In an asset sale, the buyer purchases assets of the seller but often does not assume some or all its debts and liabilities.  Prior law generally permitted buyers to assume none of seller’s liabilities or pick and choose which liabilities buyer would assume, but recently Massachusetts have begun to look more favorably on the rights of creditors.  Now, if there is a potential for successor liability, buyers should in many circumstances: (1) hold back part of the purchase price, (2) secure significant indemnities, (3) carefully structure the purchase and sale agreement and (4) of course, conduct careful due diligence among other things.  

In my November 8, 2021 post, I discussed the four areas where a court will ascribe successor liability—even if liabilities are specifically excluded in the deal.  A court will do so if it finds (1) there is an assumption, express or implicit, of liability, (2) there has been a “defacto merger,” (3) the buyer is a “mere continuation” of the seller or (4) the transaction was fraudulent.   As promised more than a year ago—at long last—is part II, a discussion of the second area where a court finds successor liability—where it finds the asset sale a “defacto merger.”

I have tried to remove as much legal jargon from the discussion below as I could, but if something is unclear, please email me at ed.polubinski@lwelaw.com and I’ll try to clarify.

Though the term, “defacto merger” had been earlier mentioned, the 1997 case of Cargill Incorporated v. Beaver Coal & Oil Co., Inc.[1]  is the leading Massachusetts case.  There, Seller, who had distributed home heating oil, sold its assets to Buyer for cash, a promissory note and the assumption of certain liabilities. Seller had purchased inventory from a wholesaler, Northeast, and at the time of the asset sale Seller owed a significant amount of money to Northeast.  This outstanding debt of Northeast was not assumed by Buyer in the deal.  Plaintiff was the successor of Northeast and sued Buyer to recover the amount Seller owed.

Significantly, after the sale, Buyer ran Seller’s business under Seller’s name in much the same manner as Seller had, before the closing.  In addition, Seller’s sole shareholder, director and officer became a shareholder of Buyer.  Was the Buyer of the assets liable for the liability Seller had not contractually assumed?

The Supreme Judicial Court said yes and listed four factors to determine whether it would characterize an asset sale a “defacto merger” and impose successor liability:

“Whether (1) there is a continuation of the enterprise of the seller corporation so that there is continuity of management, personnel, physical location, assets, and general business operations; whether (2) there is a continuity of shareholders which results from the purchasing  corporation paying for the acquired assets with shares of its own stock, this stock ultimately coming to be held by the shareholders of the seller corporation so that they become a constituent part of the purchasing corporation; whether (3) the seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible; and whether (4) the purchasing corporation assumes those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation.”[2]

            With respect to the first factor, it was clear from the foregoing facts that there was continuity of the enterprise—the businesses pre- and post-sale were essentially the same. Buyer ran the business in the same manner as Seller under the Seller’s name.

            Justice Marshall’s analysis of the second factor, continuity of shareholders, is troublesome.  The sole shareholder and director of the Seller, became a 12½% owner of the Buyer.  A footnote clarifies that the other shareholder of Buyer owned 13% and the corporation itself 74½%[3]  (apparently as treasury stock). Thus, the Seller’s principal could have had an almost 50% interest in Buyer.  Had this been expressed more clearly in the body of the case’s opinion, the continuity of ownership’s rationale set forth might have been more persuasive. But a 12½% stake in the Buyer as continuity of ownership?  Did the Court mean almost 50%?  In either event, the Court stated:

“While this does not constitute shareholder continuity in its fullest sense, there is no requirement that there be complete shareholder identity between the seller and a buyer before corporate successor liability will attach.”[4]

The third factor was satisfied as Seller ceased its business operations and clearly the Court found the fourth, namely assumption of liabilities to assure Buyer’s uninterrupted operation of Seller’s business, were satisfied as liabilities to transition the business were assumed.

          The Court then stated:

“We recognize that there is often a tension between this goal and our strong interest in respecting corporate structures. Each case must be decided on its specific facts and circumstances. Where, as here, the acquiring enterprise assumed all the benefits of and held itself out to the world as the same enterprise as its predecessor, we conclude that the tension must be resolved in favor of an innocent creditor.[5]“We recognize that there is often a tension between this goal and our strong interest in respecting corporate structures. Each case must be decided on its specific facts and circumstances. Where, as here, the acquiring enterprise assumed all the benefits of and held itself out to the world as the same enterprise as its predecessor, we conclude that the tension must be resolved in favor of an innocent creditor.”[5]

          The Federal Courts applying Massachusetts law key on the second factor, continuity of shareholders. [6]    One Court stated:

“Plaintiff also points to the dicta in Cargill that “no single factor is necessary . . .  to establish a de facto merger,” and argues that shareholder continuity is therefore merely a factor to be considered, not a prerequisite to be satisfied. While the Court acknowledges the breadth of the Cargill dicta, it also observes that no case has ever gone so far as to dispense with the “shareholder continuity” factor altogether.”[7]

