Pledge of Membership Interests: Providing an Alternative to Foreclosure
A. FORECLOSING AGAINST A MEMBERSHIP INTEREST VERSES A TRADITIONAL MORTGAGE
A lender can save time and money if it obtains a pledge of its borrower’s membership interests when it originates a loan. It can obtain control of real estate pledged as collateral for a commercial business loan without court intervention, and can market the pledged asset promptly after the borrower defaults.
In contrast, a traditional judicial foreclosure remedy is far more expensive and time consuming. Foreclosing against a membership interest is accomplished through a public or private sale under the Uniform Commercial Code (“UCC”). As such, a lender can promptly list the collateral with a licensed broker, without the lender having to take title to the property, and in the remarketing process, likely save substantial real estate transfer taxes. Moreover, a lender can still enjoy the protection of a recorded mortgage over the property, and remedies that it carries, so long as the loan documents clarify that lender’s remedies are cumulative and that no waiver occurs if lender proceeds via its UCC remedy.
B. DRAFTING A SECURITY PLEDGE*
A security pledge must be based upon an examination of the organizational documents of a borrower, which in the case of a limited liability company, means the operating agreement. The drafter must analyze and determine what percentage of pledged interests will be required to gain control over the borrower entity, and therefore to liquidate the property. The drafter must consider any high vote requirements for extraordinary transactions such for the sale of real estate, as well as impediments such as any anti- pledge provisions. Out of precaution, all voting interests should be pledged, and the UCC filed should cover “100% of the membership interests” of the entity.
C. OBTAINING ADDITIONAL DOCUMENTS FROM BORROWER
In addition to the basic pledge of membership interests, a lender should require its borrower to a) deliver certificates representing their interests; b) pledge all proceeds of such collateral, including distributions pursuant thereto and any additional interests issued in the future; c) represent that no other security interest exists in the collateral; and d) covenant that borrower will not further encumber the security interests. However, lenders may be well advised to avail themselves of certain additional protections provided by UCC Article 8, via an Article 8 “opt-in”.
D. UCC ARTICLE 8 “OPT IN”
An “opt-in” occurs when then lender requires the borrower to agree in the operating agreement to the applicability of UCC Article 8 to the membership interests. When this opt-in occurs, the membership interest is treated as investment property or securities under Article 8, as opposed to general intangibles under Article 9. If an opt-in does not occur, Article 9 applies by default, and the interests are treated as general intangibles. An interest in general intangibles can only be perfected by filing, whereas an interest in securities can be perfected more flexibly, by either filing, or by possession or control (e.g. through a brokerage) of the securities.
The reason for the opt-in is that it is conceivable that after granting one lender a security interest while remaining silent as to the applicability of Article 8 (therefore making Article 9 applicable), the borrower could pledge the memberships to a second lender and then opt in to Article 8 at the behest of such lender. This would allow the second lender to perfect under Article 8, which could put the first lender in a junior position. This outcome could take place because the priority rules of Article 9 provide that an interest perfected by filing is subordinate to a conflicting interest perfected by control or delivery.
If opt-in is pursued, the operating agreement should be amended to include a covenant to prevent the borrower from later opting “out” of Article 8 without the lender’s prior written consent. In addition, a lender should demand that a borrower pledge that it will not pledge its interest to a subsequent lender. If an opt-in is not pursued, the lender should cause the operating agreement to affirmatively prevent a later opt-in.
Moreover, in an opt-in, a security certificate should be issued to and endorsed over to lender in blank, as is done with a stock power, and kept in a secure location. The certificate should reflect lender’s security interest on its face. Certification may require an appropriate amendment to the operating agreement if it does not provide for the certification of interests. As a backstop, a UCC financing statement covering the interests should be filed in accordance with applicable state UCC rules.
E. POWER OF ATTORNEY
Finally, a power of attorney should be executed in favor of lender, or lender’s designee, permitting the lender to vote the interests as lender deems fit. The lender would then be permitted to install a new manager, managing partner or board of directors as the case may be. The lender should be prepared to name an individual(s) to constitute the new board or to act as manager.
F. OTHER ADVANTAGES OF ARTICLE 8 OPT-IN
Despite the increased documentation burden, there are other advantages of Article 8 opt- in. Under 8-303 the lender can achieve “protected purchaser” status against other creditors. Under this section, a purchaser of (or lender collateralized by) a certificated or uncertificated security that meets the requirements therein, arguably “takes free” of any adverse claim. The elements to successfully achieve “protected purchaser status” are a)
giving value; b) having no notice of any adverse claim; and c) obtaining control of the certificated or uncertificated security. There exists no comparable status with respect to general intangibles.
The foregoing analysis makes certain assumptions: that the interests are not securities traded on a public exchange or traded on a recognized exchange, that the borrower’s organizational documents permit the pledge, or are at least silent on this point, and that ownership does reside in a custodian or securities intermediary such as a broker, bank or clearing corporation. This article does not address any tax implications of the lender or its designee stepping into the shoes of the member(s).
If you would like more information relating to obtaining a pledge of membership interests or any other banking or finance need, please do not hesitate to contact John Polster at email@example.com or Adam Rome at firstname.lastname@example.org or by phone at 312-428-2740.
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*This article focuses upon limited liability companies because they are the most common vehicle of ownership.