November 15, 2010
By John Alan Lewis
Vol. 45 No. 4/Fall 2010 The Arkansas Lawyer 11
The situation is a common one. Borrower presents himself/herself to a lender and proposes to pledge an interest in a limited liability company (âLLCâ) or partnership (either entity being referred to herein as an âownership interestâ) as collateral for a loan. The lender, in recognition of the balance sheet of the partnership or LLC (either entity being referred to as the âentityâ or âissuerâ) or the distributions the entity throws off, is open to the idea so long as it has a perfected, first lien in the ownership interest. Is this possible?
While the answer is yes, the priority rules of Article 9 of the Uniform Commercial Code (âUCCâ) do not always depend on the order of perfection, particularly when Article 8 is considered. A lender can lose its lien position or never fully secure it against competing claims because the UCC treats ownership interests in partnerships and LLCs differently from corporate stock. For the reasons noted below, a lender should take the rather circuitous route of requiring the issuer to âopt-inâ to Article 8 for lien priority purposes.
The issues noted in this discussion pose a problem for a borrower and his or her counsel as well. Great care should be taken in reviewing the representations contained in most loan agreements (or in borrowerâs counselâs opinion letter) as to the status or senior position of a lien secured by an issuerâs ownership interest. It is common to see language in loan agreements that state that the lender has a first security interest in the ownership interest. Or borrowerâs counsel is frequently required to say that the lender has taken all necessary action to perfect its interest in the collateral. Until the issues noted below are resolved, the answer for borrowerâs counsel may be no.
First, some basic assumptions and disclaimers need to be cleared away. We assume the ownership interest proposed as collateral for the loan is not a publicly traded security that is dealt in or traded on a recognized securities exchange. Next, we assume the entityâs governing documents either (i) permit the pledge, hypothecation, transfer, or assignment of the ownership interests; or (ii) are silent on this point.1 In addition, we assume the ownership interest in question does not reside under the custody or control of a securities intermediary (clearing corporation), broker, or bank. Finally, we will not discuss the federal or state securities laws associated with issuance of the ownership interests by a partnership or limited liability company. The securities laws ramifications associated with closely held business entities are too complex to address in detail here.
The UCC, and the corresponding Arkansas Code, treat interests in some partnerships or LLCs differently from corporate stock. Corporate stock is specifically identified as investment property under Articles 8 and 9.2 Section 8-102(a)(15) defines the term âsecurityâ as, among other things, an obligation of an issuer or a share, participation, or other interest in an issuer represented by a security certificate in bearer or registered form, the transfer of which may be registered upon books of the issuer maintained for that purpose, and which is one of a class or series of shares, participations, interests, or obligations and which is, or is a type, dealt in or traded on securities exchanges or securities markets or is a medium for investment and by its terms expressly provides that it is a security governed by Article 8.3
Under Ark. Code Ann. Â§ 4-9-102(a)(49) and Â§ 4-8-102(a)(15) (2000), the term âissuerâ includes a partnership or LLC as well as a corporation. However, Â§ 8-103 of Article 8 establishes a special rule for partnerships and LLCs with regard to the treatment of ownership interests in those entities. Unless the governing documents say otherwise or the securities are traded on a recognized securities market or securities exchange, partnership or LLC interests are not securities and are not subject to Article 8 of the UCC.4 In other words, Article 8 will only control if the terms of the partnership or LLCâs governing documents expressly provide that its ownership interests are to be governed by Article 8. If the governing documents of the partnership or LLC are silent as to the application of Article 8, Article 9 controls.
So we now have the general rule as articulated in Â§ 8-103(c). If the governing documents of the partnership or LLC are silent, Article 9 controls and the ownership interests are not investment property or âsecuritiesâ under Â§ 8-102(a)(15). By default, ownership interests in partnerships and LLCs are treated as general intangibles under Article 9.5 The Comments to Â§ 9-102 describe general intangibles as a âresidual categoryâ or catch all.6 A security interest in a general intangible under Article 9 is perfected through the filing of a financing statement under Â§ 9-312(a). Should there be a dispute between competing lien holders, generally speaking the âfirst to fileâ rules of Â§ 9-322(a)(i) apply.
At this point it might be useful to look back on transactions all of us have worked on and consider how the consequences of the Article 8 versus Article 9 issue might play out. Issuerâs counsel carefully drafts the organizational/governing documents for the entity and even prepares certificates evidencing the ownership interests of the parties. However, never a word is mentioned in the entityâs governing documents or the certificates as to applicability of Article 8. If the documents are silent, we know that Article 9 will control. Having drafted and reviewed many partnership agreements and operating agreements, I have concluded that Article 8 is seldom invoked. Whether this omission is by design or ignorance is unclear, but it can be dangerous not to invoke it when the transaction calls for it.
