An Asset Purchase That Wasn’t—Beware the De Facto Merger Doctrine in Distressed M&A

It is a basic tenet of private company business acquisitions that buying assets from the target, rather than acquiring the equity of the target, allows the buyer to avoid taking on any of the target’s liabilities that are not expressly assumed. And, as a general rule, that is mostly right, as long as the buyer expressly disclaims any intent to assume liabilities not expressly assumed and pays fair value for the purchased assets. But mostly right isn’t the same as always right. There are in fact exceptions to that general rule;1 and sometimes exceptions created for limited, extraordinary circumstances can evolve unexpectedly so that they effectively swallow the rule. A recent Indiana Court of Appeals decision, New Nello Operating Co., LLC v. CompressAir, No. 19A-CC-603, 2020 WL 989675 (Ind. Ct. App. March 2, 2020), provides an illustration of how the general rule—that a purchaser of a business’ assets for fair value does not assume that business’ liabilities absent express agreement of the buyer—can be swallowed by an expansion of the “de facto merger” exception. And the shocker here is that this asset purchase was orchestrated by a secured lender in an out-of-court, strict foreclosure, as opposed to being orchestrated by the target’s owners.

The de facto merger exception to the general rule that an asset purchaser from a seller entity is not a successor to that selling entity appears to have been originally designed to prevent a failing business from transferring its assets to a newly formed entity with the same owners, and thereafter operating essentially the same business, while leaving unpaid creditors (or tort claimants) behind whose ongoing services are not required to keep the business operating on an uninterrupted basis. The idea was to give the court a remedy even where fair value may have been paid by the purchasing entity for the selling business’ assets (typically in the form of stock rather than cash), but the selling business has liquidated and “the economic effect of the transaction makes it a merger in all but name.”2 The traditional factors that courts have considered in making a finding that a deal structured as an asset purchase was actually a merger are:

(1) there is a continuation of the enterprise of the seller corporation so that there is continuity of management, personnel, physical location, assets, and general business operations; . . . (2) there is a continuity of shareholders which results from the purchasing corporation paying for the acquired assets with shares of its own stock; . . . (3) the seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible; and . . . (4) the purchasing corporation assumes those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation.3

The overriding principle behind this doctrine appears to have been a concern “that the same people should not be able to walk away from the corporate liabilities while keeping the corporate assets in a new entity.”4 But that is not what happened with respect to New Nello Operating Co., LLC (“New Nello”).

In New Nello Operating, an entity that the parties referred to as “Old Nello” was engaged in the business of manufacturing utility and cellular telephone towers.  Old Nello was owned by four individuals who also served as Old Nello’s senior officers. Old Nello had apparently over-extended itself and was in financial distress. Old Nello had borrowed $10 million in a first lien secured loan from Fifth Third Bank and another $3.4 million in a second lien secured loan from Live Oak Capital. The Fifth Third first lien loan was also guaranteed by the four individual owners/senior officers of Old Nello. Old Nello also had substantial unpaid debt owing to unsecured creditors. Live Oak Capital was concerned that its second lien investment was in jeopardy as Fifth Third Bank was threatening to foreclose on Old Nello’s assets and Old Nello’s estimated liquidation value was only $3.1 million. So, Live Oak Capital contacted a third-party private equity firm to explore possible solutions. A number of potential restructuring solutions designed to continue Old Nello’s business and repay its debt were explored, but none were successful. As the threats of a foreclosure by Fifth Third mounted, the third-party private equity firm switched gears and was able to negotiate a purchase of Fifth Third’s first lien debt for $3.765 million (more than the $3.1 million estimate of Old Nello’s liquidation value). The third-party private equity firm then formed New Nello to be the buyer of Old Nello’s assets in a strict foreclosure under Article 9 of the Uniform Commercial Code.5 Pursuant to the strict foreclosure agreement between Old Nello and the third-party private equity firm’s affiliate that acquired the Fifth Third first lien debt, which was apparently consented to by Live Oak Capital as the junior lienholder, New Nello acquired all of Old Nello’s tangible and intangible assets in partial satisfaction (i.e., a satisfaction of $3.765 million) of the $10 million first lien debt, leaving a significant unpaid deficiency.

As a result of the strict foreclosure, the junior lienholders claims in the secured assets were extinguished. And New Nello expressly assumed certain vendor obligations of Old Nello that were deemed necessary to the ongoing operation of the business by New Nello.  But many vendor claims were expressly listed in the strict foreclosure agreement as being unassumed. CompressAir, a vendor whose claim was unassumed and who had obtained a judgment against Old Nello, sued to hold New Nello liable for its claim against Old Nello. The trial court, while finding that there had been no fraudulent transfer and that the strict foreclosure had complied with the requirement of the Uniform Commercial Code (and, indeed, that the strict foreclosure had a “legitimate business purpose” whereby “New Nello chose the best option among several bad alternatives as a result of Fifth Third Bank’s decision to foreclose”), nevertheless concluded that there had been a de facto merger of Old Nello and New Nello. The trial court made this finding even though a seemingly crucial factor of the de facto merger doctrine was completely absent—no prior owner of Old Nello had any continued ownership of New Nello. The trial court appeared to believe that the continuity of ownership factor could be satisfied by the simple fact that the old management team at Old Nello retained the same roles at New Nello, and therefore had “the authority to participate in the management function” of New Nello. And this despite the fact that entirely new investors now owned and retained the economic benefits and ultimate control of New Nello, none of which had been at the helm of Old Nello when the various unassumed liabilities of Old Nello had been created.

