A Newsletter of the Real Estate Law Committees
of the Association of the Bar of the City Of New York

Perfecting Security Interests in LLC and Partnerships under Revised Article 8 and Article 9 of the UCC

by Aine M. Santry¹

Most states have enacted revised Article 8 ("Revised Article 8") of the Uniform Commercial Code ("UCC") with the intent and purpose of providing clarity and certainty regarding the rules that govern how interests in securities are evidenced and transferred. One result of such revisions is that limited liability company ("LLC") interests and partnership interests (collectively, the "Interests") are now, subject to three limited exceptions discussed below, excluded from the definition of Article 8 "securities" and instead become subject to the requirements of Article 9 of the UCC ("Article 9"). The procedure for perfecting a security interest is much simpler under Article 9 than under Article 8. Therefore, in general, the perfection of a security interest in the Interests has been simplified by the enactment of Revised Article 8.

On October 10, 1997, New York enacted Revised Article 8, bringing New York into conformity with 39 other states that previously enacted Revised Article 8. Although such revisions made extensive changes to Article 8 of the UCC, over two years after the enactment of Revised Article 8, many lenders and practitioners alike are still unaware of the effect of the revisions upon perfecting security interests in the Interests. Pursuant to Revised Article 8 and subject to the exceptions and qualifications described below, a security interest in the Interests can generally be perfected by simply filing a financing statement in the appropriate filing office (i.e., the state in which the debtor [i.e., the grantor of the security interest] is located²), as prescribed by Article 9.

Revised Article 8 explicitly excludes the Interests from its coverage, subject to the following three infrequent exceptions:³ (i) the entity "opting-in" to Revised Article 8 by making a statement to that effect in its organizational documents, (ii) the Interests being held in a brokerage account or similar securities account, and/or (iii) the Interests being traded on a securities exchange or in securities markets. Moreover, the Interests are not expressly covered by any provision of Article 9. Therefore, subject to the three aforementioned exceptions, if Revised Article 8 is in effect, as in New York State, security interests in the Interests should, by default, be treated as Article 9 "general intangibles" which can be perfected by filing a financing statement in the appropriate filing office.

When determining how to perfect a security interest in the Interests, a lender's due diligence should include reviewing the entity's organizational documents to confirm (a) whether the entity "opted in" to Revised Article 8, (b) whether the Interests are certificated or uncertificated, (c) whether the Interests are traded on a securities exchange or in securities markets, and (d) whether the consent of any member, manager or partner is required in order to effect the grant of a security interest in the Interests.

Moreover, a prudent lender will require a legal opinion from the debtor's counsel with respect to (i) the enforceability of the security agreement and (ii) the validity and enforceability of the security interest granted. Finally, the lender's counsel should confirm whether the Interests are traded on a securities exchange or held in a brokerage account or by another securities intermediary.

If the LLC and/or partnership has "opted-in" to Revised Article 8, a lender can still usually perfect by filing a financing statement in the appropriate filing office. However, there are superior methods of perfection under Revised Article 8 that afford a lender priority over lenders that perfected their security interest by filing alone. For example, if a secured party obtains "control"⁴ over the Interests by entering into a control agreement with the LLC and/or partnership, as applicable, that security interest will have priority over any prior or subsequent security interest perfected by filing alone. Therefore, if the security interest is in the membership or partnership interests in an LLC or partnership that "opted in" to Revised Article 8 and is perfected by filing alone, even though that secured party is "first in time," priority will nonetheless be given to the secured party that subsequently perfects its security interest by obtaining "control" over the subject Interests.⁵

In most instances, a lender will be able to perfect a security interest in the Interests by simply filing a financing statement in the appropriate filing office. However, a prudent lender should also consider perfecting under Article 8. If the Interests are certificated, whether old or Revised Article 8 is applicable, the lender will need to obtain possession of the certificate(s) together with any necessary endorsements thereto. If the Interests are uncertificated and old Article 8 is applicable the lender should become the registered pledgee of the Interests. However, if the Interests are uncertificated and Revised Article 8 is applicable (e.g., the LLC and/or partnership has elected to "opt-in" to Revised Article 8 or the Interests are held in a brokerage account), the lender will need to perfect its security interest by obtaining "control" under Revised Article 8 (i.e., the lender will need to enter into a control agreement with the LLC and/or partnership, as applicable, whereby the LLC and/or partnership agrees to act on the lender's instructions without the further consent of or direction from the debtor).

Unless and until Revised Article 8 is adopted in all 50 states, there is still a possibility that a court will treat the Interests as securities under old Article 8. Therefore, lenders should perfect their security interests in the Interests under both Article 9 and old Article 8.⁶

Endnotes

¹ Aine M. Santry is an associate in the Real Estate Department of Sidley & Austin.

² A Revised Article 9, which, among other things, amends the definition of a debtor's "location" with respect to any entity created by a filing with a state, from the state of the debtor's chief executive office to the state in which such entity was created, has been presented to all 50 states for adoption and the proposal has an effective date of July 1, 2001.

³ U.C.C. §8-103(d)(1994).

⁴ See U.C.C. §8-106 (1994).

⁵ However, security interest perfected by filing alone is strong enough to survive a challenge by a bankruptcy trustee.

⁶ See In re Turley, 172 F.3d 671 (9th Cir. 1999); Capitran, Inc. v. Great Western Bank, 872 P.2d 1370 (Colo. App. 1994); In re Holiday Intervals, Inc., 931 F. 2d 500 (8th Cir. 1991)(the holdings in each of the foregoing emphasize the wisdom of perfecting under both Article 8 and Article 9 when the collateral could be viewed as either instruments or general intangibles).