assignment of partnership interest as collateral

Current Issues with LLC/LP Interests as Collateral

An expert Q&A on recent trends relating to pledges of limited liability company (LLC) or limited partnership (LP) ownership interests as collateral in connection with secured financings.

Contributors

Partner at Morris, Nichols, Arsht & Tunnell LLP

What are LLC/LP interests?

LLC interests is a term commonly used to describe a member’s ownership interest in an LLC. Similarly, LP interests is a term for a partner’s ownership interest in an LP.

State laws may use different terminology for LLC interests, including membership interests or units. State laws may also differentiate between the status of a member and the different rights a member has relating to their LLC interest, for example, governance rights and economic rights. These same issues also apply to LP interests. If parties are not familiar with these state law issues, they should consult local counsel.

What trends have you seen recently relating to LLC/LP interests as collateral? What are the reasons for these trends?

Interests in LLCs and LPs are often important collateral for a secured party. This collateral raises additional issues for counsel compared to a pledge of corporate shares. (For more information, see Security Interests: LLC and LP Interests on Practical Law.)

One of the trends that we have noticed in recent years is a focus on the ability to exercise control rights over the LLC/LP interests. Secured parties frequently seek to ensure that the security agreement permits them, following an event of default under the security agreement, to exercise control rights in the LLC or LP so that they can cause the entity to take actions that preserve the value of the secured parties’ collateral.

One of the trends that we have noticed in recent years is a focus on the ability to exercise control rights over the LLC/LP interests.

During the COVID-19 pandemic and as a result of the economic strain on businesses, we saw many secured parties attempt to enforce the rights and remedies provided to them under their security agreement. The preferred mode of enforcement by secured parties was often the exercise of a proxy or power of attorney granted to the secured party in the security agreement.

Secured parties sought to direct the operations of the subject LLC or LP without actually becoming the owner of the LLC/LP interests. We saw secured parties use the proxy or power of attorney to:

• Put new management in place.
• Run a sale process to sell the entity.
• Effect other changes at the LLC or LP.

This trend, we believe, was a result of secured parties seeking to exercise their rights with reduced risk and in a manner that would not involve obtaining full ownership of the pledged LLC/LP interests.

What are the current drafting issues in operating agreements and security agreements for LLC/LP interests as collateral relating to UCC collateral classification?

As noted above, many secured parties are concerned about enforcement rights and therefore focus more intently on at least two issues. The first issue is ensuring that the proxy or power of attorney is drafted broadly enough to allow the secured party to:

• Take the actions it determines to be necessary or desirable to preserve the value of its collateral.
• Exercise the proxy or power of attorney without prior notice to the pledgor, consent from the pledgor, or further action by the pledgor.

For purposes of the Delaware Limited Liability Company Act (Delaware LLC Act) and the Delaware Revised Uniform Limited Partnership Act (Delaware LP Act), a proxy and a power of attorney are devices used to authorize another person to act on behalf of the person granting the proxy or power of attorney. Traditionally, a proxy is limited to granting authority with respect to acting for another under corporate law to vote the grantor’s shares. A power of attorney, however, is not limited to corporate law and permits a grant of authority to act as an agent or attorney-in-fact for a grantor more generally.

While the distinction between a proxy and a power of attorney may be relevant with respect to corporations, because statutes such as the Delaware General Corporation Law set out rules governing the use of proxies, the distinction is less relevant under Delaware’s alternative entity laws. Neither the Delaware LLC Act nor the Delaware LP Act sets out rules for the use of proxies, and these statutes generally treat proxies and powers of attorney the same.

Under the Delaware LLC Act and Delaware LP Act, unless an entity’s governing document provides otherwise, the use of proxies and powers of attorney is permitted. Consequently, this article will not distinguish between proxies and powers of attorney, and any reference to a proxy or power of attorney will refer to an authorization by the grantor to act on its behalf.

The second issue relates to ensuring that the security agreement and the entity’s governing documents act in harmony with one another, so that the governing documents of the entity do not function to prevent the secured party from exercising rights granted to it in the security agreement. For example, we have encountered a security agreement that granted the secured party a proxy to vote the pledged LLC interests but required registration of the proxy on the books of the LLC prior to exercising this proxy. The secured party therefore needed the subject LLC to register the proxy on its books and records as a condition precedent to exercise, and the subject LLC refused to do so. Additionally, we have seen governing documents that require the consent of the LLC or LP or the pledgor before a person can be admitted to the entity and exercise governance rights in the event of a foreclosure.

