Secured Lender Alert - March 1, 2009 - PAPER, ROCK, SCISSORS - - Creating, Perfecting and Enforcing Security Interests in Partnership and Membership Interests Desperate times call for desperate measures. As a secured lender, that may include looking at collateral that you might not normally be interested in taking, such as the economic interest a debtor may have as a partner in a partnership, or as a member in a limited liability company. Though the game and the rules on creating and enforcing liens on this kind of property are not as simple as those for a security interests in inventory and accounts, or a mortgage on real estate, there may be situations in which this type of collateral can make sense and can be worth the time, trouble and expense of trying to create and perfect a lien. The following discussion explores some of the issues associated with this kind of collateral. Creation and Perfection of Lien Issues What is the Collateral? Sometimes the hardest part of determining how to create and perfect a lien in any kind of intangible personal property under Article 9 of the UCC is just determining where the collateral fits under the property classification scheme of Article 9. The choice can be confusing, like looking at one or more Venn diagrams and determining which circle or circles fits your collateral best. A partnership interest (general or limited) in a partnership or membership interest in a limited liability company can qualify as a "security" if it is traded on a securities exchange, or if the ownership interest is evidenced by a "securities certificate" and the relevant partnership agreement or operating agreement provides that it is intended to be a "security" (as defined in Article 8 of the UCC). If a partnership interest or membership interest is not evidenced by a securities certificate or otherwise does not meet the definition of a "security," then it probably is a "general intangible" (as defined in Article 9 of the UCC). If it is a "security" under Article 8, then it also constitutes "investment property" under Article 9. Under Article 9, you can perfect a security interest in both general intangibles and investment property by filing a financing statement, but perfection by "control" always trumps perfection by filing. Clear as mud? Well, it gets even worse when you consider that there are a whole myriad of other provisions in Article 9 and outside of Article 9 which might restrict what you can and can't do to realize on the value of your collateral, by limiting what your security interest can reach, or by limiting your enforcement rights against partnership and membership interests. Lien on Corporate Stock is Relatively Simpler. By way of comparison, let's take the simpler case of creating and perfecting a lien in shares of stock. Shares of stock in a corporation (whether traded on an exchange or closely held) constitute "securities" under Article 8, and thus also under Article 9 of the UCC. The creation and perfection of a security interest in "securities" is fairly straightforward. You take a security agreement or pledge agreement in which you identify the relevant shares, and then perfect the security interest either by filing a financing statement (remember, a security is investment property and you can perfect in investment property by filing) or by getting "control" of those securities. Since control always trumps filing, you'd be crazy to perfect only by filing if you can get control. "Control" of a security can be obtained (i) in the case of "certificated securities," by getting possession of the certificate and getting an endorsement in blank or endorsement to the secured party, or by registering the security in the name of the secured party, and (ii) in the case of "uncertificated securities," by taking possession of the uncertificated security or by getting the issuer of the securities to agree that it will comply with transfer instructions issued
by the secured party. As an aside, you can also get a security interest in securities credited to a securities account by taking and perfecting a lien in the securities account (which also can be by filing or control, control always being the preferred method of perfection). When, however, your collateral is a partnership or a membership interest, then the rules on creating and perfecting a security interest get a little more complicated. First, you've got to figure out what the collateral is (is it a security or a general intangible?). Second, you've got to figure out how best to perfect the lien (if it s a security, you're better off if you perfect by control, whereas if it is a general intangible, you can only perfect by filing a financing statement). Finally, no matter what your collateral is, or how you perfect under Article 9 of the UCC, you have to analyze and think about in advance a number of other issues which could place practical limits on your ability to realize value from this type of collateral. Restrictions on Collection vs. Transfer, Practical Effect. You really have no choice but to examine the underlying partnership agreement or operating agreement to determine (i) whether the interest you are trying to get at is a security or a general intangible, (ii) if there are any restrictions on transfer of the underlying partnership or membership interest, and (iii) if so, the practical effect of those restrictions. A common feature of partnership agreements and operating agreements is a restriction on the sale or transfer of partnership and membership interests without obtaining advance consents. Some agreements also have rights of first refusal and purchase price formulas in connection with the exercise of those options. Some agreements also restrict the granting of a security interest in partnership interests and membership interests. Such agreements also generally provide that in connection with any transfer (i.e., whether by a grant of a security