As a commercial supplier (often referred to as a creditor), it can be hard enough to turn accounts receivable into revenue. This is especially true when the particular client or debtor goes out of business and closes its doors. But as one door closes another door opens. And just as the law allows for businesses to change freely from one form to the next, the law also recognizes the right of creditors of defunct or
reorganized businesses to demand repayment from the succeeding business. Under the laws of Successor Liability, creditors can stay in the game and put pressure on the debtor to pay what’s owed.
Consider the following typical scenario: Creditor provides goods or services to Alpha Corporation on credit. Alpha Corp. fails to pay. Between the time of nonpayment and the time it takes Creditor to commence collection of the debt, Alpha Corp. is no more – Alpha has either been sold to another business (say, Beta Corporation), or liquidated and dissolved. Sometimes this is the end of the road for Creditor. But more often than not, Beta Corp. is simply Alpha Corp. operating under a different name.
In such instances, there are several ways for Creditor to knife through this corporate maneuvering and enforce its rights to repayment.
1. Express or Implied Agreement of Assumption
When the CEO of Alpha decides to sell the business to Beta, it is not uncommon for Alpha’s CEO to protect him or herself from liability by negotiating an agreement by which Beta agrees to assume the debts and obligations of Alpha, and hold Alpha’s CEO harmless of any risks associated with the former business. In such cases, all Creditor needs to do is to obtain a copy of the Buy/Sell agreement (accomplished through simple legal discovery). If the Buy/Sell agreement shows Beta agreed to assume the obligations of Alpha, Beta is liable to Creditor.
2. De Facto Merger
Even if Alpha’s Buy/Sell agreement does not include an agreement of assumption, Creditor may still have a right to demand satisfaction from Beta.
Under the doctrine of De Facto Merger, Creditor can successfully pursue repayment from Beta if Creditor can establish just two of the following four factors: i) Beta is the continuation of Alpha – this can be demonstrated by showing the physical location, operation, management, employees, or clients have not changed (or are substantially similar) throughout the acquisition of Alpha by Beta; ii) There is a
“continuity of shareholders” – meaning the ownership of Alpha and Beta are the same or substantially similar; iii) There is a “cessation of operation” – meaning Alpha quickly ceases operations after the sale; or iv) There is an “assumption of obligations” – meaning Beta acquired all the obligations needed
to run the business, such as clients, contractors, vendors, leases, assets (including phone numbers, websites, or intellectual property).
3. Mere Continuation
In addition to the two tests above, Beta can be held liable to Alpha’s creditors if Creditor can establish Beta is a “mere continuation” of Alpha. In order to meet this burden, Creditor must show:
i) Only one of the two businesses remains after the transfer of assets from Alpha to Beta; and ii) There is a commonality of stocks, stockholders, or directors between Alpha and Beta.
This burden is often met if the owner of the former business maintains ownership in the succeeding business.
4. Fraudulent Transfer
Lastly, Creditor can pursue and prevail against Beta if Creditor can show that the sale of Alpha was for done for the purpose of helping Alpha escape its obligations to Creditor. Fraudulent Transfer can be proved (among other ways) by establishing that Alpha’s owners were given ownership interest in Beta in exchange for the assets of the former company.
In short, California law provides multiple avenues for suppliers and creditors to collect from business that are defunct, dissolved, reorganized, or sold to other businesses. Just because the business you sold to no longer exists in its original form does not mean you cannot demand payment for goods and services rendered. Don’t be swayed by a change in the name – stay in the game, and turn a write-off into revenue.