Perfecting a Security Interest in a Membership Interest in an Ohio Limited Liability Company

A lender can sometimes enhance its collateral position by accepting a membership interest in a limited liability company as additional security.

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Introduction

    Often when a commercial loan (whether secured by real estate or other assets) is the subject of a workout or restructuring, the lender will require the borrower, or a guarantor, to pledge additonal collateral to support the repayment of the loan.  Sometimes, the additonal collateral will be an assignment of a membership interest in a limited liability company (a “Membership Interest”), where the owner of the Membership Interest (the “Member”) is the borrower or the guarantor.  Usually a lender will accept a guarantor’s pledge of his or her Membership Interest if the lender believes that the underlying company has a significant net worth and. therefore, the Membership Interest has some value.  The guarantor may be the sole member of the limited liablity company, or the company may have several members. 
 
    This article will discuss the perfection of a security interest in a Membership Interest in an Ohio limited liability company (the “Company”) as collateral for a commercial loan, whether the Membership Interest is “investment property” or a “general intangible,” as those terms are defined in the Ohio version of the Uniform Commercial Code (the “UCC”).  This article will not fully address disputes over lien priority between holders of  perfected security interests in the same Membership Interest.
 

Examination of Company and Member Documents

    If  the lender has determined that a Membership Interest has value, before agreeing to accept an assignment of the Membership Interest, the lender should first conduct a search of the filing records of the appropriate jurisdiction (usually the office of the state’s Secretary of State) to determine if a UCC Financing Statement  has already been filed to perfect another lender’s security interest in the Membership Interest (see below for a discussion of when filing is an appropriate method for perfecting a security interest in a Membership Interest).  
    
    If the lender determines, after searching the UCC filing office and performing other due diligence activities, that the Membership Interest has not already been pledged as collateral for another loan, the lender should also determine whether the granting of a security interest in the Membership Interest would cause an event of default on another loan to the Member or to the Company.  

    Often a loan agreement or promissory note will contain a “change in control” provision, which prohibits the transfer, assignment, or pledge of any Member’s interest in the Company to any person other than a relative, a trust controlled by the Member, or another Member of the Company.  If the Company is subject to a “change in control” provision, a lender seeking the assignment of a Memberhsip Interest should try to obtain the written consent of the Company’s lender, thereby preventing the occurrence of an event of default on the Company’s loan.  Often, as a condition to granting consent to the assignment,  the Company’s lender will require prior written notice, from the Member’s lender, of any enforcement action against the Member or his or her Membership Interest. 
 
    Likewise, the Member may be a signatory to a loan agreement that prohibits the Member from transferring all, or a substantial portion, of his or her assets, including the granting of a security interest in a Membership INterest owned by that Member.  Before accepting a security interest in a Membership Interest, the lender should examine whatever loan documents the Member is subject to, and obtain all required consents from the Member’s other lenders.
 
    Often the operating agreement governing a Company, which is signed by all of the Members, prohibits a Member from pledging or assigning his or her Membership Interest as collateral for a loan, or requires the consent of all of the Members to any pledge or assignment.  The best practice for a lender desiring to obtain a security interest in a Membership Interest is to obtain the written consent of all Members of the Company, whether or not the operating agreement requires that consent.  

    Many operating agreements provide that a “pledgee” or “assignee” of a Member’s Membership Interest in the Company (the recipient of a security interest) may receive the distributions of Company income that the Member would otherwise receive, but the pledgee will not be admitted as a full voting member of the Company without the consent of the other Members.[1]
 

The Pledge of Membership Interest Agreement

    If the lender has decided to accept a Membership Interest as collateral for a loan, the lender should always require the Member to sign and deliver to the lender a written pledge of the Membership Interest (a “Pledge Agreement”), which acts as a secruty agreement in favor of the lender.[2]  Common provisions in a Pledge Agreement include:
 
(1)    A Recitals section:
    (a)    indicating the name of the borrower, the type of loan (for example, a commercial real estate loan) and the current outstanding balance of the loan;
    (b)    describing other facets of the subject loan, for example, a guaranty of payment of the loan or the existence of other collateral for the loan; and
    (c)    stating that the Member is receiving valuable consideration for executing the Pledge Agreement (whether the Member is the borrower or a guarantor of the loan);
 
