Asset Transfers and the Doctrine of Successor Liability

Bridge IT, Inc., was an Arizona corporation that provided technology services to businesses. Sandra Higgins was Bridge IT’s president, majority shareholder and principle employee. At its high point, Bridge IT had 12 employees and annual sales of $2 million.

Warne Investments entered into a contract with Bridge IT that called for Bridge IT to develop a website for Warne. A contract dispute arose, and Warne sued Bridge IT. Defending against Warne’s lawsuit proved to be a major distraction for Higgins; business declined drastically, and she hired a manager to run the company.

The litigation resulted in multiple awards to Warne totaling more than $155,000. In an attempt to collect on the ensuing judgments, Warne garnished Bridge IT’s bank account, essentially putting the company out of business.

After Warne filed its lawsuit and before the case went to trial, Higgins created another corporation, Bridge Info Tech. (Due to the similarity of names, we will refer to Bridge IT as the “old company” and Bridge Info Tech as the “new company.”) The newly created corporation was inactive until the summer of 2003. At that time, Higgins stopped working for the old company.

The similarities between the old and new companies didn’t end with the names:

• The new company leased office space near the old company.

• The old and new companies provided the same services and sold the same products.

• The old and new companies had at least five significant clients in common.

• The old and new companies were owned and managed by the same people and benefited from the owners’ skills, knowledge and market contacts.

• When the new company began operating, it bought some of the old company’s office equipment.

Holding judgments against the insolvent, inactive old company, Warne filed suit in July 2004 against Higgins and the new company. Warne was victorious again, getting judgments against the new company and against Higgins personally, equaling the $155,000 that the old company had been ordered to pay.

The judgment against the new company was based on the Uniform Fraudulent Transfers Act (UFTA) and the doctrine of successor liability. The judgment against Higgins was based on the successor liability and trust fund doctrines.

Successor Liability. In Arizona, the general rule is that when a corporation sells or transfers its principal assets to a successor corporation, the successor corporation is not liable for the former corporation’s debts and liabilities.

While that may appear to be a huge escape route for the owner of a troubled company, the rule is subject to various exceptions. Legal responsibility transfers to the successor corporation if any of these conditions is met:

• the successor corporation expressly or impliedly agrees to assume the liabilities of the predecessor corporation; or

• the transaction between the two corporations amounts to a consolidation or merger; or

• the successor is a mere continuation or reincarnation of the predecessor; or

• clear and convincing evidence shows that the transfer of assets from the predecessor to the successor was for the fraudulent purpose of escaping a debt or liability.

In the appeal by Higgins and the new company of the trial court’s verdict against them, the Arizona Court of Appeals found that there was sufficient evidence to support the jury’s conclusion that Bridge Info Tech (the new company) was a mere continuation of, and a successor to, Bridge IT. The mere continuation theory of successor liability requires proof of “substantial similarity in the ownership and control” of the two businesses, and the failure by the successor business to pay reasonable value to the predecessor business for the assets transferred.

In addition to observing the similarities between the two companies, as noted above, the Court of Appeals examined the adequacy of the value paid for the assets transferred. The Court acknowledged the finding of Warne’s expert witness that the old company’s value as a going concern was transferred to the new company, which used that value to quickly become a going concern itself. Higgins’ position was further weakened by the fact that the new company did not pay the old company for the transfer of any assets other than about $2,200 for office equipment. The old company’s intangible assets (e.g., goodwill, customer contacts, and the knowledge and skills of the owners and employees) were transferred to the new company without any compensation, further rendering the old company incapable of meeting its obligation to Warne.

It should be noted that the availability of intangible assets, such as good will, for transfer and the value, if any, of this type of asset is case-specific and largely dictated by the type of business involved.

In Warne, the Court recognized that this successful service business had, but was not paid for, valuable customer loyalty assets that simply followed the owner and key employees. The result: The new company was liable for the prior judgments Warne obtained against old company.

Trust Fund Doctrine. As for Higgins’ personal liability for the entire obligation owed to Warne, a discussion of the trust fund doctrine may be useful. The doctrine is meant to ensure that all creditors’ claims against an insolvent corporation are satisfied before any stockholders receive anything. In this case, liability under the trust fund doctrine required evidence that:

• corporate assets were transferred to Higgins,

• the transfer occurred while the corporation was insolvent, and

• the transfer gave Higgins preferential treatment over other creditors.

The Court of Appeals found that all of those conditions were met, making Higgins generally liable under the trust fund doctrine. However, the Court declined to impose personal liability on Higgins on either successor liability or fraudulent transfer grounds.

Lesson Learned. Sandra Higgins chose a path that the owners of many other troubled businesses have tried to follow – i.e., to limit the recourse of the creditors of Company A by transferring its assets, ownership, employees, operations, processes, customer relationships, etc., to a new, unblemished Company B, without the payment of adequate value for the assets transferred.

The exceptions to the doctrine of successor liability noted above illustrate (a) how difficult it is for a successor corporation to properly structure a transfer of assets so as to avoid the debts and obligations of its predecessor and (b) the readiness of the courts to punish sham transfers from a predecessor to its successor.