Taking Security Interests in Equity Collateral

» Articles » Banking Articles » Article

September 12, 2018
Author: Michael A Fagone
Organization: Bernstein, Shur, Sawyer & Nelson, P.A.

1. First things first
a. A security interest cannot be perfected before it has attached. See 9-308(a). Do not assume that the filing of a financing statement means that the security interest has attached. Attachment is governed by 9-203. Attachment does not occur until the security interest is enforceable and, in general, a security interest is not enforceable until (1) the debtor has rights in the collateral; (2) value has been given; and (3) the debtor has authenticated a security agreement containing a description of the collateral. See 9-203(b)(1)-(3). All three elements must be satisfied and, if any one element is not, the security interest is in jeopardy if the borrower lands in bankruptcy court. See, e.g., Wachovia Bank, N.A. v. WL Homes, LLC (In re WL Homes, LLC), No. 09-50514 (Bankr. D. Del. May 25, 2011)(rejecting chapter 7 trustee’s contention that debtor did not have rights in a deposit account established for debtor’s whollyowned subsidiary where debtor had dominion and control over the account). The UCC relaxes the requirement of an authenticated security agreement with respect to:

i. A certificated security in registered form in the possession of the secured party under 8-301 if the debtor has agreed that such possession is intended to create a security interest; and
ii. Investment property if the secured party has control under 9-106 if the debtor has agreed that such possession is intended to create a security interest.

In each instance, however, the debtor must make some type of “agreement” regarding the collateral. Be sure to consider: (i) whether the debtor has the authority to make the agreement; (ii) that the debtor has, in fact, made the requisite agreement; and (iii) that there are no defenses to the enforceability of the agreement. In general, the UCC is supplemented by principles of law and equity, including “laws relative to capacity to contract, principal and agent, estoppel, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, or other validating or invalidating cause[.]” 1-103. So, if applicable non-UCC law provides a basis for challenging the validity or enforceability of a debtor’s security agreement or other similar agreement, the filing of a financing statement or the taking of other steps to perfect a security interest may not save the day for the secured creditor. For example, under Maine corporate law, a debtor cannot grant a security interest in all of its assets without approval of the shareholders if the articles of incorporation require shareholder approval. See 13-C M.R.S.A. § 1201. While that type of requirement in the articles may be unusual, the  point is that it is possible and parties looking to challenge a secured claim should not assume that all of the state law prerequisites to attachment have occurred.

b. The sufficiency of the collateral description in the security agreement should be carefully considered. In general, a description is sufficient if it reasonably identifies the collateral. See 9-108(a). The description need not be specific, and a description by type (e.g., “Investment Property”) is usually sufficient. See 9-108(b)(3). Despite this latitude, counsel should ensure that the security agreement accurately describes the equity collateral interest in question. And state entity law should be consulted to determine how various interests in the LLC are described. For example, Maine’s LLC statute defines “limited liability company interest” as “the interest that may be assigned under section 685 and charged under section 686.” The statute also uses the term “membership interest.” See 31 M.R.S.A. §§ 684, 685. Use of either term in the security agreement could create questions about what was intended to be transferred to the lender as security. Delaware’s LLC statute, for example, does not use the term “membership interest.” Does a security agreement adequately describe the collateral where the collateral is described as “100% of the Borrower’s right, title, and interest in and to its membership interest in XYZ Company”? Does that extend to economic rights? Or voting rights? Or both? At a minimum, the creditors’ committee in the borrower’s chapter 11 case will want to raise these questions.

