Equity Pledges: Control, Enforcement, and Strategic Considerations

When credit turns sour, equity pledges can determine who controls the company and how value is preserved. For lenders, they promise a direct lever to influence management or assume ownership and an alternative exit strategy to realizing on other assets; for borrowers and sponsors, they pose risks that extend well beyond pricing. Yet the strength of an equity pledge depends on more than the pledge agreement itself — it turns on entity form, the fine print of governing documents, and requirements of the Uniform Commercial Code (UCC) and other applicable law.

This article examines how pledges of equity in certain types of U.S. entities work in practice, the remedies that truly matter in distress, and the growing role of independent directors in shaping outcomes. By cutting through the technicalities to highlight practical pitfalls and opportunities, we aim to equip both lenders and borrowers with a clearer view of when equity pledges deliver — and when they may disappoint.

Part I: What Is an Equity Pledge?

In a secured financing, a core component of the collateral package is the pledge of the equity interests of the borrower: The direct parent of the borrower, usually a passive holding company set up for such purpose, is required to execute a pledge agreement whereby it grants a security interest in its assets (including its interest in the borrower’s equity) in favor of the lender. In an “all assets” financing (i.e., a credit facility secured by substantially all assets of the company group), a lender will also receive equity pledges from each subsidiary guaranteeing the facility, giving the lender multiple access points to exert control across the company group structure.

The pledge by the direct parent of the borrower is frequently coupled with its guaranty of the borrower’s obligations. An equity pledge may be embedded within a broader all-asset security agreement or may be reflected in a standalone pledge agreement where the grant of security is limited to certain equity interests, related rights, and proceeds. 

An equity pledge is a powerful tool for a secured lender. As a threshold matter, having a pledge of equity in addition to security interests in the loan parties’ other assets provides a lender with additional collateral value in a bankruptcy and optionality when determining the easiest way to exit a distressed credit. In a downside scenario, it gives the lender several pathways to gain ultimate control of the business or to exit the credit by, among other things, replacing the incumbent governing body of the borrower. These options consist primarily of (1) a UCC foreclosure, which may take the form of a going-concern sale of the business to a buyer via public or private auction procedures, or the lender’s taking ownership of the pledged equity itself and becoming the equity holder, and/or (2) the use of proxy rights to replace the incumbent governing body of the borrower, ensuring that independent directors appropriately consider the interests of all stakeholders, guarding against an undesirable bankruptcy filing, or facilitating an asset sale, all without foreclosing on the equity directly. Each of these remedies is discussed in more detail below, but as a threshold matter, the utility of these options turns on legal and corporate governance considerations of which both the borrower and the lender should be aware.

1. What type of entity is the issuer? The enforceability of an equity pledge depends, in part, on the organizational form of the borrower.

1. Corporations
   
   Typically, corporations issue stock and are owned by stockholders but managed by a separate board of directors elected by the stockholders. Thus, the exercise of an equity pledge can allow the lender to step into the shoes of the stockholders, giving the lender the indirect ability to manage the corporation by replacing its board of directors. Often by default, corporations issue equity in the form of stock that is evidenced by physical certificates, though some have the option to forgo physical certificates at the election of the board. Shares of corporate stock typically constitute securities under Article 8 of the UCC and, in turn, investment property under Article 9 of the UCC. Lenders can, and often do, perfect their security interest in such securities and investment property by filing a UCC-1 financing statement against the pledgor. However, a secured party with “control” (as defined in Section 8-106 of the UCC) of investment property will have priority over a secured party that perfects merely by filing. Accordingly, a lender wishing to obtain a first-priority perfected security interest can perfect by control even if it also perfects by filing. If the equity is certificated, control can be obtained by taking physical possession of the pledged stock certificates (accompanied by instruments of transfer to facilitate enforcement of the pledge). If the equity is not certificated, control can be obtained by receiving the issuer’s acknowledgement that it will comply with instructions originated by the secured party without further consent of the registered owner.