interest or a sale or an attempted foreclosure and sale of a partnership or membership interests), a specified percentage of the other partners and members must consent to the transferee's admission as a partner or member. The good news for secured creditors is that, except for entities organized in Delaware, contractual and statutory restrictions on creating or perfecting a security interest in partnership or membership interests generally are prohibited and ineffective under Sections 9-406 and 9-408 of the UCC. This does not mean, however, that your security interest in a partnership or membership interest can bulldoze over all other rights of the underlying company or its partners or members rather, it can bulldoze just some of them. For example, restrictions on the enforcement of rights related to the receipt of distributions that would constitute "payment intangibles" under the UCC probably would not be enforceable. This only means, however, that a secured creditor would be entitled to receive dividends and distributions actually made or sales proceeds actually paid. Other restrictions on the enforcement of security interests in partnership and membership interests still may be valid. A secured creditor who does not become a member or partner, or who cannot sell the right to become a member or partner, is in a very poor bargaining position to compel the partnership or limited liability to make any actual cash distributions. In other words, you can take, perfect and enforce a security interest in a debtor's interest so that you can get any cash that the partnership or membership interest would throw off, but as a secured creditor you still are at the complete mercy of the company and/or the other partners or members as to whether any cash is ever going to be paid-out in the first place. Getting the Whole Enchilada. If you want to be able to have the right to become a member or partner, or to be able to sell the right to become a member or partner (which would then include the statutory rights of a partner or member, such as compelling an accounting and other contractual rights given under the partnership agreement or operating agreement), then in connection with taking a security interest in a partnership or membership interest it's necessary to obtain in advance any consents to any transfer that
could be made as a result of foreclosure of the security interest. In a single member limited liability company, a secured creditor probably can pull this off, as your debtor holds all of the cards. If, on the other hand, your debtor does not have a controlling interest in the partnership or the limited liability company, the debtor and the secured party may not have enough negotiating leverage to procure all of the necessary consents. Because Delaware has opted out of the provisions of Sections 9-406 and -408 of the UCC with respect to limited liability companies and limited partnerships, unless there are no restrictions on transfer in the relevant Delaware entity's organizing documents (highly unlikely), then you will have no choice but to obtain consents to a security interest if the underlying company was organized in Delaware, just even to have a valid security interest in the partnership or membership interest in such an entity. Enforcement Methods and Issues: Remedies Generally. Okay, let's assume that you've done everything right and you have created and perfected a security interest in a partnership or membership interest. Now there's an event of default on the underlying debt and you want to exercise your remedies with respect to your security interest. What can you do? The UCC gives secured creditors a number of options when it comes to pursuing remedies against personal property collateral, including (in increasing order of difficulty and expense): 1. Collection rights under Section 9-406 and 9-607 of the UCC; 2. Retention of collateral in satisfaction of the debt (strict foreclosure); 3. Foreclosure by private sale; 4. Foreclosure by public sale; and 5. Judicial foreclosure and then execution and sale. Collection Rights. Sections 9-607 and 9-406 of the UCC give a secured party a right following a default to (i) notify an account debtor to make payment to the secured party, and (i) enforce the obligations of an account debtor or other person obligated on the collateral. Though not readily apparent under the UCC, a partnership or limited liability company which owes a distribution or dividend, or a party which has agreed to purchase a partnership or membership interest, is an "account debtor" under Article 9 of the UCC. The right to receive money with respect to such distribution or sales proceeds is a "payment intangible" under the UCC, and an "account debtor" under the UCC includes any person obligated on an account or a general intangible (including a payment intangible). Thus, assuming you have a perfected security interest in a partnership or membership interest and the proceeds of that interest, the secured creditor has a powerful tool for collection simply by notifying any party obligated to make any payment with respect to a partnership interest or membership interest that the payment should be made to the secured party instead of the debtor. In such cases, the secured party should be able to collect any such payments which are due and owing to a debtor. Section 9-406(a) further provides that once an account debtor has been notified to pay a secured party, it must do so or run the risk of having to pay twice. As discussed above, however, this tool is useless if there are no such payments due and/or there is no practical way to make them come due. The right to receive one hundred percent of a distribution which never is made is still nothing. Additionally, it is possible for junior lien creditors to jump the claim of senior lien creditors in these instances if the senior lien creditor has not sent out such a collection notice.
