The topic of when and who can assert claims against insiders for breach of fiduciary duty and related matters is often confusing when it involves a bankruptcy estate. Extensive case law has developed over the years regarding corporations. However, there is less case law regarding limited liability companies and limited partnerships. Decisions in Delaware and elsewhere have held that once a corporation is insolvent, directors and officers owe fiduciary duties not only to shareholders, but creditors as well. When directors and officers breach those duties, creditors as well as shareholders have standing to pursue derivative claims on behalf of the corporation. However, the rules governing standing are different when the bankrupt entity is a limited partnership or limited liability company. Judge Kevin Carey of the U.S. Bankruptcy Court for the District of Delaware recently issued an opinion on this issue in In re Citadel Watford City Disposal Partners, Case No. 17-50024-KJC (May 2, 2019). In that case, the court dismissed derivative claims asserted against a former principal of a limited partnership and limited liability companies because the creditors lacked standing to bring the claims on behalf of such entities.
Derivative Claims Against Former Principal
The debtors were four entities formed under the laws of different states. Citadel Watford City Disposal Partners, LP (a Delaware limited partnership), Citadel Energy SWD Holdings, LLC (a North Dakota limited liability company), Citadel Energy Services, LLC (a Wyoming limited liability company) and Pembroke Fields, LLC (a North Dakota limited liability company) each filed Chapter 11 bankruptcy petitions on June 19, 2015, in the U.S. Bankruptcy Court for the District of Delaware. The cases were jointly administered.
A year later, on June 21, 2016, the court entered an order granting the Official Committee of Unsecured Creditors (committee) standing to pursue avoidance actions on behalf of the estate. The debtors filed their plan shortly thereafter. As is often the case, the plan provided for the creation of a liquidation trust under the supervision of a liquidation trustee to administer certain estate assets transferred to the trust under the plan, including claims against third parties. The trustee would distribute the proceeds as provided by the plan. As is typical in these liquidating plan cases, the plan incorporated a liquidation trust agreement, which provided the trustee was authorized to pursue estate causes of action, and would be substituted as the real party in interest in any action commenced by or against the debtors, their estate or the committee. The plan was effective on March 9, 2017.
On the effective date of the plan the committee already had initiated an adversary proceeding against certain of the debtors’ general partners, members, managers, officers and related entities. The complaint alleged, among other things, breach of fiduciary duty, gross mismanagement, waste, fraud, fraudulent concealment, conversion and other causes of action relating to, among other things, the defendants’ fraudulent investment practices, commingling and self-dealing, conversion of business assets, unauthorized assignments of the debtors’ assets, and the loss of a lease central to the debtors’ business.
The opinion recites that one of the defendants was Mark Dunaway, the alleged managing partner and managing member and member of the debtors. Dunaway filed a motion to dismiss the derivative claims against him. He asserted the committee lacked standing to bring derivative claims on behalf of the debtors. The liquidating trustee opposed the motion.
The Committee Lacked Standing
The court began its analysis by noting that standing is a jurisdictional matter, and therefore a motion to dismiss for lack of standing is properly brought under Rule 12(b)(1) of the Federal Rules of Civil Procedure. The court noted under the “internal affairs doctrine,” the laws of the state of a corporate entity’s formation determine whether creditors have standing to bring derivative breach of fiduciary duty claims.
Citadel Watford City Disposal Partners was a Delaware limited partnership. The Delaware Limited Partnership Act (Delaware LP Act) provides that a derivative claim may be brought by “a limited partner or an assignee of a partnership interest” if general partners have refused to bring the action or if an effort to cause the general partners to do so is not likely to succeed, 6 Del. C. Section 17-1001. Further, the Delaware LP Act provides the “proper plaintiff” in derivative actions must be a partner or an assignee of a partnership interest. The court found that language unambiguous, and held the statute did not grant authority for derivative standing to creditors who are not partners or assignees of partnership interests.
The court also noted that Delaware’s Limited Liability Company Act (Delaware LLC Act) contained virtually identical standing provisions as the Delaware LP Act. The court noted recent Delaware Bankruptcy Court decisions that ruled creditors lacked standing to bring a derivative action on behalf of a limited liability company (LLC). In HH Liquidation (590 B.R. 211 (Bankr. D. Del. 2018)), Judge Kevin Gross reasoned that different legal principals apply to different types of legal entities, and although creditors of insolvent corporations can sue derivatively, creditors of insolvent LLCs do not have standing to assert derivative claims. Gross further reasoned that creditors are presumed to be capable of protecting themselves through the contractual agreements that govern their relationships with LLCs. In PennySaver USA Publishing (587 B.R. 445 (Bankr. D. Del. 2018)), Chief Judge Christopher S. Sontchi concluded the clear language in the Delaware LLC Act limited derivative actions to members or assignees of an LLC membership interest. Here, the court observed that both decisions held that, under Delaware law, creditors of insolvent limited liability companies do not have standing to sue derivatively on behalf of the LLC. Given the similarity of the relevant statutory language between the Delaware LLC and LP Acts, the court reasoned that the result should be no different for limited partnerships.
In this case, the committee was neither a partner nor an assignee of a partnership interest of Citadel Watford City Disposal Partners. The court dismissed the derivative claims against Dunaway for lack of standing.
The court then analyzed the limited liability company statutes of North Dakota and Wyoming. The court found the statutes substantially similar to Delaware because they similarly limit derivative actions to members at the time the action is commenced. Therefore, the derivative claims asserted on behalf of the limited liability company debtors were also dismissed.
The liquidating trustee also argued derivative claims belonging to the debtors’ estates were transferred to the liquidating trust under the plan. The court agreed, but noted the adversary proceeding against Dunaway and the other defendants was initiated by the committee, not the debtors. Consequently, the liquidating trust’s rights were limited to whatever rights were held by the committee. Since the committee lacked standing to bring derivative claims, the liquidating trustee, as the successor to the committee, also lacked standing.
This case reminds us that the ability to assert derivative claims in bankruptcy must be examined carefully not only on the basis of whether the debtor was insolvent, but the type of entity involved and the law of the state of formation. Attention must be paid to this important issue of standing. Limited liability companies are a relatively recent development in the history of corporate law, and one cannot assume the same rules will apply to LLCs.
Andrew C. Kassner is the chairman and chief executive officer of Drinker Biddle & Reath, a national law firm with more than 635 lawyers in 12 offices. He chaired the corporate restructuring group for almost 20 years. He can be reached at email@example.com or 215-988-2554.
Joseph N. Argentina Jr. is an associate in the firm’s corporate restructuring practice group in the Philadelphia and Wilmington, Delaware, offices. He can be reached at firstname.lastname@example.org or 215-988-2541.