2. Interests in Corporations, Business Trusts, and Similar Entities
a. In general. Corporate stock, interests in statutory or business trusts, and interests in similar entities are “securities” for purposes of Article 8 of the UCC. See 8-103(a). That also makes them “securities” for purposes of Article 9, see 9-102(b), and, by extension, “investment property” under Article 9. See 9-102(a)(49). “Investment property” includes certificated securities and uncertificated securities. See id. The methods of perfection vary for each type of security and are discussed below.
b. Interests in Corporations. Corporate stock is relatively easy to spot. 8-102(15) defines “security” in a way that includes most shares of corporate stock, and 8-103 contains rules for determining when a share or similar equity interest is a “security.” But don’t always assume that a share of stock is a security. See, e.g., In re Turley, 172 F.3d 671 (9th Cir. 1999)(holding that a share of stock in a franchisor that organized and sponsored Indy car races was not a “security” under Michigan law).
c. Perfecting a Security Interest in a Certificated Security. If the debtor owns any certificated securities, trustees and/or creditors should carefully analyze whether the secured party has perfected its security interest(s) in those securities. As you might expect, a “certificated security” is a security represented by a certificate. See 8- 102(a)(4). A security interest in a certificated security may be perfected by: (i) filing of a financing statement, see 9-310(a) and 9-312(a); (ii) delivery of the certificated security under 8-301, see 9-313(a); or (iii) by control under 9-314, see 9-106.2 In addition, there are rules providing for temporary perfection of a security interest in a certificated security. See 9-312(e), (g), and (h).
d. Obtaining Control of Certificated Security. 9-106 points a secured party to Article 8, specifically, 8-106, to determine how to obtain control of a certificated security. See 9-106(a). The rules in 8-106 depend on whether the certified security is in bearer form or registered form. Most common securities are in registered form and, as a result, control requires (i) delivery and (ii) either an effective indorsement to the secured party or in blank or, in the alternative, registration in the name of the secured party. See 8-106(b). Delivery can be accomplished in three ways, and the most common way is possession. 8-301(a)(1). So, if the secured party possesses the certificated security, its security interest in that certificated security is perfected (assuming that it has attached). However, if the secured party surrenders possession of the certificate, its security interest may become unperfected unless the secured party has complied with 9-313(h). See,e.g., Rothrock v. Turner, 2010 WL 2267226 (D. Me. June 2, 2010) (holding that creditor’s security interest in stock owned by debtor become unperfected when the stock certificate was delivered to the debtor for the purpose of tendering the certificate to the issuer in connection with a cash-out merger).
e. Perfecting a Security Interest in an Uncertificated Security. A security interest in an uncertificated security may only be perfected by: (i) filing of a financing statement, see 9-312(a); and (ii) by control under 9-106, see 9-314.
f. Obtaining Control of Uncertificated Security. 9-106 points a secured party to Article 8, specifically, 8-106, to determine how to obtain control of an uncertificated security. See 9-106(a). Control can be obtained by delivery. See 8-106(c)(1). Delivery can be accomplished in two ways: registration in the secured party’s name or the issuer’s agreement to comply with instructions from the secured party without the debtor’s consent. See 8-301(b)(1). Control can also be obtained by the issuer’s agreement to comply with instructions from the secured party without the debtor’s consent. See 8- 106(c)(2).
g. Broker or securities intermediary as debtor. If the debtor is a broker or a securities intermediary, then any security interest in investment property created by the debtor is automatically perfected (and thus unavoidable) upon attachment. See 9-309(10). Filing of financing statement has no effect in these circumstances.

3. LLC Interests
Most commercial lawyers believe that an LLC interest is a security. An LLC interest is, without doubt, a security for certain purposes. But, when it comes to Article 9, the answer is “It depends.”

An LLC interest that is traded on an exchange or in securities markets is a security. See 8-103(c). An interest in an LLC is a security if the interest is an “investment company security.” See id. In all other cases (i.e., not publicly-traded and not an investment company security), an LLC interest is a security only if there has been an effective “opt in” to Article 8. See id. Without an effective “opt in,” an LLC interest is not a security and therefore is a “general intangible” for purposes of Article 9.

If an LLC interest is not a security, a security interest in the LLC interest can be perfected only by the filing of an effective financing statement. See 9-310.

An effective opt-in must expressly provide that the interest is a security governed by Article 8 of the UCC. Frequently, this opt-in will be located in the LLC’s operating agreement. But, in the case of certificated securities, the opt-in may exist on the face of the security certificate. Accordingly, the operating agreement and the security certificate should be reviewed carefully to determine whether there has been an opt-in.

If there has been an opt-in, does that end the inquiry? No. Make sure that there hasn’t been an “opt out” by the issuer of the interest. An LLC agreement can be amended. If the secured party has not taken steps to ensure that there is no “opt out,” counsel should examine the issuer’s corporate records to identify whether there has been an “opt out.” If so, the interest may no longer constitute a security and the secured party’s security interest may be unperfected.

