Membership interest as collateral is an increasingly common financing technique for LLC owners seeking loans, but it presents unique legal challenges under the Uniform Commercial Code and state LLC statutes. Lenders and borrowers alike must understand how security interests in membership interests are created, perfected, and enforced.
Howard East’s corporate attorneys structure secured transactions involving LLC interests across Illinois, Missouri, and New York.
Creating a Security Interest for Membership Interest as Collateral
A security interest in an LLC membership interest is created through a security agreement between the borrower (member) and the lender. The agreement must describe the collateral (the membership interest), be authenticated by the borrower, and be supported by value given by the lender. The borrower must have rights in the membership interest at the time the security interest attaches.
Perfection Under the UCC
Perfection — the step that establishes priority over other creditors — depends on whether the membership interest is classified as a “security” under Article 8 of the UCC or a “general intangible” under Article 9. If the LLC’s operating agreement opts into Article 8, perfection may require possession or control of a certificated interest. If the interest is a general intangible, perfection is achieved by filing a UCC-1 financing statement with the Secretary of State.
It is important to note that the priority of a security interest in membership interest as collateral depends on the timing of the UCC-1 filing. A lender who files first generally has priority over subsequent creditors. Lenders should monitor for lapses, as a UCC-1 financing statement typically expires after five years unless renewed with a continuation statement.
Operating Agreement Restrictions
Most operating agreements restrict or prohibit pledging membership interests without the consent of other members. A security interest granted in violation of these restrictions may be unenforceable against the LLC. Lenders must review the operating agreement before accepting a membership interest as collateral and negotiate any necessary consent or amendment.
Foreclosure and Enforcement
If the borrower defaults, the lender can foreclose on the pledged membership interest through a UCC Article 9 disposition. However, the buyer at foreclosure may only receive an assignee interest — economic rights without management or voting authority — unless the operating agreement permits full membership transfer.
Frequently Asked Questions About Membership Interest as Collateral
Can you use an LLC membership interest as collateral for a loan?
Yes, an LLC membership interest can serve as collateral for a loan. The lender and borrower must execute a security agreement identifying the membership interest as collateral. The lender perfects its security interest by filing a UCC-1 financing statement with the appropriate state authority.
What happens if the borrower defaults on a loan secured by membership interest?
If the borrower defaults, the lender may foreclose on the membership interest. Depending on the operating agreement and state law, the lender may acquire economic rights to distributions or full membership rights including voting and management authority.
Does the operating agreement affect whether membership interest can be pledged?
Yes. The operating agreement is the most important document to review before pledging membership interest as collateral. Many include anti-assignment clauses or consent requirements that limit what a lender can acquire upon foreclosure.
In many states, the primary remedy available to a creditor who forecloses on a membership interest as collateral is a charging order. A charging order entitles the creditor to receive distributions that would otherwise go to the debtor-member, but it does not grant management rights or the ability to force a distribution. Some states allow foreclosure beyond charging orders, permitting the creditor to acquire full ownership of the membership interest through a judicial sale. Understanding the distinction between these remedies is critical for both lenders structuring secured transactions and borrowers assessing the risk of pledging their LLC ownership.
Work With Howard East
Need to pledge or accept LLC interests as collateral? Schedule a consultation or call 833-952-3111.
This content is for informational purposes only and does not constitute legal advice.
