In early 1997, the Supreme Judicial Court for the first time found a corporation liable for the obligations of another corporation on the grounds that there had been a de facto merger of the two corporations. While Massachusetts is by no means alone or even out of step in adopting the de facto merger doctrine, the action of the SJC casts serious doubt upon traditional assumptions with respect to potential liability of purchasers in business acquisition transactions.
The case is Cargill, Incorporated v. Beaver Coal & Oil Co., 424 Mass. 356 (1997). The facts are straightforward: Beaver Coal & Oil Co., Inc. (Beaver) was a corporation engaged in the retail distribution of home heating oil. It sold substantially all of its assets to another corporation, Citizens Fuel Corporation (Citizens), which carried on the retail petroleum distribution business thereafter. Before the sale of its assets, Beaver had bought petroleum from a wholesale distributor doing business as Northeast Petroleum (Northeast) and had a significant balance outstanding to Northeast at the time of the asset sale. Cargill, Incorporated (Cargill), the plaintiff, was the successor in interest of Northeast. Northeast was unable to recover payment from Beaver after the sale transaction and subsequently sued both Beaver and Citizens. Citizens had not assumed this obligation of Beaver to Northeast. Nonetheless, Cargill claimed that Citizens should be liable on the grounds that the acquisition transaction was a de facto merger with the result that Citizens should be liable for this obligation of Beaver by operation of law - as would be the case if there had been a statutory merger of Beaver into Citizens with Citizens surviving such a merger. The trial judge agreed with Cargill's position, and the SJC affirmed.
While the SJC, as well as federal courts within the First Circuit, have from time to time acknowledged the de facto merger doctrine, prior to the Cargill case the doctrine had never been applied by the SJC and was applied only once by the Federal District Court in Massachusetts to find successor liability under Massachusetts law. See, e.g., Cyr v. Offen Co., 501 F.2d 1145 (1st Cir. 1974) (applying instead the "mere continuation" exception under New Hampshire law to corporate successor of sole proprietorship); Araserv, Inc. v. Bay State Harness Horse Racing and Breeding Association, Inc., 437 F. Supp. 1083 (D. Mass. 1977) (finding a lack of evidentiary support to apply the de facto merger doctrine); Dayton v. Peck, Stow and Wilcox Co. (Pexto), 739 F.2d 690 (1st Cir. 1984) (finding that an asset acquisition constituted neither a "merger" nor a "mere continuation" of the predecessor company); and McCarthy v. Litton Industries, Inc., 410 Mass. 15, (1991) (listing the de facto merger doctrine as one exception to the general rule).
The one case where the de facto merger doctrine was applied was In re Acushnet River & New Bedford Harbor Proceedings Re Alleged PCB Pollution, 712 F. Supp. 1010 (D. Mass. 1989). In Acushnet River, the United States and the Commonwealth of Massachusetts had filed complaints alleging that Aerovox, the successor corporation, was liable under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA"), 42 U.S.C. § 9607 et seq., for the contamination by Belleville, the predecessor corporation, of the Acushnet River and the New Bedford harbor. Belleville had transferred all of its assets to Aerovox, in exchange for shares of stock in RTE, Aerovox's parent company. Determining that the common law doctrine of successor liability, had viability in the CERCLA context, the court found Aerovox liable under the de facto merger doctrine.
In any acquisition of a business, regardless of form, one of the most significant issues is what liabilities of the business to be acquired will be assumed by the purchaser. The typical acquisition agreement - again, regardless of form or structure - will deal with the issue of liabilities of the subject business in many of its provisions. Thus, an agreement usually has a long list of representations and warranties by the seller with respect to existing liabilities, financial, tax, contractual, employment and the like, as well as potential third party liabilities, existing or threatened litigation or other third party liabilities, existing or threatened litigation or other third party claims. In addition to the representations and warranties, the agreement will customarily have covenants designed to ensure that between the date of signing the acquisition agreement and the closing the business to be acquired will not incur significant liabilities or exposure other than in the ordinary course of business. The closing conditions will generally give the purchaser a right to walk away if there have been any material changes in the liability exposure of the business since the date of the agreement. Finally, the agreement will customarily have provisions whereby the seller will indemnify the purchaser against any liabilities of the business relating to operations prior to the closing which the purchaser did not agree to assume. Indeed, it is probably fair to say that the typical business acquisition agreement will devote most of its provisions to the disclosure by the seller of liabilities and obligations of the business and the protection of the purchaser against liabilities which the purchaser has not agreed to assume.
