'Cause Breaking Up is Easy To Do - Divisions: A New Way to Spin Off an Entity?
As we all know, sometimes bigger is not better. For one reason or another, a company might decide to spin off part of its business. For an example, think of DowDuPont Inc.’s recent spin-off of its materials science business (now Dow, Inc.) and its agriculture business, (now Corteva, Inc.). Traditionally, if an entity wants to effectuate a spin-off, the entity first creates a wholly-owned subsidiary. The parent entity then transfers and assigns to the new subsidiary the assets and liabilities it desires to spin off. Finally, the parent causes the subsidiary to redeem the parent’s equity in the subsidiary while issuing new equity to the parent’s equityholders pro rata. In the case of DowDuPont’s spin-offs, its shareholders received 1 share of Dow, Inc. and 1 share of Corteva, Inc. for every 3 shares of DowDuPont common stock held on the respective spin-off dates.
While it may sound like three easy steps, a spin-off is not user friendly and typically requires drafting complex transfer documents and complying with numerous notice, filing, and registration requirements. But amendments last year to the Delaware Limited Liability Company Act (the “Delaware LLC Act”) and the Delaware Limited Partnership Act (the “Delaware LP Act,” and collectively with the Delaware LLC Act, the “Delaware Acts”) are poised to change how companies in the U.S. effectuate spin-offs. Specifically, Delaware law now allows both a limited liability company (“LLC”) and a limited partnership (“LP”) to de-merge or split into two or more LLCs or LPs, respectively, through a process called division.
How does the division of an entity work under Delaware law?
To put it simply, a division is essentially the opposite of a merger. In a statutory merger, two or more entities merge together to become one entity, with all of the assets and liabilities of the merging entities becoming assets and liabilities of the single surviving entity through the operation of law. The merging entities adopt a plan of merger, which states how the merger will be effected, and then file certificates or articles of merger with each of the states in which the merging entities are organized. Unlike an asset sale, no bill of sale, assignment and assumption agreement, or other transfer documents are necessary. Similarly, because contracts of the merging entities become contracts of the surviving entity through an operation of law (and not through a contractual assignment), most courts agree that a merger does not trigger assignment prohibitions in contracts.
The division of a Delaware LLC works in almost the exact same way—with the opposite result. The dividing LLC will adopt a plan of division, which outlines how the dividing LLC and its assets and liabilities will be divided between two or more Delaware LLCs, which may include both resulting and surviving LLCs. A resulting LLC is an LLC formed as a consequence of the division, whereas a surviving LLC is the dividing LLC if it survives the division. Under the law, any liabilities of the dividing LLC not allocated to a resulting or surviving LLC in the plan of division will be deemed the joint and several liabilities of all of the resulting and surviving LLCs. The dividing LLC will then file a certificate of division with the Delaware Secretary of State, effectuating the division, along with certificates of formation for each resulting LLC and a certificate of cancellation for the dividing LLC if it is not a surviving LLC. A Delaware LP can divide using a similar process.
Delaware law currently only allows for LLCs to divide into Delaware LLCs and for LPs to divide into Delaware LPs. As such, a Delaware LLC cannot be divided into corporations or partnerships, and similarly a Delaware LP cannot be divided into Iowa or California entities. However, it is anticipated that, as other states enact legislation allowing for divisions, the laws may be amended to allow divisions into different entity types and across jurisdictions.
Does this mean that Iowa entities will soon be able to effectuate divisions just like Delaware LLCs and LPs?
Well, maybe someday, but not today. Both the Iowa Revised Uniform Limited Liability Company Act, chapter 489 of the Iowa Code, and the Iowa Uniform Limited Partnership Act, chapter 488 of the Iowa Code (collectively, the “Iowa Acts”), are largely based on uniform acts devised by the Uniform Law Commission (“ULC”) – and the ULC’s uniform LLC and LP acts (collectively, the “Uniform Acts”) are very different than the Delaware Acts. Neither the Iowa Acts nor the Uniform Acts currently contemplate the concept of division. As of October 2019, the ULC has not adopted amendments to either of the Uniform Acts to address or permit divisions. Delaware’s inclusion of divisions in the Delaware Acts might encourage the ULC to consider including divisions in the Uniform Acts, but it could be years before that happens. And while each Iowa Act does deviate from its respective Uniform Act in some respects, the fundamentals of each Iowa Act—organization, operation, dissolution, merger—reflect those set forth in its corresponding Uniform Act. So it can be expected that Iowa will follow the ULC with respect to divisions. Accordingly, until the ULC takes action to include divisions in either of the Uniform Acts, it is unlikely that the Iowa legislature will take up the issue of divisions on its own.
That being said, other states are starting to follow Delaware’s lead. Both Texas and Pennsylvania also permit divisions of LLCs. And as more and more companies start to take advantage of divisions permitted in these states, the more likely it will be that more states and the ULC will follow suit and permit divisions as well.
So if an Iowa entity can’t go through a division yet, why should I care about divisions at all?
The arrival of divisions may have opened up a world of possibilities in one respect, but they have also opened up a whole new level of complexity for those doing business with entities permitted to divide. The possibility of a division can be a headache for lenders, secured parties, and others doing business with a dividing entity. Specifically, the division of a borrower could result in collateral being transferred by operation of law to multiple entities as well as the borrower’s liability for debt being severally split between those multiple entities. While many loan agreements and other contracts will include prohibitions of mergers, dissolutions, or assignments without the lender or other party’s prior consent, a division simply does not fall within the scope of those provisions.
As such, lenders to, and others in agreements with, Delaware LLCs and LPs should seek to amend their agreements to include a prohibition against division without prior consent. Going forward, new loans or agreements with Delaware LLCs and LPs should include a prohibition against division without prior consent. This could also include a requirement that the lender or other party approve the plan of division as well. Finally, lenders and other parties should consider whether to require consent to reorganization in Delaware or any other state that permits divisions.