Subtraction by Division: How Recent Changes to the Delaware LLC Act Can Pose Risks for LendersDecember 2018
Delaware has long been a popular choice for entities to use as their state of formation. As a result, lenders all over the country routinely make loans to, or that are guaranteed by, Delaware limited liability companies (LLCs). Changes to the Delaware Limited Liability Company Act (DLLCA), which became effective August 1, 2018, introduce additional risks to lenders, which lenders should take care to address in their loan documents. This article discusses the recent changes and the resulting new risks and suggests steps that lenders can take to protect themselves when dealing with Delaware LLCs.
Pursuant to Section 18-217 of the DLLCA, all existing and future Delaware LLCs may now divide into two or more domestic LLCs (referred to as “division companies”). The division is effected by the dividing company adopting a plan of division, and is effective upon the filing with the Delaware Secretary of State of a certificate of division and corresponding certificates of formation for each division company. The dividing company can either continue or cease to exist upon the division becoming effective. Unless otherwise provided in its plan of division, the dividing company is not required to wind up its affairs or otherwise pay its liabilities and distribute its assets. The termination of the dividing company in connection with a division does not constitute a dissolution under Delaware law, but instead is a “cessation of the existence” of the dividing company.
Upon division, the assets and liabilities of the dividing company are allocated as specified in the plan of division among the division companies and, if it is continuing, the dividing company. Unless the division constitutes a fraudulent transfer, each division company is liable only for the liabilities of the dividing company allocated to it in the plan of division and for any liabilities that are not allocated to a division company in the plan of division. Liens on allocated assets remain attached and follow the assets to the division company to which they are allocated in the plan of division.
The DLLCA expressly provides that a division shall not be deemed an assignment, transfer, or distribution under Delaware law. Accordingly, prohibitions or restrictions on mergers, consolidations, or other fundamental changes or asset transfers in loan documents may fail to prohibit divisions under the DLLCA. However, the DLLCA contains a “grandfather” clause for contracts entered into prior to August 1, 2018 with Delaware LLCs formed before August 1, 2018, providing that terms restricting or prohibiting mergers, consolidations, or asset transfers in those earlier contracts will be deemed to also apply to (and thus would restrict or prohibit) divisions, as if the division was a merger, consolidation, or asset transfer. Most loan documents already contain provisions limiting or completely prohibiting the formation of subsidiaries, mergers and consolidations, the transfer of assets, and dissolution. Such loan documents entered into prior to August 1, 2018 would not need to be amended so long as they include adequate prohibitions or restrictions. However, for contracts entered into on or after August 1, 2018, there is no such grandfathered protection, and lenders should consider revising their loan documents to mitigate these risks.
Loan documents that do not adequately protect the lender from divisions, through either the grandfathered protection under the DLLCA or the inclusion of specific prohibitions on divisions, could result in serious problems for the lender. For example, a borrower or guarantor that undergoes a division would not have the same assets that it had when the loan was made—or perhaps any assets at all—or it may completely cease to exist, and the lender would not have the right under its loan documents to declare a default or exercise remedies. The lender would still have the liens on the assets it had before the division, but those assets would be owned by one or more new entities that the lender has not underwritten, on which the lender has not conducted any due diligence and with which the lender has no direct contractual relationship. In addition, the lender might need to file a new financing statement naming the division company as debtor or amend an existing financing statement, in order to maintain perfection on personal property that is acquired after the division.
In their loan transactions (including amendments of existing loans) with borrowers, guarantors, or third-party grantors of liens that are Delaware LLCs, lenders should consider the following:
- Revising loan documents to include covenants prohibiting division without lender consent (such as by modifying existing provisions, or adding new provisions, regarding restrictions on dispositions of assets, mergers, and other fundamental changes);
- Requiring that the limited liability company agreement of Delaware LLCs specifically provide that the company does not have the power to divide (and providing that the organizational documents cannot be modified without lender consent);
- Adding covenants that require division companies to join the loan documents as co-borrowers or guarantors and to grant liens on their assets;
- Making the filing of a certificate of division a trigger for full recourse against the guarantor in a non-recourse guarantee; and
- Requiring lender consent for a borrower or guarantor that is not a Delaware LLC to reorganize in Delaware or any other state that permits divisions.