2. Limited Liability Companies
   1. Limited liability companies (LLCs) typically issue membership interests and are owned by their members. An LLC can be managed by its members directly, by a manager designated by the members, or by a board of managers elected by its members. Similar to a corporation, a lender may step into the shoes of the members by exercising its rights with respect to the pledged membership interests. In a member-managed LLC, this would give the lender direct and immediate control over the management of the company, while in a manager-managed LLC, the lender would have the ability to replace the individuals or entities constituting the managing body. In any event, the result is substantially the same: The lender will be able to direct the management of the company, either by exercising its voting power directly or by replacing the managing body of the entity.
   2. Membership interests can constitute general intangibles under Article 9 of the UCC or, alternatively, can constitute securities under Article 8 of the UCC (and, accordingly, investment property under Article 9 of the UCC) if an appropriate opt-in to Article 8 is obtained. The distinction makes a difference on what is required for a lender to have a first-priority perfected security interest. Though a lender’s security interest in general intangibles or investment property may be perfected by the filing of a UCC-1 financing statement under Article 9, when membership interests are Article 8 securities, a lender will typically want Article 8 “control” over the membership interests to obtain priority over a security interest perfected merely by filing. In the case of certificated membership interests, this means obtaining possession of the certificates (accompanied by instruments of transfer to facilitate enforcement of the pledge), and in the case of uncertificated membership interests, this means obtaining the issuer’s acknowledgment that it will comply with instructions originated by the secured party without further consent of the registered owner. To avoid the extra steps needed to obtain control, many lenders will require the borrower or other pledged LLC to expressly opt out of Article 8 under its LLC agreement or to covenant that it will not cause its equity interests to constitute “securities” under the UCC, thereby dictating the equity’s characterization as a general intangible.
3. Limited Partnerships: Limited partnerships (LPs) issue partnership interests and split their ownership between a general partner and any number of limited partners. The general partner typically holds all of the voting rights, controlling the management of the LP. The limited partners receive economic interests in the LP and, in some cases, limited voting rights. Therefore, to receive a fulsome pledge of a LP’s equity, both the general partner and the limited partners need to pledge their respective partnership interests to the lender. A pledge of the limited partners’ interests without a pledge of the general partner’s interests (or the equity interests in the general partner) will be of little use as the lender will be unable to exercise broad voting rights or exert control over the management of the LP. Similar to membership interests issued by a LLC, partnership interests may be certificated or uncertificated, and the same considerations as outlined in Section (b) above will apply.

2. What limitations exist in issuer’s the governing documents?

An equity pledge is only as strong as the underlying governing document. For instance, if a pledged entity’s governing document does not permit the equity holders to unilaterally replace the governing body (and similarly restricts the ability to amend the governing document to remove any such prohibitions), the lender will not be able to exert control over management, even if the lender has received an equity pledge. Similarly, if a governing document containing a legally effective restriction on the transfer of the pledged equity, or if the lender is otherwise restricted by law or regulation from owning the equity interests, a lender may not be able to foreclose on the equity, though use of a proxy in such a scenario to control voting may remain a viable option, albeit subject to limitations discussed below.

It is important for lenders to understand whether a pledged LLC or limited partnership’s governing document expressly permits the pledge of all aspects of the membership or partnership interests, including economic rights, voting rights, managerial rights, membership rights, and the transfer of the equity to the lender or a third party in an enforcement scenario. The Delaware Limited Liability Company Act and Delaware Revised Limited Partnership Act look to the governing documents of a pledged entity rather than the contractual arrangements between the pledged entity and the lender for rights to become a member or to exercise voting and managerial rights. Thus, if the governing document does not adequately permit the entirety of the equity pledge and the exercise of remedies thereunder, it may impede the lender’s ability to exercise such remedies. As other jurisdictions may look to or otherwise apply Delaware law on this issue, this fact should be top of mind when considering equity pledges of entities organized outside of Delaware as well. Some lenders will require amendments to the governing documents of the borrower and/or other pledged entities to include pledge protections.

Impediments to the equity pledge and enforcement thereof in underlying governing documents will be a key point of diligence, and any issues will generally be addressed prior to closing of the credit facility, including to enable borrower’s counsel to deliver a customary legal opinion. To preserve the state of the closing date governing documents on this point, the credit facility documentation may prohibit amendments to the underlying governing documents to the extent that they materially and adversely affect lenders’ interests.

Part II: Exercising Remedies: Foreclosure vs. Proxies

With a first-priority perfected equity pledge, a lender will have two main avenues for enforcing remedies under the UCC should an event of default occur: foreclosure or proxy exercise. Below we describe each of these avenues as well as what outcome a lender may achieve.

