Hot Potato: Liability for Corporate Successors
March 2006
© Copyright 2006. All rights reserved, Emergency Envelopes, Volume 1, Issue 2
Non-lawyers are often confused by the fact that our legal system considers a corporation to be a “person.” Corporations enjoy most of the same legal rights, and are subject to many of the same obligations, as individuals. This is certainly true in the criminal sphere. While there are obvious exceptions - such as prohibitions against disorderly conduct or rape. The substantive criminal laws generally apply with equal force to corporate entities and “two-legged clients” alike.
Things get a little complex, though, when it comes to heirs and successors. When individual defendants die, their criminal liabilities die too. Even when heirs are penalized as the illegal beneficiaries of their acts, such as through the disgorgement of ill-gotten gains, their heirs are not viewed as culpable themselves.
Corporate heirs are different. A true corporate successor takes on all of the rights and obligations of its predecessor. A successor could suddenly find itself facing considerable liability for acts with which it had no involvement. When a corporation dissolves, the odds are high that its criminal liability lives on.
Merger vs. Transfer of Assets
Given this, it is crucial for those involved in corporate acquisitions and divestitures to keep a close eye on where the liabilities are headed. Whether the liabilities involved are civil or criminal, the basic rule is simple. It relies on the distinction between a merger and a transfer of assets. A merger is an “amalgamation” of several corporations, pursuant to statutory provision, in which one corporation survives and the remainder disappear.[1] When a corporate merger becomes effective, the surviving organization is “responsible and liable for all of the liabilities and obligations” of each of its predecessors usually as fully as if it had been the entity incurring the liabilities in the first place.[2]
A transfer of assets, by contrast, is a creature of contract. In general, a purchaser of corporate assets is liable for the obligations and liabilities of the seller only if and only to the extent that the purchaser agrees to assume them.[3] Under the basic rule, if the purchaser does not consent to assume a particular liability, the liability remains in the seller, even if an asset to which it logically relates is transferred over. Note, however, that the agreement to assume liability need not be explicit in the contract documents themselves. Under certain conditions, a purchaser may be found to have implicitly agreed to assume the liability even if the asset purchase agreement does not contain clear consent. It is crucial to work through the transaction documents carefully in order to avoid this result.
Setting aside the subtleties of implicit consent, then, the basic distinction is clear. The successor to a merger assumes all liabilities; the successor to a transfer of assets assumes only those liabilities it agrees to take. As may be obvious, however, that this structure leaves considerable room for game playing. Why not move one corporation’s assets into a second corporation - leave the liabilities, and then dissolve the first corporation, leaving creditors, including prosecutors, out of luck in the first corporation?
To counteract such mischief, the law has developed a series of exceptions to the basic distinction. Even if a transaction is styled a “transfer of assets,” it will result in the transfer of liability to the purchaser under any of the following conditions:
(1) the transaction amounts to a de facto merger of the two corporations;
(2) the purchaser is a mere continuation of the seller; or
(3) the transaction was entered into fraudulently, in order to escape liability for the seller’s obligations.[4]
These three exceptions are intended to identify “transactions where the essential and relevant characteristics of the selling corporation survive the asset sale,” [5] or where a putative sale is not in fact “a bona fide transaction between separate parties.”[6]
Exception: De Facto Merger
A de facto merger occurs when one corporation is absorbed without compliance with the statutory requirements for a merger. Some of the factors that are relevant include:
- Continuity of enterprise, including management, personnel, physical location, assets, and general business operations.
- Continuity of ownership, typically resulting from the purchaser paying for the assets with shares of its own stock, and thereby converting shareholders of the seller into shareholders of the purchaser.
- Dissolution of the seller and cessation of its ordinary business as soon as practically and legally possible.
- Assumption by the purchaser of liabilities ordinarily necessary for uninterrupted continuation of the predecessor’s business.[7]
Though it is not necessary for all of these factors to be present,[8] each is an indication that the putative transfer of assets in fact represents a merger between purchaser and seller.
Exception: Mere Continuation
The mere continuation exception “refers principally to a ‘reorganization’ of the original corporation” under federal bankruptcy law or through state statutory devices.[9] It is designed to protect creditors against transactions specifically designed to put assets out of reach from them.
