Collateral Assignment of an Entity Interest: Economic v. Governance Rights
Posted on September 26, 2012 by Bernstein-Burkley
In these difficult economic times, debtors have become more creative in proposing additional or substitute sources of collateral to secure a debt or obtain a forbearance or loan modification. As real estate values have plummeted, alternatives have become more attractive, including an assignment of the debtor’s interest in an operating entity with good cash flow.
However, the recent decision of the Pennsylvania Superior Court in Zokaites v. Pittsburgh Irish Pubs, LLC , 962 A.2d 1220 (Pa. Super. 2008), appeal denied 972 A.2d 523 (Pa. 2009), provides food for thought in terms of structuring and drafting a collateral assignment of an interest in a limited liability company or partnership. In Zokaites , a creditor was attempting to enforce its judgment lien by executing upon the debtor’s interest in two limited liability companies (“LLC”) that owned and operated several Pittsburgh area restaurants. The creditor sought a court order to compel the debtor to transfer its ownership interest in the LLCs so those interests could be sold at sheriff’s sale. After much procedural wrangling in both state and bankruptcy court, the case ended up in the Superior Court, which looked to Pennsylvania’s Limited Liability Company Law, 15 Pa.C.S. §8901 et seq . (“LLC Law”), for guidance.
The Superior Court focused on a provision in the LLC Law that prohibits a transferee of an LLC interest from becoming a member or participating in the company’s management without the approval of all other LLC members. The same provision, however, allows a transferee to receive the LLC member’s distributions or other return of capital contributions. Because of this protection of an LLC’s “close-knit structure,” the Superior Court decided that a judgment creditor can secure a debtor’s economic rights to distributions and return of contributions from the LLC, but cannot obtain the debtor’s governance rights to vote and participate in managing the LLC. The Superior Court equated this remedy of obtaining the economic rights in an LLC interest to the “charging order” that is permitted against a partnership interest under Pennsylvania’s Uniform Partnership and Limited Partnership Acts (“Partnership Acts”).
In light of the decision in Zokaites , lenders considering accepting a collateral assignment of an entity interest should keep a few things in mind for due diligence and drafting purposes. First, where a debtor has interests in multiple related entities, have the debtor provide an organizational chart. It is often easier to understand a complex organizational structure from a chart or “tree” than from a description. The chart should show the relationship among the entities and include the names of each entity and the percentage interest the debtor owns. For example, in a recent transaction where several guarantors were proposing to pledge their interests in a variety of LLCs and partnerships that in turn were the general and limited partners of other entities, an organizational chart prepared by the debtor was a crucial tool in pinpointing who owned what and in targeting the collateral.
Second, once you understand what entity interest(s) the debtor owns, it is essential to carefully review a copy of the organizational agreement and any amendments (the LLC Operating Agreement or the Partnership Agreement) for each entity. Key provisions include transfer or assignment rights or restrictions and default and dissolution provisions. If the organizational agreement expressly permits assignment, then the limitations under the LLC Law and the Partnership Acts do not apply 1 . Most likely, however, the LLC or partnership interest will not be assignable without the other members’ or partners’ consent. It is also important to understand whether an assignment will trigger an unwanted result such as a dissolution or default.
Third, once you know what is owned and can be pledged, draft the assignment to specifically identify the entity interest being pledged. Taking into account the ruling in Zokaites , where not all of the LLC members or partners are involved, a pledge of economic rights only is more likely to be enforceable than a collateral assignment that appears to transfer governance and other rights as well. In most instances, the cash flow from the right to receive distributions, profits, and return of capital is the true collateral anyway.
In describing complex or multiple entity interests or owners, consider attaching as exhibits the organizational chart and a table identifying each debtor, the entity, and the percentage interest owned. Include in the body of the assignment representations and warranties by the debtor confirming all of the information on the chart and table as true, complete and correct and that the debtor’s interest has not already been pledged or assigned.
Fourth, since the creditor will not have governance rights, the pledge agreement should also contain covenants to protect the creditor’s right to receive distributions. Such covenants would include prohibiting the debtor from voting to amend the Operating or Partnership Agreement or to dissolve the entity. Another useful provision would be the debtor’s authorization for the LLC or partnership and its officers to recognize and give effect to the collateral assignment by paying distributions directly to the creditor or lender upon demand. Finally, when the assignment is being made by a married individual, if possible have the spouse join in to waive any marital or spousal interest.
Assignment of a debtor’s interest in an LLC or partnership can be a valuable and useful form of collateral. But the creditor should follow the money and remain mindful of the Zokaites decision by taking a pledge of the economic rights and leaving the governance rights alone, unless all of the entity owners consent.
