New HSR Rules for Transactions Involving Partnerships and LLCs

Forget what you know about the Hart-Scott-Rodino Antitrust Improvements Act (HSR) and partnerships. Forget what you know about HSR and LLCs. The rules have changed ' again. The good news is that the rules make more sense, and certain exemptions to the filing requirements have been codified or expanded. The bad news is that a small number of deals that used to slide under the HSR radar may now be caught. More strategically speaking, the rules now provide more opportunities to “choose” whether your next joint venture will be subjected to substantive agency review under the HSR scheme, heightening the value of HSR counselors' advice on structure issues at early planning stages.

Many business people and most business lawyers know that a large acquisition or merger may require the parties to comply with the pre-merger reporting requirements and waiting period of the HSR. Determining whether a deal triggered a filing has been fairly straightforward, as long as the parties were corporations (see the sidebar on page 4 for a brief review of the jurisdictional rules). However, the rules governing “non-corporate entities” (partnerships, limited liability companies, business trusts and so on) differed from the rules governing corporations, sometimes in startling ways: The acquisition of 99% of a partnership was not reportable, but the acquisition by a 99% owner of the remaining 1% might well have triggered a filing – even though the owner already controlled the partnership. LLC rules varied substantially from the rest of the HSR canon, and formation of joint venture corporations, LLCs and partnerships were all treated differently.

New rules and a revised Notification and Report Form published by the Federal Trade Commission (FTC) have jettisoned the oddest of these anomalies, and are intended to apply the pre-merger review rules more consistently across all forms of entities. The focus of a HSR review for a non-corporate entity should be when control of the entity changes, and that is what the new rules are trying to engineer. Following is a summary of the new rules.

Acquisitions and Valuing of Non-corporate Equity Interests

Acquisitions of non-corporate equity interests will be reportable to the FTC and the Department of Justice (DOJ) if the acquirer will obtain control (50% or more) of the non-corporate entity (assuming the jurisdictional size of parties and size of transaction tests are met ' see the sidebar, below). Under the old rule, acquisitions of partnership interests or LLC member interests were not reportable unless the acquirer would hold 100% of the entity's interests.

Now the value of an acquisition of non-corporate equity interests is not determined by valuing the underlying assets of the non-corporate entity (as was the old rule). Instead, parties will use the same rule as has long been used to value voting securities of a non-public company: The acquisition price, if determined; or if not determined, the fair market value of the non-corporate interests (partnership or membership interests) to be acquired.

The definition of “control” of a non-corporate entity has been simplified. The reference to having the right to name at least half of the “board” or similar body has been eliminated, and control of a non-corporate entity now means having the right to receive at least half of the profits of the entity, or having the right to at least half of the assets upon the entity's dissolution. (Having the contractual right to name at least half of the board will still constitute control for an entity in corporate form and, in response to certain comments during the rulemaking process, having the right to name at least half of the trustees of certain trusts will follow the corporate control rule.)

Transactions with Existing Non-corporate Entities

The contribution of assets or voting securities to an existing non-corporate entity will be regarded as an acquisition by that entity, and unless an exemption is available, will be reportable if the filing thresholds are met. This type of acquisition is contrasted with the formation of a new non-corporate joint venture entity (discussed below), and also with the now superseded provisions of Formal Interpretation 15 regarding LLC interests, which was repealed in this rulemaking. Formal Interpretation 15 had deemed the contribution of a business to an existing LLC in exchange for membership interests as a new formation of the LLC.

Formation of New Non-corporate Entity

A new rule, 801.50, governs the formation of a non-corporate entity as a joint venture entity, and largely mirrors the existing rule 801.40, which deals with formation of joint ventures in corporate form. Rule 801.50 differs from 801.40 in a couple of ways, however: Formation will only be reportable if a person or entity will acquire control of the new joint venture entity, and the “size of parties” test will be the standard test, not the special test set forth in rule 801.40.

This new rule on formation of non-corporate joint venture entities also tries to address the more nuanced profit and asset distribution arrangements used, for example, in certain kinds of venture capital vehicles where the distribution of profits or assets may vary over time in accordance with formulas set forth in the venture entity's governing documents.