1. Foreclosure

A foreclosure is the process by which a lender either (i) forces the sale of the pledged equity or (ii) takes ownership of the pledged equity itself in exchange for outstanding debt (i.e., a “strict foreclosure”).

A lender pursuing a foreclosure sale must comply with specific requirements under the UCC governing this exercise of secured creditor remedies, the overarching standard being that “every aspect of a disposition of collateral, including the method, manner, time, place and other terms” must be commercially reasonable under Section 9-610(b) of the UCC. A lender can ensure that a foreclosure sale satisfies the commercially reasonable standard by meeting the safe harbor requirements under 9-610(b) of the UCC. Among other things, the lender must provide 10 days’ prior notice to interested parties, which includes the borrower and its subsidiaries and other lienholders. Other requirements include running UCC lien searches 20 days prior to the notice of a foreclosure sale. In the case of a business reliant on goodwill or counterparty confidence or otherwise deteriorating rapidly, these hurdles can virtually eliminate the ability to recover value from the collateral. They can also create opportunities for foot-faults giving other parties-in-interest the ability to challenge the lender. The need to satisfy the commercially reasonable standard may also dictate a lender’s decision to pursue a public or a private sale. While a private sale may be preferable as, among other things, faster, cheaper, and less likely to advertise the state of a distressed business, it could invite challenges to the extent there has not been a fulsome preforeclosure marketing process.

A strict foreclosure provides an avenue for a lender to take ownership of the pledged equity in a quick, cost-effective, and private manner (even more so than a private foreclosure sale). Even if a lender is willing to own the business (which may, for reasons discussed below, not be a viable option), after default a strict foreclosure requires the consent of (or failure to timely object by) the pledgor and, in certain instances, guarantors and any other creditors with liens on the pledged equity and leaves the lenders with any liabilities burdening the business. Secured parties must also consider the applicability of federal securities laws when selling or accepting a strict foreclosure on pledged equity.

2. Proxy Exercise

By contrast to the stringent legal requirements of a foreclosure sale or constraints of ownership of a challenged business, a lender may instead allow the parent to retain beneficial ownership of the pledged equity interests, while the lender exercises the power to direct the voting rights of those equity interests. Assuming the absence of limitations in the governing documents as discussed above, this means the lender can assume full control over the governing body of the borrower, including making management decisions directly, without any involvement from the pledgor or the pledged entity.

This proxy exercise is often a more attractive option for lenders, as they can exert control quickly (and often immediately) to replace the governing body or otherwise direct management decisions without the need to abide by strict procedural requirements (including a prior notice period) or the need to become the equity holder. This can be particularly useful where the lender (1) cannot legally become an equity holder due to the regulated nature of the borrower’s business (e.g., a broker-dealer, healthcare practice, or utility company), (2) wants to avoid exposure to further downside risk, or (3) is simply not in a position to direct the management and operation of a distressed business. This tool may also avoid triggering change-of-control provisions under the borrower’s key contracts or other debt facilities, though diligence of each such contract would be needed to determine whether a “board flip” itself would constitute a change of control. Similar diligence would be needed before concluding that such an exercise would not have regulatory consequences. Additionally, a lender contemplating a proxy exercise should expect replacement directors to focus on the company’s directors-and-officers insurance and be aware that additional coverage may be required to supplement existing policies. It will also be critical for a lender to be ready with a plan to retain management. Last, after successful exercise of proxy rights, a lender should bear in mind that the newly appointed governing body will owe fiduciary duties to the company as a whole and cannot make decisions solely to benefit the lenders as explained in further detail in Part III below.

Consideration should be taken when drafting the relevant provisions of a pledge agreement. The pledgor must grant the lender an irrevocable proxy coupled with an interest that survives for the life of the credit facility. Otherwise, certain applicable law imposes a mandatory expiration date (under Delaware law, the default lifespan is three years). The lender should also be appointed as an attorney-in-fact, thereby giving it the practical means of executing and delivering documents on behalf of the pledgor.