On appeal to the Indiana Court of Appeals, the court affirmed the judgment of the trial court. Like the trial court, the appellate court did not deem the absence of continuity of ownership problematic in the finding of de facto merger. It was enough that “New Nello runs the same business with the same name, the same employees, and from the same location as Old Nello[;] . . . [and] that Old Nello’s former shareholders retained management roles at New Nello.” What? That sounds like a lot of business acquisitions structured as asset deals. If the strict foreclosure complied with the notice requirements of the Uniform Commercial Code in extinguishing all other lienholders, how can it be that unsecured creditors obtain greater rights through the de facto merger doctrine? If Fifth Third Bank had conducted the strict foreclosure itself and then sold the assets to the third-party private equity firm, would the result have been different? And if it wouldn’t have been different, how does a buyer from a lender conducting a strict foreclosure ever get comfortable? And because the third-party private equity firm legitimately acquired Fifth Third’s senior secured loan, why should the result be any different? Something seems to have been missed here. The decision makes no logical sense. If there was no fraudulent conveyance effected through the strict foreclosure agreement, how is the unsecured creditor harmed? The entire point of having secured debt is to allow a lender to sell the collateral free and clear of unsecured or junior lienholder claims. Isn’t that exactly what happened here? The fact that the third-party private equity firm acquired the first lien debt rather than being the original lender should not matter.

They say that bad facts make bad law, but what exactly was bad about these facts. While these additional facts hardly seem bad, they may provide some context for this decision, even though it’s not clear they should have been legally relevant. First, New Nello failed to make any kind of announcement to either its customer or its employee base that it had acquired the business of Old Nello and was not in fact Old Nello—the website remained unchanged for example; and it seems there was a deliberate effort to conceal the fact that there had been a foreclosure sale (except of course from those creditors actually entitled to statutory notice under the Uniform Commercial Code). Second, as part of retaining old management to continue in those roles at New Nello, New Nello discharged the guarantees of the purchased first lien debt that the four individual shareholders of Old Nello had executed in favor of Fifth Third Bank. Lastly, New Nello included certain obligations owed to the four individual shareholders of Old Nello (approximately $26,000 in total) in the assumed liabilities listed in the strict foreclosure agreement. In 20/20 hindsight these additional facts could have been avoided or mitigated, but should they really matter? Certainly it shouldn’t matter that the guarantees were discharged—they were solely for the benefit of the first lien secured debt, not the unsecured vendors. And  the fact that New Nello decided to include debts owing to the management team in assumed liabilities did not impact the unsecured vendors either. Clearly the only significant bad fact was New Nello’s failure to declare itself openly as a new business that had acquired the assets of Old Nello and was beginning anew—but even that doesn’t seem to have had any actual impact on the unsecured vendors other than the sense that something untoward had occurred. And disturbingly, neither the trial court, nor the appellate the court highlights these facts as decisive in its finding of de facto merger in any event. The only conclusion is that there appears to have been a significant broadening of the de facto merger doctrine in Indiana.

Well you say, isn’t the solution to avoid Indiana (or any other state with a more expansive view of the de facto merger doctrine) as a choice of governing law in your asset acquisition agreement? Maybe, and certainly New York and Delaware law appear much clearer on the continuity of ownership issue,6 at least with respect to the application of the de facto merger doctrine;7 and in Texas the de facto merger doctrine has been eliminated by statute.8 But is the law that governs your acquisition agreement, to which a third-party creditor is not going to have been a party, necessarily the law that governs a subsequent de facto merger claim asserted by an unsecured creditor (particularly if it’s a tort claim)? The caselaw does not provide a lot of clarity in this area. Some courts treat the effect of an asset purchase (and therefore the availability of the de facto merger doctrine) as an issue that is in fact determine by the law that governs the asset purchase agreement, while other courts (particularly with respect to tort claims) treat the issue as being one determined by the law that governs the unsecured claim, not the purchase agreement.9 So, we are left with a lot of uncertainty as to when and if this doctrine will rear its head (particularly if there is a risk of the law of a state other than the chosen law selected in the asset purchase agreement applying).

But because atmospherics can sometimes matter, certain takeaways for this Indiana appellate decision10 seem obvious in a distressed acquisition.

  • Buyers of a business through an asset purchase should clearly announce the new ownership of the business and that it is an entity entirely different and separate from the seller. Update the website to reflect the change.
  • Use a new version of the old name; change at least some of the officers if possible. Relocate headquarters if at all possible (when the same business operates out of the same location that is always one of the first things that is pointed to).
  • Incentivize the management team on a go forward basis, but avoid favoring their unsecured claims over those of other vendors.
  • Carefully consider the benefits and burdens of a “363 sale” through a bankruptcy proceeding as opposed to a foreclosure or private sale. A purchase of assets through a bankruptcy sale generally shields a purchaser from claims such as fraudulent transfer or successor liability.  This is one of the reasons purchasers of distressed assets often insist on buying through a bankruptcy proceeding.  (although there are drawbacks to a bankruptcy sale, as well ).  Get restructuring counsel involved early if the target is in financial distress. 

Bottom line, make sure your asset purchase is not only technically an asset purchase but it looks and acts like one too; not because it should matter but because it might matter to some court somewhere at some point.

Special thanks to Mark McMonigle for his research assistance.