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American Bar Association

ABA Section of Business Law


Volume 14, Number 3 January/February 2005

It's a matter of collateral
LLCs, partnerships and the UCC
    By Lynn A. Soukup

There are hundreds of thousands of partnerships and LLCs — and more being formed all the time. And more and more often, interests in partnerships and LLCs are being used as collateral for loans.

Using LLC and partnership interests as collateral raises unique issues under the UCC. How to perfect a security interest (including whether taking possession of a certificate is effective), the priority of that security interest and whether restrictions on assignment are effective depend not just on the rules in Article 9 of the UCC. Article 8 of the UCC (which most finance lawyers don't spend much time with) will affect how the Article 9 rules work. If you understand the interplay of Article 8 and Article 9, you'll understand how to best protect a lender's security interest in an LLC or partnership interest (and why the lender's lawyer may be asking the debtor for more than a financing statement).

Article 9 divides collateral into "types" and then applies different rules to the perfection and priority of a security interest in the collateral depending on its type. There are also type-based rules that determine whether (and to what extent) contractual and statutory restrictions on creating, perfecting and enforcing a security interest in the collateral are effective.

In most cases, an LLC or partnership interest is a "general intangible" for purposes of the Article 9 rules on perfection, priority and effectiveness of restrictions on assignment. However, the issuer of an LLC or partnership interest can invoke Article 8 to change those interests into "securities" for purposes of the Article 9 rules. Changing the "type" of the collateral changes the rules.

How to perfect a security interest. A security interest in a general intangible can only be perfected by filing a financing statement. Sections 9-310, 9-312(b). It doesn't matter that the LLC or partnership interest is represented by a certificate or what the applicable state's LLC or partnership statute says that certificate represents — only filing is effective.

A security interest in a security can be perfected by several methods — by filing a financing statement, by obtaining control of the security or by taking possession of a certificated security. Sections 9-310, 9-312(b) , 9-313, 9-314. A lender can obtain control of a security by taking possession of a certificated security with an effective indorsement, having the security registered in the lender's name, entering into a control agreement with the issuer of an uncertificated security or other means described in Section 8-106.

With a security as collateral, there is more than just perfecting the security interest to be considered — the method used can affect the priority of the lender's security interest.

Priority. The priority of competing security interests in a general intangible is determined by the "first in time" rules in Section 9-322. As with perfection, there are no alternatives available.

While the priority of competing security interests in a security perfected by filing would also be determined by those "first in time" rules, a security interest in a security can also be perfected by control (or by possession of a certificated security). A security interest perfected by control (or possession) will in most cases take priority over a competing security interest perfected by filing (even if the lender perfecting by control or possession had knowledge of the competing security interest), as provided in Section 9-328. A lender can use this rule — only applicable to securities — to improve the priority of its security interest.

Maintaining perfection. Perfection by control or possession of a security also has the advantage of not lapsing unexpectedly. Failure to continue or amend a financing statement or to file a new financing statement when required (such as on a change in location of the debtor, a transfer of collateral or a transaction that creates a new debtor) will result in a security interest's becoming unperfected, making it vulnerable in bankruptcy and junior to other claims to the collateral.

Better title than the debtor has. For most types of collateral (including a general intangible) a lender cannot get better rights than its debtor has — the lender takes some risk that there are defects in its debtor's title and that the lender will inherit those defects. A different rule applies to securities.

A lender with a security as collateral may qualify as a "protected purchaser" under Article 8. If it qualifies as a protected purchaser, in addition to acquiring a security interest in the debtor's rights in the collateral, the lender will acquire that interest free of all adverse claims. The lender will be a protected purchaser if it gives value, obtains control of the security and does not have notice of any adverse claim to the security.

The requirement of giving value is easily met, for example by providing any consideration sufficient to support a contract or if the security is given as collateral for a pre-existing debt. The methods of obtaining control of a security are described above.

A protected purchaser takes free of adverse claims. An adverse claim has two elements: The claimant has a property interest (including a security interest) in the security and it is a violation of the claimant's rights for another person to hold, transfer or deal with the security. Section 8-102(a)(1). Adverse claims include the claim of a lender that its debtor wrongfully transferred a pledged security or the claim of the owner of a security that he was fraudulently induced to transfer the security and has a right to rescind the transfer.

