Creditor Committees of Delaware LLCs Should Take Action to Preserve Derivative Standing

Introduction

This issue recently arose again in the Chapter 11 cases of The Collected Group, LLC and certain of its affiliates (together, Collected), filed in the United States Bankruptcy Court for the District of Delaware (the Court). During the first day hearing on Collected’s motion to approve debtor-in-possession financing, Judge Silverstein sua sponte raised concerns over the parties’ failure to address the “LLC issue” in the proposed DIP order. The “LLC issue” to which Judge Silverstein referred is the question of whether the Delaware LLC statute prevents any person other than a member of the LLC or their assignee from bringing a derivative cause of action—a question which several judges on the Delaware bankruptcy bench have answered in the affirmative. Failure to address the “LLC issue” in the proposed order could render “illusory” the proposed DIP financing provisions that preserve the rights of committees to prosecute valuable causes of action. This serves as just the latest reminder of the current status of the case law, and the larger implications that such obstacles to creditors’ pursuits of derivative standing may have on a Chapter 11 case.

Factual Background

Collected is the ultimate parent company of several apparel brands, including Joie. It filed for Chapter 11 bankruptcy protection on April 5, 2021, with a “prepackaged” plan of reorganization already approved by its key stakeholders, including KKR Loan Administrative Services LLC and certain of its affiliates (together, KKR), in their capacity as proposed DIP lender, prepetition secured lenders and/or administrative agent. In accordance with its prepackaged plan, Collected sought approval to enter into a $9.2 million debtor-in-possession post-petition secured financing loan from KKR by filing a motion (the “DIP Motion”) concurrently with the plan.

The proposed order approving the DIP Motion contained standard stipulations by the debtors in favor of the prepetition lenders as to the amount of the prepetition secured debt, the collateral securing that debt, the extent and priority of the liens on the collateral, etc. The proposed DIP order also contained releases by the debtors, their estates, and any party acting on behalf thereof of KKR of all claims and liabilities arising from the prepetition secured debt documents and the proposed DIP Order. These stipulations and releases were explicitly binding on third parties, including any creditors’ committee, unless such third party obtained derivative standing within a certain “Challenge Period” proscribed by the proposed DIP order. If a third party failed to be granted derivative standing within this Challenge Period (whether by denial of motion, or by failure to seek such standing), that third party would be forever barred from bringing suit to challenge any of the stipulations concerning the prepetition debt on behalf of the debtors.

At the telephonic first day hearing on April 6, 2021, Judge Silverstein — on her own — raised concerns over the proposed DIP order’s failure to address the question of whether a creditors’ committee had a legal right to seek derivative standing to pursue claims on behalf of Collected. Because certain of the Collected debtors are Delaware LLCs, requiring the committee to obtain derivative standing (where a legal right does not exist) may render illusory the provision in the proposed DIP order reserving the right of the committee to prosecute causes of action. This could have led to an unfortunate “gotcha” moment under the rationale of In re Dura Automotive Systems, LLC and its predecessors. As a result, Judge Silverstein required that the proposed DIP order’s stipulations in favor of the prepetition secured lenders be counterbalanced by a stipulation that the prepetition secured lender would not seek to raise the “LLC issue” against any motion for derivative standing by a creditors’ committee. The parties agreed to this amendment. The interim order as entered by Judge Silverstein included the following additional language: “[the prepetition secured lender] stipulate[s] and agree[s] that [it] will not raise as a defense in connection with any Challenge the ability of creditors to file derivative suits on behalf of limited liability companies under the Delaware Limited Liability Company Act.”

Dura and the “LLC Issue”

Judge Silverstein’s comments and guidance appear to be an attempt to prevent the inequitable outcome in Dura, where the Delaware bankruptcy court denied the official unsecured creditors’ committee’s motion for derivative standing on the basis that under Delaware law, only Delaware LLC members or entities holding assigned membership interests have standing to prosecute claims on behalf of the LLC.

