Pledge Agreements for Equity Interests and LLCs

Presenting a live 90‐minute webinar with interactive Q&A

Pledge Agreements for Equity Interests Pledge Agreements for Equity Interests in Partnerships and LLCsDrafting Security and Operating Agreements to Maximize Protection for Lenders

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, APRIL 2, 2013

Today’s faculty features:

James D. Prendergast, SVP, Legal Counsel-UCC Division, First American Title Insurance Company, Santa Ana, Calif.

Grant Puleo, Partner, Procopio Cory Hargreaves & Savitch, Carlsbad, Calif.

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CLE Webinar

Pledge Agreements for Equity Interests as Collateral

April 2, 2013

© 2013 First American Title Insurance Company andProcopio, Cory, Hargreaves & Savitch LLP

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FIRST AMERICANEAGLE 9® UCC Division

FIRST AMERICANTITLE INSURANCE COMPANY


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EAGLE 9® UCC Division

UCC EAGLE 9®UCC EAGLE 9®

NEW PROGRAMS NEW SOLUTIONS!NEW PROGRAMS, NEW SOLUTIONS!


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RESOURCESEAGLE 9® UCC Division

Domain Name (URL): www.eagle9.com E mail Address: eagle9 ucc@firstam com E-mail Address: [email protected] Toll Free Number: 800.700.1191 UCC Division Legal Team: UCC Division Legal Team: Randy Scott, President & Counsel Jim Prendergast, Senior Vice President and g

Associate General Counsel Brad Gibson, Vice President and General

CounselCounsel


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MarketingEAGLE 9® UCC Division

Marketing

Jill Sharif, Vice President, National Sales Director, 703.480.9541

Gina Sanchez, National Marketing Coordinator 714 250 8640Coordinator, 714.250.8640


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Procopio Cory Hargreaves & Savitch LLPProcopio, Cory, Hargreaves & Savitch LLP

525 B Street525 B StreetSuite 2200San Diego, CA 92101g ,619.238.1900

1917 Palomar Oaks WaySuite 300Carlsbad, CA 92008760.931.9700 www.procopio.com


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Grant Puleo EsqGrant Puleo, Esq.PartnerProcopio, Cory, Hargreaves & Savitch LLP

1917 Palomar Oaks Way, Suite 300 Carlsbad, California 92008

Direct Phone: 760.496.0776 Email: [email protected] p @p p Bio: www.procopio.com/attorneys/grant-puleo


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Equity Collateral1. Secured Creditor status in equity collateral

2. Protected Purchaser status in equity collateral

3. Membership Interest issues


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What is Mezzanine Lending?

“Mezzanine lending means lending to aMezzanine lending. . .means lending to a borrowing entity or group of entities that directly or indirectly owns a real property-owning entity,

hi h d bt i d b f t d fi twhich debt is secured by a perfected first security interest in the mezzanine borrower’s pledged ownership interests in the propertypledged ownership interests in the property owner”

(R t b M d ’ I t S i titl d “US CMBS d CRE CDO M d ’(Report by Moody’s Investors Service titled “US CMBS and CRE CDO: Moody’s Approach to Rating Commercial Real Estate Mezzanine Loans,” the “Moody’s Report,” page 3)


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What is Mezzanine L di ?Lending?

THEREFORE A PERSONALTHEREFORE A PERSONALPROPERTY SECURED

TRANSACTION!TRANSACTION!


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Mezzanine Lending

Real PropertyLender

Owner ofReal PropertyMortgage Loan p yg g

Equity Owners

MezzanineLender

AB

Equity Owners

Lender

Equity Secured Loans


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Mezzanine Lending

Property Owner ofPropertyLender Property

Mezzanine A B

Mortgage Loan

Equity Co-BLender #1

A BOwnersBorrowers

DC EMezzanineLender #2

F G HMezzanineLender #3

Mezzanine Loans

IMezzanineLender #4


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Law is the Same

PLEDGED EQUITY LENDING

L dLender BorrowerAsset Based

Loan

AEquity Secured

Equity Owners

A BEquity Secured Guarantees


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A GUIDE TO THINKING ABOUT PERFECTIONABOUT PERFECTION

Step 1: Does Article 9 Apply? Step 2: Attachment Step 3: Categorize the Collateralp g Step 4: Perfection Step

Filing (§9-310)g (§ ) Perfection under non-Article 9 law (§9-311(a)) Possession (§9-313)

C t l (§§9 314 9 104 9 106 8 106) Control (§§9-314, 9-104, 9-106, 8-106)

Step 5: Priority Consequences


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Lien Perfection

Perfection of liens (security(security interests) in )equity interestinterest collateral.