1. Similar to the LLC Law, the Partnership Acts contain provisions that, unless otherwise agreed, the assignee of a partner’s interest does not become a partner or share in partnership liability and cannot exercise a partner’s management, inspection of records, or accounting rights, but has the right to profits. 15 Pa.C.S. §8344(a) and 15 Pa.C.S. §8562(a)(2)and (c).
LLC Membership Interests as Collateral
It is not uncommon for lenders to take a security interest in a business owner’s ownership interest in the corporation, LLC, limited partnership or other entity as collateral for a loan to the business. For the most part, the transactions are documented through a standard pledge or assignment (the “assignment agreement”) of the stock or other evidence of ownership. While such an approach may be acceptable when the interests of a corporation are pledged, when the collateral is an interest in an LLC, savvy lenders will make sure that they use an enhanced form of assignment agreement and perhaps obtain the consents (and necessary waivers) from the other LLC members.
An enhanced form of assignment agreement is called for because an LLC has one distinct advantage over other entity forms. Under Maryland law, a judgment against an LLC member can only be enforced by imposing a charging order against the member’s interest. This is a court order requiring the LLC to pay the creditor the debtor member’s share of LLC distributions. In this respect, a charging order is akin to a wage garnishment, except it is against the member’s distributions rather than against wages. The lender who simply obtains an assignment of a membership interest in an LLC gets no right to attach the member’s LLC interest or be admitted as a voting member . The lender cannot, therefore, participate in company management, force a sale of company assets or distribution of profits, or inspect company books.
In contrast, shares of a corporation’s stock are freely transferable absent contrary provisions in a shareholder agreement. Consequently, a lender with a security interest can typically exercise all of the associated rights of a stockholder. Upon obtaining the shares, the lender acquires the right to inspect corporate books and records and to vote on the election and removal of directors. If the shares represent a controlling interest, the lender could actually replace all the directors and officers and take over control of the corporation. Depending on the circumstances, the lender may also have the right to seek involuntary dissolution or place the corporation in receivership.
To optimize the collateral value of an LLC membership interest, lenders will want to be sure that they, as assignees, can be admitted, automatically, as full voting members of the company once they obtain ownership of the membership interest (a complex process in and of itself). Lenders will also want to scrutinize the LLC operating agreement to see if it contains provisions that either permit the company to acquire a member’s interest for a discounted value in the event of the member’s personal bankruptcy or that limit profit distributions either by making them discretionary rather than mandatory, or by restricting distributions to insolvent members. Finally, the operating agreement should be reviewed so that the lender understands any restrictions that may be placed upon the rights of an assignee who assumes a member’s interest. If such provisions are included in the operating agreement, they should be addressed in the assignment agreement as part of the negotiations over the assignment of the LLC membership interest so as to preserve the creditor’s rights and the value of charging orders.
Savvy lenders know that the LLC is the optimal form of entity for insulating company assets from owners’ personal creditors. Hence, they are the lenders that will carefully review the LLC organizational documents and only take LLC interests as collateral using an enhanced form of assignment agreement.
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Structuring Pledge Agreements for Equity Interests in Partnerships and LLCs to Maximize Protection for Lenders
Equity interests in LLC and partnership interests are a common form of collateral in many secured finance transactions, particularly mezzanine financing. The security agreement and related documents are fundamental in establishing a security interest in an LLC or partnership interest.
Representations, warranties, and covenants in the pledge and security agreement are often different than standard provisions for other collateral. The agreement must also address the rights being pledged, including economic, voting, and management rights.
The UCC provides two distinct paths to perfect the lender’s security interest: filing a financing statement under Article 9 or taking possession or control of the interest under the opt-in provisions of Article 8. Counsel should understand the advantages and disadvantages of each.
Curtis Johnson joins an authoritative panel that outlines best practices for drafting security agreements and making corresponding amendments to the borrower’s operating agreement to maximize the lender’s protection. The panel discusses UCC Articles 9 and Article 8 requirements for the perfection and priority of a security interest in a member or partnership interest. The discussion includes amendments to UCC Sections 9-406 and 9-408 promulgated in 2018 by the American Law Institute and the Uniform Law Commission.
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Assignment of Interest In LLC: Everything You Need to Know
Assignment of interest in LLCs happens when a member communicates to other members his/her intention to transfer part or all of his ownership rights in the LLC to another entity. 3 min read updated on February 01, 2023
Updated October 28, 2020:
Assignment of interest in LLCs happens when a member communicates to other members his/her intention to transfer part or all of his ownership rights in the LLC to another entity. The assignment is usually done as a means for members to provide collateral for personal loans, settle debts, or leave the LLC. The member (assignor) and the person assigned (assignee) sign a document called the Membership Assignment of Interest.
