Corporate Successor Liability: Continuation and Fraud Exceptions (IL Law)

 


NOTE: PLEASE SEE UPDATE AT http://www.davismcgrath.com/#!Property-Is-Subject-to-Turnover-Order-Where-Buyer-Is-‘Continuation’-of-TwiceRemoved-Seller-–-Corporate-Successor-Liability-in-Illinois/cq5o/565ca4a20cf2c000e92858f0

Advocate Financial Group, LLC v. 5434 North Winthrop, LLC, 2014 IL App (2d) 130998 applies the “mere continuation” rule (a successor company that is the continuation of a prior company can be responsible for the prior company’s debts) in a creditor’s post- judgment action against a corporation twice removed from the judgment debtor.

The plaintiff was hired to help the condo developer defendant (Company 1) obtain financing to pay off a defaulted mortgage.  Company 1’s sole asset was a Chicago condo building.  When Company 1 defaulted on its payment obligations to plaintiff, the plaintiff sued and got a $90K money judgment.  After the judgment, Company 1 sold the building to another entity (Company 2) who in turn sold it to another entity (Company 3) – the building’s current owner. 

Plaintiff sought an order requiring Company 3 to convey the building to plaintiff so plaintiff could sell the building and satisfy its judgment with the sale proceeds. The trial court granted the turnover motion and found that Company 3 was the continuation of Company 1.  Company 3 appealed.

Held: Reversed. 

Rules/Reasons:

The trial court misapplied the continuation exception and failed to consider whether the fraud exception (to no successor liability) applied. 

– A corporation that purchases the assets of another corporation is generally not liable for the debts or liabilities of the transferor corporation. The rule’s purpose is to protect good faith purchasers from unassumed liability and seeks to foster the fluidity of corporate assets.  

– The “continuation” and “fraudulent purpose” exceptions to this rule apply where the purchaser is merely the continuation of the seller (continuation rule) and where the transaction is for the fraudulent purpose of escaping liability for the seller’s obligations (fraud exception). 

– Mere continuation requires a showing that the successor entity “maintains the same or similar management and ownership, but merely wears different clothes.”  The test is not whether the seller’s business operation continues in the purchaser, but whether the seller’s corporate entity continues in the purchaser. 

– The key continuation question is always identity of ownership: does the “before” company and “after” company have the same officers, directors, and stockholders?  (¶¶ 22-26). 

The trial court held that the continuation exception applied since Company 3 was basically the same (a “corporate clone”) as Company 1.  The two companies shareholders were virtually identical and Company 3 now owned the condo building. 

The appeals court noted that no Illinois court has found that the continuation doctrine applies to facts involving multiple transfers of an asset from a judgment debtor.  The critical issue here was whether Company 2 was a bonafide purchaser of the condo building.  If it was, then plaintiff couldn’t get a turn over order from Company 3. 

Had there been a direct transfer of assets from Company 1 to Company 3, the Court found that the continuation exception would apply and Company 3 would have to dispense with the building.  But the factual anomaly here was that Company 1 first transferred the building to an intermediary – Company 2 – before the building ended up in Company 3’s hands. 

If Company 2 was a “straw buyer”, then the fraud exception to the corporate successor liability rule would apply: Company 3 would be responsible for Company 1’s debt.  Another question the Court wants answered (on remand) is whether Company 2 is a sham buyer.  The record isn’t clear whether Company 2 consciously participated in a concerted plan by Company 1 to dispense with the building so that it ended up in Company 3’s hands.  According to the court, if the facts show that Company 2 was only a conduit from Company 1 to 3, the fraud exception could apply.   (¶¶ 37-39). 

Afterwords:  This case illustrates that while an intervening sale of an asset won’t always immunize the ultimate buyer from a creditor’s reach, the court will still look into the specifics of a middle-man transaction.  If the buyer intemediary has any connection to the debtor in terms of similar management personnel or other suspicious likenesses, a court can void the transaction and deem it a fraudulent effort to evade a creditor.