Borrowers under net asset value credit facilities sometimes seek to pledge their interests in hedge funds and private equity funds directly as collateral to lenders.
Whether such a pledge constitutes effective security turns critically on whether those fund interests are actually assignable under the governing law.
Under the Delaware LLC Act, an LLC Agreement can expressly restrict the assignability of the economic rights associated with LLC interests, creating a significant obstacle for lenders.
In most jurisdictions, secured lenders rely on sections 9-406 and 9-408 of the applicable state’s Uniform Commercial Code, which override anti-assignment provisions in certain circumstances.
However, the Delaware UCC explicitly provides that sections 9-406 and 9-408 do not apply to an interest in an LLC, removing that safety net for lenders operating under Delaware law.
Economic rights, meaning LLC interests, are assignable in whole or in part except as provided in the LLC’s operating agreement, which can impose strict limits.
Importantly, assignment of an LLC interest does not entitle the assignee to control rights except as provided in the LLC Agreement or upon affirmative vote or written consent of all members.
The question of which law governs a pledge of transfer-restricted membership interests is not always straightforward and depends on the facts of a given transaction.
Consider a debtor organised under Texas law entering a security agreement governed by New York law, pledging membership interests in a Delaware LLC — the answer as to applicable transfer restrictions is the law of the issuer.
Market participants should therefore be aware of what law would be expected to apply to the analysis of the scope of transfer restrictions applicable to a specific transfer-restricted asset.
The organisational law of LLCs and partnerships has long embraced the pick-your-partner principle, under which transfers of ownership interests are restricted by statute and may be tightened or loosened by agreement.
In recent years, this principle has interacted in complex and not always practical ways with Article 9 of the UCC, creating ongoing challenges for fund finance practitioners.
Where creditors are secured by transfer-restricted assets, they should anticipate having to comply with applicable restrictions in the relevant agreements, including obtaining consent from the issuer with respect to specific transfers.
Lenders must also be prepared to provide evidence of compliance with applicable laws and to give advance notice to the issuer or shareholders where rights of first refusal or analogous rights exist.
The analysis published by Cadwalader, Wickersham and Taft as part of its Fund Finance Friday series underscores that when assignability fails, the security itself fails, making careful diligence on Delaware fund interests essential for any NAV lending transaction.