturned prevailing wisdom about LLC liability, said Francis G.X. Pileggi, a Wilmington, Del., litigation partner at Philadelphia’s Fox Rothschild, who isn’t involved in the case. “The opinion itself acknowledges that most experts, commentators and even courts assumed without deciding that there was a right for a creditor to file a derivative suit against an insolvent LLC,” Pileggi said. Delaware’s CML ruling is also notable in light of a 2008 New York Court of Appeals decision in Tzolis v. Wolff. The Tzolis court ruled that members who were minority owners of an LLC could file derivative suits even though the Limited Liability Company Law lacks specific language authorizing such suits. Sheri Qualters can be contacted at [email protected].

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