Why a Member May Want to Assign Interest
A member may choose to assign interest for a number of reasons.
- The assignment of interest may happen as collateral to a loan to one of the members.
- Some members can assign interest to settle debts. The assignment will be effective until the debt is cleared.
- An assignment of interest can also' be done to a member's legal heirs , going into effect upon the death of a member.
The Rights and Limitations of the Assignee
The laws governing LLC membership interest assignments vary considerably from one state to another.
- Most states prohibit the assignee from participating in the LLC's operations or decisions unless the Articles of Organization have this provision.
- An assignee is protected from liability from the assignor until the assignee becomes a member in most states. However, the law in a few states, including California and Florida, states that the assignee does get the assignor's liability.
- Should the assignee become a member after the assignment, he is only entitled to the rights and restrictions the assignor had.
- The assignment usually gives the assignee the right to receive the assignor's share of the profits — but not necessarily the other rights.
The Rights and Limitations of the Assignor
- In many states, all LLC members have the right to assign membership interest.
- In most states, assigning interest does not necessarily lead to forfeiting of voting and management rights and can be temporary. Texas law, on the other hand, states that the assignor ceases to be a member of the LLC after the assignment.
The Rights and Limitations of Other Members
- All members of the LLC have to be notified of any type of assignment.
- Some states require the assignment of interest to be approved by all members.
- The new person who has been assigned interest does not necessarily become a member even if the assigner has decided to leave the LLC. The other members can decide whether to admit the assignee as a member or not. Should a member assign interest without the input of other members, the interest is normally limited to financial benefits.
- In a two-member LLC, one member can easily transfer the interest to the other.
The Membership Interest Assignment Document
The LLC's operating agreement should explain the rights of members on issues of transfer of interest, and the agreement should be followed during the assignment process. The Membership Interest Assignment acts as a record of the agreement, and the LLC normally keeps a copy of the document. The law in most states does not provide a formal template of the Membership Interest Assignment document but lists what should be included in the document. The document should have the following details:
- Percentage of interest that will go to the assignee
- Whether the assignee will have voting rights
- The signatures of the assignor and the assignee
Assignment of Interest Versus Selling Ownership Stake
The assignment of interest is typically different from selling the ownership stake . Selling a member's ownership stake in the LLC requires unanimous approval by the other members. A departing member may also assign his membership to another member.
If a member is being paid to transfer interest, this is treated for tax purposes as a sale, and the selling member's gains might be liable to capital gains tax. Even if a departing member is not paid for his interest, if the departure results in the assignee getting the departing members' share of liability, the departure is seen as an exchange or sale.
Assignment of Interest Versus Abandoning an LLC
If a member wants to withdraw interest in an LLC, he/she can choose to simply legally abandon the LLC in most states. The abandoning member should give some kind of notice to the other members explaining that he is abandoning membership. Abandoning membership does not usually require the approval of other members.
Abandoning an LLC does not absolve the member of liability he/she may have incurred when still a member.
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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).
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Membership Interests in a Limited Liability Company as Collateral
A limited liability company (“LLC”) is one of the most commonly chosen entity structures used by new businesses today. LLCs are owned by its members, who hold either membership units or membership interests. Membership units/interests consist of both financial and governance rights, although a particular member may have financial rights but no governance rights or vice versa. Membership units/interests may be evidenced by a membership certificate but, most frequently, are uncertificated. Whether membership units/interests are certificated or uncertificated will usually be set forth in the LLC’s organizational documents. As LLCs are commonly the entity structure of choice, it is important for banks to understand how to accept and perfect a security interest in the membership units/interests as collateral for loans.
Regardless of whether the membership units/interests are certificated or uncertificated, a security interest in membership units/interests needs to be granted to the secured party. This will typically be accomplished through a pledge agreement, which should specify whether the security interest granted to the secured party is a security interest in the pledgor’s financial rights, governance rights or both. Without such specification, a pledging party may be able to argue that the pledge is simply a pledge of the financial rights.
In many cases, the organizational documents for the LLC either (i) expressly prohibit a member from transferring or pledging their membership units/interests; or, (ii) grant a right of first refusal to the LLC or other members. In these instances, the secured party must obtain the consent and waiver from the LLC and/or the other members before accepting the pledged units/interests.
