Collateral Assignment of an Entity Interest: Economic v. Governance Rights

Bernstein-Burkley, P.C.

In these difficult economic times, debtors have become more creative in proposing additional or substitute sources of collateral to secure a debt or obtain a forbearance or loan modification. As real estate values have plummeted, alternatives have become more attractive, including an assignment of the debtor’s interest in an operating entity with good cash flow.

However, the recent decision of the Pennsylvania Superior Court in Zokaites v. Pittsburgh Irish Pubs, LLC, 962 A.2d 1220 (Pa. Super. 2008), appeal denied 972 A.2d 523 (Pa. 2009), provides food for thought in terms of structuring and drafting a collateral assignment of an interest in a limited liability company or partnership. In Zokaites, a creditor was attempting to enforce its judgment lien by executing upon the debtor’s interest in two limited liability companies (“LLC”) that owned and operated several Pittsburgh area restaurants. The creditor sought a court order to compel the debtor to transfer its ownership interest in the LLCs so those interests could be sold at sheriff’s sale. After much procedural wrangling in both state and bankruptcy court, the case ended up in the Superior Court, which looked to Pennsylvania’s Limited Liability Company Law, 15 Pa.C.S. §8901 et seq. (“LLC Law”), for guidance.

The Superior Court focused on a provision in the LLC Law that prohibits a transferee of an LLC interest from becoming a member or participating in the company’s management without the approval of all other LLC members. The same provision, however, allows a transferee to receive the LLC member’s distributions or other return of capital contributions. Because of this protection of an LLC’s “close-knit structure,” the Superior Court decided that a judgment creditor can secure a debtor’s economic rights to distributions and return of contributions from the LLC, but cannot obtain the debtor’s governance rights to vote and participate in managing the LLC. The Superior Court equated this remedy of obtaining the economic rights in an LLC interest to the “charging order” that is permitted against a partnership interest under Pennsylvania’s Uniform Partnership and Limited Partnership Acts (“Partnership Acts”).

In light of the decision in Zokaites, lenders considering accepting a collateral assignment of an entity interest should keep a few things in mind for due diligence and drafting purposes. First, where a debtor has interests in multiple related entities, have the debtor provide an organizational chart. It is often easier to understand a complex organizational structure from a chart or “tree” than from a description. The chart should show the relationship among the entities and include the names of each entity and the percentage interest the debtor owns. For example, in a recent transaction where several guarantors were proposing to pledge their interests in a variety of LLCs and partnerships that in turn were the general and limited partners of other entities, an organizational chart prepared by the debtor was a crucial tool in pinpointing who owned what and in targeting the collateral.

Second, once you understand what entity interest(s) the debtor owns, it is essential to carefully review a copy of the organizational agreement and any amendments (the LLC Operating Agreement or the Partnership Agreement) for each entity. Key provisions include transfer or assignment rights or restrictions and default and dissolution provisions. If the organizational agreement expressly permits assignment, then the limitations under the LLC Law and the Partnership Acts do not apply1. Most likely, however, the LLC or partnership interest will not be assignable without the other members’ or partners’ consent. It is also important to understand whether an assignment will trigger an unwanted result such as a dissolution or default.

Third, once you know what is owned and can be pledged, draft the assignment to specifically identify the entity interest being pledged. Taking into account the ruling in Zokaites, where not all of the LLC members or partners are involved, a pledge of economic rights only is more likely to be enforceable than a collateral assignment that appears to transfer governance and other rights as well. In most instances, the cash flow from the right to receive distributions, profits, and return of capital is the true collateral anyway.

In describing complex or multiple entity interests or owners, consider attaching as exhibits the organizational chart and a table identifying each debtor, the entity, and the percentage interest owned. Include in the body of the assignment representations and warranties by the debtor confirming all of the information on the chart and table as true, complete and correct and that the debtor’s interest has not already been pledged or assigned.

Fourth, since the creditor will not have governance rights, the pledge agreement should also contain covenants to protect the creditor’s right to receive distributions. Such covenants would include prohibiting the debtor from voting to amend the Operating or Partnership Agreement or to dissolve the entity. Another useful provision would be the debtor’s authorization for the LLC or partnership and its officers to recognize and give effect to the collateral assignment by paying distributions directly to the creditor or lender upon demand. Finally, when the assignment is being made by a married individual, if possible have the spouse join in to waive any marital or spousal interest.

Assignment of a debtor’s interest in an LLC or partnership can be a valuable and useful form of collateral. But the creditor should follow the money and remain mindful of the Zokaites decision by taking a pledge of the economic rights and leaving the governance rights alone, unless all of the entity owners consent.

1. Similar to the LLC Law, the Partnership Acts contain provisions that, unless otherwise agreed, the assignee of a partner’s interest does not become a partner or share in partnership liability and cannot exercise a partner’s management, inspection of records, or accounting rights, but has the right to profits. 15 Pa.C.S. §8344(a) and 15 Pa.C.S. §8562(a)(2)and (c).

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