Private Equity

There are few things more basic to the legal due diligence of a target company than determining whether the acquisition will trigger any required consents under change-of-control or anti-assignment clauses contained within certain “material” contracts or within shareholders’/LLC members agreements.^[1]  Anti-assignment and change-of-control clauses come in a variety of shapes and sizes, and whether they apply to your specific transaction can sometimes be a complex analysis depending on the exact wording of the clause in question.  If there is only an anti-assignment clause (and no express change-of-control provision that would otherwise apply), and the anti-assignment clause merely prohibits the transfer or assignment by the target of the contract itself (or by the specific shareholder or member of the entity being acquired), there are usually structuring alternatives, such as a merger or upper-level stock sale, that are available to avoid triggering such a clause.^[2]  But when an anti-assignment clause prohibits both direct and “indirect” assignments or transfers, even when there is no express change-of-control provision, does such a clause potentially constitute a de facto change-of-control provision?

It turns out that despite the ubiquity of provisions purporting to restrict both direct and “indirect” assignments, there is no clear cut general answer to the question of whether an indirect transfer of an asset by a party occurs simply because there is a change of control of that party.  Rather, each agreement must be analyzed in light of the totality of its provisions.  Nonetheless, there are some general legal principles that appear to govern the interpretation of these clauses.

First of all,  courts appear to generally recognize that “[a]nti-assignment clauses are normally included in contracts to prevent the introduction of a stranger into the contracting parties’ relationship and to assure performance by the original contracting parties.”^[3]  But it appears that most courts recognize as unassailable the “rule that the sale of stock in a subsidiary is not a sale of the subsidiary’s assets; when a subsidiary is sold by a parent, the subsidiary retains ownership of its assets.”^[4]  Thus, most (but not all) courts appear to agree that a simple prohibition on the target transferring or assigning a contract or an asset, without a counterparty’s consent or compliance with a first right of refusal, is not triggered by a sale of the equity interests in the target or by a reverse triangular merger where the target survives notwithstanding a change of control of the target.^[5]  And that appears to be true even when the phrase “by operation of law or otherwise” is used in the simple anti-assignment clause.^[6] 

Secondly, cases do exist in some jurisdictions where courts have found that a transfer of the equity interests in a party effectively transferred the party’s interest in the underlying agreement or asset, even without direct and indirect language (effectively treating the transfer of an upper tier entity as subterfuge to end run the anti-assignment clause).^[7]  But most cases following this “minority view” appear to achieve this result via the existence of specific language prohibiting both direct and indirect assignments or transfers, and in the absence of such language refuse to extend the scope of the anti-assignment clause.^[8]  The “majority” view appears to be that  “transfer restrictions must expressly state that they apply to upstream entities” or they don’t.^[9]  And courts following the majority view seem to require more than just direct or indirect language in order to find that the transfer restrictions specifically apply to upstream entities.  Indeed, although often cited for the proposition that a restriction on direct or indirect assignments automatically implicates upper tier transfers of equity in the party prohibited from making such direct or indirect assignment, H-B-S Partnership v. Aircoa Hospitality Services, Inc., 114 P.2d 306 (N.M. 2005), should not be so broadly read.  Although H-B-S Partnership did hold that a sale of a party’s “corporate great-great grandparent was an ‘indirect transfer’” triggering a right of first refusal, the contract in question specifically included not only “direct or indirect” transfers, but also “involuntary” transfers, transfers by “merger” or “operation of law,” and “the transfer of an equity interest in a Partner … if the transfer results in a change of control.”^[10]

Finally, even when a transfer restriction or right of first refusal is expressly triggered by proposed transfers or assignments that are effected either “directly or indirectly,” courts have looked at who was the actual person bound by that restriction or right of first refusal.  Thus, in Foundation For Seacoast Health v. HCA Health Services of New Hampshire, Inc., 953 A.2d 420 (N.H. 2008), the New Hampshire Supreme Court held that a right of first refusal to purchase a Hospital was not triggered by a sale of the corporate great-grandparent of the entity party that owned the Hospital notwithstanding that both “direct and indirect” transfers and transfers occurring “by merger or transfer of stock or otherwise” were specifically covered.  And the reason was simple.  No one other than the owner of the asset involved and its immediate parent were parties to the right of first refusal agreement.  According to the court, by specifying that the only parties to the agreement were the Hospital owner and its immediate parent, it was only those two parties whose actions could trigger the right of first refusal, either directly or indirectly, not persons higher up the corporate chain, who had not agreed to be bound by the terms of the agreement.  And in this case it was easy to see how you could still have an indirect transfer of the Hospital, through a stock sale not involving nonparties, because the immediate parent of the entity owning the Hospital was a party bound by the agreement containing the right of first refusal.

Similarly, in Maryville Hotel Associates I, LLC v. IHC/Maryville Hotel Corp., No. 4:05 CV 1493 DDN, 2006 WL 1237264 (E.D. Missouri May 5, 2006), the court held that a right of first refusal arising with respect to any transfer, “directly or indirectly,” of an LLC membership interest, did not apply to a transfer of the stock of the corporate grandparent of the member entity.  According to the court, the right of first refusal was only triggered if the member was the actual actor transferring its interest in the LLC; and only the member could be the actor who could actually do anything that constituted a direct or indirect transfer of the membership interest, not non-party upper tier parents of the member. In other words, while a party to a contract may be restricted by that contract from doing something indirectly that the party agreed not to do directly, that party’s obligation to refrain from indirect actions may not actually restrict a non-party holding company from doing whatever it wishes.  And unless the party has agreed to treat actions by a non-party holding company as constituting actions by it, the actions of the non-party holding company are not necessarily indirect actions by the party itself.

So, is there a clear-cut universal answer to determining the impact of “direct or indirect” language in transfer restrictions?  No.  All transfer restrictions must be evaluated on their own specific terms and in light of the specific state law that governs the contract in question.  And until the singularity occurs, that evaluation requires experienced judgment regarding the nuances of these provisions and the application of that law by real lawyers; thus, flag them, ponder them, apply the law, and make a judgment after considering the impact of the issue on the overall deal.