There are three basic forms in which business acquisitions are structured: acquisition of stock, merger and acquisition of assets. While the contractual mechanisms for dealing with the successor liability issues above discussed are essentially the same regardless of which form or structure is used, the legal principles involved in the imposition of that liability upon the purchaser are different:
- In a transaction involving the acquisition of stock, there is no change in the corporate entity and, accordingly, no change in the party responsible for those liabilities - it remains the corporation to the same extent as prior to the acquisition. As a practical matter, then, the purchaser has the burden, as the new owner of the stock of the corporation, of all of the corporate liabilities, including unknown or contingent liabilities, which become known after the closing. While the purchaser may have indemnification from the seller, the law will impose upon the acquired corporation responsibility for its liabilities - whenever they arose and whether or not they were properly disclosed in an acquisition agreement.
- In a merger, the ultimate result is the same - the purchaser succeeds to the liabilities of the acquired corporation by operation of law. The route is a little different. In a typical so-called forward merger, the company being acquired merges with and into the acquiring corporation, the selling corporation goes out of existence and the buying corporation which survives succeeds by operation of law to all of the selling corporation's liabilities, known and unknown. This happens because the merger statute says so. Thus, M.G.L.c. 156B, § 80 provides that a "surviving corporation shall be deemed to have assumed, and shall be liable for, all liabilities and obligations of each of the constituent corporations in the same manner and to the same extent as if such resulting or surviving corporation had itself incurred such liabilities or obligations." While there are a variety of merger themes (reverse, reverse triangular, etc.) the net result is the same - the purchaser inherits, directly or indirectly, responsibility for all liabilities - past, present and future - of the acquired corporation which is merged out of existence.
- In an asset acquisition, the law makes a different presumption. The parties by contract determine what liabilities of the acquired business, if any, will be assumed by the purchaser and the legal presumption is that if the purchaser did not assume a liability of the selling corporation by contract, it remains with the selling corporation.
There have always been certain well-recognized exceptions to this basic principle in asset acquisitions. Bulk sales laws provided for a notice to creditors of the selling entity, with the opportunity for the creditor to follow assets into the hands of the purchaser if the procedures of such laws were not strictly complied with. These statutes have been abolished in many states, including Massachusetts, and generally did not prove to be effective as a practical matter in protecting creditors' rights. Tax liens arise under various statutes when all or substantially all of the assets of a corporation are sold. Procedures for securing the release of such liens are available in many jurisdictions. More recently, federal and state environmental laws have imposed strict liability upon owners and operators of real estate, causing virtually every business acquisition transaction since the adoption of those statutes to require environmental due diligence and in some cases (e.g., Connecticut) the compulsory filing with governmental authorities of reports with respect to environmental issues as a condition of closing the acquisition transaction.
Such exceptions to the general rule have to be dealt with and there are mechanisms by which the scope of the potential liability can be determined and the allocation of that risk as between the purchaser and seller can be accommodated in a manner satisfactory to the parties. The problem with the de facto merger exception is that there may be no way to avoid its impact if a transaction falls within its purview.
In Cargill, the SJC acknowledged the general rule above stated, subject to four exceptions:
We adhere to traditional corporate law principles that the liabilities of a selling predecessor corporation are not imposed on the successor corporation which purchases its assets unless:
- the successor expressly or impliedly assumes liability of the predecessor,
- the transaction is a de facto merger or consolidation,
- the successor is a mere continuation of the predecessor, or
- the transaction is a fraudulent effort to avoid liabilities of the predecessor. Id. at 359 (citations omitted).