          Finally, we consider the case of Milliken v. Duro Textiles, LLC.[8]   The facts there are rather convoluted, but are essentially as follows.  A private equity group (“Group”) owned 51% of the equity and 100% of the secured debt of Old Duro.  The Group sought to wipe out the unsecured creditors of the business of Old Duro and permit the business of Old Duro to continue in a new “clean” entity.  The plaintiff, Milliken, was an unsecured creditor of Old Duro that had obtained a judgment in New York. The secured lenders (the Group) scheduled a foreclosure sale of all Old Duro’s assets other than its real estate assets.  The Group formed New Duro, who purchased the non-real estate assets “clean” of the unsecured lenders debt and operated the same business as Old Duro.  Old Duro retained the real estate, which was a significant asset, leasing it to New Duro.  The Group financed New Duro’s purchase of Old Duro’s non real estate assets.

On appeal, the SJC was asked to overturn a grant of summary judgment. The only issue on appeal was whether the second Cargill factor was met, whether “the seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible,” the other three factors apparently satisfied.  Defendants maintained there was no liquidation because Old Duro retained the real estate assets, which it maintained, were significant.

Justice Spina ably discussed successor liability from the standpoint of “defacto merger”  theory and the “mere continuation” theory, noting the similarities of both; “[w]hen analyzing a claim for successor liability under theories of the “defacto merger” or the “mere continuation” of the corporation of the predecessor, our focus is on whether one company has become another for the purpose of eliminating its corporate debt.”[9]

The Court then analyzed the transaction and Old Duro’s retention of its real estate:

“Here, it was undisputed that Old Duro ceased its ordinary business operations following the foreclosure sale, it currently has no offices or employees, and the former chief executive officer of Old Duro is now the chief executive officer of New Duro. Fundamentally, Old Duro, as a dyer, printer, finisher, and distributor of textile products, no longer exists. It sold its operating assets to New Duro, thereby enabling New Duro to maintain the same production capabilities and sell the same goods without any interruption to the business. We recognize that Old Duro did not legally dissolve as a corporate entity. Instead, it changed its name, and now rents to New Duro the real estate that it still owns in Fall River and recovers tax refunds. Notwithstanding this particular fact, only one among several for consideration, we decline to elevate form over substance by concluding that the nature of Old Duro’s corporate existence as Chace Street trumps the existence of New Duro as the successor corporation on whom liability properly should be imposed. The existence of Chace Street simply does not undermine the nonexistence of Old Duro as a going concern. “[10]

          The problem for structuring an asset sale becomes, therefore, how to structure the transaction so as to limit the unwanted assumption of liabilities?  It becomes difficult as a court in this case is a court of equity that may have its own ideas of what is fair and just.  Justice Spina concluded the foregoing analysis Milliken by stating:

“The doctrine of successor liability is equitable in both origin and nature. “Equitable remedies are flexible tools to be applied with the focus on fairness and justice.” Under principles of equity, a court will consider a transaction according to its real nature, looking through its form to its substance and intent. That is the essence of the imposition of principles of successor liability.”[11]

  I had been involved in similar reorganizations like the Duro transactions over the years, but after Milliken, such a deal is going to be difficult, if not impossible.

I discuss the doctrine of successor liability in my book, Business Corporations with Forms §25.5 (Mass. Practice, Vol 13, Thompson Reuters).

[1]           424 Mass. 356, 676 N. E. 2d 815 (1997).

[2]           424 Mass. at 360, 676 N. E. 2d at 818 (citing In re Achushnet River & New Bedford  Harbor Proceedings re Alleged PCB Pollution, 712 F. Supp. 1010 (D. Mass. 1989)).

[3]           424 Mass. at 361, 676 N. E. 2d at 819, fn. 9.

[4]           424 Mass. at 361, 676 N. E. 2d at 819 (Citation Omitted).

[5]           424 Mass. at 362, 676 N. E. 2d at 820.

[6]           E. g. American Paper Recycling Corp. v. IHC Corp., 707 F. Supp. 2d 114 (D. Mass. 2010); Gougen v. Textron, Inc, 476 F. Supp. 2d 5 (D. Mass. 2007)[7]           Gougen v. Textron, Inc, 476 F. Supp. 2d 5 at 14 (D. Mass. 2007).

[8]           451 Mass. 547, 887 N. E. 2d 244 (2008)

[9]           451 Mass. at 556, 887 N. E. 2d at 254.

[10]         451 Mass. at 559, 887 N. E. 2d at 256.

[11]         451 Mass. at 559, 60, 887 N. E. 2d at 257 (Citations Omitted).