Suppose, for example, that partner A is to receive 80% of profit distributions until $10 million has been paid to partner A, and thereafter partner A's distribution is limited to 20% and partner B will receive 80%. Who controls in this scenario?

Under the new rule:

• If any profit distribution arrangement contains variables whose values cannot be determined upon the joint venture entity's formation, then the rights to the profits of the venture entity will be deemed undetermined and the parties must look to the rights to the venture entity's assets;
• If at the time of formation, a party has the right to at least 50% of the joint venture entity's assets on its dissolution, then it is deemed to control the entity;
• If both the distribution of profits and the distribution of assets are unknown (because they depend on variables that will change over time), then control will be determined by applying the formula for distribution of assets upon dissolution at the time the entity is formed (as if it were being dissolved on that date) to see if any person will have the right to at least 50% of the venture entity's assets; and
• If no party would have the right to acquire 50% of the assets or profits under any of the tests above, then no one is acquiring control of the venture, and a HSR filing is not required.

More Exemptions

The proposed rules also introduce or expand several exemptions to the filing rules.

• Rule 802.4 exempts acquisitions of voting securities of issuers holding certain assets where the acquisition of the underlying assets directly would be exempt (eg, issuers holding exempt real property or certain goods acquired in the ordinary course). Rule 802.4 was amended to extend this exemption to acquisitions of a controlling interest in non-corporate entities holding exempt assets (not just corporations holding exempt assets). The scope of the underlying exempt assets has been extended to match all of the exemptions set forth in Part 802 of the HSR rules and section 7A(c) of the HSR Act. Rule 802.4 permits the issuer or non-corporate entity to hold non-exempt assets, as long as the value of those assets does not meet or exceed the $53.1 million size-of-transaction threshold. The new rule also clarifies that the value of minority interests in either corporations or non-corporate entities will not count toward the $53.1 million limitation for non-exempt assets.
• A new rule exempts the reincorporation or formation of an upstream holding company to an existing corporation, as long as no new assets will be introduced at the time of the conversion, and as long as the interests held by any acquiring person in the new entity will be pro rata with or less than that person's holdings in the new entity.
• The “intraperson” exemption, applicable to transactions where both parties to the transaction are controlled by the same ultimate parent, has been extended to intraperson transactions with non-corporate entities.
• A new rule exempts certain acquisitions in financing transactions involving the formation of non-corporate entities. In a financing where one party contributes assets to a non-corporate entity and the other party contributes cash in exchange for a preferred return over some period of time, the acquisition of interests in the financing vehicle will be exempt if: 1) the acquiring person is contributing only cash; 2) the transaction is in the ordinary course of the acquiring party's business; and 3) the constituent documents provide that the acquiring person will no longer control the entity after it realizes its preferred return.

A Little Cleanup

Finally, the new rule simply codifies a few longstanding informal policies.

• Acquiring the right to designate at least 50% of the board of directors of a not-for-profit corporation is deemed to be the acquisition of the underlying assets of that corporation.
• A combination of any two entities (corporate or non-corporate) into a new holding company is deemed to be the functional equivalent of a consolidation, even if the two entities will retain their separate legal identities (by becoming subsidiaries of the new holding company, for example).
• A secondary acquisition (of voting securities of an issuer that is not controlled by the primary acquired entity) is separately subject to the reporting requirements of the HSR Act, now even if the primary acquisition confers control of a non-corporate entity instead of a corporation.

All of the changes described above became effective in April, and their “real life” impact is only beginning to be felt. This summary just touches on the changes, and is not intended to be legal advice.

Strategic Considerations

The HSR reportability of your next joint venture may now rest on an expanded range of structural decisions within your discretion: Corporate versus partnership or LLC form, profit allocations, asset contributions and associated rights upon dissolution, and so on. In some cases, the parties may well want to consider the new HSR implications of the options available along these lines as part of the mix of considerations affecting structure issues early in the deal negotiations ' before it becomes too late to change key terms.