In other words, the purchasing corporation maintains the same or similar management and ownership but wears a “new hat.” To allow the predecessor to escape liability by merely changing hats would amount to fraud.[10]
The exception applies when “there is a continuation of the corporate entity of the transferor,” as indicated by (1) common officers, directors, and shareholders and (2) only one corporation in operation after the completion of the transfer. Additional relevant factors include (3) the continuation of the seller’s business practices and policies; and (4) insufficiency of the consideration running to the seller.[11]
Exception: Fraudulent Transaction
The most common type of transaction to which the fraudulent transaction exception applies is a transfer, without adequate consideration, “to a corporation having substantially the same ownership, by which the just claims of creditors are defeated.”[12] The circumstances in which this exception may be applied is potentially broad. In the criminal context, for example, the fraud exception has been applied to a corporate reorganization performed in order to conceal a felon’s ownership interest and thus shelter the proceeds of the felon’s racketeering activities.[13]
Exceptions in Practice
In practice, these three exceptions blend together. The de facto merger and mere continuation exceptions can be quite difficult to distinguish, for example.[14] As another example, the mere continuation exception is often justified as required to prevent commission of a fraud.
For this reason, courts often emphasize that the exceptions require a “close scrutiny of corporate realities” rather than a “mechanical application of a multi-factor test.”[15] Courts review not only the provisions of the agreement between the buying and selling corporations but also “the consequences of the transaction and the purposes of the provisions of the applicable corporation law.”[16] Cases addressing this issue are replete with warnings to courts not to allow corporate parties to “avoid liability for wrongfully caused injuries”, or “evade obligations incurred,” simply by using “sheer transaction machinations,” “manipulating the technicalities of a transaction,” or “effecting some type of corporate transformation.”[17]
In short, if a transaction is challenged, the law of corporate successors grants courts considerable latitude to push corporate liabilities in whatever direction seems most appropriate to them. A purchaser who would rather retain the choice and control that comes with a transfer of assets should work to avoid the factors underlying the exceptions:
Individuals cannot sell their criminal liabilities, and when they die, their liabilities go with them. Corporate liabilities, on the other hand, are hot potatoes. No one wants them, but someone has to take them. Every corporate successor, whether by merger, asset transfer, or judicially-created mix of the two, should make sure that it is fully aware of, and in control of, the scope of the liability it is assuming.
[1] Black’s Law Dictionary 988 (6th ed. 1990).
[2] See Minn. Stat. § 302A.641 subd. 2(e). Many of the authorities cited in this article reflect the law in Minnesota, but with few exceptions the basic rules on successor liabilities “are equally recognized in most American jurisdictions.” Ryan Beck & Co., Inc. v. Campbell, 2002 U.S. Dist. LEXIS 23627 at *10 n.6 (N.D. Ill. Dec. 4, 2002).
[3] See Minn. Stat. § 302A.661 subd. 4. See also Niccum v. Hydra Tool Corp., 438 N.W.2d 96, 98 (Minn. 1989);
[4] See Niccum, 438 N.W.2d at 98; North Shore Gas Co. v. Salomon, Inc., 152 F.3d 642, 651 (7th Cir. 1998).
[5] North Shore Gas Co., 152 F.3d at 651.
[6] Gallenberg Equip., Inc. v . Agromac Int’l, Inc., 10 F. Supp. 2d 1050, 1054 (E.D. Wisc. 1998).
[7] Fletcher Cyc. Corp. § 7124.20 (Perm. Ed.). See also Commonwealth v. Lavelle, 555 A.2d 218, 227-28 (Pa. Super. 1989); Fenderson v. Athey Prods. Corp., 581 N.E.2d 288, 291 (Ill. App. 1991).
[9] Niccum, 438 N.W.2d at 99 (citation omitted).
[10] Huray v. Fournier NC Programming, Inc., 2003 Minn. App. LEXIS 620 at *10 (Minn. Ct. App. May 20, 2003) (quoting Fletcher § 7124.10).
[11] Huray, 2003 Minn. App. LEXIS 620 at *11.
[12] J.F. Anderson Lumber Co., 206 N.W.2d 365, 369 (Minn. 1973). See also Fletcher § 7125 (applies to a sale that is “not a bona fide one for a valuable consideration and in the usual course of business.”).
[13] Lavelle, 555 A.2d at 229. But see Fletcher § 7125 (fraudulent transaction exception “is merely an application of the law of fraudulent conveyances”).
[15] North Shore Gas, 152 F.3d at 654, 650 (“equitable doctrine, not an inflexible command…”). See also Lavelle, 555 A.2d at 230 (resolve on a case-by-case basis).
[16] Lavelle, 555 A.2d at 227 (citing
Farris v. Glen Alden, 143 A.2d 25, 28 (Pa. 1958)).
[17] Fenderson, 581 N.E.2d at 292; Gallenberg, 10 F. Supp. 2d at 1054; Ashland Oil, 537 F. Supp. at 432.
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