Now, letâs recap where we are. If (i) the issuerâs governing documents permit the pledge or assignment of the ownership interest and (ii) these same documents do not contain specific âopt-inâ language stating that Article 8 governs, then Article 9 controls. This ownership interest is a general intangible and a security interest in it is perfected by the filing of a financing statement with the proper office.
As you might guess, complications may arise. If, subsequent to the loan closing, the issuer determines that additional equity capital is required and the new investors demand that certificates evidencing their ownership interests be issued, the issuer itself (or the new investorâs counsel) may decide that the provisions of Article 8 should be utilized.7 Or, as is common in the healthcare field, a new, outside entity is willing to invest money in a physicianâs ancillary operation such as an ambulatory surgery center. Is the original lender/secured partyâs lien still perfected as to the issuerâs ownership interest? While the lender (Lender 1 for our purposes) retains a perfected security interest in the ownership interest, Lender 1 may lose in a priority dispute with a subsequent lender (Lender 2). Even though issuerâs counsel carefully prepared the organizational documents as well as certificates evidencing the ownership interests of its owners, such steps may not be sufficient in a priority dispute with another lender. If the issuer subsequently adopts âopt-inâ language as to Article 8 and new certificates are issued, then Borrower 1 (he or she now becomes Forgetful Borrower or Bad Borrower for our purposes) could take the newly issued certificate and pledge it to Lender 2. Who prevails in such a situation? Does Lender 1 maintain a perfected security interest in the ownership interest? Does Lender 1âs security interest have priority over Lender 2? In most cases, under the UCC the answer is yes as to perfection but, for the reasons set out below, no as to priority.
We have established that under Â§ 8-103(c) in order to be classified or treated as securities under Article 8, the governing documents of the issuer must explicitly provide that Article 8 controls.8 If the governing documents for the entity provide that Article 8 is to control, the partnership or LLC ownership interest is treated as investment property. A security interest in investment property is perfected in one of three ways: control,9 possession,10 or filing.11 Under the priority rules of Article 9, a security interest perfected only by filing is subordinate to a conflicting security interest perfected by control or delivery.12 Article 9 tells us to look to Article 8 (Â§ 8-106 (2000)) to determine when the secured party has control of a certificated security. If represented by a certificate, the secured party is deemed to have perfected its security interest in the collateral when it takes control of the security. Section 8-106 provides that a party has control of a certificated security in registered form if the certificate of security is delivered to the purchaser [secured party] and endorsed over to the purchaser [secured party] or endorsed in blank. Comment 1 to Â§ 8-106 provides that âcontrolâ means the purchaser [secured party] has taken whatever steps are necessary, given the manner in which the securities are held, to place itself in a position where it can have the securities sold, without further action by the owner.13
If the securities issued by the entity are uncertificated, a party is deemed to have control under Â§ 8-106 if (i) the uncertificated security is delivered to the purchaser (or secured party in our case); or (ii) the issuer has agreed that it will comply with instructions originated by the purchaser (secured party) without further consent by the registered owner or borrower.14 Quite naturally, the question arises, how does one âdeliverâ an uncertificated security? Comment 3 to Â§ 8-106 says that delivery of the uncertificated security occurs in one of two ways. The first method is when the issuer acknowledges that the purchaser (second party) is now the registered holder of the interest and is thereby entitled to exercise all rights of ownership under Â§ 8-107. The second way in which control is established over an uncertificated security is if the uncertificated security is delivered to the purchaser or the issuer agrees to comply with instructions of the purchaser even though the owner remains listed as the registered owner.15 While the issuerâs cooperation is necessary to achieve control and thereby perfection over an uncertificated security, the issuer is not required to enter into such an agreement. The secured party must make sure it has the issuerâs consent, which will require a thorough review of the issuerâs governing documents to determine what constitutes approval to the issuer. Can this be accomplished through a manager or should the other partners or members consent to it? Also, what other actions must be taken before the issuerâs action can be deemed to be binding on the issuer?16 Finally, to further protect itself against the possibility that issuer might âopt-outâ of Article 8 at some later date, an agreement among the issuer, all of its members/partners, and the lender is recommended which requires the lenderâs consent before the Article 8 âopt-inâ language can be changed or amended in any way.