Certainly for any joint venture that raises no material antitrust issue, structural decisions that avoid the HSR scheme (when consistent with other business interests) make good sense ' no need to pay onerous filing fees or to deal with waiting period strictures. Some joint ventures, however, do entail significant antitrust risk, and reasonable counselors may well differ on the desirability of avoiding HSR review in these cases. Several recent developments, for example, invite second-guessing about non-compete covenants and other so-called “collateral restraints” within joint ventures between potential competitors – provisions that the parties may deem critical to their plan, but that government reviewers may deem problematic. Why not avoid potentially mischievous agency scrutiny of these arrangements when this can be done in ways allowed by the new rules?

There is room for debate over that question. If your joint venture does in fact raise possible issues, will be receiving considerable publicity in the business press, and can be expected to tempt your competitors to stir up trouble, pre-consummation government review may be desirable. Clearance will confer no immunity from subsequent challenge, but does in the view of many counselors provide a significant measure of comfort. The new rules invite some attention to this possibility and its implications for structuring options during deal negotiations.

Sidebar:
A Quick Review of HSR Jurisdictional Tests

The HSR Act requires pre-merger notification to the DOJ and the FTC for certain joint ventures, mergers, or acquisitions of assets, voting securities, or equity interests of non-corporate entities, if the “size-of-parties” and “size-of-transaction” tests are met. Generally, the “size-of-parties” test is met as long as one party (including its “ultimate parent” and everything the parent controls) has assets or annual sales of at least $10 million (as adjusted ' see below), and another party (again, including all affiliates under common control) has assets or annual sales of at least $100 million (as adjusted). The “size of transaction” test is met if, as a result of the transaction, the acquiring party will hold at least $50 million (as adjusted) of assets or equity of the acquired entity. A statutory waiting period (generally 30 days) must elapse or be terminated before the parties can complete the transaction.

“As adjusted” thresholds and tests take into account an annual adjustment mandated by Congress and indexed to changes in the Gross National Product. The latest “adjusted” figures were published in January 2005 and resulted in “size-of-parties” test amounts of $106.2 million and $10.7 million (instead of $100 million and $10 million), and a minimum “size-of-transaction” test of $53.1 million. More detailed information about changes to filing threshold can be found on the FTC's Web site at http://www.ftc.gov/.

Forget what you know about the Hart-Scott-Rodino Antitrust Improvements Act (HSR) and partnerships. Forget what you know about HSR and LLCs. The rules have changed ' again. The good news is that the rules make more sense, and certain exemptions to the filing requirements have been codified or expanded. The bad news is that a small number of deals that used to slide under the HSR radar may now be caught. More strategically speaking, the rules now provide more opportunities to “choose” whether your next joint venture will be subjected to substantive agency review under the HSR scheme, heightening the value of HSR counselors' advice on structure issues at early planning stages.

Many business people and most business lawyers know that a large acquisition or merger may require the parties to comply with the pre-merger reporting requirements and waiting period of the HSR. Determining whether a deal triggered a filing has been fairly straightforward, as long as the parties were corporations (see the sidebar on page 4 for a brief review of the jurisdictional rules). However, the rules governing “non-corporate entities” (partnerships, limited liability companies, business trusts and so on) differed from the rules governing corporations, sometimes in startling ways: The acquisition of 99% of a partnership was not reportable, but the acquisition by a 99% owner of the remaining 1% might well have triggered a filing – even though the owner already controlled the partnership. LLC rules varied substantially from the rest of the HSR canon, and formation of joint venture corporations, LLCs and partnerships were all treated differently.

New rules and a revised Notification and Report Form published by the Federal Trade Commission (FTC) have jettisoned the oddest of these anomalies, and are intended to apply the pre-merger review rules more consistently across all forms of entities. The focus of a HSR review for a non-corporate entity should be when control of the entity changes, and that is what the new rules are trying to engineer. Following is a summary of the new rules.

Acquisitions and Valuing of Non-corporate Equity Interests

Acquisitions of non-corporate equity interests will be reportable to the FTC and the Department of Justice (DOJ) if the acquirer will obtain control (50% or more) of the non-corporate entity (assuming the jurisdictional size of parties and size of transaction tests are met ' see the sidebar, below). Under the old rule, acquisitions of partnership interests or LLC member interests were not reportable unless the acquirer would hold 100% of the entity's interests.

