Perfection of Security Interests in the Ownership Interests of Borrowers Under a Mezzanine Loan: Article 9 vs. Article 8
By Richard R. Goldberg
Richard R. Goldberg is a partner in the Philadelphia, Pennsylvania, office of Ballard Spahr Andrews & Ingersoll, LLP.
The only safe way to perfect a security interest in the ownership interest of the mezzanine borrower is to require that the borrower opt into Article 8 of the UCC (so that such ownership interest is a certificated interest), agree not to opt out of Article 8, and deliver the certificated interest to the mezzanine lender along with a blank power. The agreement not to opt out should be backed up with a recourse event in a guaranty by a sponsor capable of paying under the guaranty.
Mezzanine lenders, however, often do not take this approach. As with promissory notes, major financial institutions have a propensity to lose the certificates because of the volume of pledged loans. Therefore, they prefer to secure the ownership interest with an Article 9 filing instead. Following this approach, however, leaves the mezzanine lender in a precarious position because possession trumps filing and the possessor does not take subject to a previous filing. U.C.C. § 9-328. Likewise, a control agreement regarding certificated interests also is trumped by a pledge with possession.
The mezzanine lender should avoid this situation if at all possible because of substantial risks to its security. If the borrower, whether inadvertently or by design, later grants a security interest of control to a third party (either by possession or by the execution of a control agreement), the lender with priority by control does not take subject to the Article 9 interest. Although one would hope that a subsequent lender would perform the obvious UCC filing searches for prior interests, if a subsequent lender nevertheless takes possession, this leaves the holder of the interest secured by an Article 9 filing with little recourse. The defeat of the grant of the security interest would result in a breach of a covenant in the loan agreement; perhaps there will be a cause of action for fraud; and, if the loan agreement is properly drafted, there will be recourse to a guarantor of substance. But, even if the mezzanine lender has a cause of action in contract and fraud, it cannot get at the membership interest. In the author’s experience, a borrower willing to commit these acts usually does not have the financial resources to make the lender whole.
This situation brings to mind a theory for counteracting the potential drawbacks of Article 9 perfection. A possible solution may lie within the provisions of the Delaware Limited Liability Company Act. Del. Code Ann. tit. 6, § 18-101 et seq. Mezzanine lenders should be more emphatic in insisting that Delaware be the state of choice for entity formation purposes. Although many mezzanine borrowers are formed in other states, in these uncertain times lenders will take comfort in the way Delaware has interpreted limited liability company law as well as in the uniqueness of certain provisions of the Act.
Lenders should require that the Delaware mezzanine borrower’s limited liability company agreement provide that the entity will not opt into Article 8 without the permission of the mezzanine lender. The operating agreement should also provide that the agreement will not be amended in any respect without the consent of the mezzanine lender. The Act provides as follows:
If a limited liability company agreement provides for the manner in which it may be amended, including by requiring the approval of a person who is not a party to the limited liability company agreement or the satisfaction of conditions, it may be amended only in that manner or as otherwise permitted by law (provided that the approval of any person may be waived by such person and that any such conditions may be waived by all persons for whose benefit such conditions were intended).
Id. § 18-302(e). Thus, the operating agreement cannot be amended without the consent of the mezzanine lender and any amendment may indeed be an ultra vires act by the entity. The mezzanine loan agreement should also provide for a similar “no opt in” covenant and the guaranty should provide for a recourse event if the covenant is breached.
To complete the picture, the mezzanine lender should insist on one additional step, which does not have the force of law but creates a notice situation to any future prospective lender. The certificate of formation for a Delaware limited liability company permits the entity to place comments on the face of the form. Id. § 18-201(a)(3). A comment should note that the operating agreement does not permit the limited liability company to opt into Article 8. Although this comment has no effect of law, it compels notice of a possible competing Article 9 filing to any party that has an interest in requiring the entity to opt into Article 8. There is no assurance that the suggestion above will work to prevent a limited liability company from opting into Article 8. If the mezzanine lender prefers to perfect under Article 9, however, it is worthwhile to consider insisting that the borrower follow these steps when preparing the mezzanine borrower’s formation documents.
It should be noted the technique suggested above applies to Delaware limited liability companies and Delaware limited partnerships. In other states, the provisions of the UCC trump the organic formation statutes for limited partnership and limited liability companies. Also in some states, the use of a limited liability company causes significant state tax problems that necessitate the use of a limited partnership. The suggested technique can still be used in such a situation, however, because the general partner of the limited partnership can always be required to be a limited liability company and the prohibition can be applied in the general partner’s operating agreement.
In any event, there is no substitute for the use of Article 8 to perfect a security interest in ownership interests. The use of the Article 9 solution is a Band-Aid at best and not a substitute for the methodology provided by Article 8.