Different rules regarding derivative standing exist under state corporation laws. The Delaware Supreme Court concluded that the language of the Delaware LLC statute precluded creditor derivative standing in the case of CML v. Bax, 28 A.3d 1037 (Del. 2011). Until recently, however, this state court interpretation was contrary to the practice of many bankruptcy courts, which have found that the bankruptcy code provides for the possibility of granting derivative standing to an official creditors’ committee under certain circumstances, regardless of state law. See, e.g., In re McClatchy Co., Case No. 20-10418 (Bankr. S.D.N.Y. July 6, 2020) [Docket No. 641] (Delaware LLC); In re Lincoln Paper and Tissue Co., Case No. 15-10715 (Bankr. D. Me. April 12, 2017) [Docket No. 980] (Delaware LLC); In re Know Weigh, L.L.C, 576 B.R 189 (Bankr. C.D. Cal. 2017) (California LLC); In re SGK Ventures, LLC 521 B.R. 842 (Bankr. N.D. Ill. 2014) (Illinois LLC). Recent decisions, however, have called into question the general rule in bankruptcy.

In an unpublished teleconference ruling, Judge Owens squarely confronted the question of a committee’s derivative standing where the debtor was a Delaware LLC. See In re Dura Automotive Systems, LLC, No. 19-12378 (Bankr. D. Del. June 9, 2020) [Docket No. 1115]. The committee’s motion for derivative standing was opposed by both the debtor and its secured creditor, who argued that the Delaware Limited Liability Company Act precluded the grant of derivative standing by its plain terms. The committee pressed that certain of the causes of action were purely federal claims brought under the bankruptcy code rather than state law, and that the bankruptcy code had preempted state law on the issue. To adopt the reasoning of Bax, according to the committee, would be to eviscerate the committee’s intended role under the bankruptcy code. If the members of the debtor LLC were unwilling to bring viable suits on behalf of the debtor, then there would be no recourse for the debtor’s creditors. The risk is especially pronounced when the members would be positively disincentivized from pursuing causes of action because they stand to incur losses as a result of any such suit or are involved with the intended target (likely a secured lender). A bankruptcy case could devolve into the proverbial situation of the “fox guarding the henhouse,” to the detriment of the debtor’s entire estate.

Despite these concerns, Judge Owens nonetheless denied the committee’s motion for standing on the basis of the Bax rationale. In doing so, she explicitly noted that she was following the precedent of Judges Sontchi, Gross, and Carey in the cases of In re Pennysaver USA Publishing, LLC, In re HH Liquidation, LLC, and In re Citadel Watford City Disposal Partners, L.P., respectively. Judge Owens recognized the concerns raised by the committee but countered that other remedies, such as conversion of the bankruptcy case, appointment of a Chapter 11 trustee, or assignment of claims to a trust, could be available. While acknowledging that these were “blunt tools,” Judge Owens felt herself bound by the Delaware state law and expressed hope that practitioners would find ways to craft “creative and more effective options” in the future — an aspiration that could be of little comfort to the committee.

Key Takeaways from Collected and Judge Silverstein’s Approach

The remedy crafted by Judge Silverstein in Collected appears to be one such “creative and effective option.” By requiring that the DIP order contain a stipulation by the debtors and secured creditor that they will not invoke the “LLC issue” as a defense to a committee’s motion for derivative standing, Judge Silverstein has ensured that the committee’s statutory role under the bankruptcy code and the rights and remedies provided to assert a challenge pursuant to the terms of the proposed DIP order have not been rendered “illusory.” Without the ability to bring derivative suits in appropriate circumstances, its proscribed investigative and advisory powers would be rendered edentulous. Removing the lender’s right to make the technical objection to the committee’s right to pursue derivative standing is an elegant and effective quid pro quo to resolve this conundrum.

In addition to requiring the debtor and lenders to waive the “LLC issue” defense, or requiring the debtor’s formation documents to be amended to permit derivative standing, some other possible solutions present themselves. For instance, the court could appoint an examiner (or examiner with expanded powers), or require that a special member or committee (in the role of an independent person) and counsel be appointed. The court could also order that the claims be assigned to the official committee of unsecured creditors. These are only a few potential “creative” solutions, as Judge Owens hoped to see develop.

At any rate, the Collected case serves as a timely reminder to creditors of Delaware LLCs that immediate action is required to prevent the potential for this undesirable outcome. Inactivity or lack of awareness on the part of creditors early in a bankruptcy case may result in valuable causes of action being forever lost, damaging the estate’s ultimate recovery. Judge Silverstein has provided excellent examples of how this situation may be avoided at the outset of a case, and practitioners should consider following her lead in this uncertain area.