Those of us who handle acquisition transactions can take for granted that asset acquisitions avoid the buyer assuming unintended liabilities of the seller. As a general rule, acquisitions of an entity’s equity cause the buyer to take any liabilities of the business conducted by the entity. However, asset acquisitions generally allow the buyer to selectively assume particular liabilities while avoiding responsibility for any other liabilities of the selling entity. The New Nello case from the Court of Appeals of Indiana illustrates an exception to this general rule – the de facto merger doctrine.1
Nello, Inc. (“Old Nello”), formed in 2002, manufactured utility and cellular telephone towers. Old Nello’s officers owned approximately 95%-99% of the corporation’s stock. Old Nello had two primary secured creditors. Old Nello owed approximately $10 million to Fifth Third Bank and $3.4 million to Live Oak Capital. The loan from Fifth Third Bank was senior to the loan from Live Oak Capital. The loan from Fifth Third Bank was personally guaranteed by Old Nello’s officers. After moving its headquarters to South Bend, Indiana in 2016, Old Nello began experiencing financial difficulty. Fifth Third Bank sent a demand letter to Old Nello and its president notifying them that the loan was due and payable immediately.
Live Oak Capital, fearing it would recover nothing from Old Nello, engaged the services of Michael Clevy, of the private equity firm Beckner Clevy Partners, to explore options for continuing Old Nello’s business in the face of the Fifth Third Bank demand letter. Clevy pursued several options including refinancing and locating investors. None of these options proved promising and Fifth Third Bank was ready to foreclose.
In April or May 2017, in order to maximize its chances of recovery, Clevy formed New Nello Acquisition Co., LLC to be owned by new investors. New Nello Acquisition Co., LLC then purchased the Fifth Third Bank loan for $3.765 million at a time when the liquidation value of Old Nello was approximately $3.1 million. New Nello Acquisition Co., LLC formed New Nello Operating Co., LLC (collectively referred to as “New Nello”). Thereafter, New Nello entered into a strict foreclosure of Old Nello, taking all of its assets and assuming liabilities deemed essential for business operations. As part of the foreclosure, the officers were released from their personal guarantees and paid for certain debts they were owed by Old Nello. After foreclosure, New Nello conducted Old Nello’s historic business in the same physical location, using the same name, with approximately 90% of the same employees, retaining the same officers, using the same website, and making no public announcement of the change in ownership. However, the owners of New Nello were not any of the historic owners of Old Nello or any of the officers. The business was now held by completely new ownership.
While these events were unfolding, CompressAir sued Old Nello for payment of $39,000 due from CompressAir’s installation of compressed air and oxygen piping in Old Nello facilities. By the summer of 2017, six other creditors had filed complaints against Old Nello seeking payment for outstanding bills. Ultimately, CompressAir obtained a judgment against Old Nello for $44,689.66. After obtaining judgment, CompressAir learned of New Nello and filed supplemental proceedings against New Nello as a garnishee-defendant arguing that New Nello was a successor to Old Nello and responsible for its debts.
Law – De Facto Merger Doctrine/Mere Continuation
The court started its analysis recognizing that “it has been held that when one corporation purchases the assets of another, the buyer does not assume the debts and liabilities of the seller.”2 However, there are four general exceptions to this rule:
- 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.3
The trial court found that two exceptions applied – de facto merger and mere continuation. The Court of Appeals did not address the “mere continuation” exception, but discussed the de facto merger doctrine. In discussing application of the doctrine, the court described the following factors to be considered:
- 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.4
The court was clear that all of the factors need not be satisfied in order to find a de facto merger.5 Specifically, the court stated “even though there was no continuity of ownership, we do not consider this to be fatal to a finding of a de facto merger.”6 Also, at least as of the time of trial, Old Nello had not dissolved. However, the court stated “although Old Nello was apparently never officially dissolved, all of its assets were acquired by New Nello. Old Nello is therefore a defunct corporation, even if not legally dissolved.”7
Ultimately, the court’s opinion turned on the facts that “New Nello continued Old Nello’s business enterprise as to management, location, and area of business. New Nello continued to refer to itself as ‘Nello,’ and its website stated that it was founded in 2002, the year Old Nello was founded. Moreover, New Nello assumed the debts of Old Nello that it deemed necessary to continue the business. All of these factors support a finding of a de facto merger.”8 Based on these factors, the court held that New Nello was liable for the debts of Old Nello as its successor by merger under the de facto merger doctrine.