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US CMBS and CRE CDO: Moody’sUS CMBS and CRE CDO: Moody s Approach to Rating Commercial Real Estate Mezzanine LoansMezzanine Loans

Pledge of 100% of the equity Opt In to Article 8 Certificate the Equity File a Financing Statement Control the ability to Opt Out

– hardwire or proxy UCC Insurance


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Issues in Negotiating g gMezzanine Loan Documentation Pledge Agreement UCC Insurance/Title Insurance Borrower Organizational Documents Usury Usury Senior Encumbrances

di A Intercreditor Agreements Lender’s Remedies


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A DIFFICULT MARKET CAN TESTCAN TEST

(AND IMPROVE) LOAN DOCUMENTS


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Knowing What Your Documents SayDocuments Say


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Further Refining LoanFurther Refining Loan Documents to Stop “Gaming”

by Defaulting Borrowers


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NEED TO CONSIDER NOT ONLYNEED TO CONSIDER NOT ONLY

SECURED CREDITOR STATUS UNDER ARTICLE 9 OF THE UCC;BUT ALSO

PROTECTED PURCHASERSTATUS UNDER ARTICLE 8 OFSTATUS UNDER ARTICLE 8 OF THE UCC


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Protected Purchaser Status and Equity Ownership CoverageOwnership Coverage

Mezzanine Endorsement –Primary Obligor

LENDER’S POLICY

Primary Obligor

Pledged Equity EndorsementEndorsement –Secondary Obligor

BUYER’S POLICY Equity Ownership Endorsement


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NEMO DAT QUOD NONQUOD NON HABET*HABET*

*“No man can give what he does not have”


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have

EXCEPTIONS TO NEMO DAT:

o Negotiable Promissory Notes

o Negotiable Bills of Lading

o Securities under Article 8 – if a Protectedo Securities under Article 8 if a Protected Purchaser


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“In addition to acquiring the rights of a purchaser, a Protected P rchasera Protected Purchaser also acquires its interest qin the security f f d l i ”free of any adverse claim.” §8-303(b)


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§ ( )

FIRST STEP IS TO BE AFIRST STEP IS TO BE A SECURED CREDITOR BY CONTROL OF A SECURITY UNDER ARTICLE 8 andUNDER ARTICLE 8 and INVESTMENT PROPERTY UNDER ARTICLE 9UNDER ARTICLE 9


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NOTE: If entity subsequently opts-in to be a security under Article 8 (no way to prevent), then Protected Purchaser has priority in security over first lien-holder who perfected by filing!

Is it a security under Art. 8? Perfection by Filing Perfection by Filing

Financing StatementFinancing Statement

WINS over

fili !under Art. 8? Financing StatementFinancing Statement

NO

filing!

Perfection by Perfection by P iP i

EntityEntityOwnership Ownership I t tI t t

NO

Certificated

Possession + Possession + Endorsement Endorsement

ControlControlInterestsInterests YES

Certificated

Uncertificated

Perfection by Perfection by Control Control

AA

Is it certificated or uncertificated ?


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AgreementAgreementuncertificated ?

THEN BE A PROTECTEDTHEN BE A PROTECTED PURCHASER UNDER

ARTICLE 8


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S ti 8303 f th U C C d fiSection 8303 of the U.C.C. defines a“Protected Purchaser” as a purchaser of a

it i t t hsecurity or an interest who:i. Gives value.ii. Does not have notice of any adverse claim to

the security.Obt i t l f th itiii. Obtains control of the security.


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ARTICLE 8 d ARTICLE 9ARTICLE 8 and ARTICLE 9 -INTERRELATIONSHIP

ARTICLE 8 ARTICLE 9

Opt-In to Article 8 – LLC Investment Propertypor Partnership Interest

a Security

p y

yProtected Purchaser Perfection by Control


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I WIN!!!!!!

A Case Study

Ultimate ParentStep #1

Equity Owner –

p

Equity Owner –California LLCFirst Mezzanine

Lender Loan Secured byPledge of Equity

Property Owner –Delaware LLC

Pledge of EquityIn Delaware SubLender Perfects Security

Interest in Pledged Equity by Filing UCC-1 with CA

The Property

by Filing UCC 1 with CASOS


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p y

A Case Study


Old Equity Owner –

First Mezzanine

NewEquity Owner-

SecondMezzanine

California LLCLenderq y

Delaware LLC1.3.

