Why Simply Prohibiting “Division” in Loan Documents May Not Be Sufficient Protection Against The Risks of Division

THIS CLIENT ALERT SUPERSEDES OUR EARLIER CLIENT ALERTS ON THE DELAWARE DIVISION AMENDMENT

To maintain its national preeminence, the Delaware Legislature recently amended the State's Limited Liability Company Statute (the "Amendment") to grant Delaware LLCs a right which will be of concern to lenders with respect to their borrowers and guarantors in loan transactions.

The Amendment

The Amendment permits a Delaware LLC to divide into two or more Delaware LLCs, with the pre-existing LLC either (i) surviving as one of the two or more LLCs existing post-division or (ii) terminating pursuant to a plan of division ("Plan"), in either case, resulting in the creation of multiple post-division LLCs and the allocation of the assets and liabilities of the original LLC among the two or more resulting LLCs under the Plan ("Division"). After the Plan is adopted, a Certificate of Division is required to be filed with the Delaware Secretary of State to effectuate the Division, together with Certificates of Formation for the new LLCs, all of which must have the same effective date. While there is no requirement that the Plan, which contains all of the terms, conditions and allocations, need be filed or made publicly available, the Certificate of Division must name an individual as the Division Contact (for a term of six years) who must provide creditors, upon their written request, with the name and address of the resulting LLCs to which the creditors claim has been allocated. The Amendment was effective as of August 1, 2018.

The assets and liabilities of the original LLC in existence prior to the Plan continue unaffected and unimpaired as assets and liabilities of the resulting LLCs to which they are allocated pursuant to the Plan, so long as the Division does not constitute a fraudulent transfer under applicable law. Pursuant to the Amendment, upon Division, all such assets and liabilities will without any further action be vested in, or become the obligation of, the LLC to which they are allocated pursuant to the Plan, and will not revert or be in any way impaired by the Division, and no other resulting LLC shall liable therefor, so long as the Division does not constitute a fraudulent transfer under applicable law.

All liens upon any property of the original LLC shall be preserved unimpaired, and its debts, liabilities and duties shall remain the obligation of, and enforceable against, the resulting LLC to which they have been allocated in the Division. However, if not specifically allocated, liability becomes a joint and several obligation of all of the resulting LLCs.

Risk For Lenders

LLCs formed after July 31, 2018 can, without the lender's consent, take advantage of the Amendment by dividing and then allocating a lender's collateral security (or a portion thereof) to a newly created and potentially non-credit worthy LLC without violating the traditional covenants of the lender’s loan documents. Without enforceable provisions in its loan documents protecting its collateral security against Division, the lender would have to challenge the Division as a fraudulent transfer.

However, for LLCs formed and party to a written loan agreement existing prior to August 1, 2018 that restricts, conditions or prohibits the LLC from dissolving, liquidating, consolidating, merging, selling, transferring, assigning, or distributing assets ("Prohibited Entity Acts"), such Division will be deemed to be a violation of such provisions in loan documents. That safe harbor would be lost if a pre-August 1, 2018 loan is extended or otherwise modified after July 31, 2018; and therefore the loan documents as well as the borrower/guarantor organizational documents should be amended to expressly prohibit a Division in connection with the modification or extension. The Amendment intends this safe harbor to apply even to a Delaware LLC borrower or guarantor whose loan documents are not governed by Delaware Law.

The Amendment also expressly provides that a Division shall not be considered an assignment or transfer or a distribution of the assets of the original LLC, under any contractual prohibitions on any transfer, assignment or distribution of any assets or liabilities. That provision would allow the Division allocation to be a tax free transfer under Delaware law (if not necessarily in other states), but also may limit or impair a lender's rights and remedies under Prohibited Entity Acts provisions in the loan documents as it purports to vitiate the lender’s contractual transfer, assignment or distribution prohibitions. This provision will inevitably lead to conflicting results under the law of the state where the collateral security for the loan is located and the Amendment, which is intended to govern the Delaware borrower or guarantor LLC.

