Limited Liability Company (LLC) Interests As Collateral

December 2, 2014 | dehs

By Robert E. Hayes

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The members of a limited liability company (LLC) enjoy a number of rights based on the statute authorizing the creation of limited liability companies (SDCL 47-34A) and the terms of their operating agreement. Included within these rights is the creation of a “distributional interest” for each member. With the frequent and expanding use of a limited liability company for business formation, potential borrowers may offer, or rely entirely upon, the grant of a security interest in their interest as a member of an LLC. How does a lender obtain and perfect a security interest in such collateral, and upon doing so what does the lender actually receive?

Generally speaking an interest in a limited liability company will be a general intangible. The description for a security agreement and UCC-1 purposes might be as follows: “all of the debtor’s interests, now or hereafter acquired, in XYZ LLC, including, without limitation, the debtor’s distributional interest therein, and all distributions and proceeds of the foregoing.” This interest is perfected by the filing of a UCC-1 in the state of the debtor’s residence (or formation in the event the LLC interest is owned by another entity). There are rare cases where a limited liability company interest has become a security, although that is not driven by the mere fact that a certificate has been issued evidencing the interest. To be a security the interest must be “traded on security exchanges or in securities markets” or identified in its organizational documents as intended to be a security. In that event, perfection would be attained as a security instead of a general intangible.

If a security interest has been created and perfected, what has the lender received? To determine this a lender has to look at the operating agreement of the LLC, and may have to consider some statutory limitations. For example, state statutes governing the creation of professional LLCs may drastically limit the utility of a security interest by providing that no unlicensed person may have any ownership or control in a professional LLC. South Dakota statute governing medical corporations and LLCs and optometric corporations and LLCs have these provisions. You have to look at the statute, though, because, for example, the statute covering chiropractic corporations does not have such a limitation. Thus, even if the LLC operating agreement permits a creditor to become a member of the LLC (which not all do) state statute might prevent a lender from realizing on its collateral in that fashion.

The lender isn’t prohibited from becoming a member, and if the operating agreement permits it, the lender in exercising its rights as a secured creditor could sell the membership interest whether the lender itself tries to become a member of the LLC, or tries to transfer its interest through a UCC sale to someone who would become a member of the LLC. The important consideration is that the lender or transferee “has the rights and powers, and is subject to the restrictions and liabilities of a member,” which may include the obligation to make contributions to the LLC.

More commonly, the lender may simply seek to acquire a security interest in the borrower’s “distributional interest.” This is defined as “all of a member’s interest in distributions by the limited liability company.” This allows the lender or its transferee to receive any distributions of money or property made which its borrower would have been entitled to. In that instance, though, the lender or its transferee cannot compel a distribution, and has no control or rights with respect to the operation of the LLC.

From the foregoing, one can readily see that it is important for a lender considering taking an LLC interest as collateral to be familiar with the type of LLC, the provisions of its operating agreement, and the likelihood that the members would provide for distributions after the time the security is obtained.

Davenport, Evans, Hurwitz & Smith, LLP, located in Sioux Falls, South Dakota, is one of the State’s largest law firms. The firm’s attorneys provide business and litigation counsel to individuals and corporate clients in a variety of practice areas. For more information about Davenport Evans, visit www.DEHS.com.