Last May, we told you about a decision from the Court of Appeals dealing with liability after an asset-only purchase. The Court of Appeals found that there was a de facto merger when the assets were bought, so the new company was liable for the debts of the old. The Indiana Supreme Court was sufficiently intrigued by this subject to grant transfer.
Nello was founded in 2002 to manufacture utility and cellphone towers. Four senior officers of the company owned 95% of the shares; the remaining shares were held by three different people. The company moved its operations to South Bend in 2016, but this move was more difficult than anticipated, leaving the company “cash-strapped.” Its debts included $1.4 million owed to the City of South Bend; $3.4 million to Live Oak Capital; and over $10 million to Fifth Third Bank. The four senior officers had signed personal guarantees for the Fifth Third loan.
Nello defaulted on the Fifth Third loan, and the bank demanded that Nello pay it in full. In order to help Nello, Live Oak sought alternative funding. A private-equity firm answered the call and offered Fifth Third $3.7 million as an alternative to liquidation. Fifth Third accepted this offer.
The private-equity firm created “New Nello” as a vehicle for this transaction, and New Nelo entered into a strict-foreclosure agreement with “Old” Nello. Under that agreement, New Nello only assumed the liabilities it deemed necessary to continue the business. New Nello then continued the business’s operations under the same management with 90% of the same workforce. None of Old Nello’s stockholders owned equity in New Nello.
CompressAir had installed piping in the Nello facility, for which it had not been fully paid. It obtained a judgment against Nello before the New Nello transaction was complete and found about the sale during proceedings supplemental. New Nello argued that the strict foreclosure was fraudulent and that New Nello was a “mere continuation” of the old. The trial court entered judgment for CompressAir, New Nello appealed, the Court of Appeals affirmed, and the Indiana Supreme Court granted transfer.
The Supreme Court began its discussion by reaffirming that a buyer in an asset purchase can sometimes take on the seller’s liabilities, too. And two of those circumstances were at issue here: a de facto merger and a mere continuation of the business. The question before the Court was whether there needed to be a continuity of ownership in order for these exceptions to apply. The Court found that continuity of ownership was necessary to prove a de facto merger.
The Court discussed its prior de facto merger decisions and noted that there was continuity of ownership in all of them. “What these cases imply, we now make explicit: continuity of ownership between transacting companies is essential to the de-factomerger exception in Indiana.” And the Court explained its reasoning as follows:
Under our law, we penetrate a transaction’s form to its substance and treat it as a stock purchase or merger if its “economic effect … makes it a merger in all but name.” We do so to further the de-facto-merger exception’s policy rationale, which is to prevent owners of a failing business from manipulating a transaction in a way that leaves creditors high and dry while allowing the same owners to run what amounts to the same business in a newly formed company. This rationale does not apply here. It was not Old Nello or its shareholders that set in motion the transfer of assets from
Old Nello to New Nello but Fifth Third, one of Old Nello’s secured creditors. The de-facto-merger exception would not have applied had Fifth Third itself strictly foreclosed on Old Nello’s assets in (partial) satisfaction of what it was owed. The result is no different when New Nello, as Fifth Third’s successor in interest, forecloses on them instead.
The Court then turned to the question of whether New Nello was a “mere continuation” of the old. “Unlike the de-facto-merger exception, the mere-continuation exception considers not whether business operations continue from one entity to the next, but whether the initial entity itself continues.” The Court found that a “critical” part of this analysis was whether there was a “common identity” of equity holders, which makes continuity of ownership a “necessary element.” As no owner of Old Nello was an owner of New Nello, then the new entity could not be a “mere continuation” of the old one.
Therefore, the Court ordered that a judgment be entered for New Nello.
The opinion highlights a number of open questions under both the de facto merger and mere continuation tests. However, it has set a bright-line rule in one respect; neither of those tests apply if the asset buyer is not owned by anyone who has an equity interest in the seller.
1. The general rule is that with an asset purchase, the buyer acquires the seller’s assets but not its liabilities.
2. One exception to the general rule is when the purchase is a de facto merger.
3. A second exception is when the buyer is a mere continuation of the seller.
4. Neither exception applies when there is no continuity of ownership.