1 S ll E it O hi i S b

Lender2.

2 P id NProperty Owner – Delaware LLC

1. Sells Equity Ownership in Subto Sister Sub for $100,000,000

2. Provides New Mezzanine LoanSecured by EquityOwnership in Del.

The Property

Ownership in Del. Sub – Perfects by Control and Protected Purchaser

3. Pays Off First Mezzanine Lenderwith Proceeds of Mezz Loan fromSecond Mezzanine Lender


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A Case Study


Old Equity First M i

New SecondOwner –

California LLCMezzanine

LenderEquity Owner-Delaware LLC

MezzanineLender

First Mezzanine Lender Sues OldEquity Owner for Conversion BasedOn Fraudulent Conveyance Alleging

Property Owner – Delaware LLC

On Fraudulent Conveyance AllegingProperty Worth $400,000,000 andWants $2,000,000 kicker

The Property


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Mezzanine Loans :Th V i fThe Vagaries of

Membership Interest Collateral


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Discussion Question #1Discussion Question #1$30,000,000 mezz loan to DE LLCLender & lender’s counsel – CaliforniaDocumentation standard California loan docsDocumentation – standard California loan docsCollateral description – simple & clear:

“100% of my membership interest in XYZ, LLC, a Delaware limited liability company.”

Any problems?© 2013 First American Title Insurance Company and

Procopio, Cory, Hargreaves & Savitch LLP

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y p

“M b hi I t t” C ll t l“Membership Interest” Collateral

“Membership Interest” in the LLC Colloquialism describing intended collateral Assumed by many to consist of both economic

rights and control rights Can appear in

Granting clauses of security agreements Collateral descriptions in related UCC1 financing

statements Control agreements


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Control agreements

“M b hi I t t” C ll t l“Membership Interest” Collateral

But in Delaware? “Membership Interest” is fraught with ambiguity Term does not appear in the Delaware LLC Act Instead the Delaware LLC Act discusses

Economic Rights Control Rights Member Status

So why use the term “Membership Interest?”


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St t ’ L Diff (!)States’ Laws Differ (!)

California’s LLC Act uses the term “a member’s right in the LLC, collectively,

including the member’s economic interest, any right to vote or participate in management, and any right to information concerning the businessany right to information concerning the business and affairs of the LLC”(California Limited Liability Company Act § 17001(z))(California Limited Liability Company Act § 17001(z))


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New York’s LLC Act uses the term “a member’s aggregate rights in an LLC,

including, without limitation, (i) the member’s right to a share of the profits and losses of the LLC (ii) the right to receive distributions fromLLC, (ii) the right to receive distributions from the LLC, and (iii) the member’s right to vote and participate in the management of the LLC”participate in the management of the LLC(New York Limited Liability Company Law § 102(r))


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Florida’s LLC Act uses the term “a member’s share of the profits and losses of the

LLC, the right to receive distributions of the LLC’s assets, voting rights, management rights, or any other rights under this chapter or theor any other rights under this chapter or the articles or organization or operating agreement”(Florida LLC Act § 608 402(23))(Florida LLC Act § 608.402(23))


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“Membership Interest” is defined fairly consistently in various states

But a great many mezzanine loans are intended to be secured by interests in a Delaware LLC


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Discussion Question #2

Membership interest.Limited liability company interest.Isn’t it obvious that we mean everything?Isn t it obvious that we mean everything?


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Dela are Disting ishes Economic RightsDelaware Distinguishes Economic Rights, Control Rights, and Member Status

A “limited liability company interest” is “a b ’ h f h fi d l fmember’s share of the profits and losses of an

LLC and a member’s right to receive distributions of the LLC’s assets”distributions of the LLC s assets

(Delaware LLC Act § 18-101(8))

LLC interest is merely economic LLC interest is merely economic – Herein, for clarity, “Economic Rights”


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Delaware Distinguishes Economic Rights, Control Rights, and Member Status

In Delaware an LLC interest is merely an E i Ri ht d d NOT i l dEconomic Right, and does NOT include Right to manage or control Right to information and review of LLC books

and recordsRi h l di l i Right to compel dissolution


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Delaware Distinguishes Economic Rights, Control Rights, and Member Statusg ,

In Delaware management of a single-member C i di il h l i i fLLC is ordinarily the exclusive province of

the sole member Herein, for clarity, “Control Rights” Unless otherwise provided, members hold

