Bankruptcy & Restructuring Law Monitor : Bankruptcy Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Restructuring & Chapter 11

The Delaware Supreme Court recently held that creditors lack standing to bring a derivative suit on behalf of an insolvent Delaware limited liability company (an “LLC”) under the Delaware Limited Liability Company Act (the “LLC Act”).  CML V, LLC v. Bax, No. 735, 2011 WL 3863132 (Del. Sept. 2, 2011, corrected Sept. 6, 2011).  In an opinion written by Chief Justice Steele, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of claims brought by a junior secured creditor against the LLC’s present and former officers directly and derivatively for breaching their fiduciary duties.  The Delaware Supreme Court’s holding was based on a plain reading of 6 Del. C. § 18-1002 which requires that a plaintiff be a “member” or an “assignee” of a limited liability company interest to bring a derivative action on behalf of an LLC. 

Facts and Procedural History

Defendant JetDirect Aviation Holdings, LLC (“JetDirect”), a Delaware limited liability company, was a private jet management and charter company.  In 2005, JetDirect began a series of transactions to acquire small and midsized competitor and charter service companies which left the company heavily leveraged.  Between 2006 and 2007, JetDirect’s officers and board of managers learned of “serious deficiencies” in the company’s accounting system and internal controls.  Nevertheless, the board continued its aggressive acquisition strategy.  In April 2007, on the basis of outdated information, CML V, LLC (“CML”) made a loan to JetDirect of approximately $26 million, which later increased to approximately $34 million.  Shortly thereafter, in June 2007, JetDirect defaulted on its loan obligations to CML, and by January 2008, JetDirect was insolvent and began to liquidate its assets.

CML filed a complaint in the Delaware Court of Chancery asserting derivative claims against JetDirect’s present and former managers for: (1) breach of the duty of care for their approval of transactions without informing themselves of JetDirect’s financial condition; (2) bad faith for consciously failing to implement adequate internal controls; and (3) breach of the duty of loyalty for benefitting from self-interested asset sales.  CML also brought a direct claim for money damages against JetDirect for breach of the loan agreement, but the parties agreed that the Court of Chancery would only have jurisdiction over the direct claim if any of the derivative claims survived a motion to dismiss.  The Court of Chancery granted JetDirect and the individual defendants’ motion to dismiss the claims on the basis that “CML, as a creditor, lacks standing to pursue derivative claims on behalf of JetDirect.”  CML appealed to the Delaware Supreme Court.

Delaware Supreme Court Ruling

CML advanced the following arguments on appeal: (1) the LLC Act does not deny creditors standing to bring derivative actions on behalf of insolvent LLCs and (2) if the LLC Act denies the Court of Chancery jurisdiction over such derivative actions, it places an unconstitutional limit on the Court of Chancery’s equitable powers.  The Delaware Supreme Court rejected both arguments.

The Delaware Supreme Court first addressed the plain language of § 18-1002 of the LLC Act, which provides:

In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:

(1)  At the time of the transaction of which the plaintiff complains; or

(2)  The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transactions.

6 Del. C. § 18-1002.

The court reasoned that this provision is clear and unambiguous—only a member or an assignee of an LLC interest can bring a derivative action.  The court found it significant that § 18-1002 uses the term “must” be a member or assignee rather than “may”, and applies to “a derivative action” rather than “the derivative action.”  Although a different section of the LLC Act, § 18-1001, provides that a member or assignee “may” bring “the derivative action”, the court reasoned that § 18-1001 created the right to file a derivative action by members and assignees while § 18-1002 explicitly limited that right to members and assignees.  The court rejected CML’s argument that the General Assembly intended to take the corporate rule of derivative standing (which allows creditors of an insolvent corporation to sue derivatively) and apply it to the LLC context.  The court reasoned that the General Assembly is well suited to make a policy choice to deny derivative standing to creditors of an LLC, but allow such standing for creditors of a corporation, to promote business entity diversity.  The court further acknowledged the freedom of contract provided under the LLC Act.

The Delaware Supreme Court next rejected CML’s argument that limiting the Court of Chancery’s jurisdiction over derivative standing to members or assignees violates Article IV, Section 10 of the Delaware Constitution.  Under Delaware law, the General Assembly cannot limit the equity jurisdiction of the Court of Chancery to less than the general equity jurisdiction of the High Court of Chancery of Great Britain when Delaware first ratified its constitution.  The court observed that, unlike a corporation, an LLC as an entity did not exist at the time of enactment of the Delaware Constitution.  Accordingly, the Delaware Constitution does not prevent the General Assembly from limiting the Court of Chancery’s jurisdiction over derivative claims to members and assignees of LLC interests.  Moreover, the LLC is a creature of statute and the LLC Act was passed “in derogation of the common law.”  Accordingly, common law may supplement, but cannot override, the LLC Act’s express provisions, including § 18-1002.  Finally, the court reasoned that CML had an ample remedy at law, as it could have negotiated remedies by contract.

