When two businesses engage in a transfer of assets, the transferee (the “successor”) should be mindful of the fact that under certain narrow circumstances, it may inherit the liabilities of the transferor (the “predecessor”).
As a general rule, a company that acquires only the assets of another company is not liable for the debts and liabilities of the predecessor. However, successor liability would attach to the successor company under four specific circumstances: (1) an express or implied assumption of liability; (2) the transaction amounts to a consolidation or merger; (3) the successor company is a mere continuation of the predecessor company; or (4) the transaction is entered into fraudulently to escape liability for debts.
- Express or Implied Assumption of Liability.
A successor company may choose to expressly assume the predecessor’s liabilities pursuant to an agreement between the parties. In addition and even absent an agreement to that effect, courts may still find that the successor impliedly assumed its predecessor’s liabilities.
- Consolidation or Merger
When two companies enter into a formal consolidation or merger agreement, the successor will be liable for the debts and obligations of any non-surviving company.
Absent a formal merger agreement, there may be instances when a transaction amounts to a consolidation or merger even though the transaction has not been technically called a “merger”. The following factors are often used by courts to determine whether an asset acquisition amounts to a merger, rather than the ordinary purchase and sale of assets: (1) continuity of management, personnel, physical location, assets, and general business operations; (2) continuity of ownership; (3) prompt cessation of the seller company’s operations; and (4) assumption by the purchaser of obligations ordinarily necessary for the uninterrupted continuation of normal business operations by the seller.
- Mere Continuation
The “mere continuation” exception for successor liability functions to prevent a company from purchasing the assets of another company simply to ensure that assets remain out of reach of the predecessor’s creditors. A successor would be liable for its predecessor’s debts when the two companies are essentially the same, with a change in form but not substance. Several factors would be considered to determine successor liability such as (1) common officers, directors, and stockholders; (2) whether only one corporate entity exists after the completion of the sale of assets; (3) adequacy of consideration (i.e., something of value such as money) in light of the assets being sold; (4) the transfer of any important employees from the predecessor to the successor; and (5) the purpose and effect of the asset sale.
- Fraudulent Transactions
The “fraudulent transfer’ exception for successor liability protects the rights of creditors of a company from a transfer with intent to defraud or without fair consideration. One important element to be considered as a fraudulent transfer is if the predecessor debtor is already insolvent or will be made insolvent by the conveyance or transfer.
It is important to note that while there are certainly circumstances where successor liability can attach, it is not an easy bar to reach if the parties have not agreed to the assumption of the predecessor’s liabilities. However, in a transaction where the intent is to avoid payment to creditors and where the effect is that business operations remain largely the same, the law should looks to a successor to satisfy the obligations of the predecessor.