The foregoing circumstances illustrate the importance of ensuring that the security agreement and governing documents are consistent regarding foreclosing on LLC/LP interests and ensuring that a transferee can be admitted to the LLC or LP as a member or partner and exercise governance rights following a foreclosure.

What are the current drafting issues in operating agreements and security agreements for LLC/LP interests as collateral relating to governing law?

There are no recent drafting issues related to governing law clauses. Most secured parties continue to prefer New York law as the governing law for security agreements. In spite of the security agreement’s choice of law, however, it is important for a secured party to understand the underlying law for the subject LLC or LP because this law will affect how rights are exercised with respect to that entity, including any requirements related to the exercise of a proxy or power of attorney or admission to the LLC or LP as a member or partner.

What are the current drafting issues in operating agreements and security agreements for LLC/LP interests as collateral relating to transfer restrictions?

As noted above, secured parties are keenly focused on transfer restrictions and primarily focused on making sure that the governing documents act in harmony with the security agreement. A secured party wants to make sure that it can exercise all of the rights granted to it in the security agreement, without impediment from the governing document. In particular, a secured party focuses on ensuring that the proxy or power of attorney granted to it in the security agreement can be exercised without any action by the pledgor or the subject LLC or LP.

Further, secured parties have sought to draft the operating agreement in such a way that the LLC/LP interests issued by the subject LLC or LP function similar to shares of stock of a corporation and allow a transferee to succeed to a transferor’s governance rights automatically without any action or approval by any other person. If a secured party’s diligence reveals possible issues that might arise regarding exercising its rights following a foreclosure of the LLC/LP interests, then the secured party may seek to amend the relevant governing document to ensure that it is able to exercise these rights.

Finally, in 2018, the American Law Institute (ALI) approved amendments to Article 9 of the Uniform Commercial Code (UCC) that would render Sections 9-406 and 9-408 inapplicable to a security interest in LLC/LP interests. Therefore, while Sections 9-406 and 9-408 of the UCC offered a limited override of transfer restrictions set out in a governing document, the proposed amendments will render this limited override inapplicable to pledges of LLC/LP interests.

While the Delaware UCC already provided that Sections 9-406 and 9-408 were inapplicable to LLC/LP interests, in coming years other jurisdictions are likely to adopt the proposed amendments to the UCC, making Sections 9-406 and 9-408 inapplicable to a pledge of LLC/LP interests. Therefore, secured parties will need to be even more vigilant in making sure that any transfer restrictions in an entity’s governing documents do not limit their ability to transfer the LLC/LP interests as part of their enforcement remedies.

(Sections 9-406 and 9-408 of the UCC and the override are discussed in more detail below.)

What are the current drafting issues in operating agreements and security agreements for LLC/LP interests as collateral relating to distributions and proceeds?

We are not aware of any recent developments concerning these issues. Secured parties continue to draft the security agreement to:

• Permit distributions by the subject LLC or LP before an event of default.
• Prohibit any distributions following an event of default.

What are the current drafting issues in operating agreements and security agreements for LLC/LP interests as collateral relating to remedies?

I think the primary drafting issue that we see around remedies is ensuring that:

• There is no requirement for action by the pledgor or subject LLC or LP before exercising remedies.
• Any notice requirement provides for a short notice period to allow a secured party to exercise remedies as quickly as possible.

When a secured party seeks to exercise remedies, the debtor may not be as compliant as a secured party might desire. It is therefore imperative that the provisions in the security agreement are not drafted to require any action by the pledgor or subject LLC or LP prior to exercising enforcement remedies. For example, we have found that proxies or powers of attorney that require registration by the LLC or LP before exercise may be difficult to enforce because the entity will resist the registration.

It is imperative that the provisions in the security agreement are not drafted to require any action by the pledgor or subject LLC or LP prior to exercising enforcement remedies.

What other issues are you seeing relating to llc/lp interests as collateral.

The only other issue that we have seen more recently is a focus on covenants related to an opt-in to Article 8 of the UCC. Under the UCC, LLC/LP interests constitute “general intangibles” by default. However, if the subject LLC or LP opts in to Article 8 of the UCC, then these interests are transformed into “securities” for UCC purposes.

