Protecting Your Limited Liability Company Ownership Security Interest
When most people think about a security interest in property, they think of a secured interest in real estate (i.e. a mortgage). However, you can actually obtain a security interest in more than just real estate, such as a security interest in an ownership interest in an entity. Here, we’re going to be focusing on a security interest in a limited liability company (LLC) ownership interest.
Classifying the Interest
Protecting your security interest in an ownership interest in an LLC first means determining what the interest is classified as. An ownership interest in an LLC can be classified as either a “security” or a “general intangible.” This determination tells you how you can perfect the interest. Perfection is a necessary step in order to make a security interest effective against a third party, and the right perfection method varies based on the classification of the underlying interest.
The tricky thing about an LLC ownership interest is that, based on the facts, it could be classified as either a security or a general intangible. It’s often classified as a general intangible, meaning you’ll need a UCC financing statement for perfection. This is the easiest method, if available. However, if it’s classified as a security, then possession and control may be necessary.
As above mentioned, if the LLC interest is classified as a security, perfection gets a bit more complicated. To be classified as a security, generally the LLC’s governing documents must say that it is classified as a security. The next step is to check if the interest is certificated or uncertificated. Some LLCs have certificates associated with their ownership interests, much like some corporations have stock certificates. If the ownership interest is certificated, then possession and an endorsement are needed to perfect the security interest. If the interest is uncertificated, then control is necessary by obtaining an agreement from the LLC requiring that instructions only be taken from the lender regarding the LLC interest.
Protection After Determining Perfection
So you’ve figured out how to perfect the security interest. What else do you need to worry about? Some other items that you want to be careful about when it comes to a security interest are: (i) making sure the collateral is described adequately and (ii) putting in safeguards so that the underlying interest does not change.
An LLC ownership interest has economic and voting, consent and management rights. If you’re a secured party, you want to make sure that your security interest covers what you want, whether it be just the economic rights or the economic and voting rights. Your security agreement should state this information.
You’ll want to put in some safeguards to protect the LLC interest from changing. This includes not only putting in safeguards to prevent the characterization of the underlying interest from changing, but also to prevent assignments of the interest and additional third-party security interests. You’ll ideally want to restrict all changes to the governing documents, assignments and third-party interests in the LLC ownership interest from occurring, unless written consent is obtained from you. These safeguards are to make sure not only that your security interest remains valuable, but also to make sure that your security interest remains properly perfected, as changes in the characterization of the underlying interest could lead to your perfection method no longer being adequate.
It is advised that you have an attorney draft and negotiate on your behalf if you’re obtaining a security interest in an LLC interest. You can always do it yourself, but you might miss things that an attorney might not, and when it comes to security interests, missing a detail can mean your security interest losing its value or another party taking priority over your interest, if not both. Our attorneys at Dodson Legal Group can assist you with protecting your rights as a secured party. Please do not hesitate to contact us at 844-4DODSON to schedule a consultation with one of our attorneys.