A limited liability company (“LLC”) is one of the most commonly chosen entity structures used by new businesses today. LLCs are owned by its members, who hold either membership units or membership interests. Membership units/interests consist of both financial and governance rights, although a particular member may have financial rights but no governance rights or vice versa. Membership units/interests may be evidenced by a membership certificate but, most frequently, are uncertificated. Whether membership units/interests are certificated or uncertificated will usually be set forth in the LLC’s organizational documents. As LLCs are commonly the entity structure of choice, it is important for banks to understand how to accept and perfect a security interest in the membership units/interests as collateral for loans.
Regardless of whether the membership units/interests are certificated or uncertificated, a security interest in membership units/interests needs to be granted to the secured party. This will typically be accomplished through a pledge agreement, which should specify whether the security interest granted to the secured party is a security interest in the pledgor’s financial rights, governance rights or both. Without such specification, a pledging party may be able to argue that the pledge is simply a pledge of the financial rights.
In many cases, the organizational documents for the LLC either (i) expressly prohibit a member from transferring or pledging their membership units/interests; or, (ii) grant a right of first refusal to the LLC or other members. In these instances, the secured party must obtain the consent and waiver from the LLC and/or the other members before accepting the pledged units/interests.
However, in cases where there is no direct prohibition against a pledge, or if a right of first refusal does not exist, it is still wise to obtain the consent of the LLC and other members to prevent an objection at a later time. The form of the consent and waiver from the LLC and other members can be as simple or complex as the parties agree. For example, the consent and waiver should, at a minimum, contain consent to the pledge and a waiver of any transfer or pledge prohibitions and any first refusal rights. Also, the consent and waiver should have an acknowledgment that the LLC and other members will recognize the secured party as the holder of the pledged membership units/interests should the secured party give notice of an event of default in its lending relationship. In more complex transactions, the consent and waiver may also be reflected in a modification to the LLC’s organizational documents. In addition, the secured party may want to include provisions granting the LLC or the remaining members the option to acquire the pledged membership units/interests should the secured party acquire it or vice versa (i.e. a “push provision”, or a “push-put provision”).
It should also be noted that in accepting a pledge of membership units/interests, it is often the intent of the parties that the secured party will receive the distributions made on the membership units/interests while the debt is outstanding. If this is the case, the secured party should obtain an assignment of the distributions from the pledging member. Again, the assignment of distributions should be consented to by the LLC and other members to ensure that the assignment will be honored.
As for perfection, the manner of perfection depends upon whether the membership units/interests are certificated or uncertificated. When membership units/interests are uncertificated, they are “general intangibles” under the Uniform Commercial Code (“UCC”). If such is the case, perfection and priority issues are determined by the order of UCC financing statements filed against the membership units/interests. Thus, prior to accepting the pledged uncertificated membership units/interests, the secured party should perform a current UCC search on the pledging member to ensure the secured party obtains the proper first priority security interest. Perfection of an uncertificated security can also be achieved through a control agreement between the secured party and the LLC setting forth the secured party’s security interest in the membership units/interests.
In the cases where the membership units/interests are certificated, they are generally considered to be a security, which can be perfected by filing a UCC financing statement or by taking control of the certificate(s) (i.e. actual possession of the certificate(s) or entering into a control agreement with a third party in possession). Although certificated membership units/interests may be perfected by filing a UCC financing statement, perfection by control will have priority over any parties perfected by filing alone. As a result, it is generally recommended that a secured party perfect by both methods to ensure a first priority security interest on certificated membership units/interests. Thus, prior to accepting the pledged certificated membership units/interests, the secured party should (i) perform a current UCC search on the pledging member; and, (ii) either have the original certificate delivered to the secured party at closing or, if the certificate is in the possession of a third party, have a negotiated control agreement signed at closing.
Now that you are perfected, what happens if your borrower defaults? In our second part in this series, we will detail the steps to take control of the membership units/interests and to liquidate the same.