The Court then set forth the factors to be considered in determining whether the de facto merger doctrine should apply:
The factors that courts generally consider in determining whether to characterize an asset sale as a de facto merger are whether
- 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
- 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
- the seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible; and whether
- the purchasing corporation assumes those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation. Id. at 359 (citations omitted).
The SJC went on to find that each of the four factors had been satisfied in this case. The business continued to be conducted under the old name and style, with the same personnel servicing Beaver's former customers, in the same location, even using the same telephone numbers as Beaver. Further, Citizens did assume ordinary course of business obligations of Beaver, assuming executory contractual obligations, and paying certain of the trade creditors of Beaver. Beaver, in turn, ceased all operations inasmuch of all of its operating assets were acquired by Citizens. While the corporate shell of Beaver was not dissolved right away, the Court found that the third factor had been satisfied because Beaver did not have any business operations after the sale. Finally, the sole owner of Beaver acquired 12 1/2% equity interest in Citizens and the Court found that this was enough to satisfy the continuity of ownership factor.
The significance of the Cargill case is that the de facto merger doctrine could well be applicable to many, if not most, acquisitions of businesses in Massachusetts which are structured as asset transactions. Thus, while the de facto merger doctrine is said to be one of the exceptions to the general rule that liabilities of a corporation will not pass to the purchaser of its assets unless specifically assumed by such purchaser, the exception could well apply to so many cases as to overwhelm the general rule itself. Of the four factors that courts generally consider in determining whether to characterize an asset sale as a de facto merger, at least three are probably present in the vast majority of business acquisitions. Indeed, to the extent that there is any "typical" acquisition, it is one falling within the facts of Cargill:
- an existing operating business with good will, a reputable trade name, good personnel, etc., is acquired by a new owner who has every intention of carrying on the business under existing trade names and with as little break in the continuity of the business as possible in order that customers and suppliers of the business will take as little notice as possible and be pleased to continue to do business under the new ownership. Thus the first factor is clearly not an exception to any general rule but, rather, the norm.
- The third factor is also quite common; if a corporation sells all or substantially all of its assets, it will have no reason for being thereafter and will undertake to dissolve its corporate existence within a reasonable period of time after the closing. Massachusetts law provides that even after dissolution a corporation continues "a body corporate" for three years after the dissolution for the purpose of prosecuting and defending lawsuits and settling its affairs - but not for the purpose of carrying on business. M.G.L.c. 156B, § 102. Moreover the corporation may be revived long after dissolution by the Secretary of State under certain conditions. M.G.L.c. 156B, § 108. The point is that the dissolution of a corporation which has sold all of its operating business assets is not only not unusual but what one would expect in such circumstances.
- It is also customary, especially in the acquisition of an entire business operation, for the purchaser to assume certain ongoing obligations of the business being acquired. Existing contracts, particularly if on favorable terms to the acquired business, will often be assumed by the purchaser. The real concern the purchaser has with respect to existing liabilities is knowing the full extent of those liabilities and providing in the acquisition agreement that the purchaser is assuming only the liabilities set forth in that agreement, with any others, known or unknown, to remain with the selling entity.
- The factor which is probably not as commonplace as the three above noted is the continuity of stock ownership element listed by the Court as the second of the de facto merger elements. That is not to say that it is at all unusual for former owners of an entity to have an ownership stake in the successor. Indeed, in any acquisition in which a financial buyer is involved, if the new owner wants to retain existing management, they often will be offered an equity stake in the acquiring enterprise. If such management people have also had an equity position in the selling corporation, this factor would be satisfied. Indeed, a 12 1/2% stake in the new enterprise was all the SJC needed in the Cargill case to check off this factor.