There is another important reason why a lender may require an issuer to provide certificates to evidence the ownership interest and not uncertificated securities. If governing documents of the entity provide for uncertificated securities, the lender will need the cooperation of the issuer in order to transfer its ownership interest to the lender or a purchaser at a foreclosure sale. If the issuer is controlled (or even influenced) by the defaulting borrower, the transfer process may prove difficult. Certificates endorsed in blank may be conveyed at a foreclosure sale without the necessity of cooperation from the issuing entity.17
There is little case law in Arkansas dealing with the interplay of Articles 8 or 9. J.M. Products, Inc. v. Arkansas Capital Corporation,18 involved a dispute over corporate stock between the secured creditor, Arkansas Capital Corporation (âACCâ), and the issuer, J.M. Products, Inc. (âJPIâ). ACCâs borrower was a minority shareholder in JPI and pledged his corporate security certificate in JPI. JPI claimed that ACC had notice of an issuerâs lien or prior claim against the security pledged. The Court was asked to consider, among other things, whether ACC had notice of JPIâs lien and what constitutes notice of such a lien to another creditor. The Court held that ACC was neither on notice as to JPIâs alleged lien nor could any form of constructive knowledge of such lien be imputed to it. While interesting, the case is not particularly instructive for purposes of this discussion.
Even with the issuerâs consent and cooperation, the secured party must resolve at least two other issues. First, the terms of the certificated security must be carefully reviewed, including any references on the face of the security to other, extraneous documents, instruments, or indentures or to any constitution, statute, rule, regulation, order, or the like.19 The secured partyâs review of the extraneous sources or materials may result in a finding that such a transfer, pledge, or hypothecation of the ownership interest is restricted or prohibited. The case of ALH Properties Ten, Inc., v. 306-100 Street Owners Corp.,20 analyzed the validity of a lien on corporate shares and certain restrictions imposed on the transfer of those shares contained in other documents. Not surprisingly, the ALH court concluded that when the corporate security pledged to secure a loan which references restrictions to transfer in the corporationâs bylaws, the lender is obliged to consult them and is bound by the terms of those extraneous documents. In keeping with this holding, the Official Comments to the 2000 amendments to the UCC offer some guidance. Comment 1 to Â§ 8-202 recognizes that an issuer is estopped from denying representations made in the text of a security as to its transferability.21 On the other hand, Comment 2 to Â§ 8-202 states that a purchaser or second party who obtains a certificate is entitled to assume that all of the qualifying and conditional terms of the security have been noted or referred to on the certificate.22
No doubt many of you find this discussion interesting, but irrelevant. At the end of the day, the lender and its counsel want the right to receive distributions from the issuer should the borrower default. Distributions from a partnership or LLC constitute proceeds under the Code.23 The underlying ownership interest must first be properly perfected and the rights to the proceeds (distributions) will be perfected automatically and will have priority over the holder of a security interest in the distributions alone who does not have control.24 In short, these issues matter.
Earlier, reference was made to the effect that this conflict might have on the lives of the issuer, borrower, or borrowerâs counsel. It is common to see language in loan agreements that the lender has a first security interest in the ownership interest. Or, opinion letters required from borrowerâs counsel frequently ask the lawyer to state that the lender has taken âall necessary stepsâ to perfect its interest in the collateral. Are those statements true? Short of opting-in to Article 8, it is doubtful.
Besides being accused of unnecessarily running up the transaction costs, there can be other not-so-pleasant consequences associated with the issuer opting-in to Article 8. First, lenderâs counsel must make sure the issuer and all of its entityâs owners agree they will not opt-out of Article 8 without lenderâs consent. This problem can typically be addressed with some sort of tri-party agreement among the issuer, lender, and borrower. Next, careful attention must be paid to Â§ 8-204, Â§ 8-209, and Â§ 8-108. In other words, to retain the priority position the lender will need to ensure that the issuer actually complies with Article 8. Finally, as noted above, lenderâs counsel must plan for the day when it may foreclose. Certificated securities (with appropriate transfer instructions and endorsements) will make this process much easier than if you are relying on uncertificated securities and upon the cooperation of the issuer to transfer the ownership interest into the name of the lender.