Now the value of an acquisition of non-corporate equity interests is not determined by valuing the underlying assets of the non-corporate entity (as was the old rule). Instead, parties will use the same rule as has long been used to value voting securities of a non-public company: The acquisition price, if determined; or if not determined, the fair market value of the non-corporate interests (partnership or membership interests) to be acquired.

The definition of “control” of a non-corporate entity has been simplified. The reference to having the right to name at least half of the “board” or similar body has been eliminated, and control of a non-corporate entity now means having the right to receive at least half of the profits of the entity, or having the right to at least half of the assets upon the entity's dissolution. (Having the contractual right to name at least half of the board will still constitute control for an entity in corporate form and, in response to certain comments during the rulemaking process, having the right to name at least half of the trustees of certain trusts will follow the corporate control rule.)

Transactions with Existing Non-corporate Entities

The contribution of assets or voting securities to an existing non-corporate entity will be regarded as an acquisition by that entity, and unless an exemption is available, will be reportable if the filing thresholds are met. This type of acquisition is contrasted with the formation of a new non-corporate joint venture entity (discussed below), and also with the now superseded provisions of Formal Interpretation 15 regarding LLC interests, which was repealed in this rulemaking. Formal Interpretation 15 had deemed the contribution of a business to an existing LLC in exchange for membership interests as a new formation of the LLC.

Formation of New Non-corporate Entity

A new rule, 801.50, governs the formation of a non-corporate entity as a joint venture entity, and largely mirrors the existing rule 801.40, which deals with formation of joint ventures in corporate form. Rule 801.50 differs from 801.40 in a couple of ways, however: Formation will only be reportable if a person or entity will acquire control of the new joint venture entity, and the “size of parties” test will be the standard test, not the special test set forth in rule 801.40.

This new rule on formation of non-corporate joint venture entities also tries to address the more nuanced profit and asset distribution arrangements used, for example, in certain kinds of venture capital vehicles where the distribution of profits or assets may vary over time in accordance with formulas set forth in the venture entity's governing documents.

Suppose, for example, that partner A is to receive 80% of profit distributions until $10 million has been paid to partner A, and thereafter partner A's distribution is limited to 20% and partner B will receive 80%. Who controls in this scenario?

Under the new rule:

• If any profit distribution arrangement contains variables whose values cannot be determined upon the joint venture entity's formation, then the rights to the profits of the venture entity will be deemed undetermined and the parties must look to the rights to the venture entity's assets;
• If at the time of formation, a party has the right to at least 50% of the joint venture entity's assets on its dissolution, then it is deemed to control the entity;
• If both the distribution of profits and the distribution of assets are unknown (because they depend on variables that will change over time), then control will be determined by applying the formula for distribution of assets upon dissolution at the time the entity is formed (as if it were being dissolved on that date) to see if any person will have the right to at least 50% of the venture entity's assets; and
• If no party would have the right to acquire 50% of the assets or profits under any of the tests above, then no one is acquiring control of the venture, and a HSR filing is not required.

More Exemptions

The proposed rules also introduce or expand several exemptions to the filing rules.

• Rule 802.4 exempts acquisitions of voting securities of issuers holding certain assets where the acquisition of the underlying assets directly would be exempt (eg, issuers holding exempt real property or certain goods acquired in the ordinary course). Rule 802.4 was amended to extend this exemption to acquisitions of a controlling interest in non-corporate entities holding exempt assets (not just corporations holding exempt assets). The scope of the underlying exempt assets has been extended to match all of the exemptions set forth in Part 802 of the HSR rules and section 7A(c) of the HSR Act. Rule 802.4 permits the issuer or non-corporate entity to hold non-exempt assets, as long as the value of those assets does not meet or exceed the $53.1 million size-of-transaction threshold. The new rule also clarifies that the value of minority interests in either corporations or non-corporate entities will not count toward the $53.1 million limitation for non-exempt assets.
• A new rule exempts the reincorporation or formation of an upstream holding company to an existing corporation, as long as no new assets will be introduced at the time of the conversion, and as long as the interests held by any acquiring person in the new entity will be pro rata with or less than that person's holdings in the new entity.
• The “intraperson” exemption, applicable to transactions where both parties to the transaction are controlled by the same ultimate parent, has been extended to intraperson transactions with non-corporate entities.
• A new rule exempts certain acquisitions in financing transactions involving the formation of non-corporate entities. In a financing where one party contributes assets to a non-corporate entity and the other party contributes cash in exchange for a preferred return over some period of time, the acquisition of interests in the financing vehicle will be exempt if: 1) the acquiring person is contributing only cash; 2) the transaction is in the ordinary course of the acquiring party's business; and 3) the constituent documents provide that the acquiring person will no longer control the entity after it realizes its preferred return.