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Using a LLC for Real Estate Investments: Traps for the Unwary
Important Factors When Choosing a LLC for Asset Protection in Owning Real Estate
The limited liability company (LLC) has become a favorite vehicle for owners of income-producing real estate seeking to easily and inexpensively establish a level of personal liability protection from claims of outsiders. Because the LLC is a separate legal entity, the objective is to transfer title from the individuals to the LLC thereby replacing the individuals as the targets of any lawsuit arising out of the ownership of the property. However, this protection may not be unlimited.
In addition, there are financing and other ramifications of transferring title to property into an LLC that are often overlooked or simply unknown to the property owner and even to many general practitioner attorneys who don’t practice regularly in this area.
“Piercing the Corporate Veil” Applies to a LLC
An LLC is commonly perceived as providing the limited liability protection of a corporation without the requirements of complying with all the formalities of a corporation, such as holding meetings and maintaining minutes and other records. This perception is often founded in the express language of state LLC Acts, such as a Delaware statute that states that the
“obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company."
Other state statutes, however, are not so unconditional. California’s Limited Liability Company Act (Corporations Code Sec. 17101) qualifies the same broad limited liability protection with the following provisions:
"(b) A member of a limited liability company shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable under a judgment of a court or for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, under the same or similar circumstances and to the same extent as a shareholder of a corporation may be personally liable for any debt, obligation, or liability of the corporation; except that the failure to hold meetings of members or managers or the failure to observe formalities pertaining to the calling or conduct of meetings shall not be considered a factor tending to establish that a member or the members have alter ego or personal liability for any debt, obligation, or liability of the limited liability company where the articles of organization or operating agreement do not expressly require the holding of meetings of members or managers.
(c) Nothing in this section shall be construed to affect the liability of a member of a limited liability company (1) to third parties for the member's participation in tortious conduct, or (2) pursuant to the terms of a written guarantee or other contractual obligation entered into by the member, other than an operating agreement."
Colorado’s Limited Liability Company Act is to the same effect:
7-80-107. Application of corporation case law to set aside limited liability.
(1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law.
(2) For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.
LLC Manager Held Personally Liable
In June 2009, the Colorado Court of Appeals, in Sheffield Services Co. v. Trowbridge, held the manager of an LLC personally liable for the LLC’s breach of contract even though the manager was not a member, reasoning that “LLC managers are similar to corporate officers or directors” and that LLCs should be treated like corporations when considering whether to disregard the legal entity.
Personal Liability Applies for Negligence
"Tortious conduct" is a legal term that most commonly refers to negligence and can occur in many different circumstances involving the ownership of property. Classic cases where the negligence of a property owner have been established involve the failure to have adequate lighting in a hallway, stairwell or parking lot and resulting in injury to a tenant or visitor, failure to property conduct a background check on an onsite property manager, and failing to properly or timely repair a dangerous condition on the property.
Each of these instances of negligence, or tortious conduct, may result in the loss of personal liability protection of the LLC members.
LLC Asset Protection May Be in Doubt When Bankruptcy is Filed
A 2003 Colorado bankruptcy court decision casts doubt on the use of an LLC for asset-protection purposes. In In re Ashley Albright, the debtor was the sole member and manager of a Colorado LLC at the time of the bankruptcy filing. The LLC itself was not a debtor in bankruptcy. The Chapter 7 trustee contended that because the debtor was the sole member and manager at the time the debtor filed bankruptcy, the trustee now controlled the LLC and could therefore sell the real property owned by the LLC and distribute the net sales proceeds to the bankruptcy estate.
The debtor argued that the trustee only had the rights of a creditor (i.e., at most the Trustee could get an order entitling it to any distribution of assets or profits to the member) and could not assume management of the LLC or sell its property. The court referred to the Colorado LLC statute and stated that "[b]ecause there are no other members in the LLC, the entire membership interest passed to the bankruptcy estate, and the trustee became a 'substituted member.” The court also stated that the Trustee held all authority regarding governance of the LLC including decisions regarding liquidation of the entity's assets because there were no other members in the LLC.
Members’ Actions Can Create Liability to Creditors When Approaching Insolvency
Arizona Revised Statutes, Section 29-706 states:
“A limited liability company shall not make a distribution to a member to the extent that at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company would exceed the fair value of the assets of the limited liability company (with certain exceptions)."