However, in cases where there is no direct prohibition against a pledge, or if a right of first refusal does not exist, it is still wise to obtain the consent of the LLC and other members to prevent an objection at a later time. The form of the consent and waiver from the LLC and other members can be as simple or complex as the parties agree. For example, the consent and waiver should, at a minimum, contain consent to the pledge and a waiver of any transfer or pledge prohibitions and any first refusal rights. Also, the consent and waiver should have an acknowledgment that the LLC and other members will recognize the secured party as the holder of the pledged membership units/interests should the secured party give notice of an event of default in its lending relationship. In more complex transactions, the consent and waiver may also be reflected in a modification to the LLC’s organizational documents. In addition, the secured party may want to include provisions granting the LLC or the remaining members the option to acquire the pledged membership units/interests should the secured party acquire it or vice versa (i.e. a “push provision”, or a “push-put provision”).
It should also be noted that in accepting a pledge of membership units/interests, it is often the intent of the parties that the secured party will receive the distributions made on the membership units/interests while the debt is outstanding. If this is the case, the secured party should obtain an assignment of the distributions from the pledging member. Again, the assignment of distributions should be consented to by the LLC and other members to ensure that the assignment will be honored.
As for perfection, the manner of perfection depends upon whether the membership units/interests are certificated or uncertificated. When membership units/interests are uncertificated, they are “general intangibles” under the Uniform Commercial Code (“UCC”). If such is the case, perfection and priority issues are determined by the order of UCC financing statements filed against the membership units/interests. Thus, prior to accepting the pledged uncertificated membership units/interests, the secured party should perform a current UCC search on the pledging member to ensure the secured party obtains the proper first priority security interest. Perfection of an uncertificated security can also be achieved through a control agreement between the secured party and the LLC setting forth the secured party’s security interest in the membership units/interests.
In the cases where the membership units/interests are certificated, they are generally considered to be a security, which can be perfected by filing a UCC financing statement or by taking control of the certificate(s) (i.e. actual possession of the certificate(s) or entering into a control agreement with a third party in possession). Although certificated membership units/interests may be perfected by filing a UCC financing statement, perfection by control will have priority over any parties perfected by filing alone. As a result, it is generally recommended that a secured party perfect by both methods to ensure a first priority security interest on certificated membership units/interests. Thus, prior to accepting the pledged certificated membership units/interests, the secured party should (i) perform a current UCC search on the pledging member; and, (ii) either have the original certificate delivered to the secured party at closing or, if the certificate is in the possession of a third party, have a negotiated control agreement signed at closing.
Now that you are perfected, what happens if your borrower defaults? In our second part in this series, we will detail the steps to take control of the membership units/interests and to liquidate the same.
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Using Limited Liability Company Interests and Limited Partnership Interests as Collateral
In recent years, there has been an explosion in the use of alternative entities such as limited liability companies, limited partnerships, and general partnerships (collectively referred to herein as “alternative entities”). In addition, limited liability companies have become the preferred vehicle for creating bankruptcy remote entities in many financing transactions, which may also feature mezzanine financing arrangements in which the equity interests in the limited liability company is the mezzanine secured party’s primary collateral. Therefore, it is imperative that commercial finance attorneys understand the consequences of using equity interests in alternative entities as collateral. Although practitioners may be inclined to treat equity interests in alternative entities the same as corporate stock, the provisions of the Uniform Commercial Code (UCC) relating to the use of equity interests in alternative entities as collateral are different from those relating to the use of corporate stock as collateral. Therefore, practitioners cannot approach the issue of perfecting a security interest in equity interests in alternative entities the same as he or she would approach perfection in corporate stock. This article will describe (1) the methods of perfecting a security interest in equity interests in alternative entities, (2) mistakes practitioners often make when using equity interests in alternative entities as collateral, and (3) a few helpful tips for practitioners to keep in mind when using equity interests in alternative entities as collateral. This article will primarily focus on the relevant UCC provisions related to using equity interests in alternative entities as collateral, but to the extent references are made to statutes governing alternative entities, it will refer to the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act. However, the concepts discussed will also have applicability in other jurisdictions, which might have similar statutes.
Basic Perfection Methods
In connection with any secured financing, the secured party’s counsel should first determine what type of collateral he or she is dealing with in order to determine how to perfect its security interest in such collateral. Unlike corporate stock, equity interests in an alternative entity may not always be the same type of collateral for purposes of the UCC. Equity interests in limited liability companies and partnerships can be a “general intangible” or “investment property.” UCC §§ 9-102(a)(49) and 9-102 (a)(42). Unless the alternative entity has taken affirmative steps to have its equity interests treated as “securities” for purposes of Article 8 of the UCC, such equity interests will probably be general intangibles. UCC § 8-103(c). Thus, a secured party must review the alternative entity’s governing document and certificate of interest, if any, to determine whether the subject alternative entity has opted in to Article 8 to have its equity interests treated as securities, in which case, such interests will be investment property, not general intangibles.