A Little Cleanup

Finally, the new rule simply codifies a few longstanding informal policies.

• Acquiring the right to designate at least 50% of the board of directors of a not-for-profit corporation is deemed to be the acquisition of the underlying assets of that corporation.
• A combination of any two entities (corporate or non-corporate) into a new holding company is deemed to be the functional equivalent of a consolidation, even if the two entities will retain their separate legal identities (by becoming subsidiaries of the new holding company, for example).
• A secondary acquisition (of voting securities of an issuer that is not controlled by the primary acquired entity) is separately subject to the reporting requirements of the HSR Act, now even if the primary acquisition confers control of a non-corporate entity instead of a corporation.

All of the changes described above became effective in April, and their “real life” impact is only beginning to be felt. This summary just touches on the changes, and is not intended to be legal advice.

Strategic Considerations

The HSR reportability of your next joint venture may now rest on an expanded range of structural decisions within your discretion: Corporate versus partnership or LLC form, profit allocations, asset contributions and associated rights upon dissolution, and so on. In some cases, the parties may well want to consider the new HSR implications of the options available along these lines as part of the mix of considerations affecting structure issues early in the deal negotiations ' before it becomes too late to change key terms.

Certainly for any joint venture that raises no material antitrust issue, structural decisions that avoid the HSR scheme (when consistent with other business interests) make good sense ' no need to pay onerous filing fees or to deal with waiting period strictures. Some joint ventures, however, do entail significant antitrust risk, and reasonable counselors may well differ on the desirability of avoiding HSR review in these cases. Several recent developments, for example, invite second-guessing about non-compete covenants and other so-called “collateral restraints” within joint ventures between potential competitors – provisions that the parties may deem critical to their plan, but that government reviewers may deem problematic. Why not avoid potentially mischievous agency scrutiny of these arrangements when this can be done in ways allowed by the new rules?

There is room for debate over that question. If your joint venture does in fact raise possible issues, will be receiving considerable publicity in the business press, and can be expected to tempt your competitors to stir up trouble, pre-consummation government review may be desirable. Clearance will confer no immunity from subsequent challenge, but does in the view of many counselors provide a significant measure of comfort. The new rules invite some attention to this possibility and its implications for structuring options during deal negotiations.

Sidebar:
A Quick Review of HSR Jurisdictional Tests

The HSR Act requires pre-merger notification to the DOJ and the FTC for certain joint ventures, mergers, or acquisitions of assets, voting securities, or equity interests of non-corporate entities, if the “size-of-parties” and “size-of-transaction” tests are met. Generally, the “size-of-parties” test is met as long as one party (including its “ultimate parent” and everything the parent controls) has assets or annual sales of at least $10 million (as adjusted ' see below), and another party (again, including all affiliates under common control) has assets or annual sales of at least $100 million (as adjusted). The “size of transaction” test is met if, as a result of the transaction, the acquiring party will hold at least $50 million (as adjusted) of assets or equity of the acquired entity. A statutory waiting period (generally 30 days) must elapse or be terminated before the parties can complete the transaction.

“As adjusted” thresholds and tests take into account an annual adjustment mandated by Congress and indexed to changes in the Gross National Product. The latest “adjusted” figures were published in January 2005 and resulted in “size-of-parties” test amounts of $106.2 million and $10.7 million (instead of $100 million and $10 million), and a minimum “size-of-transaction” test of $53.1 million. More detailed information about changes to filing threshold can be found on the FTC's Web site at http://www.ftc.gov/.