Lenders are accepting membership interests in limited liability companies (LLCs) and partnership interests in partnerships (referred to as equity interests) as collateral for loans now more than ever. Any lender taking a security interest in these types of collateral should be aware of the different methods of perfecting that security interest. A lender’s failure to use the correct method of perfection is exposed to the risk that a subsequent lender takes a senior lien position on the same equity interests giving that subsequent lender priority over the original lender in the foreclosure process.
The methods of perfection differ depending on whether the equity interests are classified as “securities” under Article 8 of the UCC or “general intangibles” under Article 9 of the UCC. Where the governing documents of an LLC or partnership are silent as to the application of Article 8 or 9, equity interests are governed by Article 9 and are classified as “general intangibles” regardless of whether those equity interests are certificated. The only way a lender perfects its security interest in a general intangible is by filing a financing statement, and priority among competing security interests is determined based on the order in time in which the lenders filed their financing statements. Thus, if a lender requires a borrower to certificate its equity interests and deliver possession of the certificate to the lender endorsed in blank, the lender has done nothing to perfect its security interest under Article 9 of the UCC.
However, the rules of perfection completely change where the governing documents of an LLC or partnership provide that the entity “opts in” to Article 8. By opting in to Article 8, the equity interest is transformed into an Article 8 “security” and Article 9 “investment property” that may be perfected by (1) filing a financing statement, (2) possession, or (3) control (essentially possession of a certificate evidencing the equity interest endorsed in blank or by a control agreement for uncertificated securities). As “investment property,” a security interest perfected by control trumps an interest perfected by possession, and an interest perfected by possession trumps an interest perfected by filing a financing statement. Further, perfection by possession or control trumps perfection by filing a financing statement even where the filing occurred prior to the possession or control and even if the subsequent secured party has knowledge of the competing security interest.
As you can see, a lender who takes a security interest in equity interests must take a number of steps to adequately ensure that its security interest will be properly perfected and maintain priority over competing security interests.
Of course, this is not an exhaustive discussion of the law applicable to these issues. If you would like more information on this topic, please contact Allen Bertin at firstname.lastname@example.org or (512) 735-7803.