Conclusion

In structuring a finance transaction, lenders should be mindful of the differences in lending to a corporation, LLC or other Delaware business entity.  The Delaware Supreme Court emphasized the flexibility of an LLC as a business entity, and the freedom of contract available to its creditors.  The court suggested adding provisions that would, in the event of insolvency, convert the creditor’s interests to that of an “assignee” or give the creditor control of the LLC’s governing body.  Such provisions, however, place a creditor at risk of being viewed as an “insider”, or having its debt recharacterized as equity if the borrower becomes insolvent and files for bankruptcy.  An alternative solution not mentioned by the court would be to include a contractual fiduciary duty to creditors in the LLC agreement (to the extent permitted by law), and provide that creditors are third-party beneficiaries of such provision with a right of enforcement.  The lender could also enter into an agreement directly with the managers of the LLC, outlining the managers’ duties and providing a mechanism for enforcement.  Time will tell whether creditors are able, by these or other measures, to create enforceable protections against LLC managers’ misdeeds.

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Pursuant to section 104(a) of the Bankruptcy Code (11 U.S.C. § 104(a)), starting April 1, 1998, and at each three year interval ending on April 1 thereafter, the dollar amounts in effect under various sections of the Bankruptcy Code are subject to adjustment. The adjustments are based upon the consumer price index, and a rounding to the nearest $25 amount that represents such change, with such adjusted amounts to be published in the Federal Register by the Judicial Conference of the United States not later than March 1 of each three year interval. Such adjustments apply only with respect to cases commenced after the effective date of such adjustments. On or about February 25, 2010, the Judicial Conference published the adjustments that will take affect as of April 1, 2010 (see Federal Register/Vol. 75, No. 37/Thursday, February 25, 2010/Notices, Page 8747-8749.)

The following are a few of the increases that would be relevant to business bankruptcy cases:

a.  Under the 28 U.S.C. § 1409(b), venue of proceedings arising under or related to cases under Title 11 to recover a debt against a non-insider of less than $11,725.00, may be brought only in the district court for the district in which the defendant resides. This is an increase from $10,950.

b.  In the definition of “small business debtor” under 11 U.S.C. § 101(51D)(A) and (B), the aggregate non-contingent liquidated secured and unsecured debts as of the date of the petition or the date of the order for relief has been increased from $2,190,000 to the amount of $2,343,300, each time it appears in such sections (note, these amounts exclude debts owed to one or more affiliates or insiders).

c.  The minimum aggregate amount of claims needed under 11 U.S.C. § 303(b) for the commencement of an involuntary Chapter 7 or Chapter 11 bankruptcy case has been increased from $13,475.00 to $14,425.00.

d.  Priority expenses and claims under 11 U.S.C. § 507(a) have been increased as follows:

1. priority expenses and claims under 11 U.S.C. § 507(a)(4) for wages, salaries, or commissions, including vacation, severance and sick leave pay, or for sales commissions have been increased from $10,950.00 to $11,725.00;
2. priority expenses and claims under 11 U.S.C § 507(a)(5) for allowed unsecured claims for contributions to an employee benefit plan have been increased from $10,950.00 to $11,725.00;
3. priority expenses and claims under 11 U.S.C. § 507(a)(7) for pre-petition deposits have been increased from $2,425.00 to $2,600.00.

e.  The minimum amount that a trustee may seek to recover as a preferential transfer in a case filed by a debtor whose debts are not primarily consumer debts has been increased from $5,475.00 to $5,850.00.

f.  Again, the foregoing amounts apply only to cases commenced after April 1, 2010.
 

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Unlike retailers and manufacturers that file for chapter 11 protection, real estate owners and developers must be mindful of the restrictions and special expedited procedures the Bankruptcy Code imposes upon debtors whose estates consist of a single property or project (“Single Asset Real Estate” or “SARE” cases). In those cases, the automatic stay, which typically gives debtors a “breathing spell” from lenders’ collection efforts, terminates ninety (90) days after the bankruptcy filing unless the debtor either files a confirmable plan of reorganization or commences monthly interest payments to its secured lenders. Set forth below is a brief discussion of the relevant statutory provisions and interpreting case law regarding SARE cases.
 

