Despite recent decisions by the Delaware Court of Chancery, many key corporate documents continue to include restrictions on indirect transfers of equity that may not be enforced if challenged in court. The concern comes up often—two partners create a joint venture, and each partner wants to ensure that the other cannot transfer its interest to a third party, forcing the remaining partner to work with someone they did not choose to go into business with. The partners memorialize their arrangement by forming a Delaware limited liability company (an "LLC") and entering into an LLC Agreement. Each partner holds their equity in the LLC through another LLC wholly owned by them (each a "Member LLC"). The partners' LLC Agreement prevents transfers of equity without the non-transferring partner's consent. However, unless the transfer restrictions prohibit "direct or indirect" transfers of equity, a partner could transfer the equity in its Member LLC without breaching the partners' LLC Agreement. This is because, following the transfer, the Member LLC is still the member of the company—it just has a new owner. Recent Delaware decisions have called into question the traditional "direct or indirect" language that is intended to restrict indirect transfers of equity.
In Sixth Street Partners Management Company, L.P. v. Dyal Capital Partners III (A) L.P.,[1] the court refused to grant an injunction enforcing an indirect transfer provision in an equity subscription and investment agreement, which prohibited any investor from "Transfer[ing] its Interests." "Transfer" was defined as any transfer that would directly or indirectly transfer, sell, assign, or dispose of any interest. Upstream entities of Dyal, an investor in Sixth Street, planned to undergo a change in ownership. Sixth Street sought to enjoin the indirect transfer of Dyal's interest through use of the transfer restriction in the investment agreement. To trigger the transfer restriction, the court reasoned that the transaction must satisfy three components: (1) the subject of the sentence (the investor), (2) must perform a specific action (a Transfer), and (3) with the verb's direct object (the interests). The transaction did not satisfy part (1) because Dyal was not the subject performing the Transfer. Because the upstream entities were not party to the governing agreement, the court declined to enforce the transfer restriction. The court cited two Delaware cases to support its rationale.
First, in Borealis Power Holdings Inc., v. Hunt Strategic Utility Investment L.L.C.,[2] the court found that the indirect transfer of a minority member's ownership interest through a transfer of equity in a holding company did not trigger the majority member's right of first refusal to purchase the minority membership's interest. Like its analysis in Sixth Street, the court focused on syntax and sentence structure, reiterating that a transfer is valid only if the subject performing the action is bound to the restriction.
Second, the court in Sheehan v. AssuredPartners, Inc.,[3] considered if a tag-along right tied to a majority limited partner "selling or otherwise Transfer[ing] … its Class A-1 Units" was triggered by a downstream transaction. That transaction involved the limited partnership selling a wholly owned subsidiary. The court stated that the tag-along provision was not implicated because the subject of the provision (i.e., the majority limited partner) did not perform any Transfer.
Based on these cases, the question remains—how do you draft a transfer restriction that will successfully prohibit an "indirect" transfer of equity interests? Our recommendation is to take a two-fold approach: (1) carefully draft your transfer restriction and (2) clearly articulate an enforceable remedy in the event of a breach. For part one, consider including explicit language that makes clear the parties' intent to capture indirect transfers:
No Member may Transfer, and no Transfer may occur with respect to, all or any portion of such Member's membership interests without the prior written consent of the other Member. As used herein, "Transfer" means any direct or indirect sale, hypothecation, pledge, encumbrance, assignment, attachment, or other transfer (whether voluntarily or involuntarily). The foregoing shall prohibit any Transfer of the equity interests of an entity Member (or the equity interests of a direct or indirect owner of an entity Member) except in compliance with this Section.
Even with the language above, you still run the risk of a court refusing to enjoin an upstream transfer because the parties to such transfer are not parties to your LLC Agreement. Therefore, for part two of the two-fold approach, we suggest including specific remedies applicable to the contracting parties in the event of a breach:
In the event of a Transfer in contravention of this Section, the prohibited transferee of the membership interests (or the applicable Member, if the Transfer is an indirect Transfer) (an "Involuntary Assignee") shall be entitled to only the economic benefits of the subject membership interest (and for the avoidance of doubt, shall have no voting or other rights with respect thereto).
AND/OR
At any time, the Company [and/or] the non-transferring member shall have the right to purchase the membership interests of any Involuntary Assignee at a purchase price equal to [the fair market value of such membership interests]/[50% of the fair market value of such membership interests]/[the capital account balance of the transferring member] by providing such Involuntary Assignee with notification of the Company's intent to acquire such membership interest.
Furthermore, to ensure that a court will enforce the agreed-upon remedies, the LLC Agreement should contain a specific performance provision.
When you are dealing with an LLC with several tiers of ownership, it is important to consider that upstream entities are not directly bound to the underlying LLC Agreement. More generally, LLC Agreements contain many complex provisions like the ones discussed here. Therefore, we recommend consulting with our corporate team about your LLC Agreements to make sure that all of the parties' intended agreements are both properly reflected and will be respected in court.
[1] 2021 Del. Ch. LEXIS 73, aff'd 253 A.3d 92 (Del. 2021).
[2] 233 A.3d 1 (Del. 2020).
[3] 2020 Del. Ch. LEXIS 199.