In a little noticed case reported on December 19, 2011, Condo v. Conners, the Colorado Supreme Court issued a decision on a common contract drafting problem – the effect of an anti-assignment clause.
Historically, when contracting parties wanted to prohibit each other from assigning the contract, a lawyer would include language reading something like: “A party shall not assign, sell or otherwise transfer its rights under this agreement without the written consent of the other party.”
Back in the day, that language accomplished the parties’ intent, because courts held it meant that a party did not have the power to assign a contract, and any assignment without consent would be void and treated as though it never happened. That is the “classical” or “historical” rule.
Over the last 10-20 years, a new rule has developed; some courts have held that language prohibiting assignment does not mean the parties can’t assign, it means that if they do it is a breach of the contract, but the assignment still stands. The foundation of the new rule is a public policy that the law favors assignability of contract rights. Under the new rule if a party assigns the contract without consent and in breach of the contract language, the other party could not bring an action to void or ignore the assignment, but could only bring an action for damages – a very bad outcome for someone who simply doesn’t want to be in a contract with a party he didn’t chose! Moreover, in most situations it is very difficult to measure and prove damages arising from a prohibited assignment.
Anti-assignment clauses are found in many types of contracts, but are particularly important in contracts where people are going into business together, like partnership agreements, joint venture agreements and limited liability company operating agreements. For example, if three people decide to join-up and start a business, they are usually counting on one another to contribute some special area of expertise, to invest time and money, and to be there for the others, at least until the business is established. They do not want to suddenly find they have a new business partner because one of them sold his interest or transferred it in a divorce, and that is exactly what happened in this case.
In Condo v. Conners, three people formed a Colorado limited liability company and signed an operating agreement that said “a member shall not sell, assign, pledge or otherwise transfer any portion of its interest in [the Company] without the prior written approval of all of the Members”. One of the members got a divorce, and as part of the divorce settlement he tried to assign his membership interest to his wife. The other two members did not consent, so he assigned his wife only the right to receive distributions, and also agreed to follow her instructions when voting his membership interest. When he later sold his membership interest to his partners, his ex-wife sued to void the sale and enforce the earlier assignment to her.
The outcome of the case hinged on the new rule versus classic rule debate – if the new rule applies, the assignment to the ex-wife in violation of the operating agreement is not void, but the two partners would have a breach of contract claim against the husband – the wife wins. If the classic rule applies, the wife loses because the assignment to the wife in violation of the operating agreement would be void and treated as though it never happened.
The dispute made it to the Colorado Supreme Court, where the wife argued that a Colorado LLC operating agreement should not be interpreted under contract law, but rather as a formation or governing document like corporation articles or bylaws. Fortunately, the Supreme Court disagreed. Looking to Delaware case law, In re Seneca Invs. LLC, 970 A.2d 259 (Del. Ch. 2008), the Supreme Court held that operating agreements are contracts and shall be interpreted under prevailing contract law. This part of the decision is important because limited liability company acts are divided into two categories: (1) those with extensive default rules governing the conduct of the company’s governance (like corporation acts), and (2) those with very few or no default rules, leaving all or most matters to the contract between the members (contractarian acts). The Delaware Act follows the contractarian view, and several years ago Colorado changed its limited liability company act to remove most of the default rules and became a contractarian act similar to the Delaware model. A holding by the Supreme Court that an LLC operating agreement was something other than a contract would have undermined the intent of the Colorado legislature in overhauling the LLC Act, and diminished one of the primary benefits of an LLC – the flexibility to constitute, govern and operate your company in the manner you wish, without extensive statutory constraints.
