Opinion by: Andrea M. Leahy
Holding: A court may consider the purpose of an asset sale and the adequacy of consideration as factors in the analysis of whether the “mere continuation” exception to the rule against successor liability should apply.
Facts: Plaintiff is the sole owner of a small lumber distribution business (“Plaintiff LLC;” “Plaintiff” shall refer to Plaintiff in his individual capacity). Until 2010, Plaintiff LLC also manufactured roof trusses and other engineered wood products (“EWP”). Defendant is a lumber retailer who was a customer of Plaintiff LLC.
Plaintiff LLC and Defendant negotiated a partnership for their mutual benefit. Defendant was to acquire assets from Plaintiff LLC, combine them with its own, and form a new LLC (“Predecessor”). Defendant, through its wholly-owned subsidiary (“Subsidiary”), would also contribute money to Predecessor. Subsidiary would own the majority interest in Predecessor, and Plaintiff would be an employee.
The parties agreed that Plaintiff would be employed for two years following the asset purchase in March 2010. Plaintiff was to work part-time and be compensated $10,000 per month over two years ($240,000 in total). Plaintiff’s responsibilities included integration of the roof truss and EWP businesses, sales and marketing. Plaintiff was also to supply Predecessor with lumber from Plaintiff LLC. The agreement provided that if Plaintiff was terminated by Predecessor “without cause,” he would still be owed the $10,000 monthly salary; however if he was terminated “for cause,” neither Predecessor nor Defendant would be obligated to pay the remaining salary.
Defendant also agreed to purchase a number of assets from Plaintiff LLC, including equipment, inventory, intellectual property and customer records in exchange for $139,570 and a 7.5% membership interest in Predecessor. Defendant provided employees for “back office” operations such as hiring, IT and accounting, while Plaintiff managed Predecessor’s sales force and occasionally referred to himself as “President” of Predecessor. Per Predecessor’s Operating Agreement, Subsidiary had authority over Predecessor’s managers, which included Plaintiff.
Predecessor struggled after its formation. In October 2010, Plaintiff’s salary was cut by $4,670 per month. Subsidiary lent Predecessor $425,000 in March 2011, but Predecessor was out of cash by the end of May and could not secure another loan. In May, Defendant began absorbing accounting, administrative and labor costs. Predecessor’s managers considered bankruptcy, but Plaintiff was strongly opposed because Predecessor owed $300,000 to Plaintiff LLC for its lumber supply.
Late in May 2011, it was determined that Plaintiff was no longer employed with Predecessor, although there is disagreement between the parties as to whether Plaintiff voluntarily resigned or was fired. Plaintiff continued to act as a commissioned salesman for Predecessor, however, and he still supplied Predecessor with lumber through Plaintiff LLC.
Predecessor’s management sold the company’s assets to Defendant in August 2011. At that time, Plaintiff agreed to release his membership interest to Subsidiary. Defendant acquired all of Predecessor’s assets and assumed $1,162,000 in liabilities—including $300,000 owed to Plaintiff. Defendant continued in the business of truss design and manufacture in the same location, with some of the same work force and customers. However, testimony demonstrated that the ownership structure, operation and management had changed.
Plaintiff sued Predecessor for breach of contract, alleging that he received only $147,000 of his agreed-upon total compensation of $240,000. Plaintiff sought to recover the remaining $93,000 along with treble damages. Plaintiff also alleged that Defendant was liable under the theory of successor liability because Defendant’s operation was a “mere continuation” of Predecessor’s enterprise.
The trial court declined to hold Defendant liable for nonpayment of wages or breach of contract by Predecessor, finding that (1) there was no evidence that the transaction was for the purpose of avoiding liability to Plaintiff; (2) Defendant provided Predecessor adequate consideration in the asset transfer; and (3) the overlap in management, control and ownership between Predecessor and Defendant was not alone enough to find that there was a “mere continuation.” Plaintiff appealed, arguing that the trial court erred by examining the purpose of the transaction and the adequacy of consideration in its “mere continuation” analysis.
Analysis: The court observed that in general, a corporation which acquires the assets of another corporation is not liable for the debts and liabilities of the predecessor corporation. Maryland law recognizes four exceptions to the general rule: (1) when there is an expressed or implied assumption of liability; (2) when the transaction amounts to a consolidation or merger; (3) the purchasing corporation is a mere continuation of the selling corporation; or (4) the transaction is entered into fraudulently to escape liability for debts.
The court explained that the “mere continuation” exception permits recovery against the successor corporation where the successor is essentially the same corporate entity as the predecessor. Furthermore, the exception is designed to prevent transactions where the specific purpose “is to place those assets out of the reach of predecessor’s creditors.” The exception had been addressed in only three previous opinions by Maryland appellate courts: Baltimore Luggage Co. v. Holtzman, 80 Md. App. 282 (1989), Nissen Corp. v. Miller, 323 Md. 613, 617 (1991), and Academy of IRM v. LVI Envtl. Servs. Inc., 344 Md. 434 (1997).
In Baltimore Luggage, the court explained that “the underlying theory of the [‘mere continuation’ exception] is that, if a corporation goes through a mere change in form without a significant change in substance, it should not be allowed to escape liability.” The court instructed that the “indicia of continuation” are “common officers, directors, and stockholders” and “only one corporation in existence after the completion of the sale of assets.” The court added that “[o]ther factors, such as continuation of the seller’s business practices and policies and the sufficiency of consideration running to the seller corporation” may also be considered in determining whether the exception should be applied.
In Nissen, the court drew a distinction between the “mere continuation” exception and “continuity of the enterprise” theories, the latter of which is not recognized in Maryland. In drawing the distinction, the court observed that “[t]he mere continuation . . . exception applies where there is a continuation of directors and management, shareholder interest and, in some cases, inadequate consideration.”
In Academy of IRM, the court also considered an additional relevant factor to the “mere continuation” exception: the purpose of the asset sale. The court stated that “successor liability does not lie” where the transaction is not fraudulent as to unsecured creditors. The court also cited Jackson v. Diamond T. Trucking Co., 241 A.2d 471, 477 (N.J. 1968),* which held that when deciding when to apply the “mere continuation” exception, “[m]any facts and policy factors must be weighed in the balance, most importantly, the policy protecting corporate creditors must be weighed against the equally important policy respecting separate corporate entities.”
The court reasoned that the combined effect of Baltimore Luggage, Nissen, and Academy of IRM is that five factors may be considered in determining whether to apply the “mere continuation” exception in Maryland: “(1) any change in ownership and management, (2) the continued existence of the selling corporation, (3) the adequacy of consideration, (4) the transfer of any ‘instrumental’ employees from the predecessor to the successor, and (5) the purpose of the asset sale.” Thus, the court concluded that the trial court did not err in examining the adequacy of consideration and purpose of the asset sale in its analysis of the “mere continuation” exception.
The full opinion is available in PDF.
*Editorial note: the court mistakenly identifies Jackson as "decision of the Supreme Court of Rhode Island;" however, Jackson was in fact decided by the Superior Court of New Jersey Law Division. See 241 A.2d 471, 100 N.J. Super. 186. In a decision called H.J. Baker & Bros., Inc. v. Orgonics, Inc., 554 A.2d 196 (R.I. 1989), the Supreme Court of Rhode Island did adopt the five factors provided in Jackson.