Notice of an adverse claim exists if there is actual knowledge of the claim, failure to seek further information when the known facts indicate there is a significant probability that an adverse claim exists ("willful blindness") or failure to fulfill a duty of investigation imposed by law (such as SEC Rule 17f-1, which imposes a duty on banks, brokers and other securities market participants to inquire as to whether securities offered for sale or pledge have been reported as missing, lost or stolen). Section 8-105. Notice of any adverse claim defeats protected purchaser status as to all adverse claims, even those of which the lender does not have notice.

Two "yellow lights" — a lender that knows of another security interest may not qualify as a protected purchaser, and in the case of competing security interests a lender will likely take priority over (but not free of) the competing security interest.

Benefits of requiring a certificate.If an LLC or partnership interest is a security, having the interest certificated can provide benefits to the lender that are not available if the interest is a general intangible. If the lender obtains control or possession of a certificated security, no other party can obtain control of that security. As a result, there can be no buyer of the security that is a protected purchaser (and therefore would take free of the lender's security interest) and no competing lender can obtain priority by taking control or possession of the certificate.

The lender may also find it easier to obtain control of a certificated security (by taking possession of an indorsed certificate) rather than obtaining control of an uncertificated security. Control of an uncertificated security requires either registration of the security in the name of the lender (not likely to be an available means of holding an LLC or partnership interest) or a control agreement with the issuer of the security. While the issuer of the LLC or partnership interest may be willing to take the necessary steps for the interest to be a security (described below) and to issue a certificate, it may not be willing to undertake the responsibilities (and potential liability) involved in a control agreement.

Having a certificated security as collateral does not eliminate all risks. The lender still depends on the accuracy of representations and warranties as to the interests in the issuer that are outstanding and on compliance with covenants restricting the issuance of additional interests or modifications of the terms of the interests. There are also risks unique to a certificated security. For example, the lender can be adversely affected if the debtor falsely claims that the certificate was lost, destroyed or stolen and gets a replacement; that can dilute the value of the lender's collateral if a protected purchaser acquires rights in the replacement certificate, as provided in Section 8-405. This risk can be limited by notice to or agreements with the issuer of the interest.

Effectiveness of anti-assignment provisions. Section 9-408negates certain contractual and statutory restrictions on the creation, perfection and enforcement of a security interest in a general intangible (but does not apply to a security). A lender that is thinking about requiring that its collateral be made a security needs to check on whether there are restrictions that are ineffective (because a partnership or LLC interest is a general intangible) that will be given life if the collateral becomes a security.

In some states (such as Delaware) restrictions on assignment will not be negated, regardless of whether the LLC or partnership interest is a general intangible or a security. The Delaware LLC and partnership statutes provide that the Article 9 provisions negating restrictions on assignment do not apply to any interest in a Delaware partnership, limited partnership or limited liability company (including all rights, powers and interests arising under the applicable partnership or LLC agreement or the applicable Delaware entity statute). Conforming changes were made to Delaware's version of Article 9.

As described above, there are a number of advantages for a lender if its collateral is a security rather than a general intangible. Article 8 provides the rule that determines whether an LLC or partnership interest is a general intangible or a security. Even better, Article 8 gives the lender some control over the result.

Section 8103(c) provides that an interest in a partnership or LLC is not a security unless:

  • it is dealt in or traded on securities exchanges or in securities markets,
  • it is issued by a registered investment company or similar entity, or
  • its terms expressly provide that it is a security governed by Article 8 — that the partnership or LLC "opts in" to Article 8. (Opting in to Article 8 does not affect whether the interest is a security for purposes of federal or state securities laws.)
Most LLC and partnership interests are not publicly traded or investment company securities, so a lender that wants a security as collateral will ask the issuer of the interest to opt in to Article 8.

Opting in to Article 8 is simple — the terms of the LLC or partnership interest must expressly provide that the interest is a security governed by Article 8. Under state LLC or partnership law, the terms of the interest would be set by the LLC or partnership agreement — so that agreement should provide that the interest is a security governed by Article 8. If the interest is certificated, then the certificate usually also refers to the "opt in" to satisfy any state law requirement that the certificate describe the terms of the security.

A lender with a security as collateral should take steps to keep its collateral a security. For example, the lender could have an agreement with the issuer not to "opt out" of Article 8, require that the LLC or partnership agreement provide that the opt in cannot be changed without the lender's consent, or get a proxy to vote on an opt out. If the issuer opts out, the lender's security interest may become unperfected if the lender was relying on perfection by possession or control (a good reason to also file a financing statement) and may lose its priority.

