Distress Buyer in UCC Foreclosure Sale Held Liable for Seller’s Debts Under De Facto Merger Doctrine

June 9, 2020Herrick Restructuring Review

The Herrick Restructuring Review provides insights and information related to restructuring and finance litigation. The Herrick team regularly represents official and ad hoc creditor committees, hedge funds, distressed debt investors, bondholders, and other parties in interest, and often serve as conflicts or special counsel for large-scale complex litigation matters.

The general rule is that when a corporation or other business entity buys the assets of another entity, it does not assume the liabilities of the seller. But in New Nello Operating Co., LLC v. CompressAir, 19A-CC-603 (Ind. Ct. App. March 2, 2020), the court applied the de facto merger exception and held the buyer company (“New Nello”), which had acquired the assets through a foreclosure under the Uniform Commercial Code (“UCC”), responsible for the seller’s (“Old Nello”) debt. The facts illustrate why the court imposed liability on New Nello and provide guidance on how to avoid this result.

Old Nello, founded in 2002, manufactured utility and cellular telephone towers. Old Nello encountered financial trouble beginning in 2016; its debt included a $10 million loan from Fifth Third Bank, a $3.4 million loan from Live Oak Capital and a $1.4 million obligation owed to the City of South Bend. On November 10, 2016, Fifth Third Bank accelerated its debt. When Fifth Third Bank demanded its loan, Live Oak Capital contacted Becker Clevy Partners (“Becker Clevy”), to explore a restructuring. But none of Becker Clevy’s efforts were successful and at the end of 2016, Fifth Third was prepared to foreclose on Old Nello’s assets.

In early 2016, CompressAir installed compressed air and oxygen piping at Old Nello’s South Bend facility. By the spring of 2017, Old Nello was in default on payments owed to CompressAir and the parties were unable to work out a payment agreement. In March 2017, CompressAir, filed a complaint against Old Nello seeking to recover its outstanding bills. CompressAir obtained a judgment of $44,689.66 against Old Nello. Other creditors had also brought non-payment claims against Old Nello.

In spring of 2017, Becker Clevy created New Nello, which acquired Fifth Third’s note for $3.675 million. On November 14, 2017, New Nello entered into a strict foreclosure agreement with Old Nello, under which New Nello acquired substantially all of Old Nello’s assets. New Nello negotiated with the creditors of Old Nello that it considered essential to the business and reached deals to pay those creditors. The claims of creditors that New Nello considered nonessential were not assumed, and those creditors, including CompressAir, received nothing.

Under the UCC, a secured creditor can foreclose on the collateral securing its debt by following the procedures in Article 9, which only requires the secured party to notify other creditors with an interest in the collateral. It does not require a general notice to all creditors of the debtor company. For secured creditors, UCC foreclosure can be an attractive alternative to a bankruptcy proceeding because UCC foreclosure is non-judicial, which avoids the time, expense and judicial oversight of a bankruptcy proceeding. The time savings can be substantial; a UCC foreclosure can be completed in as little as a month, which is faster than even an accelerated bankruptcy acquisition.

After New Nello completed its foreclosure on the assets of Old Nello, it conducted the same business as Old Nello, from the same physical location, and retained 90% of Old Nello’s employees. New Nello also retained the same operating management as Old Nello, although the management team no longer had an ownership interest in the business. There was no public announcement of New Nello’s assumption of Old Nello’s business to the general public or creditors, and New Nello operated under the same name, used the same website claiming the same founding date, and held itself out as the same company.

CompressAir was not informed of the merger of New Nello and Old Nello and did not learn about New Nello until after it obtained judgment against Old Nello. After learning of New Nello, CompressAir filed a supplemental proceeding against it to collect its judgment from New Nello.

Generally, when one corporation purchases the assets of another, the buyer does not assume the debts and liabilities of the seller. There are four exceptions to the rule against successor liability: (1) an implied or express agreement to assume liabilities; (2) a fraudulent sale of assets done for the purpose of evading liability; (3) a purchase that is a de facto consolidation or merger; or (4) where the purchaser is a mere continuation of the seller. The trial court held that New Nello’s purchase of Old Nello was a de facto merger and that New Nello was a mere continuation of Old Nello, and the appellate court affirmed.

Courts will find a de facto merger when there is: (1) continuity of ownership; (2) continuity of management, personnel, and physical operation; (3) cessation of ordinary business and dissolution of the predecessor as soon as practically and legally possible; and (4) assumption by the predecessor of the liabilities ordinarily necessary for the uninterrupted continuation of the business of the predecessor. On the facts, the court found that there had been a de factomerger between New Nello and Old Nello because New Nello had the same management, location, and type of business, used the same name, the same website claiming the old company’s founding date, and assumed the debts of Old Nello that it deemed necessary to continue the business.

The ownership of New Nello was different from Old Nello. The management of Old Nello had owned 95% of the shares of Old Nello but did not have any ownership interest in New Nello, which was owned by Becker Clevy and other outside investors. But this difference in ownership was not enough to avoid the application of the de factomerger doctrine because all the other factors supported it.

The decision in New Nello Operating an unintended checklist of what not to do in a distressed acquisition. New Nello took no steps to separate itself from Old Nello; it operated from the same location, had the same employees and officers, and carried on the same business as Old Nello, even to the point of holding itself out as the same company as Old Nello on the website. Some of these factors may be beyond the control of the buyer. But New Nello didn’t even get the little things right. Notice is important; the court noted that New Nello had not made a general public announcement of its acquisition and had provided no notice to CompressAir or other creditors of Old Nello. The unstated implication of the court’s emphasis on this factor is that New Nello’s failure to give notice was inherently deceptive. In addition, holding itself out on the website as the same company as Old Nello is an error that could have been avoided. The lesson from New Nello Operating that secured creditors who intend to rely on the UCC foreclosure process to gain control of a troubled company’s assets need to develop and implement a strategy to demonstrate its legal and structural separation from the prior business, and to make sure that the general public and the prior company’s creditors are aware of the changes.

For more information on this alert or other restructuring & bankruptcy matters please contact:

Stephen Selbst at +1 212 592 1405 or [email protected]
Gabrielle Fromer at +1 212 592 1575 or [email protected]

© 2020 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.