June 24, 2015
Best Practices: Due Diligence Documents for Single-Member LLCs
by Ethan W. Smith
- Do nothing. There are plenty of lenders that get push-back from their customers when they request an Operating Agreement for the borrower’s single member LLC and simply do nothing. They do not memo their files; they do not review the controlling provisions of the applicable state law; and they don’t get any additional documentation from their customer on this point. The benefits of this approach is that it avoids potential conflict with the client. The drawbacks include lack of clarity regarding the due execution of lender’s loan documents which could lead to enforceability issues for the lender; and issues for the borrower in proving that the business is separate from the individual, which could negate any limited liability protection that the borrower was hoping to obtain from setting up the LLC in the first place.
- Require the borrower to obtain an Operating Agreement for the LLC. Other lenders always require borrowers to provide an Operating Agreement, even for single member LLCs, in accordance with the requirements of the Loan Authorization. The benefits of this approach are clarity regarding the due execution of the loan documents, and unquestionable SBA compliance on this point for the lender; and less chance for the loss of limited liability protection for the borrower. The drawbacks of this approach is that it can sometimes make borrowers… “cranky” (ß legal term). Notwithstanding the fact that a quick internet search for form operating agreements turned up dozens of options for borrowers to obtain this document for free, or at a very modest cost, borrowers often are advised that they “don’t need” an Operating Agreement, and don’t want to hear differently from their lender, leading to the perception that the lender is asking for “unnecessary” documents. This can often lead to conflict between the lender and the borrower and adversely impacting the lender-customer relationship.
- Take a middle path. Finally, there are some lenders that take an approach in between doing nothing and requiring a full blown Operating Agreement. Often these lenders will require the borrower to provide an incumbency certificate or affidavit confirming that the LLC is a single member LLC, confirming the identity of the member, the capacity in which he or she can act to bind the company, and confirming that the lender may rely on this document in making the loan. If the borrower is represented by counsel, these items can also be confirmed by a letter from the borrower’s attorney. Is this approach as good as getting an Operating Agreement? No, but it does blunt much of the potential risk for the lender in obtaining duly executed and enforceable loan documents and also provides proof to the SBA that this issue was seen and addressed in a commercially reasonable manner. Additionally, while it does not address the borrower’s potential limited liability issues, it does provide an alternate solution for lenders to provide to address this due diligence requirement, avoiding conflict with the borrower and preserving the quality of the customer experience.
As a lender, the option that you choose will be based on weighing the respective risks and benefits of each, and may change from borrower to borrower and loan to loan. The best practice for lenders is to choose an option that ensures the enforceability of its loan documents and demonstrates to the SBA a commercially reasonable attempt to comply with SBA guidelines.
For more information regarding due diligence requirements for SBA loans, contact Ethan
at 267-470-1186 or at firstname.lastname@example.org.