Magic Words Still Matter, and Equitable Defenses Can’t Save a “Void” Transfer
September 19, 2022
New York’s default rules regarding LLC members’ rights to transfer their interests appear in sections 603 and 604 of the LLC Law. Section 603 provides that a membership interest is fully assignable, but the assignee does not become a full-fledged member; she becomes an economic interest holder entitled to receive the distributions and profit and loss allocations of the assignor. Section 604 requires the consent of at least the majority of the other members before an assignee can become a member.
Operating agreements often include a provision supplementing those default rules, restricting members from assigning their interests to limited circumstances, such as upon unanimous consent of the members, or only to a member’s children or heirs. Transfer restrictions like these often make good business sense; they protect against the risk of outside ownership, and they ensure that members may not transfer their interests to satisfy creditors.
Some operating agreements go a step further, specifying that assignments made in violation of its restrictions are void. In transfer restriction clauses, “void” is a magic word. For more than 30 years, New York Courts have held that assignments made in violation of a transfer restriction—while they may give rise to a damages claim—are not invalid unless the operating agreement clearly specifies that “transfers made in violation of this section are void” (Macklowe v 42nd St. Dev. Corp., 170 AD2d 388, 389 [1st Dept 1991]).
Use of the term “void,” to describe non-compliant transfers can also preclude application of certain equitable defenses, resulting in seriously perplexing results. In XRI Investment Holdings LLC v Holifield, No. 2021-0619 [Del. Ch. September 13, 2022]), the inequitable result required by the term “void” in the transfer restriction prompted the trial court to suggest an alternate approach and encourage an appeal so that the Delaware Supreme Court can reconsider its laws regarding the magic word “void.” The decision should leave no one wondering why the Delaware Chancery Court is the vanguard of developments in the laws of corporate governance.
The Transfer Restriction
Gregory Holifield is a co-founder and member of XRI Investment Holdings, LLC (“XRI”), a water-filtration and infrastructure company servicing the energy production and exploration industries. XRI’s other co-founder is Matthew Gabriel, a former structured finance attorney.
In 2016, Gabriel and Holifield sold a controlling interest in XRI to Morgan Stanley. As a result of that sale, Morgan Stanley became the only Class A member of XRI, and Holifield and Gabriel became Class B members. Morgan Stanley, Gabriel, and Holifield further agreed that XRI would loan $10 million to Entia, another company that Holifield owned, secured by Holifield’s interest in XRI (the “XRI Loan”).
XRI’s Operating Agreement included a provision restricting Holifield’s ability to transfer his interest to certain limited circumstances, including to potential “Permitted Transferees,” such as his children, testamentary trusts, and entities wholly-owned by him. The provision further required that a transfer to a “Permitted Transferee,” must be for no consideration.
The Operating Agreement also contained this critical provision:
Any Transfer or attempted Transfer in violation of this Article VIII shall be void, and none of the Company or any of its respective Subsidiaries shall record such purported Transfer on its books or treat any purported Transferee as the owner of such Units.”
Holifield Transfers His XRI Holdings
When Holifield sought to raise more capital for Entia, he turned again to his interest in XRI as security. But Morgan Stanley would not agree to let Holifield’s lender directly take a security interest in Holifield’s membership of XRI, since that would prejudice the security of the XRI Loan.
With Gabriel’s assistance, Holifield and XRI settled on a structure in which, among other moving parts, Holifield would transfer his interest in XRI to a special purpose entity, Blue Holdings, LLC. That would allow Holifield to borrow against his XRI interest without impairing XRI’s rights to Holifield’s interest under the XRI Loan.
Because Holifield would be the sole owner of Blue Holdings, the parties intended that Holifield’s transfer would be a “Permitted Transfer” under the Operating Agreement. The parties either did not consider or felt they could also satisfy the no consideration requirement.
With Gabriel’s sign-off, Holifield transferred his interest in XRI to Blue Holdings in June of 2018 and closed on the loan to Entia shortly thereafter.
XRI Forecloses on Holifield’s Interest
When Entia defaulted on the XRI Loan, XRI attempted a strict foreclosure on the security for that loan: Holifield’s interest in XRI. The strict foreclosure process allows a debtor to receive all or a portion of the pledged collateral in exchange for the debt. Under the UCC, a debtor is deemed to have consented to a strict foreclosure if the secured creditor makes an unconditional proposal to the debtor to accept the collateral in full satisfaction of the loan and the debtor does not respond within 20 days.
Here, XRI sent its strict foreclosure offer to Holifield personally, not to Blue Holdings. So the validity of the strict foreclosure turned in part on the validity of Holifield’s transfer. If Holifield’s transfer was valid, XRI sent its strict foreclosure notice to the wrong party. If the transfer was void, then XRI was correct in sending its strict foreclosure notice to Holifield personally.
