Many small business owners choose to operate as a corporation or a limited liability corporation. They often believe the corporate form will assist in avoiding personal liability for the debts of the company. They believe that those corporate debts will not become their own. Sometimes they falsely believe they can escape debts by simply shutting down a troubled and indebted LLC and continuing operations under a new LLC.
A successor company does not typically assume the liabilities from a transferring company. However, Wisconsin law provides numerous exceptions that may be utilized by creditors to collect debts against the successor company. The best way for a company owner to avoid personal liability may be to simply stop the business; apply the remaining corporate assets to resolve business debt; and avoid restarting similar operations under a new name. Business owners shifting from LLC to LLC while essentially doing the same work may be exposing themselves to much more personal liability than they are currently calculating.
A recent Supreme Court of Wisconsin case, Veritas Steel v. Lunda Construction (1), discusses fundamental successor liability issues and judicial exceptions, which may be used by a Court to prevent fraudulent avoidance of debts. A central tenet of successor liability is that the successor company’s beneficiaries are the same – i.e. same owners, stockholders, and/or managers. If you have a debt against a defunct company but the owner continued operations under a different name, this analysis could apply to you and assist you in collecting a debt from the new company. Please consider reaching out to me to discuss your options.
The Corporate Successor Liability Dispute in Veritas Steel v. Lunda Construction
Lunda held a large, unsecured debt against a company that sold its assets to Veritas in several complicated transactions. It was allegedly unable to collect its debt in full against the original company. Lunda filed successor liability claims and fraudulent transfer claims against Veritas and other related entities. It argued the sale was for “inadequate consideration” and for a fraudulent purpose (2). Lunda argued that exceptions should apply the general rule of no corporate successor liability, and that the successor should become responsible for the debt.
Wisconsin Corporate Successor Liability Rules
When a company sells or transfers all its assets to another company, the purchasing company typically does not become liable for the transferring company’s debts and liabilities. The rule is designed to protect a “bona fide” purchaser from assuming the liabilities of a predecessor corporation. The rule is also designed to protect the rights of commercial creditors and dissenting shareholders following corporate acquisitions, as well as determine liability for tax assessments and contracts of the predecessor.
Exceptions to Wisconsin Corporate Successor Liability Rules
Four exceptions to corporate successor liability exist under Wisconsin law. They apply in the following circumstances:
(1) Express Assumption: when the purchasing corporation expressly or impliedly agreed to assume the selling corporation’s liability;
(2) De-Facto Merger: when the transaction amounts to a consolidation or merger of the purchaser and seller corporations;
(3) Mere Continuation: when the purchaser corporation is merely a continuation of the seller corporation; or
(4) Fraud: when the transaction is entered into fraudulently to escape liability for such obligations.
These exceptions illustrate the balance in corporate successor liability law between two competing, and often conflicting, policy goals: to provide a necessary remedy to injured parties, often tort claimants with claims against the predecessor corporation, and to provide transactional clarity and certainty for business parties engaged in fundamental corporate transactions.
Applying De-Facto Merger and Mere Continuation Exceptions to Corporate Successor Liability
The court in Veritas focused its analysis on the De-Facto Merger and Mere Continuation exceptions. There was no express assumption of the debts and there did not appear to be strong or clear evidence of fraud. These tests ask a court to ignore the “corporate veil” and examine the substance and effect of business transformations. The court will consider whether the original organization continues to have life or identity in the subsequent business organization, and whether the new corporation has the same character and purpose of the original organization. Some facts to consider in this analysis is whether the same directors, officers, or stockholders exist in the new company, or whether the employees and managers were the same. Importantly, the key analysis is in the ‘identity of ownership’, not the ‘identity of the product’. An important consideration is whether the same people (owners, officers, managers) continue benefitting from the product or service.
The facts of this case are quite complicated, but it appears the owners of the original debtor company were not the same as Veritas, which was helpful to its defense of “successor” liability. Lunda argued that the “identity of management and control” of Veritas was close enough to apply the Mere Continuation and De-Facto Merger exceptions. The Court rejected that argument on the particular facts of this case, stating that ‘identity of ownership’ remained the central requirement. Of note, the oral argument before the Wisconsin Supreme Court sounded, at times, like someone explaining three dimensional chess. Tens of millions of dollars in assets and liabilities were transferred to several different entities that all performed different functions. At the end of the day, I suspect Lunda simply could not prove the owners of Veritas were close enough to the owners of the original debtor to satisfy the appellate courts.
Collection Considerations for Secured vs. Unsecured Debt
In a concurring opinion, Justice Roggensack evaluated more closely the strict foreclosure procedures utilized by Veritas to obtain unencumbered assets from the original debtor company. It appears the original debtor had other secured debts that primed Lunda’s less-secured or unsecured debt. Creditors with better debt claims than Lunda appear to have collected most or all the funds used to pay for the original debtor’s assets. Roggensack suggests that Lunda may have had defenses during the strict foreclosure procedure that it waived, or that there simply was not enough funds available in the sale to satisfy unsecured creditors like Lunda. Underlying the concurring opinion is that Lunda is unable to collect the debt because it made a bad business decision in acting as a creditor to a distressed company that could not pay… not because of fraud.
In a small business context, a business should always consider the risks of having an open account and mounting accounts receivable against small and potentially distressed business clients. Your ARs are legally enforceable, but they may not be easily collectible against the business in the event the business goes bankrupt. That business may have other debts that outrank yours. For risky accounts, you may want to consider making part or all of the ARs collectible against the owner of the company in his or her personal capacity. You may simply find the risk of default too large. A risk-reward analysis should be considered in every business relationship with significant outstanding ARs.
Lessons for Collecting Against a Successor Company
For creditors of defunct businesses, it may be prudent to consider whether the business may have continued operations under another name. If the identity of ownership is the same and the product or service is essentially the same, the creditor may be able to collect against the new business entity under the exceptions to the successor liability rule. If you are winding up business operations and you want to improve your defenses to business claims that may be brought against you in your personal capacity, please consider contacting me to discuss. Alternatively, if you have a debt against a defunct company but believe the owners are continuing operations under another name, please consider contacting me to discuss.
(1) Veritas Steel, LLC v. Lunda Constr. Co., 2020 WI 3, 389 Wis.2d 722, 937 N.W.2d 19 (Wis. 2020).
(2) Oral argument before Wisconsin’s Supreme Court occurred on September 19, 2019, and can be accessed here: Wisconsin Supreme Court Oral Argument: Veritas v. Lunda; If this link does not work, please email me at MEJ@MichaelJohnsonLegal.com.
