Pub. 4 2016 Issue 2

www.uba.org 6 Introduction As collateral for a loan, lenders sometimes take a securi- ty interest in the ownership interests of a borrower – which means, in many transactions, lenders take a security interest in the ownership interests of a limited liability company (LLC). When drafting a security agreement to grant such an interest, lenders and their counsel sometimes resort to terms like “mem- bership interests” or “limited liability company interests” to describe their intended collateral, assuming that these terms will allow them, or a third-party purchaser, full economic participation in the LLC (economic rights), as well as voting and managerial control in the LLC (management rights) upon foreclosure. However, while such terms may suffice in some states, they should be avoided when taking a security interest in the economic and management rights of an LLC as many states’ LLC statutes do not define “membership interests” or “limited liability company interests” to include these rights. As a result, lenders take a considerable risk when they describe their intend- ed collateral in such a simplistic manner. The purpose of this article is to warn lenders of this risk and to advise them of the simple steps they can take to avoid it. Specifically, this article illustrates this risk by looking at issues under the Delaware Limited Liability Company Act, Del. Code Ann. Tit. 6, § 18 (Delaware LLC Act) and advocates that lenders should draft their security agreements to carefully define the LLC interests they desire as collateral (i.e., define the economic and management rights by using language directly from the relevant state LLC statute and the LLC operating agreement). Lenders should also thoroughly review the LLC’s operating agreement to know whether the LLC has the power to assign such interests or whether the operating agreement may need to be amended to permit an assignment. Assigning Economic and Management Rights in Delaware LLCs As many LLCs are formed in the State of Delaware, the Dela- ware LLC Act provides a good starting point in understanding the risk a lender takes in simplistically describing its intended LLC collateral. Under Delaware law, “membership interests” are not defined. However, the Delaware LLC Act does define a “limited liability company interest” as “a member's share of the profits and losses of a limited liability company and a member's right to receive distributions of the limited liability company's assets.” 1 In other words, Delaware limits an assignment of a Beware Simplistically Defining Membership Interests in LLCs By Landon A. Hardcastle