A lender with a general intangible as collateral should take steps to prevent that interest from becoming a security. For example, the lender could have an agreement with the issuer (or a provision in the LLC or partnership agreement) prohibiting an opt in to Article 8 without the lender's consent or a proxy to vote on an opt in. If the issuer opts in when the lender did not plan to have securities as collateral, a buyer that qualifies as a protected purchaser would take free of the lender's interest and another lender could have priority over the first lender's security interest.

A lender also needs to consider restricting mergers, consolidations or conversions by the LLC or partnership that could change whether an interest is a security or a general intangible and whether the security is certificated.

If the issuer "opts in," all of Article 8 becomes applicable. Before it agrees to an opt in to accommodate a lender, the LLC or partnership should become familiar with the obligations it is undertaking and legal requirements that will become applicable. If the issuer of the LLC or partnership interest has opted in (and the interest becomes a security), Article 8 contains numerous provisions that will affect the rights and obligations of the issuer, an owner of the security, secured lenders and transferees of the interest.

For example, Article 8 provides that a restriction on transfer of a security imposed by the issuer, even if otherwise lawful, is ineffective against a person without knowledge of the restriction unless the security is certificated and the restriction is noted conspicuously on the security certificate (resulting in the familiar practice of "legending" stock certificates with notices of transfer and other restrictions) or the security is uncertificated and the registered owner has been notified of the restriction.

Article 8 also provides that the issuer has specific duties to register transfers of securities (and specifies the circumstances under which the issuer may refuse to do so), gives certain third parties rights to demand that the transfer not be made and establishes the issuer's liability for failure to comply with these obligations.

Holders of Article 8 securities also have obligations; for example, Article 8 establishes procedures for dealing with lost, destroyed or wrongfully taken securities certificates and adverse consequences for failing to notify the issuer if the certificate has been lost, apparently destroyed or wrongfully taken.

UCC Article 9 applies very different rules to general intangibles and securities. In a transaction involving an LLC or partnership interest as collateral, the lender's lawyer needs to identify what that interest is (in most cases a general intangible) and then decide whether the lender should require something different (a security). Once the Article 9 "type" of the interest has been determined, the issues of how to perfect a security interest, priority of that security interest, the effectiveness of restrictions on assignment and protection of the lender's interests fall into place.

In the case of partnership and LLC interests, the combination of UCC Articles 8 and 9 provides a lender with useful tools to enhance its rights. It also gives lawyers some thinking to do.

Using the UCC in real estate mezzanine financing
By Marci Schmerler

Mezzanine financing of real estate is an increasingly popular structure that permits a property owner to use its equity in the property as collateral even if a second mortgage on the property is not permitted.

While there are many mezzanine financing structures, a typical structure would have the ultimate equity owners of the real estate form one entity to own the property and another entity to hold the ownership interests in the property owner. A mortgage loan is made to the property owner (secured by a mortgage on the property). A mezzanine loan is made to the holding company (secured by its ownership interest in the property owner).

Mortgage lenders are generally more willing to permit a mezzanine loan than to permit a second mortgage on the real property collateral. One reason is that mortgage lenders believe that their position will be stronger in a bankruptcy of the property owner, since the mezzanine lender is not a creditor of the property owner and therefore does not have a "seat at the table" in the property owner's bankruptcy.

Mezzanine financing has become more common with the growth of securitization of commercial mortgage loans. Commercial mortgage loans originated for securitization generally strictly prohibit junior mortgage loans. The criteria for securitized loans have been evolving to permit mezzanine loans that meet specified criteria (including having a standardized intercreditor agreement between the mortgage lender and the mezzanine lender, having an eligible mezzanine lender and satisfying rating agency requirements that the mezzanine financing terms not weaken the property owner's ability to service the mortgage loan).

Because the collateral for the mezzanine loan is the equity interest in the property owner (usually an LLC or partnership), the strength of its security interest in that equity interest is critical to the mezzanine lender. Understanding the UCC Article 8 and 9 rules applicable to LLC and partnership interests as collateral is critical for that lender's lawyer.

Schmerler is a partner at Alston & Bird LLP in Atlanta. Her e-mail is mschmerler@alston.com.

Soukup is a partner at Alston & Bird LLP in Washington, D.C. Her e-mail is lsoukup@alston.com.


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