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Limited Liability Company Membership Interests
What a Lender Needs to Do with LLC Collateral on Default
By Michael VanNiel and James W. May
In the last several years, commercial borrowers have increasingly provided lenders security interests in limited liability company membership interests (LLC units) as collateral for loans. Recent market events have increased the likelihood of default on many commercial loans, including those secured by LLC units. This article will review what a lender who holds LLC units as collateral can do under the Uniform Commercial Code (UCC) after a borrower's default. Before we evaluate the foreclosure process, however, let us briefly review how a lender takes a security interest in LLC units.

The first step in understanding how a lender takes a security interest in LLC units is to understand how the UCC defines an LLC unit. Under the UCC, an LLC unit may be either a "general intangible" or a "security." Cumulatively, UCC sections 9-310, 9-312(b), 9-313, and 9-314 provide that if the lender has a security interest in a security, it can perfect its interest by filing a financing statement in the appropriate jurisdiction, obtaining control of the LLC units, or taking possession of the certificate(s) representing the LLC units (if such certificate(s) exist(s)). If the secured party's security interest is in a general intangible, the lender can only perfect by filing a financing statement in the appropriate jurisdiction, according to UCC sections 9-310 and 9-312(b). For purposes of this article, we will assume that the lender's security interest in LLC units is properly perfected.

Let us also assume that the lender has negotiated a security agreement that gives it full rights to take over the LLC upon default. Once the borrower defaults on the loan, the lender might assume that it can simply step into the borrower's shoes as an owner of the LLC following the borrower's taking all appropriate steps to admit the lender as a member of the LLC. Such an assumption would be wrong.

In order for the lender to take ownership of the LLC units, the lender must foreclose on its security interest through one of two processes detailed in the UCC. One process is commonly referred to as "strict foreclosure" and is outlined in UCC section 9-620 (strict foreclosure). The other process involves a sale of the LLC units to either the lender or third parties, subject to the requirement that such sale be commercially reasonable, as outlined in UCC section 9-610 (the 9-610 sale).

Option 1: Strict Foreclosure
According to UCC section 9-620, upon the borrower's default, the lender can accept the LLC units as full or partial payment for all of the borrower's indebtedness secured by the LLC units. If the lender accepts the LLC units in full satisfaction of the debt, then the borrower's obligation to the lender for the debt is extinguished, regardless of the value of the LLC units. If the lender accepts the LLC units as partial satisfaction of the debt, the lender can potentially obtain a deficiency judgment against the borrower for the remainder of the unpaid debt. At first blush, it would appear that a lender would always pursue partial satisfaction, since that remedy allows the lender to potentially recover more. That is not always the case, as we will discuss later. First, however, a discussion of how strict foreclosure works.

A lender needs the borrower's consent, and the consent of any junior lienholders and other parties holding an interest in the LLC units, before the lender can proceed with strict foreclosure. If a lender cannot obtain the consent of these parties, then a 9-610 sale (discussed below) might be a better option.

If a lender wants to pursue strict foreclosure, it must understand how consent works in this context. First, consent is only valid if a lender obtains it after default. A lender cannot get the required consents to strict foreclosure in the security agreement, or in any other agreement that precedes default. Second, "consent" is used broadly and contemplates both affirmative agreement and the failure of a party to timely object.

Where a lender seeks partial satisfaction, it must obtain the borrower's consent in a "record authenticated after default." Thus, for partial satisfaction, a lender needs the borrower's affirmative agreement. A lender also needs the consent of junior lienholders and other parties holding an interest in the LLC units. The consent of these subordinated parties to partial satisfaction is deemed to be given if these parties do not timely object to the lender's proposal, as provided in UCC sections 9-620(d) and 9-621.

A lender seeking full satisfaction can get the borrower's affirmative agreement (as required for partial satisfaction) or it can go through the process outlined in UCC section 9-620(c)(2), whereby the borrower is deemed to consent to full satisfaction. The borrower effectively consents to full satisfaction if the lender sends the borrower its proposal to take the LLC units for all of the borrower's remaining debt secured by the LLC units and the lender does not receive an authenticated (notarized) objection within 20 days after the lender sends its proposal. As with partial satisfaction, a lender also needs the deemed consent of parties with subordinate interests in the collateral.

