Corporate successor liability’s focal point is whether a purchasing corporation (Company 2) is responsible for the purchased corporation’s (Company 1) pre-sale contract obligations.
It’s an important question because the Company 1 will usually have no assets after the purchase. Creditors of Company 1 will then try to pin liability on Company 2.
The general rule in Illinois is that a corporation that purchases the assets of another corporation is not responsible for the debts or liabilities of a transferor corporation.
The rule is designed to protect good faith purchasers from unassumed liability and to maximize the fluidity of corporate assets.
The four exceptions to this rule are: (1) where there is an express or implied agreement of assumption; (2) where the transaction amounts to a consolidation or merger of the purchaser or seller corporation; (3) where the purchaser is merely a continuation of the seller; and (4) where the transaction is fraudulent – done for the purpose of escaping the seller’s obligations.
The express assumption exception only applies if the plaintiff can produce an agreement where the purchasing corporation agrees to assume the selling corporation’s obligations.
If the agreement is silent, there is no express assumption. Implied assumption is trickier and requires an examination of the selling and buying corporations’ conduct.
The merger or consolidation exception applies where the plaintiff demonstrates: (a) continuity of management, personnel, physical location, assets, and business operations; (b) continuity of shareholders; (c) that the seller ceases its business operations quickly after the sale; and (d) the buyer assumes the seller’s liabilities and obligations that are necessary for seamless perpetuation of the seller’s business operations.
In examining the continuation exception, the court’s focus is whether the purchasing corporation is a reincarnation of the seller corporation and has same or similar management but merely “wears different clothes”.
The continuity calculus includes whether there is a common identity of officers, directors and shareholders between the selling and purchasing corporations.
Exact commonality between the selling and purchasing corporations’ management isn’t required for the court to find a continuation.
In assessing whether the fraud exception applies to the general rule of no corporate successor liability, the court looks at multiple factors set forth in the Illinois Fraudulent Transfer Act. 740 ILCS 160/5(b)(1)-(11) including the timing of the transfer from seller to purchaser, whether the seller paid and whether purchaser received adequate consideration, whether the seller became insolvent at or shortly after the transfer, whether the transfer was to an insider (officer, director shareholder of the selling corporation), etc.
To temper the possible harsh results of a corporate transfer wiping out any chance of creditor recovery, I try to put language in a contract saying that if there is a transfer from defendant to another entity during the term of the contract, the defendant promises to both promptly notify my client in writing and make the new, purchasing company aware of the contract and its obligations under it.
In Illinois, a corporation is a legal entity that exists separate and apart from its shareholders, officers and directors. In fact, a major purpose of incorporating is to insulate yourself from personal liability. This liability-reducing function of corporations does have its limits though. If someone is abusing the corporate form, a court can disregard the corporation and “pierce the corporate veil.”
For instance, if I incorporate Paul, Ltd. and you enter a contract with Paul, Ltd. to sell widgets and Paul, Ltd. breaches, generally, you will not be able to sue me personally for Paul, Ltd.’s debts. Because, the law views me as a separate “person” from Paul, Ltd. However, if Paul, Ltd. is simply my alter-ego, or a pass-through entity – then the court can pierce Paul, Ltd.’s veil of limited liability and hold me responsible for Paul, Ltd.’s debts!
Illinois courts apply a two-prong test to determine whether to pierce the corporate veil: (1) unity of interest and ownership is such that separate personalities of the corporation and the other person no longer exist; and (2) adherence to the fiction of separate corporate existence would sanction fraud or promote injustice. Fontana v. TLD Builders, 362 Ill.App.3d 491 (2005).
Within this two-part framework, courts analyze the following factors: (1) inadequate capitalization (opening a corporate bank account with minimal $); (2) failure to issue stock; (3) nonpayment of dividends; (4) nonfunctioning officers or directors; (5) absence of corporate records (Articles of Incorporation? What’s that?!!); (6) insolvency of debtor corporation; (8) commingling of funds; (9) diversion of corporate assets to a dominant shareholder, among others.
Afterword: It’s difficult to demonstrate grounds for piercing. A creditor seeking to pierce has a very heavy burden. For this reason, when dealing with a corporation with whom you don’t have a prior relationship or that doesn’t have a track record, doing pre-contract due diligence (running credit reports, checking trade references, etc.) is critical.
In addition, getting a personal guaranty from a corporate officer is helpful. This assures that a real live person actually has some skin in the game. Otherwise, you run the risk of getting an uncollectable judgment.