Protecting Your Security Interest in an LLC Membership Interest: Methods and Considerations for Perfecting
You have made the decision to provide financing, whether as a business owner or otherwise. Perhaps you are loaning money to a borrower, or selling a company you own and financing the purchase. You will likely require some type of collateral to secure repayment of the loan.
If your collateral includes a limited liability company (“LLC”) membership interest, there are important steps you need to follow to be sure you are protected in the transaction.
First, you need to review the organizational documents to determine whether the security interest in the membership interest is permitted. If not permitted, you need to obtain consent from the company and other members. Next, you will want to have a security agreement (often called a pledge agreement) granting you a security interest in the membership interest, signed by the borrower.
However, that’s only part of the process. You also need to “perfect” your security interest in the membership interest. Perfecting a security interest protects your rights in the collateral and determines your priority in relation to other creditors.
Perfection methods vary depending on the jurisdiction and the type of collateral. To determine the appropriate method to perfect your security interest in a membership interest, you must review the company’s organizational documents, as well as the Uniform Commercial Code (“UCC”) in the appropriate jurisdiction.
Methods for perfecting
General intangible: Most commonly, a membership interest in an LLC is considered a general intangible. To perfect a security interest in a general intangible, you must file a UCC-1 financing statement with the Secretary of State’s office in the state in which the individual resides, or in which the entity was formed, depending on whether the borrower is an individual or an entity.
Once you file the financing statement, your security interest is considered perfected. Generally, the timing of filing, among other factors, determines the order of priority among multiple secured parties, with the first to file having priority.
A financing statement lapses five years from the date of filing. If the loan will be longer than five years, you must file a UCC-3 continuation statement prior to the lapse date to maintain perfection. The continuation statement can be filed up to six months before the lapse date.
Security: An LLC, however, can elect to have its membership interests classified as securities under Article 8 of the UCC. Generally, the organizational documents must expressly state that the membership interests are to be treated as securities. Additionally, if the membership interests are certificated, they are also considered securities. As the secured party, you must review the organizational documents to determine whether the “opt in” language is included or the membership interests are certificated, to properly perfect your security interest.
If the membership interests are securities, then you perfect by taking possession or control of the securities – or both. If the membership interests are certificated, then you perfect by taking possession of the certificates and by taking control by having the security interest noted in the company’s records. If the membership interests are not certificated, then you perfect by taking control by entering into an agreement with the company that specifies the company will take instructions from you, the secured party, as well as having the security interest noted in the company’s records. In each case, the borrower will also give you an assignment of the membership interest so that you can transfer title if there is a default on the loan.
Note: You can also perfect by filing a UCC-1 financing statement. However, possession or control take priority over a UCC-1 filing, so they are better forms of protection.
Considerations after perfecting
After you have perfected your security interest, a company can amend its organizational documents to either opt in or opt out of Article 8, or to certificate or uncertificate its membership interests. If that occurs, the method of perfection could change, and your priority could be jeopardized.
As the secured party, you can protect your security interest as follows:
- Obtain a written commitment from the company that it will not alter the current status, whether it is opted in to or opted out of Article 8, until you are paid back your loan.
- Obtain a written commitment from the company that it will not change the membership interests from certificated to uncertificated, or vice versa, until you are paid back your loan.
- If the company has opted in to Article 8, request that the company provide certificates for its membership interests and then take possession of the certificates.
- Depending on the situation, you also may choose to file a financing statement, take possession of any certificates, and get the appropriate agreements and actions from the company.
Because of the complexity and varying factors involved in obtaining and perfecting a security interest, lenders should consider consulting with an attorney who can assist them with reviewing the organizational documents and properly obtaining and perfecting their security interest.
At Henson Efron, our attorneys have extensive experience assisting secured parties in protecting their collateral. If you’d like to learn more about how our experience and knowledge can help protect your business, please contact Henson Efron.
The purpose of this article is merely to provide general information and should not be construed as legal advice.