Control Rights in proportion to their Economic Rights


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Delaware Distinguishes Economic Rights,Delaware Distinguishes Economic Rights, Control Rights, and Member Status

In Delaware, Control Rights can be vested in “managers” who need not be members Managers can be further designated as officers,

directors, or otherwise The Delaware LLC Act provides few operational

requirements and procedures for exercising C t l Ri htControl Rights

Such matters should be addressed in the LLC Agreement


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Agreement

Delaware Distinguishes Economic Rights,Delaware Distinguishes Economic Rights, Control Rights, and Member Status

In Delaware, a “Member” is simply a person who is admitted to an LLC as a member

(Delaware LLC Act § 18-101) Herein, for clarity, “Member Status” Member Status bears little fixed correlation to

Economic Rights or Control Rights A Member need not have any Economic Rights

or Control Rights at all


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Di i Q ti #3Discussion Question #3

Revised collateral description:“100% of my membership interest in XYZ,

LLC, a Delaware limited liability company, including without limitation all of the economic i d h i h h i linterest and the right to vote or otherwise control the LLC.”

A bl ?Any problems?


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Economic Rights and theEconomic Rights and the Anti-Assignment Override

Delaware’s LLC Act explicitly incorporates the public policy to give “maximum effect to the principle of freedom of contract and to theprinciple of freedom of contract and to the enforceability” of LLC agreements Delaware LLC Act § 18 1101(b)) Delaware LLC Act § 18-1101(b))

Delaware permits and enforces restrictions on the alienability of rights and statuses relating to LLCs -alienability of rights and statuses relating to LLCs Economic Rights, Control Rights, and Member Status


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Economic Rights are assignable unless the LLC agreement provides otherwiseD l LLC A t § 18 702( )Delaware LLC Act § 18-702(a)

UCC Article 9 generally overrides restrictions on assignment of certain rights to receive paymentsassignment of certain rights to receive payments (§406 and 408)

Are anti-assignment provisions effective withAre anti assignment provisions effective with respect to Economic Rights?


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The Delaware LLC Act provides that UCC 9-406 and 408 do not apply to “any interest in an LLC” “including all rights, powers and interests arising under an

LLC t thi h t ”LLC agreement or this chapter.” “This provision prevails over §§ 9-406 and 9-408 of

[UCC Article 9]. [ ] For Delaware LLCs, there’s no override for Economic

Rights, Control Rights, or Member Status.


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Debtor & SP agreed the Security Agreement is governed by California law.

Don’t California’s UCC and California’s definition of “membership interest” control?


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"whether a debtor's rights in collateral may be voluntarily or involuntarily transferred is governed by law other than this article ”by law other than this article. UCC Article 9 Section 401(a)

“S b ti ( ) dd th ti h th “Subsection (a) addresses the question whether property necessarily is transferable by virtue of its inclusion within the scope of Article 9 It gives ainclusion . . . within the scope of Article 9. It gives a negative answer . . . .” Official Comment 4 to Section 401


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E i Ri ht d thEconomic Rights and the Anti-Assignment Override

This result is harmonious with the internal affairs doctrine “a state should not regulate the internal operations g p

of a foreign corporation but leave such governance to the state of incorporation.” 18 Am. Jur. 2d Corporations § 15 (2d ed. 2008).


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Further revised collateral description:“100% of my membership interest in XYZ, LLC, a Delaware limited liability company, including without limitation all of the economic interest and the right to vote or otherwise control the LLC and all my rights as a member.”

Any problems?


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The Further Challenge of Control Rights &The Further Challenge of Control Rights & Member Status

l h id h i Unless the LLC agreement provides otherwise, "[a]n assignment of a limited liability company interest does not entitle the assignee to become or to exercise any rights or g y gpowers of a member."

Section 18-702(b)(1) The assignee of a member's Economic Rights “shall have no

right to participate in the management of the business and affairs of a limited liability company except as provided in a y p y p plimited liability company agreement”. Delaware LLC Act § 18-702(a).


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§ ( )


Summary observations on Economic Rights Delaware law is clear and controlling Default rule - a secured party can freely enjoy

Economic Rights Exception - subject to compliance with any

restrictions in the LLC Agreement Assignment doesn’t affect Control Rights Assignment for security doesn’t affect Member


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Status


Summary observations on Control Rights Delaware law is clear and controlling Default rule - a secured party has no Control

Rights Exception – a secured party has whatever rights

it’s given in the LLC Agreement Note: Control Rights are positively correlated

with Member Status unless otherwise providedi f C l Ri h i M


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e.g. vesting of Control Rights in a Manager


Summary observations on Member Status Delaware law is clear and controlling Default rule - a secured party has no right to

Member Status Exception – as provided in the LLC agreement

and upon Approval of all members, or Compliance with procedure in LLC Agreement


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F l G Y Wh E l ?Foreclosure Gets You What, Exactly?

