This post was also written by Aaron Bourke

Most secured lenders have experience taking a security interest in limited liability company (“LLC”) interests.  Indeed, such arrangements are so common that lenders can easily fall into the trap of using shorthand (such as “membership interests”) to describe their collateral.  However, depending on the state of formation of the issuing LLC, such shorthand descriptions may be inadequate to protect the lender’s interests or, even worse, completely meaningless.  Lenders should be particularly careful when taking as collateral LLC interests of an LLC formed in Delaware because Delaware law contains a number of nuances that must be taken into account.

Nature of Limited Liability Company Interests Under Delaware Law

First, the term “membership interest” does not appear in the Delaware Limited Liability Company Act (the “DE LLC Act”).  Instead, the DE LLC Act defines a “limited liability company interest” as “a member’s share of the profits and losses of a limited liability company and a member’s right to receive distributions of the limited liability company’s assets” – a definition that only includes economic rights and does not include control rights (such as the rights to manage the LLC, access information, review the LLC’s books and records, and compel dissolution).

A secured lender should therefore ensure that its collateral description covers (i) economic rights, (ii) control rights and (iii) the right to be admitted as a member upon foreclosure (which may be, but is not necessarily, correlated with control rights).  However, this objective is complicated by provisions of the DE LLC Act, which provide in relevant part as follows:

  • Economic rights (i.e., LLC interests) are assignable in whole or in part except as provided in an LLC’s operating agreement (an “LLC Agreement”).  §18-702(a).
  • The assignment of an LLC interest does not entitle the assignee to control rights except as provided in the LLC Agreement or upon the affirmative vote or written consent of all of the members of the LLC.  §§18-702(a).
  • An assignee of an LLC interest may only become a member as provided in the LLC Agreement or upon the affirmative vote or written consent of all of the members of the LLC.  §§18-702(b)(1), 18-704(a).

This means that a pledge of “limited liability company interests” merely gives the lender a security interest in economic rights, and the LLC interests can only be assigned upon foreclosure to the extent that the LLC Agreement does not prohibit this type of assignment.  Further, the lender cannot obtain control rights or member status absent facilitative language in the LLC Agreement (or unanimous consent of the existing members).  Obviously, foreclosing on the LLC interests provides limited benefit to the lender if the control rights remain with the pledgor.

Anti-Assignment Provisions

As noted above, the DE LLC Act provides that an LLC Agreement can expressly restrict the assignability of the economic rights associated with LLC interests.  In most jurisdictions, secured lenders usually rely on sections 9-406 and 9-408 of the applicable state’s Uniform Commercial Code (the “UCC”), which override anti-assignment provisions in some circumstances for partial relief in such a situation.  However, the Delaware UCC explicitly provides that sections 9-406 and 9-408 do not apply to an interest in an LLC.  See §§9-406(i)(5), 9-408(e)(4).  Therefore, it is imperative that lenders understand what the applicable LLC Agreement says with respect to assignments and, if needed, at the time of the creation of the security interest, require an amendment of such LLC Agreement to enable the debtor to assign both its economic and control rights.

Membership Status

Generally under Delaware law, unless the LLC Agreement provides otherwise, a person may not become a member without the consent of the existing members.  If proper precautions are not taken, when a lender forecloses on the economic interest of a debtor, (i) the debtor will effectively cease to be a member of the LLC, and (ii) unless the LLC Agreement provides otherwise, the lender cannot become admitted as a member without the consent of all of the existing members.  In a single-member LLC scenario, this is particularly troubling: upon foreclosure, the company would essentially have no members, resulting in automatic dissolution of the LLC.  Accordingly, lenders should build a mechanism into both the underlying security agreement and the LLC Agreement to permit the secured party (or its 3rd party transferee) to acquire the LLC interests, and to be automatically admitted as a member of the LLC upon an event of default under the loan agreement.

Recommended Actions

Delaware law is fraught with potential stumbling blocks for secured lenders seeking to take a security interest in LLC interests.  However, lenders can protect themselves by taking the following actions:

LLC Agreement:  The DE LLC Act expressly incorporates the public policy to give “maximum effect to the principle of freedom of contract and to the enforceability” of LLC Agreements.  §18-1101(b).  Further, the DE LLC Act explicitly permits LLC Agreements to provide rights to third parties.  §18-101(7).  Accordingly, secured lenders should use their leverage during the course of negotiations to insist upon the insertion of certain protective language into the relevant LLC Agreement.  We recommend inclusion of the following concepts:

  • Notwithstanding any other provision of the LLC Agreement, a member may pledge all of its right, title and interest in the LLC, whether derived under the Certificate of Formation, the LLC Agreement, the DE LLC Act, or otherwise, and upon foreclosure, the secured party or other successful bidder will automatically succeed to all of such pledged right, title and interest, including without limitation: (i) its “limited liability company interest” (as such term is defined in section 18-101(8) of the DE LLC Act); (ii) its right to participate in the management of the business and affairs of the LLC; and (iii) its status as a “member” (as such term is defined in section 18-101(11) of the DE LLC Act).
  • Notwithstanding any other provision of the LLC Agreement, a secured party or other successful bidder at a foreclosure sale or other disposition will automatically be deemed admitted as a member of the LLC immediately before the debtor ceases to be a member.

Collateral Description:   Secured lenders should ensure that all descriptions of their collateral – in granting clauses of pledge agreements, collateral descriptions in UCC-1 financing statements, and control agreements (if any) – are uniform and sufficiently broad to encompass economic rights, control rights and membership.  Remember that the term “membership interest” has no meaning under the DE LLC Act.  An example of a well-crafted collateral description follows:

“All of the Pledgor’s interest in XYZ, LLC, a Delaware limited liability company, including without limitation all of the Pledgor’s limited liability company interests in XYZ, LLC, all of the Pledgor’s right to participate in the management of the business and affairs of XYZ, LLC or otherwise control XYZ, LLC, and all of the Pledgor’s rights as a member of XYZ, LLC.”

These actions are, of course, in addition to other standard steps that a secured lender takes to protect and perfect a security interest in LLC collateral under Delaware law.