In Wells Fargo Bank, N.A., f/b/o Jerome Guyant, IRA v. Highland Construction Management Services, L.P. et al., Nos. 18-2450-52 (4th Cir. March 17, 2020), the Fourth Circuit Court of Appeals recently upheld that a borrower’s indirect economic interests in a limited liability company (LLC) were not assigned to a lender under a conveyance in a security agreement assigning mere membership interests, pursuant to Virginia state law.
The case unfolds from a way-to-common event in chapter 11 cases that are arguably administratively insolvent. Post-confirmation, a secured lender objected to the debtor’s counsel’s fees on the basis that such fees could not be paid from encumbered property until the lender’s claim was fully satisfied.
A few years before filing bankruptcy, the debtor executed a security agreement in favor of the secured lender, assigning 50% of the debtor’s membership interest in a Virginia LLC to the lender. Because the debtor only directly owned a 20% membership interest in the LLC, the debtor contended that it only assigned a 10% membership interest in the LLC.
The governing agreement was an amendment to a security agreement, which, in addition to assigning 10% of the debtor’s membership interest, included an ambiguous recital providing that the debtor “agree[d] to increase the security interest in [debtor]’s membership interest in  LLC to fifty percent (50%) of [debtor]’s interest in  LLC.” The parties agreed that the debtor’s direct and indirect interests in the LLC equaled 16% of the total membership interests in the LLC.
The lender claimed that, rather than merely assigning a 10% membership interest, pursuant to the above recital, the debtor assigned 16% of all distributions it was entitled to receive from the LLC. To support its argument, the lender pointed to the debtor’s 50% ownership in a separate entity (SP), which, in turn, held a separate 24% membership interest in the same LLC, affording the debtor an additional 12% beneficial interest (on top of its own 20% membership interest), which the lender characterized as an “indirect” interest falling within the purview of the conveyance in the security agreement.
The bankruptcy court and district court disagreed with the lender and the Fourth Circuit affirmed.
Under Virginia law, a membership interest in a limited liability company is personal property. Va. Code § 13.1-1038. Moreover, “a limited liability company is a legal entity entirely separate and distinct from the shareholders or members who compose it.” Mission Residential, LLC v. Triple Net Props., LLC, 654 S.E.2d 888, 891 (Va. 2008). Thus, when a limited liability company acquires property, title vests in the company, not in its members. Erie Ins. Exch. v. EPC MD 15, LLC, 822 S.E.2d 351, 356 (Va. 2019) (citing Va. Code § 13.1-1021).
To sum up the scenario: the LLC and SP were both Virginia limited liability companies in which the debtor held a direct ownership interest and the SP held a separate ownership interest in the LLC. Pursuant to the above-authority, when the debtor agreed to assign its LLC interests to the secured lender, it–alone–could only assign its own property interests; not that of the SP.
Contrary to the secured lender’s argument that the debtor’s right to distributions–or economic interest–in the LLC were also intended to be assigned, the Court found that the security agreement never mentioned the SP or any “indirect” interests, like distributions. The recitals in the amendment alone could not modify the conveyance language in the security agreement, as they were not binding on the parties absent an ambiguity–which the Court found did not exist. See Va. Fuel Corp. v. Lambert Coal Co., 781 S.E.2d 162, 168 n.5 (Va. 2016).
Accordingly, the Fourth Circuit affirmed that the debtor only assigned its 10% membership interest in the LLC to the secured lender, and the remaining SP membership interests were unencumbered and could be used to satisfy the fees of the debtor’s counsel.
In the Highland Construction case, while the secured lender made a clever argument about an ambiguous term (interest) in a recital in a security agreement, state law property rights and the clear language in the conveyance provisions of such agreement dictated the accurate interests conveyed to the secured lender. While unnecessary–and with the benefit of hindsight in this case–borrowers, in the future, may also want to consider specifically excluding other unspecified interests not being conveyed under a security agreement.