More LLCs are formed in the US each year than corporations and partnerships combined. The reason: maximum flexibility in profit sharing (LLCs allow corporate-type liquidation preferences or partnership-type profits interests), pass-through taxation (as in partnerships and S corporations), and the potential to reduce fiduciary duties or even to eliminate them (as has been suggested for some time in the context of Delaware LLCs). Now the LLC’s popularity may have a further boost. A recent Delaware court opinion (CML V LLC v. JetDirect Aviation) somewhat surprisingly provides the LLC a potentially greater shield from creditors than a corporation.
The court considered whether a creditor can file a derivative lawsuit against the holders of LLC interests. A derivative action is brought by shareholders in the name of a corporation to recover judgments in its favor when current management has failed or refused to do so. Derivative lawsuits are possible in the name of an LLC, but the Delaware LLC Act limits them to a plaintiff (i) who is a member or an assignee of a member at the time of bringing the action; or (ii) who became a member or an assignee by operation of law or pursuant to the terms of an LLC agreement from a person who was a member or assignee at the time of the transaction.
The private lender plaintiff in the CML sued the individual members of the borrower LLC as defendants in a derivative claim, seeking to recover damages from them individually for breach of their fiduciary duties as managers of the LLC after the borrower LLC became insolvent and defaulted on the loan. It is clear under Delaware law that an insolvent corporation’s non-shareholder creditors can pursue derivative claims against the corporation’s directors, but non-member plaintiffs pursuing defaulting LLC debtors, by contrast, are barred from derivative actions altogether. The statutes may clearly require this strange distinction, although it is hard to envision a sound policy reason for it.
The result? The LLC form may now be even more popular for new business founders in Delaware. At the same time, this decision may cause sources of commercial debt financing to become even more wary of non-corporate structures than they already may be.