Once the secured party’s counsel has determined what type of collateral the equity interests are for UCC purposes, then he or she can determine how to perfect the secured party’s security interest in the collateral. If the equity interests are general intangibles, the sole method of perfection is by filing. UCC § 9-310(a). Therefore, if the equity interests are general intangibles, for priority purposes, the familiar rules of first to file will govern multiple interests in the equity interests. UCC § 9-322(a). To the extent the equity interests are “securities,” and therefore “investment property,” then the secured party’s counsel must determine whether such interests are “certificated securities” or “uncertificated securities.” If the equity interests are “certificated securities,” the secured party can perfect its interest by filing, control or possession. UCC §§ 9-312(a), 9-313(a), and 9-314(a). If the equity interests are uncertificated securities, a secured party can perfect by control or filing. UCC §§ 9-312(a) and 9-314(a). For purposes of priority, a security interest perfected by control has priority over a security interest held by a secured party that does not have control of the investment property. UCC § 9-328(l).
To recap briefly, equity interests in alternative entities can be “investment property” or “general intangibles” and the nature of the collateral will determine the permissible methods of perfection. This all seems relatively simple, but now let’s briefly describe some of the mistakes that practitioners make in dealing with this type of collateral. As an overarching premise, it is imperative that the practitioner appreciate that he or she is not dealing with corporate stock and therefore what might apply to corporate stock will not apply in the world of alternative entities. Thus, it will not be sufficient to simply follow the same procedures that such practitioner has followed to perfect an interest in corporate stock. For example, under Delaware law, in contrast to corporate stock, an equity interest in a limited partnership or a limited liability company is made up of distinct economic rights and governance rights, and the two sets of rights are not bound together by statute. Ultimately, a secured party will want to have the right, upon default, to take control of the equity interests, and have the ability to receive, or transfer, the economic benefits of the equity interest as well as the governance rights. Thus, it is critical for the secured party to adequately describe the collateral to ensure that the collateral description is broad enough to create a security interest in the economic and governance rights.
A practitioner should be careful about simply using terms like “membership interests,” “limited liability company interests,” or “partnership interests,” which may not be sufficient to encompass economic and governance rights. For example, under the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act, the terms “limited liability company interest” and “partnership interest” under the relevant act simply refers to a person’s right to share in the entity’s profits and losses and the right to receive distributions not governance rights. Delaware Limited Liability Company Act § 18-101(8) and Delaware Revised Uniform Limited Partnership Act § 17-101(13). Thus, a collateral description using the terms “limited liability company interest,” “partnership interest,” or “membership interest” to describe an equity interest in a Delaware entity would not be sufficient to include the governance rights in the secured party’s collateral. Therefore, a secured party that used such a collateral description might find itself with a security interest in the economic rights of such entity only and no ability to cause a distribution of the entity’s assets or to exercise any governance rights.
The second mistake we often see is a failure to perfect the security interest in a manner that provides the secured party with priority over other secured parties with a competing security interest in the collateral. The method of perfection depends on the type of collateral being perfected. Are the equity interests in the alternative entity “general intangibles” or “investment property”? If the equity interests are investment property, the secured party may perfect by filing, control, or possession, but a security interest perfected by control will have priority over a security interest held by a secured party that does not have control of the investment property. UCC § 9-328(l). Again, the mistake we often see here is a failure to realize that the collateral is “investment property” and the secured party’s failure to perfect its security interest by control or possession.
Some of the great benefits of Revised Article 9 are the self-help remedies that enable a secured party to take a number of actions without judicial assistance to realize the value of its collateral in order to satisfy the obligations secured by the security interest. Those self-help remedies include, but are not limited to, strict foreclosure, and selling or otherwise disposing of the collateral to a third party. UCC §§ 9-620 and 9-610. Thus, one of the other mistakes we see is a failure by secured parties to take advantage of the contractual flexibility inherent in most alternative entity statutes to protect its security interest and facilitate such self-help remedies. Furthermore, such a mistake is often compounded by practitioners using corporate stock pledge agreements as precedent and substituting member for shareholder and membership interests for shares, which without more will probably be insufficient to protect fully the interests of the secured party. Also, if practitioners simply follow corporate precedent, he or she may fail to use the entity’s governing document to enhance the secured party’s protection and facilitate many of the self-help remedies available under the UCC.
Thus, as will be described below, the secured party will want to make sure that the security agreement and the entity’s governing documents contain the necessary protections to allow the secured party to effectively, and efficiently, exercise the self-help remedies available to a secured party under the UCC.
