Divisive Mergers: Trailblazing Law Allows for Division of Delaware Limited Liability Companies
A relatively recent change in Delaware limited liability company law will likely have lasting impact on businesses, real estate developers, lenders and investors in business and loan transactions.
The new law took effect on August 1, 2018 when a Delaware Limited Liability Company Act amendment allowed Delaware limited liability companies to divide into two or more LLCs while allocating their assets, liabilities, rights, and duties among the newly created LLCs.
While a similar law is not currently on the books in Maryland, the District of Columbia, and/or Virginia, Delaware tends to be at the forefront of laws affecting business organizations. This means it is possible (if not likely) that a law with similar import could be adopted locally in the coming years.
Lawyers, accountants, and investors need to be mindful of the potential bearing that the law may have. In particular, those who represent lenders (and lenders themselves) may need to consider revising some of their “boiler plate” provisions in loan documents to adjust to the new law. The amendment also presents a planning opportunity for structuring transactions and a trap for the unwary who may not carefully review organizational documents for new LLCs.
Terms of Amendment
While the amendment does not have retroactive effect, meaning companies cannot use it to circumvent contractual obligations under agreements effective prior to August 1, 2018, affected legal and accounting professionals, lenders, and creditors should consider addressing divisive mergers in future contracts with LLCs formed under Delaware law.
The amendment does not require the dividing or original LLC to wind up its affairs when an LLC is terminated or wound down. Rather, the dividing entity may either split into two or more newly formed and/or surviving LLCs, or survive the division while retaining or allocating its assets, liabilities, rights, and duties pursuant to a proposed plan of merger filed with the State of Delaware before the division.
The plan of division must include:
- The terms of the division, including the conversion or exchange of LLC interests of the dividing entity for LLC interests or other securities of the resulting LLC(s);
- The allocation of assets, properties, rights, series, debts, liabilities, and duties of the dividing LLC among the surviving entities;
- The name of each resulting limited liability company, together with the business address of a contact person who is required to retain custody of a copy of the plan of division; and
- Anything else the dividing entity wishes to include in the plan of division. The plan of division may serve as a de facto amendment to the dividing entity’s operating agreement (assuming the original LLC survives the division) or as a brand new operating agreement for the newly formed entity(s).
An LLC may address a plan of division in an operating agreement at the time the entity is created. If an operating agreement does not provide that the LLC may adopt a plan of division, the entity must adopt a plan of division in the same manner as a plan of merger if the operating agreement provides for adoption of a plan of merger. If an operating agreement is silent on this issue, a plan of division can be adopted by 50% or more of the members of the dividing company.
The plan of division need not include each individual asset, right, series, debt, liability or duty of the dividing LLC to be allocated if those issues are reasonably identified in an objectively determinable manner. Importantly, the debts and liabilities of the dividing LLC not allocated by the plan of division shall be deemed the joint and several debts and liabilities of both the dividing entity and all entities resulting from the division.
What Happens After the Split?
After the division, the allocated rights, privileges, powers, interests in property, debts, liabilities and duties of the dividing entity remain vested in each resulting LLC and are not deemed to be assigned or transferred.
Most significantly, for lenders and creditors, a company may take the position that it can utilize a divisive merger to circumvent an anti-assignment or prohibition on transfer provision in a contract or loan agreement if the language of the restriction is not broad enough to preclude assignments or transfers that can result by operation of law. In addition, conceivably, minority members of an LLC may be deprived of assets in an organizational restructuring.
Impact on Transactions
Because loan agreements typically prohibit mergers and asset sales, but most do not currently contemplate divisions as outlined in the amendment, lenders should consider revising the definition of “merger” or “asset sale” in their loan documents to address the effective transfer of assets under a division as contemplated by the new law.
The divisive merger amendment may have a “divisive” impact on Delaware limited liability companies and their creditors. On one hand, members of Delaware LLCs gain additional flexibility when drafting organizational documents in managing and disposing of the company’s assets, liabilities, rights and duties. This flexibility allows creative legal and accounting advisors to allocate assets and liabilities in an LLC in a manner that may make it difficult for lenders or other interested parties to reach assets upon a contractual or loan default or organizational restructuring of a LLC.
On the other hand, because a party may use the new flexibility of Delaware law to circumvent an assignment or transfer restriction in a contract or loan document, parties entering into transactions with Delaware limited liability companies should be cognizant of the repercussions the new law may have on restrictive covenants, including anti-assignment restrictions.
Careful drafting of contractual and loan documents as well as Delaware LLC documents becomes all the more important. It is to be expected that this issue will be addressed in the courts as a lender or an aggrieved party in a transaction will almost certainly take the position that a divisive merger has the same practical effect as an assignment or a transfer. As these are “uncharted waters,” parties utilizing Delaware LLCs in a transaction need to be mindful of the potential impact of the new law and review potential concerns with their legal advisors.