If a loan or extension of credit requires collateral, banks prefer collateral that is readily marketable rather than taking a security interest in a closely-held business.  Occasionally, the only collateral that is available or that the borrower can offer is corporate stock that is not traded on a public market, an interest in a limited liability company ("LLC") or a partnership interest.  It is common for closely-held business entities to prohibit an assignment of an owner's interest or require as a condition to an assignment the consent of the other owners of the entity.

This memorandum will discuss some of the concerns a lender should address in taking a security interest in collateral that limits or prohibits an assignment.

Assume that the stock of a closely-held corporation ("Company A") is offered to your bank as collateral for a loan.  The stock certificate bears the following language on the reverse side:

The shares represented by this certificate have not been registered under the Securities Act of 1933.  The shares have been acquired without a view to distribution and may not be offered, sold, transferred, pledged or hypothecated in the absence of an effective registration statement for the shares under the Act and under any applicable state securities laws, or an opinion of counsel to the corporation that such registration is not required as to such sale or offer. 

In addition, the shareholders of Company A have entered into a Stock Restrictive Agreement ("SRA"), which states that unless the voting stock agrees to a pledge, the pledge shall be null and void and no security interest shall be transferred.

These issues were addressed in the United States Bankruptcy Court for the Western District of Arkansas in In re Garrison [1].

There the lender made a loan secured by stock subject to both restrictions.  In the bankruptcy proceedings the lender sought a declaratory judgment that it held a valid perfected security interest in the stock.  After a thorough analysis of the lender's claims, the Court held that the first restriction, the one noted on the stock certificate, did not prohibit the lender from having a perfected security interest in the stock.  After first noting that the validity of a restriction on a transfer of stock is determined by the law of the state of incorporation, the Court said in part, applying Oregon law:

The Court concludes that while the restriction may be valid and enforceable under Section 60.167, the applicable Oregon statute, by its terms it is not applicable to the transfer at issue.  The statute authorizes the restriction to preserve the corporation's federal and state exemptions and that purpose is not furthered by prohibiting the pledge, which does not threaten the availability of those exceptions.  The pledge, being a transfer that is neither a public distribution nor a transaction by an issuer, underwriter or dealer, does not violate the restriction.  The restriction remains in effect as to the bank to the extent that any future transfer might necessitate the action of the stock transfer agent referred to in the legend.  The record does not contain any evidence that the stock transfer agent was required to take action by the pledge at issue.

As to the second restriction, the one contained in the SRA, the Court ruled against the lender, stating in part:

Applying these rules regarding attachment and perfection, a Court finds that when the Debtors attempted to give the Bank a security interest in their stock, they had already voluntarily agreed to refrain from pledging the stock without unanimous consent of the other signatories to the agreement.  The Debtors having conditionally relinquished their transfer rights, a security interest could not attach to those rights and without attachment, perfection could not be accomplished.  Accordingly, the Bank's lien in the stock is unperfected unless the Bank's estoppel and apparent authority arguments have merit, issues to be subsequently discussed.

Colorado permits inclusion of restrictions on the transfer of shares of stock.[2]  Subsection (2) of the Colorado statutes provides:

A restriction on the transfer or registration of transfer of shares is valid and enforceable against the holder or a transferee of the holder if the restriction is authorized by this section and its existence is noted conspicuously on the front or back of the certificate or is contained in the information statement required by Section 7-106-207(ii).  Unless so noted, a restriction is not enforceable against a person without knowledge of the restriction.

The use of limited liability companies has grown exponentially during the last few years.  Where an LLC is involved, the owner of an interest in the LLC may offer his or her interest as collateral for a loan.  It is not unusual for an LLC's operating agreement to provide some restriction on the transfer of a member's interest.  In In re West[3] the United States Bankruptcy Court dealt with the pledge of an LLC interest as security for a $91,800 loan from the Heartland Bank.  The operating agreement provided that a member does not have the right to assign, pledge or hypothecate his interest "except as otherwise specifically provided herein."  Both unanimous consent was required for the transfer of an interest and if no unanimous consent had been obtained, "no transfer shall be effective unless and until written notice has been provided to the company and the non-transferring members."

Because the funds borrowed by the member using his interest in the LLC as collateral benefitted the LLC, the Court held that the written notice requirement was waived.  Heartland Bank's security interest was held to be valid.

Colorado permits the transfer of an interest in a LLC subject to the limitation set forth in the following statutory provision:[4]

The interest of each member in a limited liability company constitutes the personal property of the member and may be assigned or transferred.  Unless the assignee or transferee is admitted as a member, the assignee or transferee shall only be entitled to receive the share of profits or other compensation by way of income and the return of contributions to which that member would otherwise be entitled and shall have no right to participate in the management of the business and the activities of the limited liability company or become a member.[5]

The cited bankruptcy cases are not binding on other courts, but they do teach two important lessons.  First, any lender proposing to take a security interest in a closely-held entity, be it a corporation, LLC or partnership, should seek to determine whether there are any limitations or prohibitions on the transfer or pledge of the borrower's interest.  Violation of such restriction may result in the lender not having a valid, enforceable security interest in the borrower's ownership interest.

Second, a limitation or restriction on the transfer or assignment of an ownership interest may not always negate a security interest granted to the lender.  Understanding the scope and purpose of the restriction is as important as determining whether a restriction exists.  Also, there may be instances where a statutory provision authorizing an assignment or pledge overrides a stated restriction.  At times it may be advisable to get an opinion of counsel as to the scope and meaning of a transfer restriction or whether a statutory provision controls.