As part of the Bankruptcy Reform Act of 1994, Congress added two new sections to the Bankruptcy Code to expedite single asset real estate cases and enhance the leverage held by secured lenders. First, Congress added section 101(51B) of the Code, which defines “single asset” real estate as:
[R]eal property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of the debtor and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental thereto having aggregate non-contingent, liquidated secured debts in an amount no more than $4,000,000.
 

Second, Congress amended section 362 of the Bankruptcy Code to require that the automatic stay be terminated if the debtor does not file a plan of reorganization or commence monthly interest payments within ninety (90) days of the petition date. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) eliminated the $4 million cap in section 101(51B), expanding the reach of the SARE provisions and making them applicable to much larger projects and entities, including the many public and private homebuilders facing today’s economic pressures.
 

The text of section 101(51B) does not elaborate as to the meaning of the phrases “substantial business” or “other than the business of operating the real property.” Courts interpreting those phrases have benefitted little from the legislative history accompanying the amendments. Without meaningful legislative guidance, courts have focused on whether the real estate is used in the operation of a business or whether it is simply held for “passive” income. Many courts interpreting the 1994 SARE amendments have determined a debtor that actively operates a business on its property, even when the operation of such business centers around the use of a debtor’s property, does not constitute a SARE. See In re CBJ Dev., Inc., 202 B.R. 467 (9th Cir. BAP 1996) (finding that hotel operations were not the mere “operation of a property” because, in addition to operating a gift shop, it required (i) a substantial number of employees; (ii) actively maintaining each of the rooms, (iii) cleaning bed sheets and towels; and (iv) providing basic amenities to guests, specifically phone service); Prairie Hills Golf & Ski Club, Inc., 255 B.R. at 228 (Bankr. D. Neb. 2000) (operation of golf and ski facilities connected to residential land developments is not merely operating the property); Larry Goodwin Golf, Inc., 219 B.R. 391 (Bankr. M.D.N.C. 1997) (operation of a golf course and pool with concession stand is not merely operating the property); In re Khemko, Inc., 181 B.R. 47 (Bankr. S.D. Ohio 1995) (marina not a single asset real estate debtor under section 101(51B) because, in addition to providing for the mooring of boats, the marina also stored, repaired and winterized boats, provided showers and a pool, sold gas, and sold concessions); and Whispering Pines Estate, Inc., 341 B.R. 134 (Bankr. D. N.H. 2006) (debtor, which operated an 89-room hotel, conducted operations in connection therewith that were “sufficiently active in nature to constitute a business other than the mere operation of property”).
 

As noted above, however, the elimination of the $4 million cap as part of the 2005 BAPCPA amendments have caused SARE issues to appear with somewhat greater frequency in more substantial cases. Of note in these troubled times for homebuilders is Kara Homes, Inc. v. Nat’l City Bank (In re Kara Homes, Inc.), 363 B.R. 399 (Bankr. D. N.J. 2007). There, a parent entity and several of its subsidiaries filed chapter 11 cases. The parent oversaw the overall residential development business and each debtor subsidiary owned real estate on which it developed residential projects. None of the debtor subsidiaries had its own employees or a separate permanent facility from which to operate. The court found each debtor subsidiary was a SARE because its business operations “[we]re merely incidental to their efforts to sell the homes or condominium[s] and thus did not constitute substantial business.”
 

In contrast, however, is In re Scotia Dev., LLC, 375 B.R. 764 (Bankr. S.D. Tex. 2007). There, the court adopted the “active-versus-passive” criterion in addressing whether a timber harvester was a SARE debtor. The court made detailed findings regarding the debtor’s activities and noted those activities are extensive and require hands-on supervision by teams of experts. Taking into account those extensive operations, the court concluded the debtor did not constitute a SARE. The court applied a “practical approach” to construing section 101(51B) of the Bankruptcy Code, and followed the approach of prior courts that “includ[ed] within its [section 101(51B)] ambit only those debtors who have no revenue from their property except the passive collection of rent from tenants and excluding from its reach those entities that undertake and pursue various sorts of active economic, commercial, and business activities on the property.”
 

In sum, the restrictions imposed by the SARE provisions of the Bankruptcy Code are meaningful and create material hurdles for real estate debtors. The ways in which courts apply those provisions will be noteworthy as more real estate entities consider chapter 11 as part of their restructuring strategies.

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