(2)    A “granting” section stating that the Member assigns to the lender, as security for the loan or the guaranty, as applicable: (a) the Member’s entire interest in the Company, including the Member’s right to receive distributions, his or her right to participate in the management of the Company, and all of the other rights in the Company that the Member may possess, and (b) the proceeds of any sale of the Membership Interest;
 
(3)    Representations and warranties that:
    (a)    the Member is the sole owner of the Membership Interest being pledged,
    (b)    the Membership Interest is or is not evidenced by a certificate or other ownership document;     
    (c)    the Member is entitled to receive a certain percentage of each distribution of cash or other property by the Company,
    (d)    no person, other than the lender, has a security interest in the Membership Interest;
    (e)    the Member has the authority to execute and deliver the Pledge Agreement to the lender; 
    (f)    the Member has provided a copy of the current operating agreement for the Company, including all amendments, to the lender; and
    (g)    the granting of the security interest will not cause a default on any obligation of the Company or any obligation of the Member;
 
(4)   Covenants stating that the Member will
    (a)    defend the lender’s first lien priority in the Membership Interest;
    (b)    notify the lender of any Company distribution of cash or other property to its Members;
    (c)    notify the lender of any event that would have an adverse impact on the value of the Membership Interest or the value of the lender’s security interest in the Membership Interest;
    (d)    provide the lender with prior written notice of any intended change in the name or business location of the Member or of the Company;
    (e)    refrain from selling or transferring the Membership Interest, and from granting a security interest in the Membership Interest, to another person;
    (e)    perform all of his or her obligations as a Member of the Company;
    (f)    not allow any change in the operating agreement, or articles of organization, of the Company that would have an advers impact on the value of membership interests, without the lender’s prior written consent;  
 
(5)    the agrement of the Member and the Company that, if the loan secured by the Membership Interest is in default:
    (a)    the Member’s voting rights in the Company vest in the lender;
    (b)    the lender has the right, as attorney-in-fact for the Member, to receive Company distributions of cash and other property that would otherwise go to the Member;
   (c)    upon a default on the loan or guaranty secured by the Membership Interest, the lender has the right to sell the Membership Interest and apply the sale proceeds to the outstanding balance of the loan, obtain injunctive relief to enfoce the lender’s security interest in the Membership Interest, and utilize all remedies of a secured party under the Uniform Commercial Code; and
    (d)    the Company will adhere to the instructions of the lender with respect to the Membership Interest; 
    
(6)    the Member’s agreement to indemnify the lender for all actions of the lender with respect to the Company or the Membership Interest; and
 
(7)    a waiver of jury trial by the lender and the Member.
 
    The Member and the Company should sign the Pledge Agreement.  In addition, all other Members of the Company should consent to the Member’s pledge of his or her Membership Interest, either by signing the Assignment or by signing a separate consent letter or agreement.
 

Classification of Membership Intersts 

Membership Interest as a “Security” and “Investment Property”

    The sections of this essay discussing perfection of a security interest in a Membership Interest are not intended to be a comprehensive explanation of the laws govening the perfection and retention of a security interest in personal property, but merely an introduction to those laws with respect to Membership Interests.  A lender contemplating accepting a security interest in a Membership Interest as collateral should consult an attorney well-versed in secured transactions, to determine the appropriate method of perfecting that interest under the particular circumstances.
 
    A Membership Interest is classified as personal property in Ohio.[3]  To properly perfect a security interest in a Membership Interest, the lender or its attorney must first carefully examine the Company’s operating agreement, if any[4] and articles of organization, to determine if a membership interest in the Company is a “security” under Ohio’s version of the UCC, in particular, Ohio Revised Code (R.C.) Chapters 1308 and 1309.  
 
