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Article of Interest

Indirect Transfers: Circumventing Transfer Restrictions—Delaware and Texas
By:  Ty Sheehan, Attorney, Hornberger, Sheehan, Fuller & Beiter

Frequently, the governance documents of closely held businesses (shareholders agreements, company agreements and partnership agreements, among other ownership and governance documents) provide for transfer restrictions which prevent the outright and free transfer of interests in the entity in question. These are sometimes referred to as anti-assignment provisions. By restricting the transfer of interests in a closely held company, the owners have some assurance regarding who their "partners" will be in the future. There are a variety of different ways to draft transfer restrictions, from an outright restriction against transfers without the consent of all or some portion of the other owners, to temporary restrictions against transfers which burn off after a period of years, to preferential rights in favor of the non-transferring owners which may include a discounted buy-out of the attempted transferor or a right of first refusal in favor of non-transferring owners (among a multitude of other forms of restriction or devises to discourage transfers or protect non-transferring owners).

Regularly, our clients request that we assist them in transferring their interests in various companies, or to assist them in preventing the prohibited transfer of interests in a company by one of their co-owners. Sometimes, when not carefully drafted, anti-assignment provisions can be circumvented. Often, an investor will not own an interest in a company as an individual but will, instead, own and control those interests by and through another entity (sometimes referred to as a holding company). For the purposes of this article, we'll discuss what is called an "indirect transfer" or "change of control" transfer which comes into play when an owner in a company is an entity as opposed to an individual.

Consider the following scenario: OperatingCo, LLC, is owned by four parties, being Individuals A and B, and also HoldingCo, Inc. and InvestmentCo, LLC (these types of companies may be referred to generally herein from time to time as an "owner entity"). The governance documents of OperatingCo may prohibit the transfer of interests therein without the consent of all of the other owners. What if HoldingCo desires to transfer its interest in OperatingCo but cannot gain the approval of the other owners for such transfer? To circumvent the anti-assignment provisions in the OperatingCo's governance documents, the owners of HoldingCo may simply sell their stock in HoldingCo to the party desiring to be an owner in OperatingCo and voilà!—the purchaser is now an indirect owner in OperatingCo by and through its ownership in HoldingCo.

The issue is, when a company is owned at least in part by another entity, whether the transfer of ownership interests in that owner entity is tantamount to a transfer of interests in the company itself for the purpose of triggering anti-assignment provisions or preferential rights.

The legal ownership and governance matters related to an entity will be analyzed under the law of the state of formation of the entity in question, meaning governance matters between the owners of Texas entities will be analyzed using Texas law and governance matters between owners of Delaware entities will be analyzed using Delaware law. As Delaware is the most favored state for incorporation of a business[1], an analysis of Delaware law regarding indirect transfers is appropriate.

Indirect Transfers or Change of Control Transfers in Delaware

Statutory law in Delaware generally provides that ownership interests in the various entities are freely assignable except as otherwise provided in the governance documents of the relevant entity.[2] As such, Delaware courts interpret the effect of indirect transfers based on the specific language used in the relevant anti-assignment provision.[3]

Under Delaware law, transfer provisions will be analyzed in light of applicable contract interpretations principles.[4] In Delaware, a simple transfer provision which provides, for example, that "no owner may transfer his or her interests in the Company without the consent of all other owners," or "transfers of interests are prohibited without the consent of a majority in interest of the owners," would likely be construed as inapplicable on its face to an indirect transfer or change of control transfer. Based on the interpretation of the plain meaning of the simple anti-assignment provision, a court would likely conclude that a sale of the member entity's stock would not actually be a sale of the interests in the company in question.

Applying this general rule in Integrated Resources, Inc.,[5] a Delaware court reached the conclusion that the phrase "[a partner] is prohibited from transferring its Partnership Interest," constituted a prohibition against a partner's transfer of its general partner interest in a partnership, but did not prohibit the sale of the stock of the entity owning that general partner interest.6] The court held that "[c]ourts . . . must exercise prudence and care when implying rights lest they make the contract speak where it was intended to be silent."[7]
Similarly, in Star Cellular Telephone Company, Inc., v. Baton Rouge CGSA, Inc.,[8] a Delaware court determined that the phrase "[a partner] may transfer or assign its General Partner’s Interest only after written notice to all the other Partners and the unanimous vote of all the other Partners" constituted a prohibition against a partner's transfer of its interest in a partnership, but did not prohibit mergers, which would affect an indirect transfer (based on the concept that the parties would have not chosen the unaided term "transfer" to express that intent).[9] This court concluded that "[i]f a writing is plain or clear on its face, there is no room for interpretation, construction, or a search for the intent of the parties . . . . It therefore must be inferred that had the parties contemplated this specific dispute and intended to prohibit all mergers . . . they would likely have . . . . provided by appropriate language that 'transfer' means all transfers, including those arising by operation of law."[10]

Notwithstanding the Delaware courts' interpretations of simple prohibitions against transfers, when an entity's governance document has a more comprehensive anti-assignment provisions, for example restricting all "direct and indirect transfers," a Delaware court will likely reach a different conclusion than was reached in Integrated Resources Inc., and Star Cellular Telephone Company, Inc. In Asian Yard Partners,[11] a Delaware bankruptcy court analyzed the effect of the following anti-assignment clause on an indirect transfer under Delaware law: "No Partner may sell, assign, transfer, give, hypothecate or otherwise encumber (any such sale, assignment, transfer, gift, hypothecation or encumbrance being hereinafter referred to as a 'Transfer'), directly or indirectly, or by operation of law or otherwise, any interest in the Partnership which consent shall be given or withheld in each Partner’s sole discretion." In Asian Yard Partners, the court addressed the ruling in Integrated Resources, Inc. and determined that it was distinguishable.[12] The Court provided that "the anti-transfer provision is broadly stated. It bars a transfer of the partner interest 'directly or indirectly, or by operation of law or otherwise.' These words cannot be ignored in applying the provision to the proposed transfer. By using the words 'directly or indirectly' the parties obviously meant that a partner could not do indirectly that which it was prohibited from doing directly."[13]

