Delaware Divisions: Are Your Loan Documents Sufficient to Protect You?

December 3, 2018

By Levi J. Smith

Due to recent amendments to the Delaware Limited Liability Company Act, banks and other lenders who make loans to limited liability companies (LLCs) formed in the state of Delaware should carefully review their loan documents and modify restrictive covenants related to mergers, reorganizations, acquisitions, dispositions, and similar transactions to address a newly created form of transaction called a “division.”

Existing transaction forms, such as mergers, acquisitions, and dissolutions, are often prohibited or conditioned in loan documents to ensure the lender’s security interest and other rights are protected. However, this may not be the case with divisions. The amendments, effective August 1, 2018, permit the division of an LLC into two or more separate LLCs. The dividing LLC may allocate its assets, rights, liabilities, and duties among the separate LLCs pursuant to a written plan of division. The original LLC may continue in existence or be dissolved, and following the division, each LLC (absent a fraudulent transfer) owns the assets and has the liabilities allocated to it in the plan of division.

The division creates the possibility that a Delaware LLC that is contractually obligated under a loan agreement as a borrower or other credit party could allocate all of its assets to two or more LLCs that are not party to the loan agreement. Unless additional action is taken by the lender, the lender would no longer have a perfected lien on the assets that have been so allocated and would essentially be unsecured (or at least under-secured).

Existing loan documents typically contain negative covenants that prohibit certain changes in the borrower’s structure or form, including acquisitions, dispositions, mergers, and reorganizations. However, these existing provisions may not be sufficient to contractually prohibit a Delaware LLC from undertaking a division. Therefore, loan documents entered into on or after August 1, 2018, should contain additional negative covenants that specifically prohibit divisions, since general statements prohibiting dispositions, mergers, and reorganizations are likely not sufficient to prohibit divisions with respect to loan documents entered into on or after August 1, 2018.

In addition to negative covenants prohibiting divisions, loan documents should also be reviewed and revised to make sure that such documents contain affirmative covenants that the lender’s security interest will continue in effect notwithstanding a division and that the loan parties will take further actions to ensure such liens continue to be valid, perfected, and enforceable against the grantors thereof (including a requirement that any entities into which a Delaware LLC has been divided will grant a security interest in favor of the lender). Lenders should also ensure that agreements governing guaranties provide that such guaranties will continue to be enforceable against the guarantor notwithstanding a division.

Fortunately, the Delaware legislature included a safe harbor provision for loan documents with Delaware LLCs that were in effect prior to the August 1, 2018, effective date of the amendments. For these loan documents, a general statement contained therein prohibiting dispositions, mergers, and reorganizations will be construed to be sufficient to prohibit divisions, even if the concept of a division is not specifically mentioned. However, it would be prudent to review existing loan documents and add language with respect to divisions when such loan documents are being amended or renewed, particularly if a new Delaware LLC may join such loan documents as a loan party.