The issue of consent brings us back to why a lender might pursue full satisfaction instead of partial satisfaction. As a practical matter, a lender might have an easier time obtaining consent to full satisfaction than partial satisfaction. As discussed above, obtaining deemed consent for full satisfaction does not require the affirmative agreement of the borrower. The borrower might not have incentive to agree to partial satisfaction because such consent exposes the borrower to a deficiency judgment. Even if the borrower consents to partial satisfaction, a deficiency judgment might be worthless. For example, the underlying assets of the LLC might already be encumbered. If there is no other value for a lender to pursue, the path of least resistance (and minimal cost) will likely be full satisfaction.

On the other hand, there could be instances where a borrower does have incentive to consent to partial satisfaction, as it might if it defaulted on its loan and sought a forbearance agreement from the lender. In such case, the lender might require the borrower to consent to partial satisfaction in the event of breach of the forbearance agreement. The borrower's consent to partial satisfaction in the forbearance agreement seems like it would meet the standard of section 9-620(c)(1) since the consent would be given to the secured party after default under the terms of the original loan agreement. However, the lender should not rely on the enforceability of consent to partial satisfaction in a forbearance agreement since, to date, this approach has not been widely approved by courts.

Obtaining consent to strict foreclosure can be inefficient and frustrating, especially if the borrower or junior lienholders object to the lender's proposal. Unfortunately, if a lender wants to use strict foreclosure, there is no way to avoid the hassle of getting these consents.

Option 2: Commercially Reasonable Sale
If the borrower or another party with an interest in the LLC units objects to strict foreclosure, or if the lender does not want to take ownership of the LLC units, the lender has another remedy—a 9-610 sale. UCC section 9-610 says that, after a debtor's default, a secured party may sell, lease, license, or otherwise dispose of any or all of the collateral in a commercially reasonable manner. A 9-610 sale can be either private or public, although a lender cannot purchase the LLC units in a private sale unless the LLC units are of a type that are customarily sold on a recognized market or the subject of widely distributed standard price quotations (which is not the case for many LLC units). The UCC requires that the sale of LLC units has to be commercially reasonable in every aspect.

The Vornado Decision
Ensuring that a sale of LLC units is commercially reasonable is a challenge. There appears to be no direct authority on commercially reasonable sales of LLC units, but the Delaware case of Vornado PS, L.L.C. v. Primestone Inv. Partners, L.P., 821 A.2d 296 (Del. Ch. 2002), reviewed an analogous sale of partnership interests. Vornado demonstrates that a lender who carefully prepares a sale of collateral to be commercially reasonable may still be subject to a lawsuit alleging that such sale is commercially unreasonable. In Vornado, the borrower granted the lender a security interest in the partnership units of an affiliated limited partnership (the "LP units"). The LP units were exchangeable for shares of such limited partnership's publicly traded affiliate (Public Co.) or a cash equivalent. When the borrower defaulted on the loan, the lender hired an investment bank to find prospective purchasers and set up an auction for the LP units. The investment bank contacted numerous prospective purchasers and advertised the auction in multiple newspapers with national circulation. The prospective purchasers were only given publicly available information on the limited partnership (rather than privately held, internal information on the LP that the lender possessed), which purportedly discouraged many of the prospective purchasers from bidding on the LP units. At the public auction, the lender was the only bidder and it purchased the LP units on a per-unit price that was equal to the share price of Public Co. on the day of the foreclosure sale. The borrower claimed that the auction was commercially unreasonable because (1) the sale was not private, and comment 2 to UCC section 9-610 encourages private sales, and (2) the net asset value of the LP units was nearly twice the value paid by the lender at the auction.

The Vornado court rejected the first argument on the grounds that a private sale would have potentially resulted in a lower sale price. According to the court, the lender was the primary person interested in buying the LP units. But, as discussed above, a secured party cannot participate in a private sale. Thus, the borrower's proposed format (private sale) would have eliminated the lender from bidding on the LP units and would have potentially caused the LP units to sell at a much lower price.

The Vornado court also rejected the borrower's argument that the sale price was disproportionately low based on the net asset value of the LP units. According to the court, the net asset value of the assets owned by the limited partnership (primarily real estate) were not liquid and the exact value of such assets could only be determined in a sale. Since those assets were not up for sale, the borrower's net asset value calculation was minimally reliable.

The only major weakness in the 9-610 sale, according to the opinion, was that the lender possessed inside information relating to the LP to which other potential bidders did not have access. The Vornado court excused this nondisclosure by saying that the secured party had no sense of how reliable the inside information was.