From these cases, it appears that the current state of the law in Delaware would dictate that a court will analyze the language of an anti-assignment provision under the general tenets of contract interpretation to determine whether an indirect transfer or change of control transfer is prohibited by the relevant anti-assignment provision, and that the use of modifiers, such as "directly or indirectly" and "by operation of law or otherwise," may be the deciding factor in a court's interpretation. This is something to keep in mind when drafting instruments for your client or interpreting their right to effect indirect transfers in the face of anti-assignment provisions or preemptive rights.

Indirect Transfers or Change of Control Transfers in Texas

In 1996, in Tenneco Inc. v. Enterprise Products Co., the Supreme Court of Texas addressed, in a case of first impression, the effect of a stock sale on a right of first refusal which, although not an anti-assignment provision, is a preferential right which is triggered upon attempted transfers in the same way.[14] The relevant provision provided that "if any Owner should desire to sell, transfer or assign all or any part of its Ownership Interest, the other Owners shall have the prior and preferential right and option to purchase proportionately the interest to be sold by such Owner."[15]

In Tenneco, all of the outstanding stock of an entity party to an operating agreement was purchased by a third party. The plaintiffs argued that that transaction was, in substance, a transfer of an ownership interest which invoked the right of first refusal.

The Court was not persuaded by this argument and held that "[t]he purchaser of stock in a corporation does not purchase any portion of the corporation’s assets, nor is a sale of all the stock of a corporation a sale of the physical properties of the corporation. Sound corporate jurisprudence requires that courts narrowly construe rights of first refusal and other provisions that effectively restrict the free transfer of stock."[16] The Court further stated that the preferential right language "says nothing about a change in stockholders. The [parties] could have included a change-of-control provision in the agreements that would trigger the preferential right to purchase. None of the agreements . . . contained such a provision. We have long held that courts will not rewrite agreements to insert provisions parties could have included or to imply restraints for which they have not bargained."[17]

In conclusion, the Court provided that "[i]n holding that the sale of a corporation’s stock does not trigger rights of first refusal, we join courts from other jurisdictions that have considered this issue[18] . . . . We also recognize the insight of commentators who have long maintained that stock sales do not invoke preemptive rights."[19]

In Tenneco, the Texas Supreme Court opinion was clear in ruling that a simple preemptive right provision will not be triggered by an indirect transfer. It is not clear what the result would be under Texas law if modifiers such as "directly or indirectly" are used in an anti-assignment clause or preemptive right language in Texas. However, we can be confident based on the suggestions of the Court in Tenneco, that "change of control" provision, providing something to the effect of "it is expressly agreed that a change of control of an owner entity shall constitute a transfer subject to the restrictions of this Section," will restrict change of control transfers—something to consider in your drafting and when advising your clients.

Conclusion

Based on review of relevant law in Delaware and Texas, we can conclude that if you desire to restrict a company's owners from effecting indirect transfers, specifically address such transfers in the anti-assignment provisions of company's governance documents by including change of control language and modifiers such as "directly and indirectly" to reflect the parties' intent that indirect transfers are subject to restriction. The use of broad language, such as "no owner may transfer his or her interests, directly or indirectly, or by operation of law or otherwise," and change of control provisions providing that "it is expressly agreed that a change of control of an owner entity shall constitute a transfer subject to the restrictions of this section," will support a position that indirect transfers were contemplated by the parties and should be restricted.

On the other hand, if your client desires to effect a prohibited transfer, in the event the relevant anti-assignment language does not expressly include change of control language or modifiers such as "directly or indirectly," a Texas or Delaware court is unlikely to interpret that anti-assignment language as prohibiting an indirect assignment of interests—and so it may be possible for your client to circumvent such restriction or preferential rights by effecting an indirect transfer.

Ty Sheehan is an associate at Hornberger, Sheehan, Fuller & Beiter in San Antonio, and represents companies and individuals in business, commercial real estate and securities transactions. His email address is tysheehan@hsfblaw.com.

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[1] This results from a number of considerations such as well developed and flexible corporate statutes in Delaware, a specialized and efficient court which focuses on corporate matters (the Court of Chancery), favorable usury laws, and the fact that it is a state with a small population that might be characterized as mostly pro-business, among others.

[2] Del Code Ann, tit. 6 § 18-702 and 17-1702 (2011)
[3] Integrated Resources, Inc., 1990 WL 325414 at 6; Star Cellular Telephone Company, Inc., 1993 WL 294847 at 884.
[4] Star Cellular Telephone Company, at 884.
[5] 1990 WL 325414.    
[6] Id.
[7] Id. (citing throughout Restatement (Second) of Contracts §§ 203-04 (1981) and 17 Am.Jur.2d Contracts § 255 (1964), as well as several New York cases).
[8] 1993 WL 294847
[9] Id. at 888.
[10] Id.
[11] 1995 WL 1781675.
[12] Id. at 7.
[13] Id.
[14] Tenneco Inc. v. Enterprise Products Co., 925 S.W.2d 640 (1996).
[15] Id. at 643.
[16] Id. at 645
[17] Id. at 646
[18] Id. (citing LaRose Mkt. v. Sylvan Ctr.,530 N.W.2d 505, 508 (1995); K.C.S., Ltd. v. East Main Street Land Development Corp., 40 Md.App. 196, 388 A.2d 181, 183 (1978).
[19] Id.