Recommended Risk Mitigation

Given the ease of affecting a Division and a lender’s limited remedy after a Division has been completed, lenders should consider the following with respect to their existing and future extensions of credit, as well as any future modification of loans closed before August 1, 2018 to better preserve and protect their rights, liens, remedies and collateral security for their loans to Delaware LLC borrowers and guarantors:

Loan Documents

  • Review form term sheets and loan commitments as well as form loan documents to determine whether they contain provisions regarding Division or need appropriate prophylactic modifications concerning Division.
  • Review pre-August 1, 2019 loan documents, if a modification or extension of an existing loan is contemplated, for appropriate prophylactic modifications concerning Division.
  • Expressly restrict a borrower’s exercise of the new Division power granted by the Amendment and add, where appropriate, the words "divide" and "division" to borrower and guarantor representations, SPE requirements, affirmative covenants, distribution and transfer restrictions and other provisions limiting or conditioning Prohibited Entity Acts, as well as add a negative covenant against adoption of plan of division or filing a certificate of division.
  • Require that the loan documents expressly prohibit borrower and guarantor LLCs from having the right, power or authority to divide and include an affirmative covenant that the borrower and guarantor LLC agreements expressly prohibit borrower’s and guarantor’s right to divide and further prohibit any amendment of such prohibition.
  • As a further disincentive, require a full recourse carveout guarantee should the borrower or guarantor adopt a plan of division or file a certificate of division or otherwise proceed with a Division in breach of the absolute prohibition of Division or amend in any way the LLC's organizational document’s Division prohibition.

Borrower/Guarantor Organizational Documents

  • As the Amendment specifically allows that a "limited liability company agreement may provide that a domestic limited liability company shall not have the power to divide" (see Section 18-217 (k)), the lender should require that the organizational documents of borrower and guarantor expressly provide that such entity:shall have no right, power or authority, express or implied, to divide into multiple entities pursuant to any applicable law allowing an entity to divide or conduct a divisive merger. This provision shall not be amended, modified or otherwise changed to grant such right, power or authority, and any attempt to divide or to amend this absolute prohibition of division shall, to the fullest extent permitted by law, be void ab initio and of no force or effect whatsoever.Unlike other Prohibited Entity Acts which are often conditioned on, or otherwise limited by, Lender’s consent, we recommend that Division be unconditionally prohibited in loan documents and organizational documents to avoid some of the unintended consequences of the Amendment more specifically discussed below.

Prohibition Of Division

If the absolute prohibition of Division is included in the LLC's organizational documents as well as the lender's loan documents, any attempted Division by the LLC would be an ultra vires act which would allow the lender to sue to set aside the Division as void and ineffective. However, if the loan documents and/or organizational documents were to permit (or are amended to permit) an LLC the power to divide with the lender's consent, a court strictly construing Section 18-217(k) might interpret the statutory language narrowly and hold that allowing an LLC the power to divide with a lender's consent does not deprive the LLC of the power to divide as required by the statutory language, but rather only limits the LLC's ability to divide on the sole condition that the lender has consented to it. In this circumstance, if an LLC divides without the required consent of the lender, a court may well hold that the LLC has simply breached a consent condition which would constitute a non-monetary default under the loan documents, rather than having taken an ultra vires act. As a loan default, the lender’s rights would limited to the sole statutory remedy of challenging the division as a fraudulent transfer. The ability of a lender to have the Division deemed void ab initio as an ultra vires act, would be conclusive and clearly preferable in time, effort and expense to a lender having to prove a fraudulent transfer, which is a difficult and time consuming process, the result of which would be uncertain.

A separate consideration is whether the credit rating agencies may view the addition of "without the consent of Lender" to a division prohibition in the loan documents and/or the organizational documents as "credit negative", a question that credit rating agencies have not yet addressed.

We are available to discuss this change in Delaware LLC law and its negative impact on lenders' traditional rights and remedies and to review and recommend appropriate protective Division modifications to your existing form loan documents as well as to any agreements extending or modifying existing loans made prior to August 1, 2018.

NOTE: The States of Texas (2006), Pennsylvania (2015) and Arizona (2015) also allow for division (or "divisive merger"), but in each case for all of their domestic statutory entities not just LLCs.