New Delaware LLC Right of Division
ZAG-S&W Client Advisory
To maintain its national preeminence, the Delaware Legislature recently amended the State’s Limited Liability Company Statute to grant Delaware LLCs a right which will be of concern to lenders. It amended its LLC law to permit 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 a 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 was 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 amended statute, 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 LLCs.
Risk For Lenders
LLCs formed after July 31, 2018 can, without the lender’s consent, take advantage of the new Delaware legislation 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 covenants of the lender’s loan documents. Without enforceable provisions in its loan documents protecting its collateral security, the lender would have to challenge the Division as a fraudulent transfer.
However, for LLCs formed and party to a written agreement existing prior to August 1, 2018 that restricts, conditions or prohibits the LLC from merging or consolidating or transferring assets, such Division will be deemed to be a violation of the express provisions in loan documents prohibiting merger, consolidation or transfer of assets. This provision is intended to apply even to a Delaware LLC borrower or guarantor whose loan documents are not governed by Delaware law. Needless to say, if a pre-August 1, 2018 loan is extended or otherwise modified, the loan documents as well as the borrower/guarantor organizational documents should be amended to expressly prohibit a Division, without the lender’s prior written consent.
The new law also provides that a Division shall be deemed neither an assignment or transfer, nor a distribution, of the assets of the original LLC under Delaware law, which allows the transfer etc. to be tax free under Delaware law (but not necessarily in other states), but also may limit a lender’s rights and remedies under SPE and other covenants in the loan documents.
Recommended Risk Mitigation
To better preserve and protect their rights, liens and collateral security for their loans to Delaware borrowers and their guarantors, lenders should consider the following with respect to their existing and future extensions of credit as well as any future modification of existing loans:
- review form term sheets and loan commitments as well as form loan documents to determine if they contain covenants expressly prohibiting a Division, as the customary due on sale, merger, consolidation or transfer of assets provisions as well as anti-assignment or distribution prohibition provisions may be ineffective against Divisions;
- specifically review SPE covenants in form loan documents and LLC organizational documents for possible protective language;
- add negative covenants to form loan documents that expressly prohibit a Division without express lender written consent; and
- require negative covenants be added to the borrower/guarantor’s LLC organizational documents that expressly reference the new law and prohibit exercise of the power to consummate a Division without the lender’s prior written consent and provide further that the failure to obtain such consent shall render the Division void.
We are available to discuss this problematic change in Delaware law and its impact on lender’s rights and remedies and to review and recommend appropriate prophylactic modifications to your existing forms of loan documents as well as to any subsequent extension or other modification to existing loans originally made prior to August 1, 2018.
NOTE: The State of Texas already has a similar LLC division statute.