XRI argued that because Holifield’s transfer to Blue Holdings was for consideration—namely, a capital infusion into Entia—the transfer failed to satisfy the Permitted Transfer exception of the Operating Agreement and was void ab initio.
Holifield argued that even if the transfer to Blue Holdings violated the no consideration requirement, XRI surely knew about and acquiesced to the transfer. Gabriel—a board member of XRI—helped structure the deal, and representatives from Morgan Stanley advised Gabriel that as long as Holifield kept the transaction “on his side of the ledger,” Morgan Stanley “did not care.” What’s more, Holifield argued, a year after the transfer, XRI’s lawyers reviewed the transfer, concluded that a violation of the no transfer provision had occurred, but made a business decision not to challenge the transfer. They only took issue with the transfer when it became an impediment to their strict foreclosure.
V.C. Laster’s Invitation to the Delaware Supreme Court
After a one-day trial in June, Vice Chancellor Laster authored a 153-page memorandum opinion that—in addition to offering a masters-level course in structured finance—painstakingly recounts and catalogues XRI’s knowledge of and involvement in the transfer that they now contested. The Court wrote:
If the defense of acquiescence were available, then the court would find that XRI acquiesced in the Blue Transfer and could not challenge its validity. The court then would declare that the Blue Transfer caused Blue to become the owner of an assignee interest in the Disputed Units, and the court would grant judgment in favor of Holifield and Blue.”
But, said the Court, the defense of acquiescence was not available. The Court explained that because the Operating Agreement used the word “void” to describe the consequences of transfers made in violation of the transfer restriction (“Any Transfer or attempted Transfer in violation of this Article VIII shall be void”), the transfer from Holifield to Blue Holdings was, under binding Delaware precedent, void ab initio (see CompoSecure, LLC v CardUX, LLC, 206 A3d 807 [Del. 2018]). And under the common law, a transaction that is void ab initio is incurably void, and a party cannot invoke equitable defenses to validate the transaction.
In other words, by using the word “void” to describe the consequence of a breach of the no transfer provision, the parties to the Operating Agreement opted for a mandatory and exclusive remedy of incurable voidness. Equitable defenses could not intervene.
V.C. Laster was clearly troubled by this result:
Under CompoSecure II, XRI can avoid the consequences of a transaction notwithstanding its acquiescence. For a court of equity, [this] is an uncomfortable outcome, and it provides an impetus to explore a different approach.”
In what he described as “admittedly dictum,” V.C. Laster authored an exhaustive and interesting history of the law governing voidness, pre-CompoSecure cases concerning acts that were void ab initio, and the practical implications of allowing parties to contract away their equitable remedies and defenses. He proposed his alternate approach:
Under that different approach, the consequence of incurable voidness would be reserved for acts that violate limitations that the state has imposed, in its capacity as sovereign, on the actions that parties can legitimately take. When parties have gone outside the boundaries that the state has set, it makes sense that the state would treat the impermissible act as if it never occurred. But just as parties cannot agree contractually to other remedies that only the state can impose, such as criminal sanctions, parties would not be able to agree contractually to an outcome of incurable voidness. No matter what words the parties used in a contract, the noncompliant act would be voidable, not void. A court still could determine that the act was invalid, but parties would be able to raise equitable defenses to defeat that result. Parties could not use the word “void” to contract out of equity.”
He concluded by respectfully recommending the reconsideration of CompoSecure. We can only hope that Holifield gives the Delaware Supreme Court a reason to do so.
Acquiescence Under New York Law
New York Courts hold that “[a]cquiescence as a defense has, speaking generally, a dual nature” (Pollitz v Wabash RR Co, 207 NY 113 ). “It may, upon the one hand, rest upon the principle of ratification, and may be denominated implied ratification, or it may, upon the other hand, rest upon the principle of estoppel, and may be denominated equitable estoppel” (id. at 129). And in New York, the answer to the question, “can a party acquiesce to a void transfer?” depends on which form the acquiescence defense takes.
When acquiescence rests on the principle of ratification, New York Courts hold, consistent with CompoSecure, that a party cannot ratify an act that is void ab initio (see ETH NEP, LP v Disoni, LLC, 2015 NY Slip Op. 30615[U] [New York County 2015] [holding that void lease could not be ratified]).
On the estoppel side of the tracks, however, the Court of Appeals has held that “[w]hen a party with full knowledge . . . freely does what amounts to a recognition or adoption of a contract or transaction as existing, or acts in a manner inconsistent with its repudiation, and so as to affect or interfere with the relations and situation of the parties, [that party] acquiesces in and assents to it and is equitably estopped from impeaching it, although it was originally void or voidable” (Rothschild v Title Guar & Trust Co., 204 NY 458  [emphasis added]).
Given these apparently mixed results on acquiescence, it may not be long before a New York Court takes note of XRI’s compelling reasoning in support of a change.