Acceptance of Collateral in Satisfaction of Debt (Strict Foreclosure). Until Article 9 was revised in 2001, there was no way to do a strict foreclosure on intangible personal property (i.e., property which cannot be physically possessed), such as partnership interests and membership interests. Under the revised version of Article 9, not only can you do such a foreclosure, it seems almost to be encouraged. You can make offers to accept a partnership or membership interest in full satisfaction of a debt, and with proper notice, silence can equal consent from both a debtor and junior lienholders. You also can make offers to accept partnership and membership interests in partial satisfaction of a debt, but for such an arrangement to be effective as to a debtor, the arrangement must be consented to by the debtor in "a record authenticated after default." The notice period for proposals to accept collateral in satisfaction of a debt is 20 days, and notice must be sent to the debtor, secondary obligors and other parties that have a security or other interest in the collateral. Becoming a partner or member may give you statutory rights or contractual rights under the partnership agreement or operating agreement which would increase the possibility of your being able to compel cash distributions. Of course, while this method is attractive in terms of its speed, relatively low expense and the increased bargaining leverage it can create, it would not be available or would be pointless if there did not already exist the necessary consents for the secured party to become a partner or member of the relevant company. This method also might not be available to certain banks which have regulatory restrictions on the amount of ownership stakes which can be taken in nonbanking affiliates. Foreclosure by Private Sale. There are a variety of issues that can come up in a disposition of partnership and membership interests either by a public or private sale. First, all aspects of a disposition of collateral must be commercially reasonable. Because selling partnership interests and membership interest might run afoul of federal and state securities laws which prohibit the offering and public sale (which probably includes a private sale for Article 9 purposes) of unregistered securities, the universe of buyers of partnership interests and membership interests probably will be rather limited. Does this limitation on buyers mean that any sale, private or public, would never be commercially reasonable? Probably not. Additionally, in connection with a private sale, a secured party cannot be the successful buyer of a partnership or membership interest at its own privately-conducted sale. This only is permissible where the collateral is of a kind that is customarily sold on a recognized market, or is the subject of widely-distributed standard price quotations. Because of the limitation on the potential universe of buyers and because of the uncertain valuation of partnership and membership interests, this is not likely to be a practical remedy, unless there is a sale to another partner or member in connection with some buy-sell formula under the partnership agreement or operating agreement. Additionally, the remedy would not be available or would be pointless if there did not already exist the necessary consents for the purchaser from the secured party to become a partner or member of the relevant company, or such consents could then readily be obtained. Foreclosure by Public Sale. As noted above, there are securities-laws aspects to a public sale of partnership and membership interests. When coupled with other commercial reasonableness issues related to a public sale of such collateral, this simply may not be a viable option. While a secured party could be the successful bidder at a public sale, it is unlikely that this is a practical remedy unless the partnership interest or membership interest is a publicly-traded security which already has been registered under the federal and any necessary state securities laws. Judicial Foreclosure. Because of the time and expense involved, and because you then would loop back into a significant number of the issues already discussed, pursuing judicial foreclosure would seem the least
attractive option. Conclusion: Except in the case of a single member limited liability company, Article 9 of the UCC forces a secured party which wants to create and perfect a lien in a partnership or membership interest to engage in a game of paper, rock and scissors with at least two other players. There is a tri-lateral negotiation among the secured party, the debtor and the other partners or members of the business entity which has issued the equity interests. Sometimes a secured party will be able to obtain all that it needs and wants, but other times not. Please call us if you need help in figuring out the rules and your strategy. Game on! Please contact any of our Commercial And Real Estate Lending Practice Group or Creditors' Rights and Bankruptcy Practice Group attorneys if you have questions about the topics presented in this Secured Lender ALERT or any secured lender issues. KRIEG DEVAULT LLP is a 140-professional, diversified law firm representing a wide variety of local, regional and national clients. It is a general practice commercial law firm with offices in Indianapolis, Carmel, Noblesville, Schererville, and Mishawaka, Indiana, Chicago, Illinois, Atlanta, Georgia, Boca Grande, Florida, and Minneapolis, Minnesota. The firm's attorneys have significant experience in key areas that address the needs of a diversified client base. Through its membership in Meritas, the firm's ability to assist clients reaches around the world. For more information, please visit www.kriegdevault.com. 2009 Krieg DeVault LLP. All Rights Reserved. This page, and all information on it, is proprietary and the property of Krieg DeVault LLP. It may not be reproduced, in any form, without the express written consent of Krieg DeVault LLP. This Krieg DeVault LLP publication should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer on any specific legal questions you may have concerning your situation. This newsletter may constitute advertising materials in some jurisdictions. If you forward this newsletter, please designate it as such.