Conclusion â Steps to follow
So what is a lender to do to avoid a priority dispute and maintain peace of mind? These are the suggested steps a lender should take to ensure compliance with Articles 8 and 9:
â˘ review the terms of the governing documents to confirm that the interest can be pledged;25
â˘ require the issuer to âopt-inâ to Article 8;
â˘ determine whether the interest to be pledged is certificated or uncertificated and, if possible, require that certificates be issued so as to avoid further complications in the event of default;
â˘ if the interest is certificated, have an endorsement in blank made over to the secured party, like a stock power;
â˘ so as to prevent the issuer from âopting-outâ of Article 8 at some later date, have the issuer and its members enter into an agreement with the lender to this effect as part of the loan closing and which agreement requires that the lender consent to this step;
â˘ take possession of the certificated security or receive an acknowledgement from the issuer as to the security interests held by the secured party if the security is uncertificated (but see concerns as to this approval noted above);
â˘ confirm that your security agreement contains language that specifically references the right of the lender to receive all proceeds of the described collateral including the right to distributions from the issuer of any sort, type, form, or classification; and
â˘ as a backup, file a financing statement referencing the security interest in the partnership or limited liability company interest as well as the lenderâs rights to all proceeds.
By taking these steps, the secured party has obtained control and protected itself from any subsequent actions that might be deemed to call into question the priority of its security interest as well as provided a ânotice filingâ as to the security interest being granted. The alternative is simply a failure of priority and perfection.
1. If the documents prohibit the pledge or assignment of the ownership interest, the lender must first obtain the consent of the other owners of the issuer. However, once this housekeeping measure has been accomplished, the nagging uncertainties noted in this article may continue to pester the lender and its lien position.
2. Ark. Code Ann. Â§ 4-9-102(a)(49), Â§4-8-102(a)(15), and Â§ 4-8-103(a) (2000).
3. Ark. Code Ann. Â§ 4-8-103(c)(2000).
4. Ark. Code Ann. Â§ 4-8-103(c) (2000).
5. Ark. Code Ann. Â§ 4-9-102(a)(42) (2000).
6. See Official Comment 5(d) to Â§ 4-9-102 (2000).
7. The new investorâs request could be made for a variety of reasons, including its fear that the partnership or LLC interest might be further diluted. In such a situation it is not uncommon for the new investor to require the issuer to âopt-inâ to Article 8 and amend its governing documents accordingly so as to ascertain exactly what its ownership is.
8. There is nothing particularly technical or special about such âopt-inâ language. Adding the following language to the partnership agreement or operating agreement should work for most purposes: âThe [membership interest] [units] [partnership interest] in this partnership company shall constitute a âsecurityâ governed by Article 8 of the Uniform Commercial Code and any certificate evidencing such [membership interest] [units] [partnership interests] is a âcertificated securityâ within the meaning of Â§ 8-102(a)(4).â However, it is advisable to comply with Â§ 8-207 and note on the face of any certificates that are issued that the issuer is governed by Article 8.
9. Ark. Code Ann. Â§ 4-9-106, Â§ 4-9-310(B)(8), Â§ 4-9-314 (2000).
10. Ark. Code Ann. Â§ 4-8-301 (1999), Â§ 4-9-313(a) (2000).
11. Ark. Code Ann. Â§ 4-9-312(a) (2000).
12. See Ark. Code Ann. Â§ 4-9-328(1) Â§ 4-9-106(a) (2001).
13. Official Comment 1 to Â§ 4-8-106 (2000).
14. See Ark. Code Ann. Â§ 4-8-106(c).
15. See Official Comment 3 to Â§ 4-8-106 (2000); see also Ark. Code Ann. Â§ 4-8-106(c) (2000).
16. See Ark. Code Ann. Â§ 4-8-106(g).
17. The disposition of collateral under Ark. Code Ann. Â§ 4-9-610 and Â§ 4-9-620 are beyond the scope of the article. Careful attention should be paid to the procedures and guidelines of the two sections should an event of default arise.
18. 51 Ark. App. 85, 910 S.W.2d 702 (1995).
19. See generally, Ark. Code Ann. Â§ 4-8-202(a).
20. 191 A.2nd 1, 600 N.Y.S.2d 443 (1993).
21. Official Comment 1 to Â§ 4-8-202.
22. Official Comment 2 to Ark. Code Ann. Â§ 4-8-202 (2000).
23. Ark. Code Ann. Â§ 4-9-102(a)(64)(B) (2000).
24. Ark. Code Ann. Â§ 4-9-328(a)(2) (2000).
25. If the interest cannot be pledged, then consideration needs to be given to either amending the governing documents to permit the contemplated loan or obtaining an affirmative statement from the partnership or LLC that it will not so amend the governing documents at some later date without giving the lender adequate notice.