Thus, as will be described below, the secured party will want to make sure that the security agreement and the entity's governing documents contain the necessary protections to allow the secured party to effectively, and efficiently, exercise the self-help remedies available to a secured party under the UCC.
As a general matter, due to the contractual flexibility inherent in most alternative entity statutes, a secured party should take advantage of its ability to build additional protections into the subject entity's governing documents, and not simply rely upon the representations, warranties, and covenants set forth in the security documents. For example, the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act each contain features that enable creditors to obtain additional rights and protections. Each act specifically permits the governing document to provide rights to a person that is not a party to the governing document. Delaware Limited Liability Company Act § 18-101(7) and Delaware Revised Uniform Limited Partnership Act § 17-101(12). Thus, counsel for the secured party should take steps to marry the contractual flexibility afforded by the alternative entity statutes to the favorable self-help remedies available under the UCC to ensure that the secured party will be able to realize the value of it equity interest collateral upon a default.
First, provide an adequate description of the collateral in connection with the creation of the security interest. Many alternative entity statutes, including Delaware, disaggregate economic rights from the governance rights provided to a holder of equity interests in the alternative entity. Therefore, the description of the collateral set forth in the security agreement that creates the interest must be broad enough to give the secured party a security interest not only in the economic rights but also the governance rights; otherwise if the description is not broad enough a secured party may find itself holding an interest solely in the economic rights that a debtor has in the alternative entities, similar to a charging order. Thus, the collateral description should make clear that it refers to the debtor's governance rights under the governing document as well as the debtor's economic rights.
Second, it cannot be emphasized enough: know your collateral. As mentioned above, a secured party should have a good understanding of what type of collateral the equity interests in the alternative entity are for purposes of the UCC. Thus, is the collateral a general intangible or investment property, and if investment property, is it certificated or uncertificated. Each of the foregoing conclusions will influence how a secured party perfects its security interest. In the event that the collateral is a general intangible, a secured party may want to request that the subject alternative entity actually opt-in to Article 8 of the UCC and perfect its security interest therein by control. Not only does opting in have the benefit of providing the secured party with a superior method of perfecting its interest, by control, but because the equity interests will be governed by Article 8, the secured party may in certain cases receive the benefits of being a "protected purchaser" and therefore actually receive an interest in the subject collateral that is superior to the interest of the debtor in such collateral because the secured party may take free of any adverse claims. UCC § 8-303(b). Opting in to Article 8 can be accomplished by executing a short amendment to the subject governing document, which expressly provides that the alternative entity's equity interests will be governed by Article 8.
Related to knowing your collateral, it is also important that the secured party make sure that the subject collateral stays the same type of collateral after the security interest is perfected. Thus, in order to protect itself, the secured party should certainly build covenants into the security document, but also to the extent permitted by the applicable alternative entity statute, the secured party should hardwire protections into the alternative entity's governing documents. Hence, a provision should be added to the governing document to prohibit the entity from amending the governing document to opt-in or opt-out of Article 8, as the case may be. Furthermore, for an entity governed by Delaware law, such entity can expressly provide in its governing document that the secured party must consent to any amendment that would change an equity interest's status as a security or non-security.
Third, provide a mechanism in the documentation to permit the transfer of the equity interests and the admission by a transferee to the alternative entity. In order to fully take advantage of the self-help remedies available to a secured party under the UCC, a secured party should build a mechanism into the security agreement and the subject alternative entity's governing document to permit the secured party or a third-party transferee of such equity interest to acquire the equity interests and to be admitted to the entity upon an event of default. This is a common pitfall for secured parties seeking to exercise self-help remedies. Unless the secured party takes steps to facilitate a transfer and automatic admission following a default by the debtor, a secured party may find that it is only able to acquire the economic rights under the equity interest. For example, under Delaware law, unless otherwise provided in the governing documents, the secured party's admission to the alternative entity will require the cooperation of the debtor, and possibly the other equity holders, (Delaware Limited Liability Company Act § 18-301(b) and Delaware Revised Uniform Limited Partnership Act § 17-301(b)), and following a default, the debtor and the other equity holders may not be thrilled to assist the secured party with transferring the interest and admitting the transferee to the entity. Thus, in dealing with an alternative entity where admission is required to exercise governance rights, the parties may want to add a mechanism directly into the governing document whereby upon an event of default, the secured party will be automatically admitted to the entity, or alternatively, in some cases, a power of attorney can be granted to the secured party in order to facilitate such admission.
In addition, the secured party may require that the governing document contain language that structures the entity's interests more like corporate stock, whereby a transferee succeeds to the transferor's rights automatically upon transfer without further action on the part of the issuer or its equity holders. Under the Delaware statutes governing alternative entities, it is crucial to make sure that the admission issue is addressed if the entity only has one member or one limited partner because the transfer of the equity interest by the debtor to the secured party will cause the entity to dissolve because it has no members or limited partners. Delaware Limited Liability Company Act § 18-801(4) and Delaware Revised Uniform Limited Partnership Act § 17-801(4). That is the case because under the Delaware laws governing alternative entities, the debtor will cease to be a member or partner, as applicable, following the transfer of the interests and unless the governing document provides for an admission mechanism, the secured party or third-party transferee will not be admitted to the entity, which will cause the entity to lack the requisite partner or member needed to avoid dissolution.
Finally, due to the contractual nature of alternative entities, and particularly in Delaware, which expressly states that the policy of its alternative entity statutes is to give maximum effect to the principle of freedom of contract, the secured party should not merely rely upon the covenants and representations in the loan documents. Thus, instead of relying upon covenant defaults, protections may be added to the governing document that remove from the power and authority of the entity the ability to take certain actions that reduce, or might reduce, the secured party's protection. As previously mentioned, the governing document should limit the entity's ability to change the status of the collateral from a security to a non-security or vice versa, and it should prohibit amendments to the governing document that remove other secured party protections. In addition, the secured party may consider adding limitations on the power to issue additional equity interests or limit the authority to make distributions while obligations are outstanding. Thus, the secured parties should take advantage of the ability to enhance their protections in the alternative entity's governing documents.
As the use of alternative entities increases, it is incumbent upon commercial finance attorneys to understand the characteristics of such interests and to ensure that they understand how to perfect such collateral, and otherwise deal with such collateral. Due to the flexibility of many of the alternative entity statutes and the contractual freedom available to the parties thereunder, care should be taken to ensure that a secured party sufficiently protects its security interest by taking some of, or at least considering, the actions described above. As stated at the beginning, the most important step in this process is to recognize that equity interests in alternative entities are not exactly like corporate stock and the approach by a secured party to protect its security interest in such collateral should be markedly different.