The method of perfection and priority rules vary depending on how the LLC/LP interests are categorized for UCC purposes. Therefore, a secured party should seek assurances through the covenants in the security agreement to make sure that these LLC/LP interests remain the same type of collateral for UCC purposes during the term of the security agreement.

How has the legal landscape for LLC/LP interests as collateral changed recently, including in Delaware?

The legal landscape in Delaware for LLC/LP interests has not really changed. However, the legal landscape outside of Delaware has changed regarding the limited transfer restriction override provided by Sections 9-406 and 9-408 of the UCC.

One of the fundamental principles underlying the Delaware LLC Act and Delaware LP Act is the “pick your partner” principle, which holds that it is important to the owners of an LLC or LP who their co-owners are, and a co-owner should not have the ability to transfer its equity interests and force a new co-owner on the non-transferring owners. Therefore, by default, LLC/LP interests are non-transferable without the consent of the other owners. The pick your partner principle is in tension with the principle underlying the UCC, which seeks to facilitate voluntary transfers of personal property. This UCC principle is reflected in the anti-assignment provisions set out in Sections 9-406 and 9-408 of the UCC, which seek to override certain transfer restrictions.

As discussed above, many years ago, Delaware included in its UCC statute a provision that makes clear that Sections 9-406 and 9-408 of the UCC do not apply to security interests in LLC/LP interests. In 2018, the ALI approved amendments to the UCC that would follow the Delaware UCC by rendering the transfer restriction overrides provided by Sections 9-406 and 9-408 inapplicable to security interests in LLC/LP interests. Florida became the first state to enact the 2018 ALI amendments, effective January 1, 2023.

As of February 2023, the Uniform Law Commission website indicates that bills to enact the 2018 ALI amendments have been introduced in ten states (California, Indiana, Kentucky, Massachusetts, Nebraska, New Mexico, Oklahoma, South Dakota, Washington, and West Virginia) and the District of Columbia. Further, according to the analysis submitted with the Florida senate bill enacting the 2018 ALI amendments, Colorado, North Carolina, Texas, and Virginia have already adopted language similar to the 2018 ALI amendments. We believe more states will adopt the 2018 ALI amendments in the near future. Once a state passes the 2018 ALI amendments or amendments of similar effect, it will put more pressure on secured parties to draft security agreements and governing documents in such a way that the transfer restrictions set out in the governing documents do not adversely affect their ability to enforce the remedies in the security agreement.

Even in states that do not adopt the proposed amendments, secured parties should still recognize the limited benefits provided by Sections 9-406 and 9-408 of the UCC, in that these provisions do not apply to collateral that constitutes securities for purposes of the UCC. LLC/LP interests do not constitute securities for UCC purposes unless the issuer of these LLC/LP interests opts in to Article 8 of the UCC pursuant to its constituent documents. Therefore, to the extent that a secured party is taking LLC/LP interests as collateral that are subject to an opt-in, the secured party should be aware that it will not be able to rely on the anti-assignment override of Section 9-406 and Section 9-408 at all. In this case, a secured party will either:

• Need to understand that an issuer’s transfer restrictions may limit its enforcement rights.
• Enter into documentation with the issuer and co-owners to allow the secured party to exercise its rights under the security agreement without limitation.

What do you think will be the most important issues in the future for LLC/LP interests as collateral?

I believe that the use of proxies or powers of attorney will be one of the most important issues that affect the use of LLC/LP interests as collateral. These enforcement mechanisms can be a powerful and quick way for a secured party to step into the shoes of the pledgor and preserve its collateral without the obligation of becoming an owner of the subject LLC or LP. During the COVID-19 pandemic, we saw secured parties use this tool to quickly step in and preserve their collateral when other more cumbersome enforcement remedies could not have been exercised in a timely manner.

The use of proxies or powers of attorney will be one of the most important issues that affect the use of LLC/LP interests as collateral.

Related content on practical law, expert q&a on the delaware law amendments relating to registered series of limited liability companies, expert q&a on the delaware law amendments relating to limited liability company divisions, security interests: llc and lp interests.

Boost your productivity.

Practical Law’s resources help you get up to speed quickly and practice with confidence.

Join the ABA M&A Committee!

Join the M&A Committee meetings, September 7–9, virtually or in-person in Chicago, as part of the ABA Business Law Section meeting, to hear the latest M&A developments, trends, and more.

Read More in The Journal

Reverse break-up fees and specific....

To address the possibility that a buyer will fail to close an acquisition, counsel must carefully...

