Lenders risk losing collateral and credit support and other adverse results if provisions in new loan documents restricting merger and sale of assets are not properly drafted following a recent change in Delaware law governing limited liability companies.

On August 1, 2018, the Delaware Limited Liability Company Act (the “Delaware LLC Act”) was amended, adding a new §18-217 [DE LLC Act §18-217] that allows the “division” of a limited liability company (“LLC”) and allocation of the assets and liabilities of the dividing LLC to two or more new limited liability companies pursuant to a “plan of division.” The dividing LLC may terminate as a result of the division or survive the division and retain assets and liabilities that are not allocated to the newly formed LLCs.

A Delaware LLC can effectuate a “division” fairly easily under the Delaware LLC Act. Unless the limited liability company agreement of the dividing LLC expressly prohibits division, the LLC may be divided by creation of a “plan of division.” The plan specifies the allocation of the assets and liabilities among the dividing LLC and the new LLCs. It is not necessary that this be done on an individual asset or liability basis, “as long as the assets, property, rights, series, debts, liabilities or duties so allocated are reasonably identified….” [§18-217(l)(7)] Any debts or liabilities that are not allocated become the joint and several debts and liabilities of the new LLCs and the dividing LLC, if it survives.

Delaware LLCs are a common form for companies of all types, including private equity funds, securitization vehicles, and real estate companies. Many lenders require that specified assets against which a loan is made, particularly real estate lenders, be owned by a borrower through a newly formed, single-purpose Delaware LLC. Delaware LLCs are also not confined to borrowers, so attention should also be paid to other obligors and guarantors.

Most loan agreements have restrictions on mergers and consolidations and transfers of assets by LLC borrowers and other obligors. However, these restrictions do not address “division” of an LLC borrower or obligor. Lenders should implement changes in their loan documents to address this new form of entity or asset transfer. New documents should specifically address “dividing” and creating a “plan of division,” much the same way as they address mergers and consolidations and transfers of assets. The key areas that lenders should consider modifying are: (1) single purpose entity covenants; (2) definition of “transfer” and transfer provisions; (3) modification of organizational documents (i.e., prohibiting division without lender consent); (4) events of default pertaining to transfers; and (5) bad-boy guarantees. Some lenders have already modified their form loan documents to limit the ability of LLCs to divide.

The new division section of the Delaware LLC Act applies to LLCs formed both prior to and after August 1, 2018; however, the new section on division provides some relief for lenders with loan agreements executed prior to August 1, 2018. The new section provides that if an LLC is a party to an agreement entered into prior to August 1, 2018 and that agreement has existing restrictions on mergers and consolidations or transfers of assets, then such restrictions “shall be deemed to apply to a division as if it were a merger, consolidation or transfer of assets, as applicable.” [§18-217(o)] Notwithstanding that the new section provides some lender protective language, lenders should address “dividing” and “plan of division” in any amendment, extension, or modification of any existing loan.

Lenders should update their loan document forms to address “division” much in the same manner as loan documents address mergers and consolidations and transfers of assets, and Borrowers should expect to see this new language in loan documents (including amendments or extensions of existing loan documents).