However, the Supreme Court also recognized that an LLC operating agreement is different from the average commercial contract, because it has a statutory scheme at its foundation – the Colorado Limited Liability Company Act. Each operating agreement must be interpreted as a contract, but within the language and requirements of the act. For example, the husband’s operating agreement prohibited assignment of “any portion of” the membership interest. The Supreme Court looked to C.R.S. Sec. 7-80-102(10), which says that a membership interest in an LLC includes the “right to receive distributions”, and C.R.S. Sec. 7-80-108(4), which requires the courts to give “maximum effect” to the operating agreement. Since the right to receive distributions is part of a membership interest, and the husband assigned his right to receive distributions, then he assigned a “portion” of his membership interest, in breach of the operating agreement.
In light of the breach, the court had then to decide whether to apply the modern rule and let the assignment stand anyway, or apply the classical rule and void the assignment. So, when faced with the opportunity to say which rule applies to contracts in Colorado, the Supreme Court…………punted. Instead of adopting a hard and fast rule for the interpretation of anti-assignment clauses, or even anti-assignment clauses only in operating agreements, the Supreme Court held that either rule might apply to a contract under Colorado law, and which rule applies can only be determined by discerning the intent of the parties and the facts of a specific case. In THIS CASE, the Supreme Court applied the classical rule, holding the assignment by the husband to his wife was void because the language of the operating agreement, read in conjunction with the language of the statute, indicated that the parties wanted to restrict who they would do business with and prevent any assignment without consent. The ruling implies that similar language in other operating agreements might be interpreted the same way, but it is not a rule. Moreover, the court specifically said it was not rejecting the modern rule, which might apply to other contracts, including other operating agreements, if the facts and intent warranted.
The lessons from this decision are not new. Courts seldom adopt a hard and fast rule when it is unnecessary to decide the case before them – doing so often invokes the law of unintended consequences, and restricts the flexibility of courts to fashion justice in other cases. It is up to the parties to say what they want. Since at least 2003 and possibly earlier, legal commentators have been advising lawyers who want to strictly prohibit assignment of a contract to address this very issue. In Negotiating and Drafting Contract Boilerplate (ALM Publishing 2003), Tina Stark dedicates an entire chapter to this issue (Chapter 3, Assignment and Delegation).
An anti-assignment clause in an important contract should not be thrown in as “standard language” or culled from form boilerplate. If you might want to assign the contract or certain rights or obligations in the future, but don’t want to raise the issue during negotiations, then vague language of the type used in Condo v. Conners may be best – leave that fight for another day. But if it is important to you that the contract not be assigned, language of the following type will avoid the type of analysis and uncertainty reflected in Condo v. Conners:
No party may assign its rights or delegate its obligations under this Agreement, without the written consent of the other party. Any purported assignment or delegation in breach of the preceding sentence shall be void.
Posted in Contracts | Tagged anti-assignment, Condo v. Conner, limited liability company, LLC, operating agreement | Leave a Comment
One of the key considerations in structuring merger and acquisition (M&A) transactions is determining which contracts of the target company, if any, will remain in effect for the acquiror following closing. This post will briefly outline: (1) the general rules of contract assignment; (2) the effect of anti-assignment clauses and other exceptions to the general rule of assignability; and (3) the effect of four common M&A structures on contract assignment.
General Rule: Contracts are Freely Assignable
The general rule is that contracts are freely assignable unless the contract itself, a statute, or public policy dictates otherwise. This is true in Washington State, where courts have found that contractual rights are generally transferable unless the contract expressly prohibits assignment in “very specific” and “unmistakable terms.”
Exceptions to the General Assignability Rule
The exceptions to the general rule of free assignability fall into two broad categories: (1) contractual prohibitions on free assignability (“anti-assignment clauses”) and (2) case law prohibitions on free assignability of certain types of contracts that arise out of public policy concerns.
In light of the general rule of free assignability, most business contracts contain a clause – commonly referred to as an “anti-assignment clause” – that expressly prohibits the assignment of contractual rights without the consent of the other party to the contract. These anti-assignment clauses typically take one of two forms. The first, which we will call “simple” anti-assignment clauses, simply prohibit the contractual right from being assigned without the consent of the other party to the contract. For example, a simple anti-assignment clause might state:
This contract shall not be assigned or transferred by Party X without first obtaining the consent of Party Y.
