By Jay Horrey, Frost Brown Todd LLC
The Indiana Court of Appeals recently expanded the de facto merger principles to impose successor liability on the purchaser of assets in New Nello Operating Co., LLC v. CompressAir. The de facto merger doctrine is an exception to the general rule that the purchaser of assets is not responsible for the seller’s liabilities absent fraud or an agreement to assume the liability. In New Nello, the Court concluded that the purchaser of assets in a strict foreclosure sale was responsible for certain liabilities of the seller, notwithstanding that there was no overlapping ownership between the companies.
The facts of New Nello are instructive. Nello, Inc. (Old Nello) was owned by its four officers. Old Nello had significant secured and unsecured debt. Old Nello defaulted and the senior creditor called the loan. At the same time, CompressAir sued Old Nello for unpaid services provided at Old Nello’s South Bend facility and six other creditors also filed complaints against Old Nello seeking payment for outstanding bills.
The secondary secured creditor engaged a private equity firm to buy the senior note. The private equity company created New Nello Acquisition Co. (New Nello Acquisition), 100% owned by the private equity company, which purchased the senior note for $3.765 million (a significant discount, but at a premium to the estimated liquidation value of $3.1 million). New Nello Acquisition then formed New Nello Operating Company (New Nello), as a wholly-owned subsidiary, and the two companies entered into a strict foreclosure agreement with Old Nello, where New Nello acquired Old Nello’s assets. The prior owners of Old Nello had no ownership interest in New Nello.
New Nello operated the same business as Old Nello, under the same name, Nello, at the same location, with the same employees and officers, and even the same website (which stated that the company was founded in 2002). There was no announcement to the public or employees about the change in ownership. New Nello also negotiated with certain of Old Nello’s vendors and creditors that New Nello deemed essential to the operation of the business and subsequently paid them. CompressAir was not paid and subsequently obtained a summary judgment against Old Nello. CompressAir filed a proceeding supplemental naming New Nello as a garnishee defendant upon learning Old Nello transactions. Following a hearing, the trial court concluded that New Nello was a mere continuation of Old Nello and that there was a de facto merger of the companies.
The general rule is that when one company purchases the assets of another, the buyer does not assume the debts and liabilities of the seller, unless one or more of the four exceptions apply:
- an implied or express agreement to assume liabilities;
- a fraudulent sale of assets done for the purpose of evading liability;
- a purchase that is a de facto consolidation or merger; or
- where the purchaser is a mere continuation of the seller.
The Court of Appeals focused its analysis on the third exception and outlined four factors to determine if a de facto merger has occurred:
- continuity of ownership;
- continuity of management, personnel, and physical operation;
- cessation of ordinary business and dissolution of the predecessor as soon as practically and legally possible; and
- assumption by the successor of the liabilities ordinarily necessary for the uninterrupted continuation of the business of the predecessor.
In prior cases and other jurisdictions (notably New York and Delaware), the first factor – continuity of ownership -- was dispositive. Without at least some continuity of ownership between the seller and the buyer, courts have been very reluctant to impose successor liability (in Mississippi, one owner was not enough continuity for the court). In New Nello, however, because New Nello kept the management, location, business, name, and website of Old Nello and assumed certain of the debts and obligations of Old Nello that it deemed necessary to continue the business, the Court concluded that New Nello should be liable.
This case serves as an important reminder that when a company is either reorganizing or purchasing the assets of a financially distressed company, careful consideration should be given to whether the new business or owners will retain the liabilities of the old business or owners. It is also a reminder that structure and formalities matter in a transaction.