One wonders whether the SJC would have reached a different result in this case if the sole owner of Beaver had not acquired any equity interest in Citizens. On the one hand, the Court states, after the recitation of the four factors: "No single factor is necessary or sufficient to establish a de facto merger." Id. at 360. On the other hand, in a footnote the Court mentions a Michigan case which found successor liability with no continuity of equity ownership, essentially relying on the other three factors of the de facto merger test.
Where no stock is exchanged, corporate successor liability has more frequently been imposed on a theory of "continuity of enterprise." See, e.g., Turner v. Bituminous Cas. Co., 397 Mich. 406, 411 (1976). There is no claim here by Northeast that we should apply that theory of liability and we do not do so. Id. at 361 n.8.
If the Court were presented with a case in which there is no continuity of ownership, it would not be very big step from the Cargill facts for the Court to find successor liability.
The Court concludes its discussion of the de facto merger doctrine with the following observations:
Citizens held itself out to the world as the same enterprise as Beaver, apparently not notifying its customers of any change in ownership. It continued to function in the same manner with the same employees, delivering the same product, and providing the same services as Beaver. Citizens argues that the public policy concerns such as tort liability or compliance with environmental laws that have impelled a finding of successor liability in other cases are not present in this case. We consider the fair remuneration of corporate creditors a policy worthy of advancement.
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. On these facts we conclude that the Citizens is the corporate successor to Beaver, and is liable to Northeast for Beaver's preexisting debt to it. Id. at 362.
There is a strong suggestion here that the SJC has reached out to protect an "innocent creditor" in order to advance a public policy in favor of "the fair remuneration of corporate creditors". It is interesting to compare this analysis and rationale with the position taken by the Court in 1991, rejecting the "product line" theory of tort liability under which a party which acquires a business and continues to operate it in the same manner as the prior owner would have tort liability for products manufactured and sold by the predecessor simply because the new owner stayed in the same business. Guzman vs. MRM/Elgin, 409 Mass. 563 (1991). In Guzman, the court rejected the rationale for the product line liability theory:
- The virtual destruction of plaintiff's remedies against the original manufacturer caused by the successor's acquisition of the business;
- The successor's ability to assume the original manufacturers risk spreading role; and
- The fairness of requiring the successor to assume a responsibility for the predecessors defective products as a burden necessarily attaching to the original manufacturer's good will being enjoyed by the successor in the continued operation of the business.
With respect to the first point, the SJC noted that it was not the purchase by the successor corporation that deprived the plaintiff of a remedy but rather the demise of the predecessor and further that the plaintiff's lack of a remedy against the predecessor was not a justification for imposing liability on the successor absent some fault on the part of the successor. As to the second point, the Court noted that strict liability should be limited to those who sell defective products and that it would be contrary to this principle to impose liability on a successor corporation which did not manufacture, sell or market the defective product.
Finally, the Court noted that to impose liability upon a successor on the grounds that the successor is reaping the benefits of the good will of the predecessor is to ignore the fact that the successor has, in fact, paid for the predecessor's good will in the asset purchase.
If the foregoing rationale had been applied by the SJC to the facts of the Cargill case the result would presumably have been different. It is also interesting to note that the Court in the Guzman case concluded by suggesting that if successor liability is to be imposed, the legislature is best equipped to make that judgment. Id. at 571. The Court declined to defer to the Massachusetts legislature in the Cargill case, even though in some states the de facto merger doctrine has been abolished by statute. See, e.g., Tex. Buss. Corp. Act, Art. 5.10B.
"Traditional corporation law principles" say that a purchaser of assets acquires only those liabilities of the seller expressly assumed by the purchaser, subject to limited exceptions.
Indeed, the avoidance of liabilities, known and unknown, of the seller may well be a significant reason for the purchaser's preference for an asset acquisition rather than a stock or merger transaction. However, the de facto merger doctrine erases much of this potential benefit of asset acquisitions. Accordingly, purchasers and their legal representatives must rely upon the provisions of the acquisition agreement, especially indemnification provisions, to the same extent as in a merger or stock acquisition transaction.