Chasing Crooks: Successor Liability and Transfers of Trust
by Kenneth P. Weinberg July/August 2016
Attorney Ken Weinberg teaches equipment lessors how to protect their companies from crooks, particularly those who enter into a legitimate transaction only to later attempt to defraud creditors by transferring assets from an original lessor to another entity.
Kenneth P. Weinberg, Shareholder, Baker, Donelson, Bearman, Caldwell & Berkowitz
Even the most careful equipment leasing and finance company eventually enters into a transaction with a lessee/borrower that turns out to be an unethical deadbeat that not only refuses to honor its obligations but also seeks to continue to use the equipment (aka the “crook”).
In some instances, the crook hatches a scheme prior to entering into the transaction. The classic example, closely watched by prudent equipment finance companies, is where the “vendor” is either a fabrication or otherwise in cahoots with the crook, so the equipment being leased or financed is overpriced or, even worse, non-existent.
Other examples of front-end fraud abound. One of the most interesting frauds occurred in the 90s when a crook posing as a senior Philip Morris executive told several banks that he was in charge of a secret tobacco research program called Project Star (an international project to develop cigarette alternatives, including smokeless cigarettes). The program was allegedly so secret that all contacts with Philip Morris about the loans had to be made only through the crook. Diligence was further limited since Philip Morris allegedly wanted the financing kept separate from its other relationships. Multiple banks advanced the loans for Project Star on this basis and they, and their syndication partners, were left holding the bag for more than $300 million worth of loans.
In other circumstances, a thief who originally entered into a legitimate transaction, but later encountered sufficient financial stress, making bankruptcy or another insolvency proceeding imminent, fraudulently tries to deprive existing creditors of their rights by transferring assets from the original lessee/borrower (OldCo) to another company (NewCo) that continues the same general business. This edition of Dispatches from the Trenches focuses on the latter situation, highlighting a handful of helpful tools in the creditors’ toolbox.
1. Lien Survives Transfer
Section 9-315(a)(1) of the Uniform Commercial Code states, “a security interest or agricultural lien continues in collateral notwithstanding the sale, lease, license, exchange or other disposition thereof, unless the [creditor] authorizes the disposition free of the security interest or agricultural lien.” This provision comforts creditors when crooks transfer equipment out of trust by assuring that the creditors’ security interest in the equipment survives the transfer.
However, the applicable provisions sometimes place a burden on the creditor to discover the transfer within the first year. This result stems from the fact that the usefulness of a security interest depends in large part on whether it is a perfected security interest. The applicable code provisions provide that any security interest that survives a transfer remains perfected with respect to the collateral for at least one year, even if the creditor does not file a new financing statement.1
The one-year limitation comes into play only if NewCo is “located” (for Article 9 purposes) in a different state than OldCo. Recall that, under Article 9, the location of the registered entity is where it is incorporated or otherwise formed.2
Because of this risk, if NewCo is located in a different state than OldCo, the creditor must file a new financing statement against NewCo in the state where NewCo is located within one year, or it will become unperfected with respect to the collateral that has been transferred. It should be noted that the creditor is specifically authorized to file against NewCo with respect to the existing collateral.3 However, the creditor must be careful to describe only the collateral transferred and proceeds of it. Any security interest granted by OldCo in after-acquired collateral would not be “existing collateral” covered by UCC §9-509(c), and the creditor would not be authorized to file a financing statement against such collateral unless OldCo had assumed all obligations under the equipment lease or finance documentation or by operation of law.
2. Successor Liability Theories
There is also a well-developed body of law that sometimes holds NewCo liable for the debts and liabilities of OldCo. As a general rule, a “purchaser does not assume the seller’s liabilities unless: 1) there is an express or implied agreement of assumption, 2) the transaction amounts to a consolidation or merger of the two [entities], 3) the purchasing [entity] is a mere continuation of the seller or 4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts.”4
Whether a purchasing company manifests an express or implied assumption of the selling corporation’s liabilities will depend in large part upon the wording of the purchase agreement executed by the purchasing and selling corporation.5 Of course, in the types of fraud discussed in this article, it is highly unlikely that there is a purchase agreement between OldCo and NewCo which provides for NewCo to assume the obligations. The equipment leasing and finance company’s strongest claims for successor liability will therefore be under the de facto merger, mere continuation and fraudulent purpose theories, each of which is discussed below.
Determining whether a transaction amounts to a consolidation or a merger (sometimes called a de facto merger) is very similar to determining whether the NewCo is a “mere continuation” of OldCo. As a result, many courts combine these two bases for successor liability.6
A de facto merger is conceptually identical to an ordinary merger, except for the fact that there has not been “compliance with the statutory requirements for a merger.”7De facto mergers have been found where a sale of assets results in NewCo’s absorbtion of OldCo with OldCo going out of existence and losing its identity to NewCo.
