A debtor’s membership interest in a limited liability company (“LLC”) will often serve as collateral for secured loans. The secured party, however, must be very careful to correctly perfect its security interest in that type of asset. Any mistake can be costly, as the secured party discovered in the recent case In re: 11 East 36th, LLC, 2016 WL 1117588 (S.D.N.Y. March 21, 2016).
11 East 36th, LLC owned 15 units in a building located at 11 East 36th Street in Manhattan. In addition, 11 East 36th, LLC was the sole member of Morgan Lofts, LLC (“Morgan Lofts”), which owned 13 other units in the same building. Both entities were owned by the Bobker family.
In 2007, Guthrie (the “Lender”) made a loan to Morgan Investment Fund, LLC (“Morgan Fund”), another entity owned by the Bobker family. When the loan matured in 2009, the Lender agreed to extend the maturity date. In exchange, the Bobker family agreed to have 11 East 36th, LLC grant the Lender a security interest in its Morgan Lofts membership interest.
The Lender perfected its security interest by filing a UCC financing statement. The financing statement, however, described the collateral as the real property owned by Morgan Lofts instead of the membership interest of 11 East 36th, LLC in Morgan Lofts.
In May, 2013, both 11 East 36th, LLC and Morgan Lofts filed for Chapter 11 bankruptcy. The Lender filed a proof of claim based on the Morgan Fund’s promissory note. The Bankruptcy Court disallowed the Lender’s secured claims because the pledge agreement did not give the Lender a security interest in Morgan Loft’s real property and because the financing statement was defective and the security interest was therefore subject to avoidance.
The Lender appealed the decision to the District Court. The Lender’s first argument on appeal was that the Bankruptcy Court erred in finding that a claim against the property of a debtor’s bankruptcy does not constitute a claim against the debtor. The District Court found that the Lender misconstrued the earlier decision. In fact, the bankruptcy court had determined that the Lender’s financing statement was defective and therefore subordinate to the rights of the debtor in bankruptcy.
The Lender also argued that the financing statement was prepared by 11 East 36th, LLC and Morgan Lofts. Therefore, any errors in the UCC record were caused by the misconduct of those parties. As such, the Lender requested that the District Court impose a constructive trust that would render the claim unavoidable. However, the Lender raised this issue for the first time on appeal. Consequently, the District Court declined to consider the argument. The District Court concluded by affirming the decision of the Bankruptcy Court.
The takeaway from this case for those who file UCC records is that a security interest in an LLC membership interest is not the same as a security interest in the property of the LLC. When perfecting a security interest in just an LLC membership interest by filing, it is critical that the financing statement describe the membership interest, not the LLC’s assets. This is the case even though the value of the membership interest may be entirely dependent on the value of the property owned by the LLC.
Paul Hodnefield is associate general counsel for Corporation Service Company® and a frequent speaker/writer on UCC due diligence issues. Please feel free to contact him with questions or comments at firstname.lastname@example.org or 800-927-9801, ext. 61730.