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The Federal Trade Commission’s Premerger Notification Office ("PNO") published in the Federal Register on March 8, 2005 a final rule amending the Hart-Scott-Rodino ("HSR") Act regulations, effective on April 7, 2005.  The new regulations expand the applicability of the HSR notification requirements to transactions involving partnerships, limited liability companies ("LLCs") and other unincorporated entities, along with making various conforming and administrative changes. 

Under the current PNO rules and policies applicable to partnerships and LLCs, the acquisition of a partnership interest or membership interest in an existing LLC is not reportable unless, as a result of the transaction, the acquiring person will hold 100% of the partnership or membership interests.  The formation of a partnership is never reportable, and the formation of an LLC is not reportable unless (a) two or more pre-existing, separately controlled businesses are being contributed and (b) at least one of the members will control the LLC. 

The new rules will make reportable the acquisition of a controlling interest in a partnership, LLC or other unincorporated entity.  It is important to note, however, that the new rules do not affect the HSR size-of-person or size-of-transaction thresholds.[1]  In addition, the existing HSR exemptions continue to apply to the reportability of transactions involving unincorporated entities. 

This memorandum summarizes the principal provisions of the new rules and comments on their practical impact.

Rule: Acquisition of Control / Formation of Unincorporated Entities  

Under the new regulations, the acquisition of control of an unincorporated entity is potentially reportable under the HSR Act.  Further, a notification is potentially required upon formation of an unincorporated entity when one or more of the forming parties acquire a controlling interest in the new entity.  The new regulations define "control" with respect to an unincorporated entity as having the right to 50% or more of the profits of the entity or having the right to 50% or more of the assets of the entity upon dissolution (after the payment of its debts).  

Comment.  Subjecting the acquisition of a controlling interest in an unincorporated entity to a filing requirement represents a significant shift in the PNO’s policy on the treatment of unincorporated entities.  Under the current PNO rules and policies applicable to LLCs and partnerships, the acquiror of an interest in 50% or more of the profits of an unincorporated entity or 50% of its assets upon dissolution is said to "control" the entity.  However, under the current rules, the acquisition of such control does not trigger an HSR filing obligation.  Rather, an HSR notification may be required if the acquiring person would hold 100% of the unincorporated entity as a result of the transaction.  This has led to the anomalous situations in which no HSR notification is required for a transaction where 99% of an unincorporated entity is acquired, but a subsequent transaction to acquire the remaining 1% of the entity may trigger a filing requirement. 

The new rules now focus on the acquisition of control of an unincorporated entity.  Thus, acquiring a controlling interest in an unincorporated entity, either by means of an acquisition of an existing unincorporated entity or in the formation of a new unincorporated entity, may trigger an HSR filing requirement.  The examples below illustrate how the new rules would apply to the acquisition or formation of an unincorporated entity.  (Assume for each example that the size-of-person and size-of-transaction thresholds are satisfied and no exemption applies.)

• Company A holds an interest giving it the right to 35% of LLC X’s profits, and purchases an additional interest such that A has the right to a total of 60% of LLC X’s profits.  This transaction is reportable because Company A has acquired control of LLC X.
• Companies A and B create joint venture LLC X where each of A and B has the right to 50% of LLC X’s profits.  In this case, both A and B are deemed to control LLC X, so each must file an HSR notification for its respective acquisition of control.
• Companies A, B and C create partnership X, and each has a one-third interest.  No HSR filing is required as none of the partners controls the partnership.[2]

Rule: Definition of "Control" When Profits Vary over Time

In cases where a variable profit-sharing mechanism applicable to the distribution of profits of an unincorporated entity makes determination of control unclear, the new rules provide that control shall be based on which party has the right to greater than 50% of the assets of the unincorporated entity upon dissolution.  If no such right is conferred, the entity shall be deemed its own ultimate parent entity, and its formation will not be reportable.

Comment.  Where the rights to profits and assets upon dissolution vary over time, the new rules provide that control be determined by applying the formula for determining rights to receive assets upon dissolution of the entity at the time of the acquisition, as if the entity were being dissolved at that time.  The PNO recognizes that this methodology may produce anomalous results, and may be willing to consider alternative methods for determining control based on the specific facts of a transaction.

Rule: Exemption for Certain Financing Transactions

In the context of financing transactions, the new rules exempt certain acquisitions of interests in unincorporated entities from the notification requirements under the HSR Act.  This exemption is available when three conditions are satisfied: (1) the acquiring person must contribute only cash; (2) the cash must be contributed for the purpose of providing financing; and (3) the formation agreement must provide that the acquiring person will not control the entity once it receives its preferred return. 

Comment.  This rule is intended to address the common structure in financing transactions where one party contributes assets to an unincorporated entity and the other contributes cash.  In a typical scenario, the cash investor retains the rights to more than 50% of the profits initially, and thus technically controls the entity, but that interest diminishes to less than 50% once the investor reaches a preferred return threshold.  The new rules treat this transaction as analogous to creditors taking secured debt, a transaction that does not require an HSR notification. 

Additional Technical Corrections and Conforming Changes

The new rules include several other provisions addressing issues such as valuation of newly-acquired non-corporate interests, contributions to existing unincorporated entities, adjustments to the existing exemptions for foreign entities and reorganizations.  For the most part, these additional changes involve conforming the HSR regulations to reflect the new treatment of unincorporated entities, codify certain longstanding PNO policies and implement certain corrections and clarifications.

It is important to emphasize that an HSR Act notification analysis is very fact-specific.  A determination as to whether a particular transaction will require an HSR Act filing will depend on the particular terms and structure of the transaction, and on the availability of any HSR Act exemptions.

[1]  The current HSR jurisdictional thresholds are as follows:

 Commencing this year, the HSR thresholds will be adjusted annually to track gross national product growth.  

[2]  Note, however, that if in this example the joint venture X were a corporation with each of A, B and C receiving one-third of X’s voting securities, the transaction would be reportable.

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Please contact a member of the HSR Act team in our Washington, D.C. office if you have any questions concerning the HSR Act or the new regulations.

W. Stephen Smith  
Bradley S. Lui   
Aki Bayz   
Jonathan S. Gowdy  
Jeffrey A. Jaeckel  
Jonathan T. Linde  
Matthew M. Sikes  

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.