In de facto merger situations, the factors generally considered have included: a) continuation of the same equity owner’s control (particularly in the instance of a single equity owner), b) intention to dissolve OldCo, c) NewCo’s retention of executive and operating personnel of OldCo, d) transfer of assets, e) assumption of only those liabilities necessary to operate the business and f) a “pooling of interests.”8
The mere continuation theory of liability overlaps considerably with the de facto merger theory but traditionally seems to focus on instances in which NewCo resembles a restructured or reorganized version of OldCo. Some factors include: a) common identity of officers, directors and equity owners, b) continuation of business at the same location, c) the use of the same employees and d) the fact that OldCo is no longer a functioning entity.9
When applying the de facto merger and mere continuation theories of liability, some courts focus on whether NewCo paid adequate consideration to OldCo for the assets purchased. For example, in Darrel Franklin, the California Court of Appeals noted, “The common denominator [for the de facto merger and mere continuation theories of merger] which must be present in order to avoid the general rule of successor nonliability, is the payment of inadequate consideration.”10
3. Fraudulent Intent
Sometimes, courts invoke equitable principles to avoid wrong doings that can result when OldCo transfers substantially all of its assets to NewCo and argues that the liabilities of OldCo are not also assumed by NewCo. The California Supreme Court expressed this idea in Lusanna Shea v. Leonis: Corporate separate existence will be disregarded where to recognize it would be to sanction a fraud or promote injustice. For example, a debtor may not evade payments of his debts by forming a corporation which does not assume the debt and thereafter transferring all his assets to it.11
A good example of this fraud theory of liability can be found in the case of Stratford Hotel v. Schwind.12 There, a company transferred all of its assets to a new company except for a single lease, and the new company maintained practically the same stockholders and directors. The court applied equitable principles to treat the new corporation as a mere continuation of the former corporation.13
It should be noted that the above theory differs from fraudulent transfer laws under the Bankruptcy Code and state fraudulent transfer acts. Those tools can be used to unwind the transfers and provide other equitable release and also are very helpful to combat the crooks discussed in this article. For a more thorough discussion on these laws, see the author’s prior edition of Dispatches from the Trenches on this topic.14
See UCC §9-507(a), “A filed financing statement remains effective with respect to collateral that is sold, exchanged, leased, licensed or otherwise disposed of and in which a security interest or agricultural lien continues, even if the secured party knows of or consents to disposition.”
For a useful example of this rule in action, see Official Comment No. 3 to UCC §9-507.
See UCC §9-509(c) “by acquiring collateral in which security interest or agricultural liens continues under UCC §9-315(a)(1), the debtor authorizes the filing of an initial financing statement, and an amendment, covering the collateral…”.
Ray v. Alad Corporation, 19 Cal.3d 22, 28 (Cal. Supreme Court, 1977)(emphasis added). See also 15 Fletcher, Cyclopedia Corporations, §7122 (Perm. ed. 1973); and 19 Am. Jur. 2d §1546.
See e.g. Darrel Franklin v. USX Corporation, 87 Cal. App.4th 615, 621-22.
See e.g. Darrel Franklin, Id. at 625 “Although these two theories have been traditionally considered as separate bases for imposing liability on a successor corporation, we perceive [the mere continuation theory] to be merely a subset of [the de facto merger theory].”
Arnold Graphics Indus., Inc. v. Independent Agent Ctr., Inc., 775 F.2d 38, 42 (2d Cir.1985).
See e.g. Woodrick v. Jack J. Burke Real Estate, Inc., 703 A.2d 306, 312 (N.J. Super. 1997); City of New York v. Charles Pfizer & Co., 260 A.D.2d 174, 688 N.Y.S.2d 23, 24 (1st Dep’t 1999) (explaining that the de facto merger exception derives from “the concept that a successor that effectively takes over a company in its entirety should carry the predecessor’s liabilities in order to ensure that a source remains to pay for a victim’s injuries”); North Shore Gas Co. v. Salomon, Inc., 152 F.3d 642, 650 (7th Cir. (Ill.) 1998); Johnston v. Amsted Indus., Inc., 830 P.2d 1141, 1146-47 (Colo. App. 1992); Harashe v. Flintkote Co., 848 S.W.2d 506, 509 (Mo. Ct. App. 1993); Philadelphia Elec. Co. v. Hercules, Inc., 762 F.2d 303, 310 (3d Cir.), cert. denied, 474 U.S. 980 (1985).
See e.g. Straton v. Garvey International, Inc., 676 P.2d 1290 (Kansas App. Court 1984). See also Dorff, Selling the Same Asset Twice: Towards a New Exception to Corporate Successor Liability Rules, 73 Temp. L. Rev. 717, 724, “Courts applying the ‘mere continuation’ doctrine focus on factors such as an identity of name, place of business, shareholders, officers and directors.” and Weaver v. Nash International, Inc., 562 F. Supp. 860, 863 (S.D. Iowa 1983), “the traditional indicia of the ‘mere continuation’ exception are a common identity of officers, directors and shareholders in the selling and purchasing corporations and the existence of only one corporation at the completion of the sale of assets.”
87 Cal. App.4th at 627.
14 Cal.2d 666, 669 (Cal. Supreme Court, 1939).
180 Cal. 348 (Cal. Supreme Court, 1919)
See also McClellan v. Northridge Park Townhome Owners Assoc., 89 Cal.App.4th 746, 754 (2001) “[C]orporations cannot escape liability by a mere change of name or a shift of assets when and where it is shown that the new corporation is, in reality, but a continuation of the old. Especially is this well settled when actual fraud or the rights of creditors are involved, under which circumstances the courts uniformly hold the new corporation liable for the debts of the former corporation.” (emphasis added)
Kenneth P. Weinberg,
Baker, Donelson, Bearman, Caldwell & Berkowitz
Usury laws vary from state to state, which can make a lease or loan more complicated when the lessor is in one state and the lessee in another. Kenneth Weinberg discusses how this has played out so far in the courts, with favorable rulings for a lessor often depending not only on who files first, but where they file from.
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