As a general matter, due to the contractual flexibility inherent in most alternative entity statutes, a secured party should take advantage of its ability to build additional protections into the subject entity’s governing documents, and not simply rely upon the representations, warranties, and covenants set forth in the security documents. For example, the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act each contain features that enable creditors to obtain additional rights and protections. Each act specifically permits the governing document to provide rights to a person that is not a party to the governing document. Delaware Limited Liability Company Act § 18-101(7) and Delaware Revised Uniform Limited Partnership Act § 17-101(12). Thus, counsel for the secured party should take steps to marry the contractual flexibility afforded by the alternative entity statutes to the favorable self-help remedies available under the UCC to ensure that the secured party will be able to realize the value of it equity interest collateral upon a default.
First, provide an adequate description of the collateral in connection with the creation of the security interest. Many alternative entity statutes, including Delaware, disaggregate economic rights from the governance rights provided to a holder of equity interests in the alternative entity. Therefore, the description of the collateral set forth in the security agreement that creates the interest must be broad enough to give the secured party a security interest not only in the economic rights but also the governance rights; otherwise if the description is not broad enough a secured party may find itself holding an interest solely in the economic rights that a debtor has in the alternative entities, similar to a charging order. Thus, the collateral description should make clear that it refers to the debtor’s governance rights under the governing document as well as the debtor’s economic rights.
Second, it cannot be emphasized enough: know your collateral. As mentioned above, a secured party should have a good understanding of what type of collateral the equity interests in the alternative entity are for purposes of the UCC. Thus, is the collateral a general intangible or investment property, and if investment property, is it certificated or uncertificated. Each of the foregoing conclusions will influence how a secured party perfects its security interest. In the event that the collateral is a general intangible, a secured party may want to request that the subject alternative entity actually opt-in to Article 8 of the UCC and perfect its security interest therein by control. Not only does opting in have the benefit of providing the secured party with a superior method of perfecting its interest, by control, but because the equity interests will be governed by Article 8, the secured party may in certain cases receive the benefits of being a “protected purchaser” and therefore actually receive an interest in the subject collateral that is superior to the interest of the debtor in such collateral because the secured party may take free of any adverse claims. UCC § 8-303(b). Opting in to Article 8 can be accomplished by executing a short amendment to the subject governing document, which expressly provides that the alternative entity’s equity interests will be governed by Article 8.
Related to knowing your collateral, it is also important that the secured party make sure that the subject collateral stays the same type of collateral after the security interest is perfected. Thus, in order to protect itself, the secured party should certainly build covenants into the security document, but also to the extent permitted by the applicable alternative entity statute, the secured party should hardwire protections into the alternative entity’s governing documents. Hence, a provision should be added to the governing document to prohibit the entity from amending the governing document to opt-in or opt-out of Article 8, as the case may be. Furthermore, for an entity governed by Delaware law, such entity can expressly provide in its governing document that the secured party must consent to any amendment that would change an equity interest’s status as a security or non-security.
Third, provide a mechanism in the documentation to permit the transfer of the equity interests and the admission by a transferee to the alternative entity. In order to fully take advantage of the self-help remedies available to a secured party under the UCC, a secured party should build a mechanism into the security agreement and the subject alternative entity’s governing document to permit the secured party or a third-party transferee of such equity interest to acquire the equity interests and to be admitted to the entity upon an event of default. This is a common pitfall for secured parties seeking to exercise self-help remedies. Unless the secured party takes steps to facilitate a transfer and automatic admission following a default by the debtor, a secured party may find that it is only able to acquire the economic rights under the equity interest. For example, under Delaware law, unless otherwise provided in the governing documents, the secured party’s admission to the alternative entity will require the cooperation of the debtor, and possibly the other equity holders, (Delaware Limited Liability Company Act § 18-301(b) and Delaware Revised Uniform Limited Partnership Act § 17-301(b)), and following a default, the debtor and the other equity holders may not be thrilled to assist the secured party with transferring the interest and admitting the transferee to the entity. Thus, in dealing with an alternative entity where admission is required to exercise governance rights, the parties may want to add a mechanism directly into the governing document whereby upon an event of default, the secured party will be automatically admitted to the entity, or alternatively, in some cases, a power of attorney can be granted to the secured party in order to facilitate such admission.
In addition, the secured party may require that the governing document contain language that structures the entity’s interests more like corporate stock, whereby a transferee succeeds to the transferor’s rights automatically upon transfer without further action on the part of the issuer or its equity holders. Under the Delaware statutes governing alternative entities, it is crucial to make sure that the admission issue is addressed if the entity only has one member or one limited partner because the transfer of the equity interest by the debtor to the secured party will cause the entity to dissolve because it has no members or limited partners. Delaware Limited Liability Company Act § 18-801(4) and Delaware Revised Uniform Limited Partnership Act § 17-801(4). That is the case because under the Delaware laws governing alternative entities, the debtor will cease to be a member or partner, as applicable, following the transfer of the interests and unless the governing document provides for an admission mechanism, the secured party or third-party transferee will not be admitted to the entity, which will cause the entity to lack the requisite partner or member needed to avoid dissolution.
