Many companies have gone out of business and many more are in danger of going out of business as the COVID-19 pandemic continues. As a consequence, many creditors are facing debtors that have no money or assets from which a judgment can be collected. As an example, a commercial landlord might have a contractual lease claim for unpaid rent against a tenant. However, if the tenant has had few customers and has had little or no revenue, likely, the tenant has gone out of business. Suing the tenant might be pointless since there is no deep bank account and, likely, few assets exist from which a potential court-awarded judgment can be collected.
Because of this, we can predict that, in the coming months and years, there will be a significant uptick in the filing of corporate successor liability litigation. Successor liability is one legal avenue that can be taken by creditors to potentially locate entities and individuals with financial assets that might allow collection of debts owed by defunct businesses.
For the same reasons, successor liability issues will require a more intensive focus with future business mergers and/or acquisitions. There will certainly be an uptick in deals that are structured as asset purchases rather than as stock acquisitions. Nothing can spoil a deal more than a pack of creditors bringing suit against the new or acquiring business to collect past-due debts and obligations.
Here in Michigan, the nature of the transaction determines the potential liability of a successor corporate entity. If the acquisition or merger is accomplished via a stock sale/exchange, the successor business entity is almost always deemed to have assumed all the predecessor’s debts, liabilities and legal obligations. However, if the deal is structured as an asset purchase — cash or value exchanged for specified assets — then the successor is generally deemed NOT to have assumed the predecessor’s liabilities. However, under Michigan law, there are five exceptions to this general rule of no-successor-liability for asset purchases:
- If there is an express or implied assumption of liability by the successor
- Where there exist what is called a “de facto consolidation or merger”
- Where the asset transfer lacks good faith or consideration or
- Where the transferee corporation is a mere continuation or reincarnation of the old business entity
There is a large overlap in the legal analysis of exceptions two and five. These are the two legal theories that a COVID-19 creditor is most likely to use when trying to locate a business with assets that might be used to collect a judgment. When considering a merger or acquisition and when structuring the deal, the parties must evaluate various “red flags” that the courts consider when evaluating a de facto merger and/or an allegation that the transaction is a mere continuation. These “red flags” include these questions:
- Is there a continuation of management, employees, and business locations between the new and old corporate entities?
- Is the new business generally conducting the same or similar business operations as the old business?
- Did the old corporate entity cease to exist shortly after the acquisition?
- Is there a significant overlap in the shareholders?
- Did the owners/shareholders of the old corporation become equity owners in the new entity?
- Did the acquiring entity assume some debts and obligations of the old entity, and if so, were those obligations of the sort that allowed an uninterrupted continuation of the general business operations of the business acquired?
If the answer is “yes” to one or more of these questions, then there is a potential for a court to find the existence of a de facto merger or that the entities are a mere continuation.
As such, these are the types of facts that should cause concern for potential business acquisitions. Significant efforts should be made to limit the legal effect of facts of this sort including contractual indemnification provisions, hold harmless clauses, representations and warranties, mandated purchase of insurance products (if available), money holdbacks, advance negotiated settlements with known potential creditors and other mechanisms that can protect a buyer. These are the types of facts that will be examined by COVID-19 creditors in seeking to collect debts from defunct businesses that have recently been bought/sold and from those involved in future business acquisitions.
For more information, contact the business lawyers at Revision Legal at 231-714-0100.