The statutes further provides that
"If a member receives a distribution with respect to his interest in a limited liability company in violation of this chapter or an operating agreement, he is liable to the limited liability company for a period of six years thereafter for the amount of the wrongful distribution."
Several courts have held that as an entity approaches insolvency, i.e., becomes unable to pay its debts as they become due in the ordinary course of business, the directors owe a fiduciary duty to all the creditors of the company.
Though there are few reported cases, the question arises whether the members of an LLC, approaching or being insolvent, may distribute the assets of the LLC to themselves with impunity while the obligations to the creditors of the LLC go unsatisfied.
The Arizona statute gives the LLC members the right to seek reimbursement of a previous distribution to a member or former member in this situation because the member received distribution to the detriment of a creditor when the LLC was insolvent.
Does a creditor also have the right to seek such reimbursement from the LLC members? This question remains unanswered but the creditors may have a compelling argument that the members had a duty not to prefer themselves over the creditors when the LLC was insolvent or insolvency was imminent.
Mortgage Financing Issues: Unintended Violations of "Due-on-Sale or Transfer" Clauses
Property owners who form an LLC often own property in their personal name and have existing financing in place. Consistent with the vesting of title on the property in a personal name, the note and trust deed recorded on the property will have been signed in the owner’s personal name.
When the owner forms an LLC and transfers title to the LLC, what impact does this have on the existing loan?
Too often in this situation the owner simply forms the LLC for the personal liability protection and is unaware of the issues raised by title changes. If the owner doesn’t transfer title to the LLC, the owner remains personally liability for any claims against the owner of the property because the owner has personally remained on title, not the LLC.
If the owner records a grant deed transferring title to the LLC, the personal liability protection concern is addressed, but the owner has unknowingly compromised the foreclosure rights of the mortgage holder because the note and trust deed remain in individual names but the title is now held by the LLC.
With a standard deed of trust, the owner faces a possible undesirable and unintended consequence. Trust deeds commonly contain provisions known as “due-on-sale” or “due-on-transfer” restrictions in which the lender retains the right to call the loan due if the title to the property has changed without the lender’s consent. Does a transfer from an individual to an LLC in which the individual owner(s) retain the same ownership percentage as members as they did as individuals constitute a “transfer?”
The most logical resolution may be to contact the lender and determine whether they will permit the transfer of title to the LLC, and if so, what conditions will be imposed. The risk, of course, is that the lender may have a policy disallowing such transfers or may impose conditions such as increasing the interest rate, charging an assumption fee, or other unwelcome requirements.
If the lender is not contacted, either out of apprehension of such undesirable conditions being imposed or simply unawareness of any lender issues being involved in the property transfer, the question will remain as to whether the transfer has invested the lender with these powerful enforcement remedies.
Seek Advice Before You Start Your Real Estate LLC
Absent lender acquiescence to a transfer, a property owner is well-advised to seek the assistance of an attorney to analyze the particular trust deed involved and research the state court decisions to gain insight into how a transfer of title to the LLC may be viewed.
Whatever approach an owner decides to pursue, ï»¿it is an issue that should be considered ï»¿bï»¿eï»¿fï»¿oï»¿ï»¿ï»¿rï»¿eï»¿ making a decision to form an LLC to hold title to property.
Transferring Property to a LLC May Have Unanticipated Consequences with Property Insurance
If you own a parcel of real estate in your individual name, you undoubtedly also have a liability insurance policy on the property to cover you in the event someone, perhaps a tenant, is injured on the property. This liability insurance is usually written as a personal policy at personal rates.
When you transfer title on the property to an LLC, how does this impact your liability insurance policy? Can you simply add the LLC to your personal policy as an “additional insured?” It depends on your insurance carrier and possibly the insurance regulations in your state. The insurance regulations or carrier may require the liability insurance to now be rated as a commercial policy, which is generally significantly more expensive than an individual policy. Once again, this is an issue that should be investigated prior to forming the LLC and transferring title.
The main objective for an owner in forming an LLC to take title to property is to achieve the limited liability protection provided to LLC members. It is important to understand that this protection may not be unlimited. It is equally important to be aware of the myriad of additional issues that such a transfer of title may involve and consider each ï»¿oï»¿nï»¿eï»¿ carefully before implementing the LLC formation.