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Creditor claims, business structure and Delaware law: One important distinction

On Behalf of | Oct 28, 2022 | Corporate Bankruptcy & Restructuring

Entrepreneurs who are choosing a business structure must review the benefits and risks of each before making their choice. Although tax obligations can be difficult with a corporation, the personal liability protection is hard to beat. Limited liability companies (LLCs) generally offer more flexibility and still provide a shield against creditors.

But it is important to remember that entrepreneurs do not make this decision in a bubble. Location matters. As such, those who choose to invest in or otherwise work with businesses are wise to look into their structure and state of formation because when it comes to business structure and creditor claims, state law plays a huge role in the outcome of the case.

How does the state of incorporation impact creditor claims?

Delaware’s Division of Corporations states that over 66% of Fortune 500 members and 93% of U.S. initial public offerings were registered in Delaware. Since Delaware is home to so many businesses, we will use their laws as an example of the role state law can play when a creditor tires to make a claim.

One way a creditor will try to get payment is to make a claim on behalf of the business against its leaders. This is referred to as a derivative action. The Delaware Limited Liability Company Act creates a right for LLC members to bring a derivative action in the Court of Chancery on behalf of the LLC. If successful, the derivative action can result in a judgment, compromise, or settlement as well as the award of additional reasonable expenses. But the law limits this remedy to certain plaintiffs. Why does this matter? Because the law defines the applicable plaintiff as a member or assignee of the LLC. End scene. No more options. Thus, in Delaware a creditor cannot use this same remedy against an LLC.

This means the Delaware Limited Liability Company Act does not allow for the possibility of a creditor bringing a derivative action, like a breach of fiduciary duty, against an LLC. Yet this remedy is available if the target company were a corporation.

Is this fair?

Creditors have argued this point. They contend that the importance of being able to step in on behalf of the entity and seek restitution from members on the entity’s behalf is one that should apply to LLCs as it does corporations. Without this legal remedy, they argue the law fails to provide an equitable resolution.

In a case that made it out of the Court of Chancery and all the way up to the Supreme Court of Delaware, CML V, LLC v. BAX, a creditor argued that a failure to provide this remedy would mean members of an LLC have little incentive to perform their fiduciary duties. The court reasons that these are two very different business structures and that investors should be well versed in these differences and choose where to put their money with these differences in mind.

Could this mean that there are situations were investments in an LLC come with more risk to the creditor? Possibly. As such, creditors who find themselves attempting to make claims against a business that is going through bankruptcy are wise to explore other legal remedies to better ensure a successful claim.