   A Membership Interest is a “security” under R.C. 1308.02(C) [section 1308.02(C) of he Ohio Revised Code], and therefore a “security” under R.C. Chapters 1308 and 1309, if: 
        
“it is dealt in or traded on securites exchanges or in securities markets. its terms expressly provide that it is a security governed by this chapter [Chapter 1308 of the Ohio Revised Code], or it is an investment company security.  However, an interest in a partnership or limited liability company is a financial asset if it is held in a securities account.”[5] 

 

     If the Membership Interest is a “security,”  it is also a “financial asset”[6], but not all financial assets are securities.  Except as otherwise provided in R.C. 1308.02, “financial asset,” as defined in R.C. 1308.01(A)(9), means:
 
    
“(a)    A security;
    (b)    An obligation of a person or a share, participation, or other interest in a person or in property or an enterprise of a person which is, or is of a type, dealt in or traded on financial markets, or which is recognized in any area in which it is issued or dealt in as a medium for investment; or 
    (c)    Any property that is held by a securities intermediary for another person in a securities account if the securities intermediary has expressly agreed with the other person that the property is to be treated as a financial asset under this chapter.”

 

   Arguably, then, for a Membership Interest to be a “financial asset,” it must fall within the scope of R.C. 1301.01(A)(9) and be held in a securities account under R.C. 1308.02(C).  

   If the Membership Interest is a security under R.C. Chapter 1308, it is also “investment property” under R.C. Chapter 1309, which governs the perfection of security interests in personal property.  Both securities that are evidenced by a certificate (“certificated securities“), and those that are not (“uncertificated securities“), are included within the scope of “investment property.”[7]  A Membership Interest that is a financial asset, but not a security, does not appear to fall within the definition of “investment property” in R.C. Chapter 1309.

Perfecting a Security Interest in Investment Property

Filing 

   A lender has several methods of perfecting its security interest in a Membership Interest that is also investment property,  Under R.C. 1309.312, a lender may perfect a security interest in investment property by filing a UCC financing statement with the secretary of state, or similar state-wide registrar of records, of the state of the Member’s “location.”  For example, the “location” of a Member who is a natural person is his or her residence, and the “location” of a Member that is a limited liability company organized under the laws of a particular state is that state of organization.[8]   For purposes of this article, assume that the Member who is offering a Membership Interest as collateral is located in Ohio, and that the certificated security, if any, evidencing the Membership Interest, is at all times physically present  in Ohio.[9]  
 
    In Ohio, if filing is an appropriate method for perfecting a security interest in the particular Membership Interest, the lender accomplishes perfection, through filing, by filing a UCC financing statement with the Ohio Secretary of State.[10]  The UCC financing statement reflects the lender’s security interest, as granted in the Pledge Agreement.  If the Membership Interest is “investment property,” and, therefore, a security, the lender can perfect its security interest in that Membership Interest by filing.  
 

Possession    

    Filing, however, is not the only method to perfect a security interest in a Membership Interest that is also a “certificated security.”[11]  If the Membership Interest is a “certificated security,” the lender can also perfect its security interest through “possession.”  The lender perfects by “possession” by taking delivery of the certificated security.[12]     A lender takes “delivery” of a certificated security: (1) by taking actual physical possession of the certificated security, (2) by having an agent take delivery of the certificated security on behalf of the lender, or (3) by having a “securities intermediary” take delivery of the certificated security on behalf of the lender, if the certificated security is in registered form.l[13]  

Control 

   If the Membership Interest is a certificated security or an uncertificated security (recall that both are considered ”investment property” in R.C. Chapter 1309), the lender can also perfect its security interest by gaining ”control” over the security.[14]   If the Membership Interest is a certificated security, and the certificated security is in bearer form, the lender gains “control”  over the Membership Interest by taking delivery of the certificated security.[15]  If the Membership Interest is an uncertificated security, the lender gains “control” over the Membership Interest if (1) the uncertificated security is “delivered” to the lender, or (2) the Company has agreed that the Company will comply with instructions from the lender without further consent by the registeed owner of the uncertificated security (usually the Member).[16]  

    According to Official Comment 3 to R.C. 1308.24, an uncertificated security is “delivered” when the “purchaser,” in this case the lender, becomes the registered holder of the security. The Offical Comment goes on to state that, so far as the issuer (the Company) is concerned, the purchaser (the lender) would then be entitled to exercise all rights of ownership of the Membership Interest.
 
    Therrefore, as explained above, if the Membership Interest is a certificated security, the lender can perfect its ecurity interest in the Membership Interest by filing a UCC financing statement, by taking possession of the certificated security, or by taking control of the certificated security.[17]  If the Membership Interest is an uncertificated security, the lender can perfect its security interest by filing a UCC Financing Statement or by gaining control of the uncertificated security.

