The Article 8 Opt In

Thus, knowing the proper and best way to perfect a security interest in a given type of asset is critical for parties and advisors involved in secured lending. Navigating the intricacies of the system can be challenging, even for experienced professionals. However, some types of assets present an extra degree of challenge because the best way to perfect interests in such assets may vary depending on the situation and the organizational documents of the entity in question. Membership interests in limited liability companies, general partnerships, and limited partnerships are one example of this phenomenon.

Security or General Intangible

In the absence of the steps discussed below, membership interests in limited liability companies and partnerships will be treated as general intangibles. Pursuant to ' 9-310 of the UCC, the means by which to perfect a security interest in a general intangible is the filing of a UCC-1 financing statement in the proper jurisdiction. UCC ' 9-310. Thus, assuming a secured lender has obtained a valid security interest in a limited liability company or partnership membership interest, once the financing statement is filed in the appropriate jurisdiction, the lender's interest will be perfected. If no other creditor has taken similar steps, the lender will have a first priority security interest in the membership interest (conversely, if another party has already taken the necessary steps to perfect a security interest in the entity's membership interest, then the “first to file” rules set forth in Article 9 will govern priority (see UCC ' 9-322)).

To illustrate, if Blue Bank agrees to provide financing to Red Corp., and as part of the transaction, Red Corp. grants Blue Bank a security interest in among other things its membership interest in Red LLC, then once Blue Bank files a financing statement in the appropriate jurisdiction, it will have a perfected security interest in the membership interest of Red LLC that is held by Red Corp.

However, a limited liability company or partnership may take certain steps which, for purposes of perfection under the UCC, will change the character of the entity's membership interest from a general intangible to a security. This is commonly referred to as the Article 8 “opt in.” Whether an entity has elected to opt in will affect the optimal means by which to perfect a security interest in the entity's membership interest.

The 'Opt In' Mechanism

For a limited liability company or partnership to “opt in” under UCC Article 8, the entity must adhere to the requirements contained in section 8-103 of the UCC. Specifically, an entity's operating agreement must contain explicit language stating that the entity has opted to have its membership interest treated as a security. See UCC ' 8-103(c). To effectively opt in under Article 8, an entity's operating agreement should contain language such as that shown below:

Each interest in [name of issuer] shall constitute and shall remain a 'security' within the meaning of (i) Section 8-102(a)(15) of the Uniform Commercial Code as in effect from time to time in the State of [state of organization of issuer] [cite to UCC in applicable state] and (ii) the Uniform Commercial Code of any other applicable jurisdiction that now or hereafter substantially includes the 1994 revisions to Article 8 thereof as adopted by the American Law Institute and the National Conference of Commissioners on Uniform State Laws and approved by the American Bar Association on February 14, 1995, and the [issuer] has, pursuant to the [list relevant organizational documents of the issuer], 'opted in' to such provisions for the purpose of the UCC. Notwithstanding any provision of this Agreement to the contrary, to the extent that any provision of this Agreement is inconsistent with any non-waivable provision of Article 8 of the UCC, such provision of Article 8 of the UCC shall be controlling.

When dealing with an entity that is considering the Article 8 opt in, or one that has already opted in, several issues are important to keep in mind. First, section 8-103's opt in provision explicitly applies only to limited liability companies, limited partnerships, and general partnerships; it does not apply to corporations or other entities.

Additionally, as section 8-103(c) of the UCC makes clear, an entity must expressly elect to have its membership interest treated as a security; otherwise, its membership interest will be treated as a general intangible. Thus, it is impossible for a limited liability company or a partnership to accidentally or inadvertently opt in.

Finally, for an entity that chooses to opt in, its membership interest can be certificated or uncertificated. If the entity chooses to issue certificates, the certificates will frequently (though not always) contain language noting that the entity has elected to opt in under Article 8. As discussed below, if an entity has elected to opt in, the lender will often require that the membership interest be certificated so as to enable the lender to take possession of the certificates.