Finally, due to the contractual nature of alternative entities, and particularly in Delaware, which expressly states that the policy of its alternative entity statutes is to give maximum effect to the principle of freedom of contract, the secured party should not merely rely upon the covenants and representations in the loan documents. Thus, instead of relying upon covenant defaults, protections may be added to the governing document that remove from the power and authority of the entity the ability to take certain actions that reduce, or might reduce, the secured party’s protection. As previously mentioned, the governing document should limit the entity’s ability to change the status of the collateral from a security to a non-security or vice versa, and it should prohibit amendments to the governing document that remove other secured party protections. In addition, the secured party may consider adding limitations on the power to issue additional equity interests or limit the authority to make distributions while obligations are outstanding. Thus, the secured parties should take advantage of the ability to enhance their protections in the alternative entity’s governing documents.
As the use of alternative entities increases, it is incumbent upon commercial finance attorneys to understand the characteristics of such interests and to ensure that they understand how to perfect such collateral, and otherwise deal with such collateral. Due to the flexibility of many of the alternative entity statutes and the contractual freedom available to the parties thereunder, care should be taken to ensure that a secured party sufficiently protects its security interest by taking some of, or at least considering, the actions described above. As stated at the beginning, the most important step in this process is to recognize that equity interests in alternative entities are not exactly like corporate stock and the approach by a secured party to protect its security interest in such collateral should be markedly different.
- Commercial Law
- Commercial Law - Secured Transactions
- Finance and Financing
- Finance and Financing - Commercial Finance
- Partnerships and LLCs
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A collateral assignment involves granting a security interest in the asset or property to a lender. It is a lawful arrangement where the borrower promises an asset or property to the lender to guarantee the debt repayment or meet a financial obligation. Moreover, in a collateral assignment, the borrower maintains asset ownership, the lender holds the security interest, and the lender has the right to seize and sell the asset in event of default. This blog post will discuss a collateral assignment, its purpose, essential considerations, and more.
Key Purposes of a Collateral Assignment
Collateral assignment concerns allocating a property's ownership privileges, or a specific interest, to a lender as loan collateral. The lender retains a security interest in the asset until the borrower entirely settles the loan. If the borrower defaults on loan settlement, the lender can seize and market the collateral to recover the unpaid debt. Below are the key purposes of a collateral assignment.
- Enhanced Lender Protection: The primary purpose of the collateral assignment is to provide lenders with an added layer of security and assurance. Also, by maintaining a claim on the borrower's properties, lenders lower their risk and improve the probability of loan settlement. In case of default, the lender can sell the collateral to recover the unpaid balance. This security authorizes lenders to offer loans with lower interest rates, as the threat associated with the loan is reduced.
- Favorable Loan Terms: Collateral assignment allows borrowers to access financing on more favorable terms than unsecured loans . However, the terms of the loan will vary depending on the borrower’s creditworthiness and the value of the collateral. Generally, lenders are more willing to extend larger loan amounts and lower interest rates when they have collateral to fall back on. The presence of collateral reassures lenders that they have a viable means of recouping their investment, even in case of default. This increased confidence often leads to more competitive loan offers for borrowers.
- Unlocking Asset Value: Collateral assignment enables borrowers to leverage the value of their assets, even if those assets are not readily convertible into cash. For instance, a business owner with valuable machinery can assign it as collateral to secure a business loan. This arrangement allows the borrower to continue utilizing the asset for operational purposes while accessing the necessary funds for expansion or working capital. Collateral assignment, thus, enables the efficient allocation of resources. However, the collateral will still be considered in determining the loan amount and terms.
- Access to Higher Loan Amounts: When borrowers promise collateral against a loan, lenders can present greater loan amounts than for other unsecured loans. The worth of the collateral serves as a reassurance to lenders that they can recover their investment even if the borrower fails to settle the loan. Therefore, borrowers can obtain higher loans to finance important endeavors such as purchasing property, starting a business, or funding major projects.
- Diversification of Collateral: Collateral assignment offers flexibility for borrowers by allowing them to diversify their collateral base. While real estate is commonly used as collateral, borrowers can utilize other valuable assets such as investment portfolios, life insurance policies, or valuable personal belongings. This diversification allows borrowers to access financing without limiting themselves to a single asset, thereby preserving their financial flexibility.