Priority of Security Interests in Investment Property   

    If the Membership Interest is investment property (a certificated security or an uncertificated security), certain provisions of the UCC govern the priority of creditors who have a perfected  security interest in that investment property.  Under R.C. 1309.328[18], the priority ranking of conflicting perfected security interests in investment property, from highest priority to lowest priority, is as follows:

           (1)    If the investment property is a “security entitlement”[19] or a “securities account”[20], maintained with a securities intermediary, the security interest of that securities intermediary has priority over all other security interests in the investment property;
          (2)    If the investment property is a commodity contract, or a commodity account, maintained with a commodity intermediary, the security interest of that commodity intermediary has priority over all other  security interests in the commodity contract or commodity account; 
          (3)    After the security interest of a securities intermediary or a commodity intermediary, if applicable, in the investment property, the next highest priority belongs to the security interest of a secured party having  ”control” over the investment property under R.C. 1309.106[21], which has priority over a security interest perfected other than by control;
       (4)    If the investment property is a certificated security in registered form, and the secured party perfected its security interest by taking delivery of the certificated security under R.C. 1309.313(A)[22], and not by control under R.C. 1309.314[23], that security interest has priority over conflicting security interests perfected other than by control.

    R.C. 1309.328 sets forth other priority rules for conflicting security interests in the same investment property, where each security interest has been perfected by control.  The rules for determining the priority of competing security interests in investment property that do not fall within the scope of R.C. 1309.328, for example, competing security interests that have each been perfected by filing, are set forth in R.C. 1309.322[24] or R.C. 1309.323[25]    

      Based on R.C. 1309.328, if a Membership Interest is a security and, therefore, investment property, perfection by “control” of the Membership Interest appears to be the best method of perfecting a security interest in that Membership Interest.  If the Membership Interest is a certificated security in registered form, the lender should exercise “control” by taking delivery of the Membership Interest under R.C. 1309.313(A).    
 

Membership Interest as “General Intangible” 

    For the purpose of perfecting a security interest in personal property, R.C. Chapter 1309 divides personal property into several specific classifications, including, for example, investment property, accounts, chattel paper, deposit accounts, equipment, and inventory.[26]  If a Membership Interest is not a “security” within the scope of R.C. 1308.02(C),  it is also not “investment property” under R.C. Chapter 1309.  Other than investment property, none of the specific personal property classifications in R.C. Chapter 1309 appears to apply to a Membership Interest.  Therefore, a Membership Interest that is not investment property falls under the “default bucket” classification of “general intangible” in R.C. 1309.102(A)(42).[27]
 
    Section 1309.102(A)(42) of the Ohio Revised Code defines “general intangible” as “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas or other minerals before extraction.  ’General intangible’ includes payment intangibles and software.”

    The only proper method for perfecting a security interest in a general intangible is by filing a UCC financing statement in the filing office of the appropriate state.  As with failure to perfect a security interest in other forms of personal property, a lender’s failure to perfect a security interest in a general intangible means the trustee of a bankruptcy estate that includes the general intangible may sell the general intangible free of the security interest.[28] 

Conclusion    

    When  contemplating whether to accept a Membership Interest as collateral for a loan, a lender should thoroughly examine the articles of organization and operating agreement of the Company, and existing loan documents with other lenders executed by the Company or by the Member, to determine the existence of any restrictions on a pledge of the Membership Interest.  If the lender decides to accept the Membership Interest as collateral, the lender should require the Member owning the Membership nterest to sign a Pledge Agreement, and the other Members of the Company to consent in writing to the pledge.  If the lender determines that the Membership Interest is a “security” under R.C. Chapter 1308, and therefore ”investment property” under R.C. Chapter 1309, the lender can perfect its security interest by filing, possession, and/or control, depending on the circumstances.  If the lender determines that the Membership Interest is a “general intaqngible” under R.C. Chapter 1309, the lender can perfect its security interest only by filing a UCC financing statement with the Ohio Secretary of State, if the Company was organized under the laws of the State of Ohio.     
 

Donald E. Miehls, Esq.

Walter & Haverfield LLP


This overview is intended as general information only.  Please note that this information is not legal advice.  The reader should consult an attorney with knowledge in this area of the law to determine how the information applies to any specific situation.

 

 

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