The newsLINK Group - Beware Simplistically Defining Membership Interests in LLCs

Editorial Library Category: Banking & Finance Topics: LLCs Title: Beware Simplistically Defining Membership Interests in LLCs Author: Landon A. Hardcastle with Jones Waldo Synopsis: As collateral for a loan, lenders sometimes take a security interest in the ownership interests of a borrower – which means, in many transactions, lenders take a security interest in the ownership interests of a limited liability company (LLC). Editorial: Beware Simplistically Defining Membership Interests in LLCs 4064 South Highland Drive, Millcreek, Utah 84124 │ thenewslinkgroup.com │ (v) 801.676.9722 │ (tf) 855.747.4003 │ (f) 801.742.5803 Editorial Library | © The newsLINK Group LLC 1 Introduction As collateral for a loan, lenders sometimes take a security interest in the ownership interests of a borrower – which means, in many transactions, lenders take a security interest in the ownership interests of a limited liability company (LLC). When drafting a security agreement to grant such an interest, lenders and their counsel sometimes resort to terms like “membership interests” or “limited liability company interests” to describe their intended collateral, assuming that these terms will allow them, or a third-party purchaser, full economic participation in the LLC (economic rights), as well as voting and managerial control in the LLC (management rights) upon foreclosure. However, while such terms may suffice in some states, they should be avoided when taking a security interest in the economic and management rights of an LLC as many states’ LLC statutes do not define “membership interests” or “limited liability company interests” to include these rights. As a result, lenders take a considerable risk when they describe their intended collateral in such a simplistic manner. The purpose of this article is to warn lenders of this risk and to advise them of the simple steps they can take to avoid it. Specifically, this article illustrates this risk by looking at issues under the Delaware Limited Liability Company Act, Del. Code Ann. Tit. 6, § 18 (Delaware LLC Act) and advocates that lenders should draft their security agreements to carefully define the LLC interests they desire as collateral (i.e., define the economic and management rights by using language directly from the relevant state LLC statute and the LLC operating agreement). Lenders should also thoroughly review the LLC’s operating agreement to know whether the LLC has the power to assign such interests or whether the operating agreement may need to be amended to permit an assignment. Assigning Economic and Management Rights in Delaware LLCs As many LCCs are formed in the State of Delaware, the Delaware LLC Act provides a good starting point in understanding the risk a lender takes in simplistically describing its intended LLC collateral. Under Delaware law, “membership interests” are not defined. However, the Delaware LLC Act does define a “limited liability company interest” as “a member’s share of the profits and losses of a limited liability company and a member’s rights to receive distributions of the limited liability company’s assets.” In other words, Delaware limits an assignment of a “limited liability company interest” solely to an assignment of economic rights in a LLC. While economic rights are freely assignable under Delaware law, management rights are a different matter. Absent permissive language in the LLC operating agreement or specific action by the members of the LLC authorizing the assignment of management rights, the assignee of a “limited liability company interest” under Delaware law will not have the right to participate in the management of the business and affairs of the LLC. For practical purposes, this means that while a lender will most likely have the right to economic participation upon the assignment of “membership interests” in a Delaware LLC, such lender will have no right to control the economic direction of the LLC, to demand financial information or review other records of the LLC, or to compel dissolution of the LLC. At first glance, such an outcome seems irrational. How is it possible that Delaware law permits a secured party to succeed to economic rights, while allowing the borrower to retain all management rights in the LLC? However, it must be remembered that this outcome is not mandated by the Delaware LLC Act, but merely follows from the careless use of the phrase “limited liability company interests” as well as the application of Delaware’s default laws when the parties have not brought about their intended outcome by careful review of the LLC’s operating agreement and inclusion of appropriate contractual provisions in the security agreement. Another important issue to acknowledge is that while “limited liability company interests” may generally be

RkJQdWJsaXNoZXIy NjAyOTE=