While simple anti-assignment clauses are generally enforceable, certain types of M&A deal structures effectively circumvent such provisions and, accordingly, the necessity of third-party consents (see the discussion below regarding the impact of M&A deal structures on contract assignment for more detail).
Comprehensive Anti-Assignment Provisions
In response to the inability of “simple” anti-assignment clauses to protect contractual rights in certain M&A contexts, many contracts include more robust anti-assignment provisions designed to require third party consent prior to an M&A event, even where the content itself will not be transferred. For example, a comprehensive anti-assignment clause might state:
Party X shall not assign this Agreement in whole or in part without Party Y’s prior written consent, which consent shall not be unreasonably withheld, conditioned or delayed. Any change in control of Party X resulting from a merger, consolidation, stock transfer or asset sale shall be deemed an assignment or transfer for purposes of this Agreement that requires Party Y’s prior written consent.
Courts will generally enforce these types of comprehensive anti-assignment clauses and conclude that consummation of a change of control transaction without consent is a breach of contract. Accordingly, to assign contracts with comprehensive anti-assignment provisions, the target must seek the consent of the counterparties to each such contract. Obtaining third party consents in connection with M&A transactions may create sticky situations or cause costly delays. The target company may not want their customers, suppliers or others to know that they are going through an M&A event, while the acquiror may want assurances that important contracts will remain in place. What is more, certain contract counterparties may use the leverage of their consent to renegotiate the terms of the contract or extract concessions from the target company. Accordingly, it is important that the parties identify and address comprehensive anti-assignment clauses early in the process – particularly where the contracts to be acquired make up a large portion of a target company’s value.
Contracts That Involve a “Personal” Right
Contracts involving “personal rights” or contracts deemed “personal” by contractual recital or federal law are considered non-assignable or non-transferable unless specific consent is given by the non-assigning party. Generally, “personal” contracts are those that contemplate personal services, skills or performance from the non-assigning party, such as employment, consulting, and partnership agreements. Courts have found that these types of agreements are not freely assignable as a matter of public policy because assigning personal contracts may result in materially adverse consequences (e.g., a material change in duty, risk, or burden) to the non-assigning party. In addition to general contracts for personal services discussed above, courts have also found many types of intellectual property (IP) licenses to be “personal” in nature due to the profound importance of an IP holder’s right to choose who may use the protected IP. Accordingly, non-exclusive IP license rights pertaining to copyright, trademark, and patent licenses are generally considered non-assignable, unless specific consent is given by the non-assigning party. Personal contracts are also treated differently from other types of contracts in the context of M&A events (see the discussion below regarding the impact of M&A deal structures on contract assignment for more detail). Each of the types of “personal” contracts described above should receive heightened contract-by-contract due diligence to ensure that assignment does not violate applicable law.
Courts may also consider the subject matter of the contract and the material risks associated with transferring those rights to the acquiror. For example, where the non-merging entity is a competitor to the acquiring entity, courts may find that given the high risk and burden to the non-merging party, the assignment is ineffective on equitable grounds.
The Effect of the Four Most Common M&A Structures on the Assignment of the Target’s Contracts
The structure employed in a given M&A transaction is critical to determining the treatment of the target company’s various contractual rights. This section will examine the treatment of contractual rights in connection with four common M&A structures: (i) reverse triangular mergers, (ii) forward-triangular mergers, (iii) stock purchases, and (iv) asset purchases. For more information regarding M&A deal structures, please see here and here. While reviewing each of the deal structures that follow, please note that each of the general rules are subject to the exceptions discussed above.
Reverse Triangular Merger
A reverse triangular merger occurs when an acquiror forms a subsidiary and the newly created subsidiary merges with and into the target company. The target survives as a wholly-owned subsidiary of the acquiror following the merger, and continues to own its assets, owe its liabilities, and be party to its contracts.