Under the Delaware default rules Secured party succeeds to all Economic Rights,

but to neither Control Rights nor Member Status Debtor Member (or Manager) retains Control Rights

D b M b i M b S Debtor Member retains Member Status

The party with incentive to “run” the LLC has no power to do sopower to do so

The party with power to “run” the LLC has no incentive to do so


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incentive to do so


What if there’s a foreclosure? Under Article 9 the purchaser will succeed to all of the

i ht th d bt h l d d ll t lrights the debtor has pledged as collateral. Under the Delaware LLC Act a different result follows

(unless the parties contract otherwise)( p ) no one can possess Control Rights or achieve Member Status

absent approval of any remaining members or as provided in the LLC agreementLLC agreement.

Even the outright assignee of Economic Rights does not automatically or necessarily succeed to the Member Status lost by his assignor


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by his assignor.


Granting of a security interest is a type of assignment

An assignee does not achieve Member Status or possess Control Rights absent facilitative language in the LLC agreement or consent by the other members


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Foreclosure Gets You What, Exactly?

If the debtor member loses Member Status and the secured party does not achieve Member Status, the LLC has no members It must commence dissolution and winding up


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C l iConclusions

Always describe the collateral by use of words and phrases with antecedents in the Delaware LLC Act or the relevant LLC Agreement The term “membership interest” appears nowhere

in the Delaware LLC Act


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C l iConclusions

The Delaware LLC Act is controlling with respect to prohibitions on and preconditions to the granting of a security interest, even those merely in Economic Rights Economic Rights can be pledged unless restricted Control Rights and Member Status cannot be

pledged absent facilitative language or action


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C l iConclusions The Delaware LLC Act affords the contractual

flexibility necessary to facilitate a secured party’s succeeding to Economic Rights Control Rights andsucceeding to Economic Rights, Control Rights, and Member Status

LLC Agreements and Security Agreements need to LLC Agreements and Security Agreements need to be drafted with great care to facilitate that outcome

Audit or review of existing security interests and Audit or review of existing security interests, and corrective measures, may be warranted


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S t d t t b dd d i i lSuggested concepts to be addressed in special section of LLC agreement

Supercedes all other provisions of LLC p pagreement

LLC agreement provides rights to and can be LLC agreement provides rights to and can be enforced by secured party (18-201(7))

Member may transfer or assign his LLC Member may transfer or assign his LLC interest to secured party


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Suggested concepts to be addressed in specialSuggested concepts to be addressed in special section of LLC agreement (cont’d)

all of the Member’s right, title, and interest in the LLC, whether derived under the Certificate of Formation the LLC Agreement the LLC Act orFormation, the LLC Agreement, the LLC Act, or otherwise, including without limitation

its “limited liability company interest” (as such term is its limited liability company interest (as such term is defined in Section 18-101(8) of the Statute),

the Member’s status as a “member” (as such term is defined in Section 18-101(11) of the Statute), and

the Member’s right to participate in the management of the business and affairs of the LLC


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of the business and affairs of the LLC


the Lender or other successful bidder at a foreclosure sale or other disposition automatically succeeds to the debtor’s “limited liability company interest” (as such term

is defined in Section 18-101(8) of the Statute), status as a “member” (as such term is defined in

S i 18 101(11) f h S ) dSection 18-101(11) of the Statute), and right to participate in the management of the

b i d ff i f th LLC© 2013 First American Title Insurance Company and

Procopio, Cory, Hargreaves & Savitch LLP

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business and affairs of the LLC


the Lender or other successful bidder at a foreclosure sale or other disposition is deemed admitted as a member of the Company

immediately before the Member ceases to be a bmember,

has power and authority to remove managers, and has power and authority to amend & restate LLC

Agreement.


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if at any time the LLC would otherwise dissolve, such dissolution shall not occur if the Lender designates a successor member for

admission to the LLC (Section 18-801(a)(4)(b)), Such admission shall be consummated and

memorialized in any manner designated by the L d i it di tiLender in its discretion.


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FORECLOSURE


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