Effect of Article 8 Opt In on Perfection

As noted above, if a limited liability company or partnership has taken the steps to opt in, then for purposes of perfection, the membership interest will no longer be classified as a general intangible ' rather, it will be classified as a security. In such an instance, the best way to perfect a security interest in the membership interest is no longer the filing of a financing statement; instead, the optimal perfection method is either control or possession.

If the membership interest is uncertificated, then the best means to perfect the security interest is through control. Conversely, if the membership interest is certificated, the best way for a secured party to perfect is to take possession of the certificate (methods by which to perfect a security interest in a security are addressed in UCC ” 9-310 (filing of financing statement), 9-312 (various means), 9-313 (possession), and 9-314 (control)). Even if an entity has elected to opt in, the filing of a valid financing statement will perfect the lender's interest; however, this method of perfection does not provide the lender with the highest form of protection, which is best achieved via control or possession. See UCC ” 9-312 and 9-328.

Dangers for the Unwary Lender

There are several risks for a lender providing financing secured, at least in part, by a membership interest in a partnership or limited liability company. If the lender perfects its security interest in the membership interest solely by filing a financing statement, and the entity has elected to opt in, then the lender is at risk of its security interest being trumped by a party that perfected either by control or possession, which are superior methods of perfection under Article 9 of the UCC. See UCC ' 9-328.

By way of illustration, if Blue Bank provides financing to Red Corp. and, as part of the transaction, Red Corp. grants Blue Bank a security interest in its membership interest in Red LLC, then once Blue Bank files a financing statement in the appropriate jurisdiction, it will have a perfected security interest in the membership interest of Red LLC that is owned by Red Corp. If Red LLC has not elected to opt in, then Blue Bank's priority would only be at risk if another party filed a financing statement that qualified as a prior filing under ' 9-322 of the UCC. However, if Red LLC did opt in, then Blue Bank's priority could be primed by another party that perfects by control or possession of Red LLC's membership interest. This would be the result even if the other party perfects its interest after Blue Bank files its financing statement.

Another ongoing risk for a lender is an entity's ability to change its opt-in status. A lender's security interest may be weakened or abrogated if the entity either opts in or elects to opt out after the lender has taken necessary steps to perfect its security interest in the entity's membership interest. For example, if Red LLC opts in after Blue Bank provided Red Corp. with financing, and another lender subsequently perfects by control or possession of the membership interest, then Blue Bank would face the same priority issues discussed above.

Conversely, if an entity chooses to opt out after a lender has provided financing, and the lender has not filed a financing statement perfecting its security interest in the entity's membership interest, then the lender will be unperfected, since the entity's membership interest will be classified as a general intangible which, as noted above, can only be perfected through the filing of a financing statement.

Consequently, many lenders require a borrower to affirmatively represent and warrant that any limited liability company or partnership whose membership interest is being pledged as security either has or has not elected to opt in under Article 8, and that such entity will not alter its election status. Additionally, when an entity has opted in, many lenders require the entity's membership interest to be certificated and possession of the certificates to be transferred to the lender.

Conclusion

The Article 8 opt-in election adds an additional layer of complexity to the already labyrinthine rules governing perfection of security interests under the UCC. A lender that is unaware of the nuances created by the opt in (or if the entity's Article 8 opt in status is different than the lender believes) may find its security interest vulnerable to being primed by another party that has taken steps to perfect in a superior manner under the circumstances. Even worse, the lender may discover that it is unperfected entirely with respect to the membership interest in question.

As a final matter, it is also worth noting that while the opt in provides additional complications with respect to perfection of security interests in limited liability and partnership membership interests, the opt in may also provide several additional benefits for a secured lender. Among other things, when an entity has elected to opt in, a secured lender may in certain circumstances qualify as a protected purchaser under ' 8-303 of the UCC. As these added opt-in benefits are worthy of a separate article unto itself, a fuller discussion of them will come at a later date.

Andrew L. Turscak, Jr. is a partner and James J. Henderson is an associate in the Business Restructuring, Creditors' Rights & Bankruptcy Group at Thompson Hine LLP in Cleveland. They can be reached at [email protected] and [email protected], respectively.