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PLEDGING LLC AND LP INTERESTS: ARE YOU REALLY GETTING WHAT YOU THINK YOU’RE GETTING?

Lenders frequently take stock pledges when making loans but are you getting what you think you are getting? Stock pledges are common but you probably also see pledges of ownership interests in an LLC or limited partnership. However, unlike with common stock pledges, an unwary lender may not be receiving the LLC or LP rights that are expected when it receives the pledge. For that reason, it is important to know how Ohio law treats pledges of these interests, as well as perfection of such security interests in LLCs and partnerships.

Since LLCs are more common in today’s business climate let’s start there first. Ownership interests in LLCs come with two primary rights: (1) the right to receive distributions and allocations (a financial interest), and (2) the right to participate in the management and governance of the LLC (a control interest).  Under Section 1705.18 of the Ohio Revised Code (“R.C.”), unless otherwise prohibited by the operating agreement, LLC interests are assignable.  However, the assignee only receives the right to receive distributions and allocations of profits and losses (again unless the operating agreement provides otherwise and most do not).  The assignee does not become a member and has no voting or management rights.  Ohio law gives an assignee a financial interest only.  Under ORC 1705.20, an assignee becomes a member only if the operating agreement so provides or if all of the other members consent.  A lender should be wary of these state law provisions because, if the LLC is taxed as a partnership, the other members may have the flexibility to make uneven allocations, and may be able to greatly reduce the amount of income that the lender/assignee would receive. To be properly assigned both aspects of the LLC interest, you should review the operating agreement to determine whether or not an assignee may become a member upon assignment and the language in the pledge description should be explicit.  That is, even if the operating agreement allows for assignment of both financial and control interest, your security interest is in “The LLC Units” you are only receiving the financial interests and not the control interests so your position is vulnerable. To receive both financial and control interests, the pledge should contain language similar to the following:  “All rights of the Pledgor embodied in or arising out of Pledgor’s status as a member of the LLC consisting of:  (1) all economic rights, including without limitation, all rights to share in the profits and losses of the LLC; and (b) all governance rights, including without limitation, all rights to vote, consent to action and otherwise participate in the management of the LLC.” Failure to ensure that sufficient language is found in the pledge may result in you taking less than you initially anticipated.

ORC 1782.40 and ORC 1782.42 are the parallel provisions for limited partnerships and are essentially the same.  An assignee of an LP interest will not be a partner unless the partnership agreement so provides or the other partners consent.  The assignor will no longer be a partner, but ORC 1782.42(C) states that even if the assignee becomes a partner, the assignor is not released from certain liabilities to the LP.  The LLC rules typically will be of more importance to you as a lender because limited partners in an LP only have financial interests.  As a result, taking a pledge of only a financial interest in an LP does not much alter the rights you have versus what the assignor previously had.  General partners, however, have both financial and control rights, so if a general partner interest is pledged, it is important that you determine the nature of the interest pledged.

Once you have received the pledge, you need to ensure that your interest is perfected.  Perfection of such interest is governed by Article 8 or Article 9 of the Uniform Commercial Code as adopted in Ohio (the “UCC”).   Under the UCC in Ohio, LLC and LP interests can either be investment securities governed under Article 8 or general intangibles governed under Article 9.  The default classification is as a general intangible under Article 9 unless the operating agreement or partnership agreement cause an “opt in” to Article 8.  The only method of perfection of an interest in general intangibles is through filing a financing statement. So even if a borrower/pledgor delivers a certificate evidencing LLC or LP interests, a filed financing statement will take priority over the mere possession or control of such certificate; unless such possession or control perfects the interest under Article 8.  
ORC 1308.02(C) (Article 8-103(c) of the UCC) states: “An interest in a partnership or limited liability company is not a security unless it is dealt in or traded on securities exchanges or in securities markets, its terms expressly provide that it is a security governed by this chapter, or it is an investment company security.”  Assuming that LLC or LP interests are not traded on an exchange, an operating agreement or partnership agreement can simply state that interests in the entities are to be deemed securities governed by Article 8.  The ability for the operating agreement or partnership agreement to so provide or to remain silent on the issue is what gives these entities the ability to “opt in.”  Silence as to Article 8 in these agreements causes the interests to be governed by Article 9 as discussed above.  Being under the purview of Article 8 causes the interests to be classified as investment securities.  Unlike with general intangibles under Article 9, a security interest in an investment security can be perfected by control, possession, or filing a financing statement.  However, remember in your filing to describe both the financial interest and the control interest of the LLC.  If you rely on the description of “general intangibles” you may only be receiving a perfected interest in the financial interest.

Not all of the potential traps associated with the pledge of LLC or LP interests are discussed herein and so we encourage you to contact your CPM Attorney to further discuss or to review your loan documents and borrower’s organizational documents to ensure that you are getting exactly what you expect when you take a pledge of an LLC or LP interest. 

 

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