Even though the Vornado court excused the secured party's nondisclosure of facts relating to the LP, other courts may not be so generous. An aggrieved borrower could make an effective argument that nondisclosure of material facts relating to the underlying assets of the LLC by a lender in a 9-610 sale is commercially unreasonable. Of course, how much a lender tells prospective bidders about the LLC units will vary from case to case, but the more that the lender keeps to itself, the more likely that a 9-610 sale will be overturned by a court.

While the lender prevailed in Vornado, the case shows that even a lender who is scrupulous in organizing a commercially reasonable sale may be subject to litigation. And a lender who has a security interest in LLC units may not have facts like those in Vornado that may have inclined the Vornado court to declare the sale commercially reasonable. Valuing LLC units may be much more difficult than valuing the LP units in Vornado since rarely is the value of LLC units directly linked to a publicly traded security.

Compliance with Securities Law
In addition to the problems that a lender might have complying with the commercially reasonable sale requirements and paying the related expense, a lender might also face issues related to securities law compliance. While securities law liability for lenders in this context is too complex to address in detail here, it is worth mentioning at least one potential pitfall. The issuance of LLC units to members in an LLC is often done pursuant to an exception to the Securities Act of 1933 (the act) and the applicable state blue sky laws, allowing the issuer of LLC units to avoid registering such securities with the Securities and Exchange Commission (SEC) and the state-level equivalent, in a "private placement." If a lender wanted to do a public 9-610 sale of the LLC units, would the lender need to register the sale with the SEC? Comment 8 to UCC section 9-610 says, "although a 'public disposition of securities under this Article may implicate the registration requirements of the Securities Act of 1933, it need not do so. A disposition that qualifies for a 'private placement' exemption under the Securities Act of 1933 nevertheless may constitute a 'public' disposition within the meaning of this section. " This comment indicates that a lender can conduct a public 9-610 sale without registering the LLC units, if the 9-610 sale meets the private placement (or other) exemptions from the act. In other words, simply because a 9-610 sale is structured to meet the private placement exemption does not mean that it must be a private 9-610 sale (which might prohibit a lender from purchasing the LLC units).

Structuring the 9-610 sale to make sure that it does not violate the act, or other securities law, is a fact-intensive matter and should be examined carefully by a securities lawyer beforehand. A lender also should consult a securities lawyer when considering strict foreclosure.

Possible Barriers and Drawbacks
For a lender who has a security interest in LLC units, the borrower's right to vote on business matters involving the LLC and/or to manage the LLC is very important. If the borrower defaults, a lender may want to control the LLC via the borrower's voting or management rights. A careless lender or third-party purchaser of the LLC units may only get a financial distribution right instead. Delaware law, for example, provides that an assignee of LLC units has no right to participate in the management of the business and affairs of the company, or to exercise any rights or powers of the members, unless the operating agreement provides otherwise. Even if the operating agreement allows the assignee (in our case, the lender) to exercise rights and powers of a member, the assignee cannot manage the LLC until either all nonassigning members approve of the transfer of management power or the procedure for complying with the transfer of management responsibilities, as stated in the operating agreement, is followed (DEL. CODE ANN. tit. 6, § 18-701).

A lender should examine the law of the LLC's organization to determine the default rights of an assignee of LLC units. A lender also should review the LLC's operating agreement to determine if that operating agreement puts significant restrictions on the admission of new members and its process for approving management. The security agreement between the lender and the borrower should clearly articulate the borrower's obligation to take all necessary action to admit the lender, or any third-party purchaser of the LLC units pursuant to a 9-610 sale, as a member and a manager.

If there is not a market for the LLC units, then the lender will be the purchaser of the LLC units at the public sale, which might not be the best option for a lender, depending on the circumstances of the parties and the loan. Making a sale of LLC units commercially reasonable might be prohibitively expensive if there is no third-party purchaser to defray the costs of advisors, publication of notices, etc. Assuming that the lender's purchase complies with the requirements of UCC section 9-610, including the requirement to pay a commercially reasonable price for the LLC units, the borrower will owe all indebtedness due to the lender upon default (plus applicable fees, default interest, etc.) and the lender will have put forth additional money to ensure compliance with UCC section 9-610, including the advisor expenses mentioned above, and to pay for the LLC units. If the lender cannot later sell the LLC units that it purchased at the 9-610 sale, a 9-610 sale may increase the lender's expense and may not improve its position from where it would have been had it used the strict foreclosure process.