Steps to Execute a Collateral Assignment
A collateral assignment is a financial procedure that involves utilizing an asset as security for a loan or other responsibilities. Below are the essential steps involved in the collateral assignment process.
- Assess the Need for Collateral Assignment. The initial step in collateral assignment is determining whether collateral is necessary. Lenders or creditors may require collateral to mitigate the risk of default or ensure repayment. Evaluating the value and marketability of the proposed collateral is crucial to ascertain if it meets the lender's requirements.
- Select Appropriate Collateral. The next step involves choosing a suitable asset for collateral assignment. Common classifications of collateral comprise stocks, real estate, bonds, cash deposits, and other valuable assets. The collateral's value should be sufficient to cover the loan amount or the obligation being secured.
- Understand Lawful and Regulatory Requirements. Before proceeding with collateral assignment, it is essential to comprehend the lawful and regulatory provisions specific to the jurisdiction where the transaction happens. Collateral assignment laws can vary, so seeking advice from legal professionals experienced in this area is advisable to ensure compliance.
- Negotiate Provisions. Once the collateral is recognized, the collateral assignment provisions must be negotiated among the concerned parties. It includes specifying the loan amount, interest rates, repayment terms, and any further duties or limitations associated with the collateral assignment.
- Prepare the Collateral Assignment Agreement. The collateral assignment agreement is a lawful document that typically includes details about the collateral, the loan or obligation being secured, and the rights and responsibilities of both parties. It is highly advised to engage the services of a legal specialist to prepare or review the contract.
- Enforce the Collateral Assignment Agreement. After completing the collateral assignment agreement, it must be executed by all involved parties. This step ensures that all necessary signatures are obtained and copies of the agreement are distributed to each individual for record-keeping objectives.
- Notify Relevant Parties. To ensure proper recognition and recording of the collateral assignment, it is important to notify all relevant parties. It may involve informing the lender or creditor, the custodian or holder of the collateral, and any other pertinent stakeholders. Sufficient documentation and communication will help prevent potential disputes or misunderstandings.
- Record the Collateral Assignment. Depending on the nature of the collateral, it may be necessary to record the collateral assignment with the appropriate government authority or registry. This step provides public notice of the assignment and establishes priority rights in case of multiple claims on the same collateral. Seeking guidance from legal professionals or relevant authorities can determine if recording the collateral assignment is required.
- Monitor and Maintain the Collateral. Throughout the collateral assignment term, it is crucial to monitor and maintain the value and condition of the collateral. This includes ensuring insurance coverage, property maintenance, and compliance with any ongoing obligations associated with the collateral. Regular communication between all parties involved is essential to address concerns or issues promptly.
- Terminate the Collateral Assignment. Once the loan or obligation secured by the collateral is fully satisfied, the collateral assignment can be terminated. This involves releasing the collateral from the assignment, updating relevant records, and notifying all parties involved. It is important to follow proper procedures to ensure the appropriate handling of the legal and financial aspects of the termination.
Key terms for collateral assignments.
- Security Interest: It is the legal right granted to a lender over the assigned collateral to protect their interests in case of borrower default.
- Collateral Valuation: The process of determining the worth or market value of the assigned collateral to assess its adequacy in securing the loan.
- Release of Collateral: The action taken by a lender to relinquish its claim over the assigned collateral after the borrower has fulfilled the loan obligations.
- Subordination Agreement : A legal document that establishes the priority of multiple creditors' claims over the same collateral, typically in the case of refinancing or additional loans.
- Lien : A legal claim or encumbrance on a property or asset, typically created through a collateral assignment, that allows a lender to seize and sell the collateral to recover the loan amount.
Final Thoughts on Collateral Assignments
A collateral assignment is a valuable instrument for borrowers and lenders in securing loans or obligations. It offers borrowers access to profitable terms and more extensive loan amounts while reducing the risk for lenders. Nevertheless, it is essential for borrowers to thoughtfully assess the terms and threats associated with collateral assignment before proceeding. Seeking professional guidance and understanding the contract can help ensure a successful and beneficial financial arrangement for all parties involved.
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Firm rated best ADR firm for Wisconsin and won an award for cultural innovation in dispute resolution from acquisition international magazine in 2016 and it was rated "Best of Brookfield" by Best Businesses in 2015. Attorney Maxwell C. Livingston was rated 10 best in Labor & Employment Law by American Institute of Legal Counsel and 40 Under 40 by American Society of Legal Advocates for 2016; he also won 10 Best by American Institute of Family Law Attorneys. He is licensed in Wisconsin in all state and federal courts, and in the 7th Circuit Court of Appeals, wherein he won a landmark decision in McCray v. Wielke.
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