When individuals set up corporations and limited liability companies, one of the driving concerns is to prevent any personal liability for that individual for the debts of the business. Furthermore, when someone “buys a business”, the buyer needs to limit or eliminate the risk that the buyer will be responsible for the business debts of the selling business. This is why so many transactions involving the “sale of a business” are in fact the sales of certain assets of a business. In order to prevent this type of personal liability for the corporate debts, or successor liability for the debts of a selling entity, certain formalities need to be followed and the transactions structured appropriately so as to fit into the guidelines of Indiana law.
The Indiana Court of Appeals recently decided a case in which a party that was owed debts by one corporation sued that corporation and another corporation seeking to collect on the debt.
In Ziese & Sons Excavating v. Boyer Construction Corporation, et al., decided by the Indiana Court of Appeals on March 29, 2012, Ziese sued Boyer Construction Group (“Group”) and Boyer Construction Corporation (“Corporation”) under various theories of liability, including piercing the corporate veil and successor liability.
The short version of the facts is that Ziese had performed work for Corporation, but was never paid. One of the principals of Corporation later formed Group, and “bought” certain of the assets from Corporation. However, the evidence showed that Group was using all of the assets of Corporation, even those that were not purchased under the purchase agreement between Construction and Group. The website for Group also claimed as its former projects several projects that were done by Construction many years before Group was even formed.
In the decision, the Indiana Court of Appeals looks at some of the issues that all businesses must be concerned about when entering into an asset purchase sale or when those businesses are considering setting up a new entity that will look substantially similar to a former entity. In looking at the first theory raised by Ziese, that of piercing the corporate veil, the Court went through the various factors that a court must look at when determining whether or not to pierce the corporate veil, which means that the owners of the corporation will be personally responsible for the debts of that corporation. While no one factor is ever conclusive, the Court did note that the following factors are typically considered:
- Absence of corporate records;
- Fraudulent representation by corporation shareholders or directors;
- Use of the corporation to promote fraud, injustice, or illegal activities;
- Payment by the corporation of individual obligations;
- Comingling of assets and affairs;
- Failure to observe required corporate formalities; and
- Other shareholder acts or conduct ignoring, controlling, or manipulating the corporate form.
Another part of the corporate veil theory is the “corporate alter ego doctrine.” Under that doctrine, a party tries to show that two corporations are so closely connected that the plaintiff should be able to sue one for the actions of the other. The purpose is to avoid the inequity that results when one corporation uses another corporation as a shield from liability. There are additional factors that the court will look at under this theory, including whether similar corporate names were used; whether the corporations shared common principal corporate officers, directors, and employees, whether the business purposes of the corporations were similar; and whether the corporations are located in the same offices and use the same telephone numbers and business cards.
Ziese also argued that Group should be liable for the Corporation’s debt to Ziese under a theory of “successor liability”. As a general rule, when one corporation purchases the assets of another pursuant to an asset purchase agreement, the purchaser does not assume the debts and liabilities of the seller. There are exceptions to this rule, including where there is an implied or expressed agreement to assume liabilities; there has been a fraudulent sale of assets done for the purpose of evading liability; a purchase that is a de facto merger; or where the purchaser is a mere continuation of the seller. In reviewing whether or not a sale was done for the purpose of evading liability, the court will look for “badges of fraud”, which typically means those transfers made by a debtor during the pendency of a lawsuit, a transfer that renders the debtor insolvent or greatly reduces its assets; hurried transactions not done in the usual manner; a transaction where that seller retains benefits over the property; or where there has been little or no payment made for the transfer, or a transfer of property between family members. In those types of situations, the courts often will find that there has been fraudulent intent, i.e., an intent to evade collection from creditors of the seller.
As has been noted previously in this blog, litigation is expensive and very time consuming, often lasting for years. This is not the pace at which businesses normally operate, and most business people with whom we work get very frustrated by the litigation process. The point from the Ziese opinion is that the courts will examine very closely these types of transactions where it is fairly obvious that a seller is trying to evade paying its debt by simply setting up a new company and transferring the assets from the old company to the new company for little or no payment. The courts are also very skeptical when family members are involved on both sides of transactions.
There are certainly ways to handle these transactions that will minimize the risk of alter ego/successor liability/piercing the corporate veil types of arguments prevailing, but those transactions that are done at the last minute with a clear intent to avoid having to pay debts are always going to be subject to substantial scrutiny and, depending on the aggressiveness of the creditor, may cause all involved to be ties up in litigation for years to come.