Direct and Derivative Claims

Scope of the chapter. This chapter opens Part VII, which examines litigation among the members and managers of an LLC. Its subject is the threshold question in nearly every such case: whether the plaintiff sues in its own right or in the right of the company. A direct claim belongs to the member and is prosecuted for the member's benefit. A derivative claim belongs to the LLC, is asserted by a member on the company's behalf because those who control the company will not assert it, and produces a recovery that belongs to the company. The characterization decides who may sue, whether the plaintiff must first make a demand on those in control, whether the claim survives a merger or a transfer of the plaintiff's interest, whether the company may take control of the claim through a committee, to whom any recovery is paid, and whether the court will award fees. The chapter examines the tests by which courts draw the line, the statutes that govern derivative standing and procedure in Delaware, under the uniform act and in the principal states that depart from both, and the provisions by which an operating agreement may channel member litigation.

Why the question matters more in an LLC. Corporate law developed the distinction for publicly held corporations with dispersed stockholders, where the derivative suit served to police directors whom no individual stockholder could control. Most LLCs are closely held. Their members often know one another, often manage the business themselves, and often sign an operating agreement that states their rights in detail. Each of these features complicates the distinction. A member who has signed the agreement will argue that its breach gives the member a contract claim of its own. A member of a two-member company will argue that a derivative recovery paid to the company, which the wrongdoer co-owns, is no remedy at all. A manager facing suit will argue that the agreement, by eliminating fiduciary duties, left the member with nothing to assert directly. The Delaware Supreme Court has rejected the view that the contractual character of an alternative entity makes every claim under its agreement direct. El Paso Pipeline GP Co. v. Brinckerhoff, 152 A.3d 1248, 1259–60 (Del. 2016). The uniform act states the same position in its commentary. Rev. Unif. Ltd. Liab. Co. Act § 801 cmt. (2013). The result is that the corporate tests apply to LLCs, adjusted at the margins by statute and by the terms of the agreement.

Organization. The chapter proceeds in nine parts:

• the distinction and the functions it serves (¶ 3510);
• the Delaware test stated in Tooley, the end of the Gentile exception in Brookfield, and their application to LLCs (¶ 3520);
• claims for breach of the operating agreement, which present the most frequent and most contested characterization problem in LLC litigation (¶ 3530);
• statutory standing to sue derivatively, including the position of assignees, transferees and creditors (¶ 3540);
• demand, demand futility and special litigation committees (¶ 3550);
• the effect of mergers and conversions on standing, and double derivative claims in holding structures (¶ 3560);
• recovery, settlement and fees (¶ 3570);
• the contractual ordering of member litigation, including forum, arbitration and the practical position of the Delaware forum (¶ 3580); and
• a survey of state statutes and a pleading checklist (¶ 3590).

Relation to other chapters. The fiduciary duties whose breach gives rise to most derivative claims, and their modification or elimination, are examined supra chs. 21 and 22. Exculpation, indemnification and advancement, which determine who bears the cost of member litigation, are examined supra ch. 23, and conflicts of interest supra ch. 24. Transfers of interests and the distinction between a member and a transferee are examined supra ch. 29. Judicial dissolution and the remedies for deadlock and oppression, which a minority member often pursues together with direct and derivative claims, are examined supra ch. 32. Books-and-records actions, which commonly precede a derivative complaint, are examined infra ch. 36. Jurisdiction, forum selection and arbitration are examined infra ch. 37, and the remedies available once a claim is established infra ch. 38. The choice of formation state, including the Delaware forum, is examined supra ch. 5.

Sources. The Delaware provisions discussed are sections 18-109, 18-1001 to 18-1004 and 18-1101 of the Delaware Limited Liability Company Act, read on the official Delaware Code. The uniform act provisions are sections 105 and 801 to 806 of the Revised Uniform Limited Liability Company Act as amended in 2013, with the official comments. The Florida, Texas and California provisions were read in their current text. The decisions discussed were read in full text; where a reporter page could not be confirmed, the decision is cited without a pincite.