In a reverse triangular merger, simple anti-assignment clauses generally are not triggered because, as a matter of law, no assignment of the contract has occurred (the target company survives and is the same legal entity as the original contracting party). Accordingly, the contracts of the target remain with the surviving entity without the need to obtain third party consents or take other action. Despite the general rule that no assignment occurs in connection with a reverse triangular merger, thorough contract-by-contract due diligence is still required to identify all contracts that include comprehensive anti-assignment provisions and/or may be deemed to be contracts for personal services (and therefore require consent) under applicable law.
Forward Triangular Merger
In a forward triangular merger, the acquiring entity forms a subsidiary corporation and the target corporation merges directly with and into the newly created subsidiary. As a result, the subsidiary survives the merger. Under this structure, the subsidiary obtains all of the target company’s assets and liabilities by operation of law.
Simple anti-assignment clauses are generally not triggered in a forward triangular merger because the rights are vested, and not assigned, by operation of law. Therefore, the target’s contracts generally transfer automatically to the acquiror without the need to obtain third party consents. However, courts have created considerable ambiguity around the applicability of this general rule in the context of forward triangular mergers. Accordingly, acquirors frequently require target companies to obtain third party consent as a matter of risk allocation and to create certainty that important contracts will remain in place after the merger. As with the above, contract-by-contract due diligence is required to identify contracts that contain anti-assignment language or may be considered to be “personal.”
Direct Stock Purchase
In a direct stock purchase, the acquiror purchases all the outstanding shares of the target directly from its stockholders. Instead of owning certain assets and related liabilities, the acquiror owns the entire selling company. The selling company continues to exist as a separate legal entity and wholly-owned subsidiary of the acquiror (assuming 100% of the outstanding stock is purchased).
In a sale of the target company through a direct stock purchase, the individual assets of the target company (including its material contracts) need not be separately assigned because only the ownership rights of the target are being transferred. Like a reverse triangular merger, a direct stock purchase generally does not trigger a simple anti-assignment provision because the assets are not conveyed to a different entity. Accordingly, the contracts of the selling company remain entirely in place without the need to obtain third party consents. However, contract-by-contract due diligence is required to identify any contracts that contain comprehensive anti-assignment language that would be triggered by the change of control that occurs upon consummation of a stock sale and contracts that may be considered “personal” under applicable law.
The sale of some or all of the assets of a company is one method of transferring part or full ownership in the underlying business. In an asset purchase, the acquiror purchases certain enumerated assets and liabilities of the target in exchange for the cash, the acquiror’s stock, or other consideration.
In an asset purchase transaction, the acquiror is only responsible for the assets and liabilities specifically enumerated in the purchase agreement. All other assets and liabilities remain with the target. Without the protection of a merger statute, the purchaser of contractual assets will need to become a party to the purchased contracts through the general rule of assignability (and the absence of any exceptions). Therefore, if a contract purchased as part of an asset sale contains an anti-assignment provision (whether “simple” or “comprehensive”) or may be considered “personal”, then the target company must obtain the consent of the counter party in order to convey the contract to the acquiror. In the event that neither of the exceptions to the general rule apply, then the contract is generally assignable to the acquiror.
Although contracts are generally freely assignable, in the context of any M&A transaction or other proposed contract assignment, careful consideration should be given to: (1) whether the contract in question includes an anti-assignment provision and, if so, whether the provision is “comprehensive” (i.e., applies to change of control transactions even where, by operation of law, no assignment would be deemed to occur); (2) whether the contract is “personal” in nature; and (3) how the proposed deal structure impacts the treatment of the target’s contractual rights. Given the fact-specific standards for assignment, each of the target’s contracts should be carefully reviewed during the due diligence phase of an M&A transaction to ensure that they are assigned in compliance with applicable law.