05.15.2024 | Articles

Why Do We Care About Equity Pledges?

By Brent W. Barringer, Joseph E. Brooks, Brian F. Plunkett

Lenders in commercial loan transactions often require as part of their underwriting that the lender take a security interest in the owner’s equity in the borrower (e.g., stock if the borrower is a corporation or membership interests if the borrower is a limited liability company) as collateral for the loan. But why do lenders do so and why do we care about the pledge of equity interests?

Considerations in the Foreclosure of an Equity Pledge

Once a borrower has defaulted under its obligations to the lender, the lender will have a myriad of rights and remedies available to it. A “last resort” remedy that a lender may elect is the foreclosure of the assets of the borrower. Once the determination to foreclose is made by a lender, the best method to attempt to maximize a loan recovery may involve the sale of the borrower as a going concern to a third party rather than a liquidation of all of its assets. Taking a pledge of the equity interests in the borrower, affords the lender another tool in the case of a troubled loan situation. If the lender holds an equity pledge for a borrowing entity, the exercise of the lender’s rights under such pledge could potentially facilitate a third-party sale.

Typically, in addition to an equity pledge, the lender would also have a first-priority security interest in all assets of the borrower (which would be perfected by filing a Uniform Commercial Code (“UCC”) financing statement with the applicable secretary of state). By holding both the borrower’s assets and its ownership interests as collateral, the lender has two options to sell the business: it can foreclose on its security interests in the borrower’s assets, or it can sell the equity of the borrower via the equity pledge.

In order to effectively sell equity of the borrower through a pledge, the lender’s lien should cover one hundred percent (100%) of the ownership interests in the borrower. A pledge of less than one hundred percent (100%) of such interests will deter most, if not all, potential buyers, since any such buyer would not have complete control or ownership of the purchased entity. For this reason, the identity of the borrower’s owners will determine the ease with which the lender can obtain a pledge of all the equity interest in the borrower. A common organizational structure, and one that greatly simplifies the pledge process where there are multiple investors, is for the borrower to be owned by a holding company. Then, the lender need only receive one pledge from the holding company, rather than needing to collect executed pledges and possibly other necessary agreements (as further discussed in the section Perfecting a Security Interests in Equity below) from multiple investors.

Unfortunately, the foreclosure of equity interests is not typically an attractive option for a lender or a potential buyer of an ongoing business, as such foreclosure does not operate to “clear” existing liens or liabilities of the underlying business. The purchaser of equity interests simply “steps into the shoes” of the existing owners of the borrower and inherits, among other things, all existing indebtedness, ongoing tax liabilities, required payroll and employee payments, ERISA obligations, and any potential claims by minority shareholders. In addition, such an ownership change can also trigger defaults under other obligations of the borrower such as equipment or real property leases or other contracts of the borrower. For these reasons, even when a lender holds an equity pledge, a lender will most often decide to conduct a UCC-secured party sale of the borrower’s assets rather than attempting a sale of the equity interests.

Equity Pledges in Commercial Real Estate Loans

We have noticed an emerging trend in commercial real estate loans where lenders have been requiring an equity pledge from the owner of the borrower/mortgagor. Such a loan structure potentially affords the lender control over both the property and the owner of the property. Upon default, the lender then would have the option of foreclosing the mortgage covering the underlying property, foreclosing on the ownership entity itself through the equity pledge, or availing itself of both options. While a foreclosure of the equity pledge may be more efficient and cost-effective, a foreclosure on the real property would eliminate all other encumbrances and liens on the property. We have found that in mezzanine lending situations involving commercial real estate, the mezzanine lender will often obtain the consent of the senior lender in advance (as part of the intercreditor agreement between the senior lender and the mezzanine lender) to permit the mezzanine lender, upon default, to foreclose the pledged equity interests and “step into the shoes” of the borrower. In this way, the foreclosure of the pledged equity interests does not create a default under the senior debt documents, provided that the mezzanine lender also cures existing defaults under the senior debt.

Perfecting a Security Interest in Equity

In order to avail itself of the benefits of taking a pledge of equity interests, a lender must take care in perfecting its lien on such interests under the UCC. A share of stock or similar equity interest issued by a corporation is considered a security under the UCC. If the equity interests are considered securities, then the lender must then determine if the securities are certificated (as evidenced by a stock certificate) or uncertificated. In the case of certificated securities, the lender can perfect its interest by filing under the UCC or by exerting control (i.e., possession of the original certificates and an endorsement or stock power). However, with respect to uncertificated securities, or membership interests in a limited liability company (unless the limited liability company has taken the required steps to have its membership interests treated as securities under Article 8 of the UCC), such uncertificated securities or membership interests will likely be treated as general intangibles under the UCC. Valid perfection for general intangibles is accomplished by filing a UCC-1 financing statement under the UCC. Note that for the purposes of priority, a security interest perfected by control (i.e., possession of a certificated security) has priority over a security interest perfected by filing under the UCC. For this reason, it is a best practice to take possession of certificated securities when available.

The pledge of equity interests in the borrower is an important term which should be carefully considered by lenders in many commercial loan transactions. The lender should work with knowledgeable and experienced counsel in discussing the issues detailed above. As always, please contact us if you have questions on this or any other lending or business topic.

This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.

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