August 16, 2018

Lending to Delaware LLCs? Add Division to Your List of Concerns

In July 2018, Delaware enacted revisions to its Limited Liability Company Act (the DLLCA) allowing any Delaware limited liability company (LLC) to “divide” into two LLCs, with an allocation of assets and liabilities between the resulting entities. The revisions may have significant implications for creditors of Delaware LLCs.

What Is “Division” of an LLC and Why Does It Matter?

Under the revisions, a Delaware LLC may adopt a “plan of division” under which the LLC allocates its assets and liabilities among itself and one or more new LLCs, or among two or more new LLCs.

Prior to the revisions, an LLC could not shed liabilities without the consent of the affected creditors outside of bankruptcy and similar proceedings. The most radical aspect of the revisions allows an LLC to allocate its liabilities to just one of the resulting LLCs in a division.

The revisions expressly state that a division does not constitute a dissolution, assignment, transfer or distribution. Those actions are typically expressly limited by credit agreements and other loan documents. However, if a division does not constitute one of those actions, it is less likely to be prohibited by a credit document drafted without an eye on the DLLCA revisions.

What Protections Does a Creditor Have if an LLC Divides?

The statute includes several protections for creditors:

  • All liens upon property of the dividing LLC are “preserved unimpaired.”
  • If a division is determined to be a fraudulent transfer, each LLC that is part of the division will be jointly and severally liable on account of the fraudulent transfer.
  • If the dividing LLC has an agreement (such as a credit agreement) entered into before August 1, 2018 that prohibits merger or transfer of assets, that prohibition is deemed to prohibit division as well.

Why Might the Statutory Protections Be Inadequate?

At least three unanswered questions are significant for debtor-creditor relations:

  1. How will courts apply the protection of pre-division liens to after-acquired property? Suppose that Alpha LLC has granted a security interest in all of its receivables and inventory to secure debt to First Bank. If Alpha LLC divides into Beta LLC and Delta LLC, and allocates the First Bank debt to Beta LLC, it can be assumed (but not with certainty) that First Bank’s lien attaches to inventory and receivables of Beta LLC arising after the division. However, it is not at all clear whether that lien attaches to inventory and receivables of Delta LLC arising after the division.
  2. Will the revisions’ references to fraudulent transfer law be enough to protect creditors from debtor mischief? For example, if Alpha LLC divides by retaining all of its assets while transferring all of its liabilities to new Beta LLC, the transaction doesn’t fit neatly into fraudulent transfer law, which restricts transfers of assets but doesn’t contemplate transfers of liabilities.
  3. Will other states recognize the intended effects of division? A court outside of Delaware may conclude that, as a matter of contract interpretation, a division should be treated as a transfer of assets for purposes of a contractual prohibition, despite the statute’s statements to the contrary.

What Can a Creditor Do to Reduce the Risk of Division?

Lenders should add “division” to the list of prohibited actions in their agreements with Delaware LLCs. Even if the underlying agreement was entered into before August 1, 2018, the prohibition should be added when the agreement is amended. It is not known whether a pre-enactment agreement that is amended after August 1, 2018 will still be treated under the statute as an agreement “entered into prior to August 1, 2018.”

In some circumstances, lenders may also require LLC agreements to be amended to prohibit division, or to require the consent of the LLC’s lenders for any division. The statute expressly allows an LLC agreement to provide that the company does not have the power to divide.

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