Have you ever encountered the frustration of pursuing a debtor and obtaining a judgment, only to learn that the debtor is either no longer in business or operating under a different name? This Article explores the criteria by which courts evaluate whether an asset acquirer should be treated as a “successor” to the transferor and thereby held liable for the transferor’s debts.
As a general proposition, absent fraudulent transfers, a buyer does not ordinarily assume the liabilities of the seller merely by purchasing its assets, except where (1) the purchasing corporation expressly or impliedly agrees to assume such debts and liabilities; (2) the transaction amounts to a consolidation or merger of the seller and purchaser; (3) the purchasing corporation is merely a continuation of the selling corporation; or (4) the transaction is entered into fraudulently in order to escape responsibility for such debts and liabilities. Essentially, the “mere continuation” or “de facto consolidation” of a business allows a creditor to recover from a successor entity whenever the successor is substantially the same as the predecessor.
In determining whether a particular transaction amounts to a de facto consolidation or mere continuation, most courts consider four factors: (i) continuity of management, personnel, physical location, assets, and general business operations; (ii) cessation of ordinary business and dissolution of the predecessor as soon as practically and legally possible; (iii) assumption by the successor of the liabilities ordinarily necessary for the uninterrupted continuation of the business of the predecessor; and (iv) continuity of ownership/shareholders. However, courts have held that not all of these factors need be present for a de facto merger or continuation to have occurred, and ascribe varying emphasis on each of these considerations. The crucial inquiry is whether there was intent on the part of the contracting parties to effectuate a merger or consolidation rather than a sale of assets. The more an acquiring entity resembles its predecessor, the more likely a Court will find successor liability. Furthermore, when analyzing the commonality of assets, it is not merely equipment and other tangible assets that are compared. Courts have held that successor corporate liability can apply even if the only assets transferred are intangible, such as goodwill and a customer list. The Vermont Supreme Court , for example, imposed successor liability in a circumstance where the assets transferred were “relatively minor” and “largely intangible”; a manager’s decision-making resulting in access to films for public viewing, expertise in selecting films and goodwill was deemed sufficient.
A de facto merger occurs when a transaction, although not in the form of a merger, is in substance a consolidation or merger of a seller and purchaser. The law treats the de facto merger as a traditional consolidation or merger and will hold the successor entity responsible for the predecessor’s liabilities. Overall, in most jurisdictions, the Courts adoption of “de facto merger” or “mere continuation” has expanded over the years.
Initially, Courts typically focused on the importance of finding continuity of management and stockholder interest before imposing liability upon the successor. Continuity of operations alone was insufficient to find “mere continuation”. More recently, however, Courts have expanded their view by focusing on the degree to which the predecessor’s business entity remains intact. Generally, the more an acquiring entity physically resembles its predecessor (e.g. office location, officers, employees, key equipment), the more reasonable it is to hold the successor fully responsible. Even where the usual elements of a de facto merger–a transfer of stock, and retention of physical location and employees–are absent, a mere continuation may be found where it can be demonstrated that the intent was for the successor to assume all the benefits and burdens of the predecessor’s business, with the successor simply becoming a “new hat” for the predecessor. Most courts will generally not find the mere continuation or de facto merger exceptions apply unless there is continuity of ownership between the selling and acquiring entity. In fact, a majority of jurisdictions require continuity of shareholders or owners, believing it is the ultimate justification for allowing liabilities to carry over to the successor.
In a recent decision, one court found the following factors significant in concluding that the new company was a mere continuation of the former and, accordingly, legally responsible for the liabilities of the old company:
- The old company was named Bridge IT, Inc., and the new company was named Bridge Info Tech, Inc.
- The old and new companies provided the same services and sold the same products.
- The old and new companies had at least five significant clients in common.
- The old and new companies were owned and managed by the same people, had identical or substantially similar directors, officers and stockholders, and benefited from the owners’ skills, knowledge and market contacts.
- When the new company began operating, it bought some of the old company’s office equipment.
Most courts look to several factors including: (1) a common identity of directors; (2) a common identity of stockholders; and (3) whether only one entity exists at the conclusion of the transaction. There is no bright line rule as to what percentage of ownership must be acquired by the seller in the new company to constitute “continuity of ownership.” However, two recent decisions by the United States Bankruptcy Court in the Eastern District of Pennsylvania found that ownership interests following transfer of 71% and 41.26% in the new companies were sufficient to constitute continuity of ownership.
Given the foregoing, creditors must be particularly vigilant in investigating company principals who have closed a business only to re-open a new one immediately thereafter. In such cases, creditors should make every effort to scrutinize the new business operations by conducting site inspections and public record searches, reviewing asset-purchase agreements to determine what, if any, liabilities of the Seller the acquiring entity agrees to assume. Further, a thorough review of the ownership, structure and control of the acquiring entity should be undertaken with an inquiry as to what employees, managers, shareholders/members/managers, the acquiring entity has assumed. A diligent creditor may find sufficient proof to recover against a newly-formed entity based upon a theory of successor liability.
By Gerald R. Salerno
1 Gladstone v. Stuart Cinemas, Inc., 2005 VT 44, ¶12, 178 Vt. 104.
2 Warne Investments Ltd. V. Higgins, 195 P.3d 645, 650 (Ariz. Ct. App. 2008).
3 In Re: Total Containment, Inc., 335 B.R. 589, 617-18 (Bkrtcy. E.D. Pa. 2005) and In Re: Asousa Partnership, 2006 WL 1997426 (Bkrtcy. E. D. Pa. 2005).