4. Partnership Interests
The analysis with respect to partnership interests is similar to the analysis for LLC interests. This is true for both general partnership interests and limited partnership interests.

5. Anti-Assignment Provisions
Transfer restrictions that may prevent a security interest from being created (or, in other words, from attaching) should be carefully analyzed. These restrictions may be found in the applicable state entity statute or in the issuer’s organizational documents (LLC agreement or partnership agreement). In re Weiss, 376 B.R. 867 (Bankr. N.D. Ill. 2007), illustrates the dangers of failing to analyze the underlying entity statute and operating agreement when taking a security interest in equity collateral.

Weiss involved a debtor who had assigned his interests in several closely held companies as security for his obligations under two promissory notes. See 376 B.R. at 870-71. However, the operating agreements for each entity expressly required written consent by all limited liability company members or partners, or the manager, prior to the transfer of any interests, and the creditors did not obtain such consent prior to the debtor’s purported assignment. Id. at 873.

The creditors subsequently filed financing statements in an attempt to perfect their alleged security interests in the companies. Yet the court found that their interests never properly “attached” at the outset, and denied their motion for relief from the automatic stay. Id. at 876. Pursuant to applicable state law, a security interest attaches to collateral only when it becomes enforceable against a debtor; because the debtor did not have the power to transfer his rights in the companies under the operating agreements, the attempted assignment of interests was invalid. Weiss, 376 B.R. at 876-79.

There are, however, circumstances in which certain transfer restrictions may be overridden in part by Article 9. As discussed above, if there not been an effective opt-in, an LLC interest constitutes a general intangible. With respect to general intangibles, Section 9-408 provides:

a term in . . . an agreement between an account debtor and a debtor
which relates to . . . a general intangible . . . and which term
prohibits, restricts, or requires the consent of the . . . account
debtor to, the assignment or transfer of, or creation, attachment, or
perfection of a security interest in . . . the general intangible, is
ineffective to the extent that the term:

(1) would impair the creation, attachment or
perfection of a security interest; or

(2) provides that the assignment or transfer or the
creation, attachment, or perfection of the
security interest may give rise to a default,
breach, right of recoupment, claim, defense,
termination, right of termination, or remedy
under the . . . general intangible.

9-408(a). 9-408(c) contains a similar rule with respect to rules of law, statutes, and regulations. See 9-408(c). Observe that 9-408(a) and (c) only invalidate restrictions on the creation, attachment, or perfection of a security interest. In other words, 9-408 is designed to allow the security interest to be perfected notwithstanding restrictions to the contrary. It does not disrupt limitations on the creditor’s exercise of any remedy or remedies, or impose duties on the account debtor. See 9-408(d) and Official Comment 6.3

9-408 does not apply where there has been an opt-in, as the interest is a security, not a general intangible. However, the opt-in may give rise to other potential transfer restrictions. The important point is to carefully consider whether anything outside the four corners of the security agreement may prevent the security interest from attaching.

1 Mr. Fagone is a shareholder in Bernstein Shur, where his practice focuses on bankruptcy, insolvency, and
commercial transactions.
2 Control and delivery of a certificated security are described below.
3 Several states, including Delaware, have made 9-408 subject to generally applicable LLC and partnership law, such that 9-408’s “override” does not apply with respect to interests in LLCs and partnerships. See, e.g., 6 Del.
C. § 15-104(c) (general partnerships), 6 Del. C. § 17-1101(e) (limited partnerships), and 6 Del. C. § 18-
1101(g)(limited liability companies).

The material appearing in this web site is for informational purposes only and is not legal advice. Transmission of this information is not intended to create, and receipt does not constitute, an attorney-client relationship. The information provided herein is intended only as general information which may or may not reflect the most current developments. Although these materials may be prepared by professionals, they should not be used as a substitute for professional services. If legal or other professional advice is required, the services of a professional should be sought.

The opinions or viewpoints expressed herein do not necessarily reflect those of Lorman Education Services. All materials and content were prepared by persons and/or entities other than Lorman Education Services, and said other persons and/or entities are solely responsible for their content.

Any links to other web sites are not intended to be referrals or endorsements of these sites. The links provided are maintained by the respective organizations, and they are solely responsible for the content of their own sites.