Practical Law Corporate and M&A

Conducting a Pay Equity Audit

Employers facing heightened pressure to ensure equitable pay practices and remedy pay disparities...

Ryne C. Posey, Skadden, Arps, Slate, Meagher & Flom LLP

Mitigating Product Liability Claims

Given the significant costs associated with litigating product liability claims, product...

Jeffrey A. Soble, Foley & Lardner LLP

IP Rights in the Metaverse

Although the metaverse has great potential to significantly expand the digital economy, it...

Rakiya Moore, Thomson Reuters

M&A Market Trends in Focus

An expert Q&A on topics of interest to M&A practitioners, including the ABA’s Business Law Section...

Jessica C. Pearlman, K&L Gates LLP and Tatjana Paterno, Bass Berry & Sims PLC

Purchase Agreement: Earn-Out with...

A model clause for contingent earn-out payments after the closing if the target company or business...

Representation and Warranty...

A discussion of representation and warranty insurance (R&W insurance) used in private acquisition...

Draft Revised Merger Guidelines

Key takeaways from the draft revised merger guidelines recently released by the Antitrust Division...

Practical Law Antitrust

AI and the Role of the Board of...

Artificial intelligence (AI) has the capacity to disrupt entire industries, with implications for...

Holly J. Gregory, Sidley Austin LLP

BIPA Compliance and Litigation

The Illinois Biometric Information Privacy Act (BIPA) recognizes the unique privacy and security...

Justin O’Neill Kay, Faegre Drinker Biddle & Reath LLP

Supply Chain Dispute Resolution in...

Counsel for supply chain participants should employ specific contracting practices to minimize the...

Sarah K. Rathke, Squire Patton Boggs (US) LLP

Public Interest Profile

Mary Frances Palisano, Gibbons P.C.

Checking In

Kathryn (Katie) J. Kennedy, University of Illinois Chicago School of Law

Counseling a Cannabis-Related...

Attorneys counseling a cannabis-related business must monitor the rapidly changing state laws that...

David S. Ruskin, HMB Legal Counsel

Remote Employees: Best Practices

The rapid expansion of remote work in recent years underscores the need for private employers to...

Rosemary Joyce, Practical Law

GC Agenda: July 2023

A round-up of major horizon issues for general counsel.

Practical Law The Journal

Software License Agreement...

A model short-form agreement for the license of off-the-shelf, unmodified software for a licensee’s...

Practical Law Intellectual Property & Technology

Law Firm Preferred Provider...

Guidance for in-house counsel on building a persuasive business case to create a law firm preferred...

Practical Law

CEO-Related Shareholder Activism

Company boards should understand and prepare for heightened shareholder activism related to CEO...

Francis J. Aquila, Sullivan & Cromwell LLP

Commercial Letters of Credit

Commercial letters of credit are often used to make payments in transactions for the sale of goods...

Practical Law Finance and Practical Law Commercial Transactions

Lien Priority for Commercial Real...

Guidance on how to establish a first priority commercial deed of trust lien in Texas and protect...

Practical Law Real Estate

General Counsel File

Arnold Pinkston, Edwards Lifesciences Corporation

Sharon L. Klein, Wilmington Trust, N.A.

ChatGPT and Generative AI: Key...

An expert Q&A on the legal issues that ChatGPT and similar generative artificial intelligence (AI)...

Jeffrey D. Neuburger, Proskauer, Karla Grossenbacher, Seyfarth Shaw LLP, Avi Gesser and Megan K. Bannigan, Debevoise & Plimpton LLP, and Robert H. Newman, Reed Smith LLP

Promote Crystallization in Real...

Promote crystallization incentivizes an operating partner to generate profits in a real estate...

Peter E. Fisch and Ruobing Chen, Paul, Weiss, Rifkind, Wharton & Garrison LLP

• Advertise With Us , opens new tab
• Advertising Guidelines , opens new tab
• Cookies , opens new tab
• Terms of Use , opens new tab
• Privacy , opens new tab
• Digital Accessibility , opens new tab
• Corrections , opens new tab
• Site Feedback , opens new tab

Opinions expressed do not reflect the views of Reuters News, which operates independently of Practical Law.

© 2023 Reuters. All rights reserved

LLCs/LPs: Assignment of LLC/LP Interests (Short Form) | Practical Law

LLCs/LPs: Assignment of LLC/LP Interests (Short Form)

Practical law standard document 7-521-6949  (approx. 8 pages).