Deficiency Judgments
If the underlying assets of the LLC have value, a lender might be very interested in a deficiency judgment. As discussed above, a lender can seek a deficiency judgment if the strict foreclosure requirements for partial satisfaction are met. However, partial satisfaction requires the consent of the borrower and, potentially, other parties. If a lender wants to seek a deficiency judgment and obtaining consent from the applicable parties is not realistic, then a 9-610 sale might be preferable to strict foreclosure for full satisfaction. Based on the facts of the particular 9-610 sale, (1) the LLC units might be sold to a third party and the proceeds of such sale distributed to the lender or (2) the lender might purchase the LLC units itself for a commercially reasonable price that still leaves the borrower with some debt to the lender. In either case, the lender could get a deficiency judgment for the remainder of any of the borrower's indebtedness that was secured by the LLC units. With that deficiency judgment, the lender could pursue other assets of the borrower.

In some cases, a deficiency judgment is not a realistic goal for a lender. For example, lenders often take LLC units as collateral in mezzanine lending arrangements, where the borrower LLC is a single-purpose entity, created solely for the ownership and operation of real property. In many mezzanine finance deals, the property is encumbered by a first priority mortgage and the LLC has no other assets. A lender might want to repossess the LLC units through strict foreclosure or a 9-610 sale in order to manage the property or negotiate new terms with the mortgage lender. However, in this case, a deficiency judgment would not be valuable.

Unanticipated Risks and Burdens
A lender who becomes a member of an LLC, whether through strict foreclosure or a 9-610 sale, potentially owes fiduciary duties to other members of the LLC by virtue of its equity interest. After becoming a member of the LLC, if the lender takes action that other members do not like, that could subject the lender to litigation. Even if such litigation is resolved favorably to the lender, the lender will have expended time, energy, and resources. And if the LLC in which the lender now owns a membership interest after foreclosing on its security interest is in the so-called zone of insolvency, the lender could owe fiduciary duties to consider the interests of creditors of the LLC. Although recent decisions, particularly in Delaware, have greatly restricted creditors' ability to bring direct claims for fiduciary duty breach against owners and management, the risk of such claims should be evaluated by the lender before foreclosing.

Lastly, when a borrower defaults on a loan, the borrower often is insolvent. If that is the case, then the lender should evaluate whether state or federal fraudulent transfer laws might permit a post hoc challenge to the lender's acquisition of the LLC units. There is little or no risk that the lender's acquisition could be subsequently avoided if it occurred in the context of a regularly conducted, commercially reasonable foreclosure sale. However, if the lender acquires the LLC units in another manner, that could give rise to litigation regarding whether the lender had received a fraudulent transfer. This is another risk that the lender should consider when determining whether and how to proceed against the LLC units.

Conclusion
It is important to note that strict foreclosure and 9-610 sales are not limited solely to the disposal of LLC units. In fact, as the economic crisis deepens, countless secured lenders will use these actions to get value for collateral ranging from shares of publicly traded companies to go-carts. In comparison to foreclosures on and resale of these kinds of collateral, strict foreclosure and 9-610 sales of a borrower's LLC units can be especially complicated and, because of sparse case law, may expose a lender to unanticipated risks. Whether a lender who holds LLC units as collateral chooses the strict foreclosure process or the 9-610 sale (or decides to forgo foreclosure on its security interest altogether) will depend on the particular facts of the loan and the parties to the transaction. However, as a general rule, it is essential that the lender understand its options under the UCC, compare the benefits of each option, and act promptly upon default. A secured lender that fails to do so jeopardizes its basic remedies under the UCC for a default on a loan secured by LLC units.

Additional Resources

For a more comprehensive evaluation of security interests in LLC units, you can retrieve the following article on the Business Law Today Web site.

It's a matter of collateral—LLCs, partnerships and the UCC
By Lynn A. Soukup
Business Law Today
January/February 2005
Volume 14, Number 3

All issues since 1995 maybe be accessed under the "Past Issues" heading at the bottom of the Web page.
VanNiel is a partner and May is an associate at Baker & Hostetler LLP in Cleveland, Ohio. Their respective e-mails are mvanniel@bakerlaw.com and jmay@bakerlaw.com.

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