When acquiring a business, often a key component is the contracts to which the company is a party to. Whether they are contracts with customers and the source of a company's revenue, contracts with service providers or various licensing agreements that allow the company to operate, or a lease for a particularly favourable location or on particularly favourable terms, a company's contracts are often an important part of a business, adding substantial value. Ensuring the transfer of any such contracts can significantly impact the structure and timing of the acquisition of a business. The following article outlines the rules and exceptions with respect to transferring contracts and the effects of such rules and exceptions in the context of the purchase and sale of a business.
The General Rule and Exceptions
The general rule with respect to contracts is that they are freely assignable. Like other types of property, agreements and the rights under those agreements can be transferred from one party to another. There are, however, exceptions to this general rule. Legislation can restrict the assignability of certain types of contracts, as can public policy (as is the case with agreements dealing with spousal support). Contracts that are personal in nature, involving personal relations or personal skills, are not assignable. An assignment of a contract cannot result in an increase of the burden on the remaining third party to the contract. Finally, contracts may also include anti-assignment provisions, which outright prohibit assignment of the contract, or provide that such assignment can only occur under certain conditions. In the context of most purchase and sale transactions, the relevant exception will be the inclusion in the contracts of anti-assignment provisions; the remainder of this article will focus on such clauses and their implications.
A standard anti-assignment clause, typically referred to as an assignment clause, will prohibit the transfer of a contract without consent. Such a clause will state that the agreement will not be assigned by any party without the prior written consent of the other party. Such a clause may also go on to specify that a party's consent can or cannot be unreasonably withheld. These provisions are typically included in contracts to ensure that each of the parties have control over who they engage in commercial arrangements and continue to do business with.
The above noted standard assignment clause, however, does not address all forms of business acquisitions. In order to guard against becoming involved with unintended parties through the sale of a company and not just its assets, anti-assignment provisions are often broadened to include language that addresses the transfer of ownership or sale of the shares of a company. This expanded language prohibits the change of control of a party, stating that the sale of the majority of the voting shares of either party to the contract will require the prior written consent of the other party. Sometimes these change of control provisions can deem that a change of control is an assignment for the purposes of the agreement, thereby triggering the same assignment requirements, including whether consent can or cannot be unreasonably withheld.
In an asset purchase transaction, the vendor is the company that owns the assets. The vendor sells some or all of its assets to the purchaser resulting in a transfer of such assets, including those desired contracts to which the company is a party to. Such transfer of the contracts will be done by way of an assignment. The need to obtain consent in the above noted anti-assignment clause would therefore arise in the context of an asset purchase transaction.
In a share purchase transaction, the vendor is the shareholder or shareholders of the target company. The vendor sells the shares to the purchaser, which does not result in any transfer of assets as all assets of the target company, including any desired contracts to which the company is a party to, remain the assets of the target company. In this context, an assignment of a contract is not needed, as the parties to the contract remain the same, only the ownership of one of the parties changes. The need to obtain consent in the above noted anti-assignment clause would not arise in the context of a share purchase transaction, but the need to obtain consent in the change of control clause would arise.
When proceeding with either an asset purchase or a share purchase where the consent of third parties is required, the timing of obtaining such consents must be considered. The contracts themselves may stipulate when consent must be obtained, in some cases requiring several weeks, allowing the remaining party to assess whether they want to provide consent or not. There can also be costs associated with obtaining consents from third parties, as is often the case in leases where landlords will want to review, among other things, the financial strength of the purchaser. Being required to obtain consent of third parties also raises issues with respect to the confidentiality of such a transaction. Either, or both, the vendor and purchaser may want the proposed transaction to be kept confidential from their respective employees, customers, suppliers and competitors. Both parties will also want to consider the impact of any consents not being obtained, especially if such contracts are material to the business. Because of these various issues, it is important to review any contracts that will be transferred or remain with the target company early in the process and discuss how any required consents will be obtained.
To effect an assignment in the context of an asset purchase, the vendor and the purchaser should enter into an assignment agreement whereby the vendor assigns the contract and all rights, obligations and benefits thereunder to the purchaser and the purchaser agrees to assume and perform, as applicable, such rights, obligations and benefits. The contract being assigned may stipulate what the vendor's obligations will be under the contract after an assignment. In many cases the vendor will not be released of its obligations, regardless of any assignment. In such instances, if the remaining party to the contract is not willing to release the vendor from its obligations, the vendor and purchaser should address each of their obligations in relation to the contract and the third party going forward. Typically, the purchaser agrees with the vendor to be solely responsible and agrees to indemnify the vendor for any non-performance or breach by the purchaser under the contract from and after the date of assignment.
If consent is required from the remaining party to the assignment, such party can either be made a party to the assignment agreement, or their written consent can be obtained prior to entering into the assignment agreement. If consent is not required, contracts can also require that notice of any assignment be given to the remaining party. Regardless of any such provision, notice should be given to the third party that the assignment has occured or will occur. Again, the contract may specify whether such notice needs to be provided prior to the assignment or not.
To effect an assignment in the context of a share purchase, nothing more than the documents effecting the purchase of sale of shares is needed. Depending on the presence and content of any change of control provisions in each contract the company is a party to, notice to or consent of, the third party to each of the contracts may be necessary.
Although generally contracts are assignable, when contemplating the purchase or sale of a business consideration should be given to any contracts that will be assigned or remain with the company being purchased. Each contract should be carefully reviewed in the context of the specific type of transaction being contemplated so as to determine whether any consents or notices will be required before or after completion of the proposed transaction. Specifically, in the context of an asset purchase, only anti-assignment provisions will necessitate obtaining consent, and in the context of a share purchase, only change of control provisions will necessitate obtaining consent. Each party should also have regard to the timing and confidentiality issues that may arise in obtaining any necessary consents. Finally, when effecting the assignment of contracts, consideration must again be given to the type of transaction contemplated as well as provisions detailing any ongoing obligations.
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.