Initially, this may seem to be a sensible result. Why should a business be able simply to operate through a new entity and avoid its debts? Clearly, if the owner of a distressed business were to simply form a new legal entity and start operating through it in the same location, with the same employees, etc., most of us can understand the new entity should assume the liabilities of the old entity. However, this case is different for a number of reasons. Of primary importance is that the owners of New Nello are not the historic owners of Old Nello. Also, the secured creditors of Old Nello received in excess of liquidation value when the debt was purchased. Certainly, the unsecured creditors were left empty handed, but that is how priority works between multiple creditors. Secured creditors are paid before unsecured creditors (at least with respect to their collateral) who only recover once the secured creditors are satisfied.
Here, consider the result of this ruling. Ultimately, CompressAir, an unsecured creditor, recovers in full when the secured creditors of Old Nello did not (after selling their debt). Also, what if Fifth Third Bank had foreclosed directly against its collateral, selling the assets in a foreclosure sale? Would the outcome have been different than under the facts of this case? If not, can anyone safely acquire a business in a strict foreclosure sale? The results of the court’s ruling in this case are not what one typically expects in distressed business acquisitions. Should cautious purchasers in asset acquisitions of distressed businesses go so far as to insist on acquisition through a bankruptcy sale?
However, this is one just case, in just one state. Other states handle the de facto merger doctrine differently. For example, New York and Delaware require some level of continuity of ownership (how much is its own question).9 Texas abolished the de facto merger doctrine by statute.10 Mississippi has refused to apply the de facto merger doctrine when one of the shareholders remained the same between the old corporation and the new corporation but others changed (i.e. any change in shareholders).11 Clearly, Indiana will be liberal in its application of the de facto merger doctrine. It is unclear whether choice of law provisions in asset purchase agreements or similar documents will bind creditors. Therefore, care must be taken in structuring transactions to consider states’ laws that could apply.
After many asset acquisitions, the acquired business continues to operate under the same name, largely with the same employees and management, and in the same location. If that causes the buyer to assume all of the corporate liabilities of the seller, many transactions would be negatively affected. While this risk is most stark in distressed business acquisitions, the theory could apply to unknown liabilities as well. Indiana seems to be applying the de facto merger doctrine more broadly than other states. However, the issues certainly warrant consideration in asset acquisition transactions.
It is unclear which of the facts cited by the court could be changed to reach a different result (i.e. move office locations, replace certain officers, update the web site, make a public announcement, etc.). Regardless, during an asset acquisition where the buyer will continue the seller’s business largely unchanged, parties may be well served by considering how to mitigate any potential exposure to the de facto merger doctrine through steps to distinguish the buyer from the seller, especially when owners of the seller will retain any equity in the business post-transaction.
- New Nello Operating Co., LLC v. CompressAir, 142 N.E.3d 508 (2020).
- Id., 142 N.E.3d at 512.
- Id. See also Philadelphia Electric Co. v. Hercules, Inc., 762 F.2d 303 (3rd Cir. 1985) for a slightly different statement of the relevant factors.
- Id. at 512.
- See also SmithKline Beecham Corp. v. Rohm and Haas Co. 1995 WL 117671 (E.D. Penn. 1995), reversed at SmithKline Beacham Corp. v. Rohm and Haas Co., 89 F.3d 154 (3rd Cir. 1996).
- Id. at 513.
- Id. See also Knapp v. N. Am. Rockwell Corp., 506 F.2d 361 (3rd Cir. 1974) holding that dissolution of the old corporation was not necessary for application of the de facto merger doctrine.
- Id. at 513.
- See Bonanni v. Horizions Inv’rs Corp., 179 A.D.3d 995 (N.Y. App. Div. 2020); Cargo Partner AG v. Albatrans, Inc., 352 F.3d 41 (2nd Cir. 2003); and Marnavi S.p.A. v. Keehan, 900 F. Supp. 377 (D. Del. 2012). But see East 34th Street (NY), LP v. Bridgestreet Worldwide, Inc., 2019 NY Slip Op. 33310 (N.Y. Sup. Ct. 2019) where the theory of “mere continuation” survived a motion for summary judgment when there was no continuity of ownership.
- Tex. Bus. Org. Code § 10.254. See also C.M. Asfahl Agency v. Tensor, Inc., 135 S.W.3d 768 (Tex.App. – Houston [1st Dist.] 2004). Texas also has held that the “mere continuation” theory must be inapplicable as against the state’s public policy. Mudgett v. Paxson Mach. Co., 709 S.W.2d 755 (Tex. App. 1986).
- Paradise Corp. v. Amerihost Development, Inc., 848 So.2d 177 (Miss. 2003), but the court did apply the “mere continuation” theory to hold the new corporation liable for the debts of the old corporation.