From a commercial perspective, the focus of both borrowers and lenders is undoubtedly whether advance notice to the pledgor by the lender is required for a proxy exercise (or any other exercise of rights and remedies with respect to equity, for that matter). Lenders typically prefer concurrent notice, while borrowers will push for as much notice as possible. Though the market differs based on the creditworthiness and size of the borrower, it is not unusual to see lenders conceding to provide one to three business days’ prior notice (and occasionally longer in the institutional term loan B market or where sponsors otherwise wield power in negotiations). Theoretically, this may give sufficient time for the borrower to file for bankruptcy during the intervening period, at which point the lender will be prevented from exercising its proxy rights due to the automatic stay intended to preserve the prebankruptcy status quo. The severity of this risk depends on the facts and circumstances, as a bankruptcy filing on such short notice may or may not be feasible.

As a general matter, the exercise of a proxy will not allow a lender to sell the equity in a borrower outside of an Article 9 foreclosure process if the direct parent that pledges this equity and grants the proxy will not consent to the sale. Any rights granted under a security agreement remain subject to applicable law, which generally requires equity holders’ approval to sell their stock unless a secured creditor is exercising UCC foreclosure rights.

Part III: Options Before Remedies: Forbearance Agreements and Independent Directors

When a borrower is in default under its credit documents, in lieu of exercising remedies of foreclosure or proxy exercise, it is common for lenders to negotiate certain operating or even sale milestones for the company in exchange for forbearing from exercising rights and remedies or waiving the default. The full suite of milestones can vary, but may include a requirement that the company appoint one or more independent directors with varying degrees of authority vis-à-vis the incumbent board or other governing body.  

1. Role of Independent Director

An independent director is not an employee of the company, does not derive any income from the company (other than compensation for acting as an independent director), and is not involved in day-to-day management. Independent directors are typically appointed when a company is facing persistent distress and generally tasked specifically with evaluating the company’s strategic alternatives, such as a sale or restructuring transaction.

Under applicable state law and its respective organizational documents, directors owe fiduciary duties to the company and may owe duties to creditors or other stakeholders. Fiduciary duties include the duty of care and the duty of loyalty. The duty of care requires directors to make informed business decisions and act in a manner that the director reasonably believes are in the best interests of the company. The duty of loyalty requires that a director put the best interests of the company before any interest of its own. While the duties of an independent director are no different from that of any other director, the perception is that these individuals, with specific expertise and experience and no vested interest, will more aptly exercise such duties and bolster the legitimacy to decisions of the full board. 

2. Benefits for Lender and Companies

Where the appointment of an independent director is predicated on a negotiated waiver or forbearance, it is common for a lender to require the borrower to appoint an independent director chosen from a list of individuals provided by the lender. These individuals are frequently restructuring professionals with experience with the lender and/or the sponsor (or their respective advisers) and may also have industry experience.

From the lender’s perspective, an independent director can assist the company in making decisions that maximize the value of the borrower’s assets and, thus, recovery for its constituents (including the lender). However, it is important for the lenders to remember that independent directors cannot exert full control over the company’s decision-making on the lender’s behalf, nor can they act with only the lender’s interests in mind. An independent’s director’s powers under a company’s operating agreement must comport with its fiduciary duties to the company.

An independent director provides many of the same benefits to a company and related sponsor as it does a lender. A sponsor benefits from an impartial decision maker who can guide a distressed portfolio company to make strategic decisions to maximize not only recovery for creditors but also value for investors. Moreover, in a distressed or insolvency scenario, any transactions a company undertakes will likely be examined with heightened scrutiny by creditors, trustees, and courts. The involvement of an independent director can bolster the company’s arguments that strategic decisions were intentional, impartial, and considered all interested parties.

Conclusion

Equity pledges are powerful but nuanced tools in private credit. Their effectiveness depends not only on the pledge agreement itself but also on the borrower’s corporate form, the terms of the borrower’s governing documents, the requirements of the UCC or other applicable law, and the result a lender is looking to achieve. For lenders, in addition to providing economic value, equity pledges can provide leverage, optionality, and, in some cases, a clear path to control. For borrowers and sponsors, equity pledges are about more than collateral for a secured loan — they affect governance, bankruptcy strategy, and overall capital structure stability. At the same time, lenders and borrowers should keep in mind the legal and practical limitations on, as well as the additional avenues opened by, a lender’s ability to take control via an equity pledge of its borrower.

Private Credit Perspectives is a series focused on legal and market developments impacting private credit investors.