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Recent “Common Sense” Rulings Benefit Creditors

August 03, 2022

New Possibility for Successor Liability Claims

Creditors are occasionally faced with a scenario where the debtor which owes the money has shut down its business and transferred all of its assets to a third party, leaving the debtor judgment proof. Virginia provides creditors with the opportunity to unwind certain transactions under its fraudulent and voluntary conveyance statues; if the creditor is successful, the assets are returned to the debtor and the creditor can then exercise its statutory and any contractual rights and remedies of collection such as levy and sale. But what can a creditor do if the value of the assets transferred lies in those assets being used or operated as part of an ongoing business, i.e., client lists, trade secrets, good will and other intangible items, and the transferee is now operating essentially the same business as the debtor once did?  Returning the assets to a defunct debtor could be a hollow victory. The Virginia Supreme Court recently looked at this fact pattern not once but twice in connection with the same parties.

La Bella Dona Skin Care, Inc. (La Bella Donna) obtained a judgment against three of its former employees and their competing business, Bon Air Med Spa, LLC (Bon Air) for misappropriation of trade secrets. La Bella Donna attempted to levy on the property of Bon Air, at which point it discovered that Bon Air had granted a lien on its assets in favor of its law firm, which then conducted a judgment lien sale, bought the assets at such sale and thereafter sold those same assets to a new entity, Belle Femme Enterprises, LLC (Belle Femme). Not surprisingly, Belle Femme operated a business that was almost identical to what Bon Air (now defunct) had operated prior to the lien sale. La Bella Donna asserted both a fraudulent conveyance claim and one for “successor liability” against Belle Femme, claiming that the latter entity was essentially the successor of Bon Air and thus liable for the judgment debt owed to La Bella Donna. La Bella Donna ultimately was not able to meet the fraudulent conveyance test, but the Supreme Court ruled in its favor with respect to the successor liability claim on the basis of Belle Femme being a “mere continuation” of Bon Air. 

Applicable Law Prior to La Bella Donna

The general rule in Virginia is that one company may acquire the assets of another company without assuming responsibility or becoming liable for its debts and liabilities.  There are only four exceptions to this general rule, (1) expressed or implied assumption of the debt, (2) a finding that there was a consolidation or de facto merger of the two companies, (3) the purchasing company is merely a continuation of the selling company, or (4) the transaction is fraudulent in fact. Harris v. T.I. Inc., 243 Va. 63, 70, 413 S.E.2d 605, 609 (1992).  It is the third exception which forms the basis of the “mere continuation” successor liability claim at issue in the La Bella Donna case.  Prior to the La Bella Donna decisions, Harris had been the leading case in Virginia for successor liability claims. There is an old maxim which states that hard facts make bad law, but the Harris Court was not swayed by some very difficult facts and ruled against the plaintiff. Harris was the executor of the estate of a blind individual who had been killed by a heavy equipment truck which lacked the industry standard back up warning alarm. The manufacturer of the truck, T.I., Inc., formerly Truxmore Industries, Inc. (“Truxmore Industries”), had several years after manufacture of the truck at issue sold all of its assets to Truxmore, Inc. (“Truxmore”).  The executor claimed that Truxmore was a "mere continuation" of Truxmore Industries since it had acquired all of its predecessor's assets, including the goodwill, performed essentially the same manufacturing operation as its predecessor, even at the same location, held itself out to the world as the ongoing continuation of its predecessor, employed essentially the same personnel, made an active effort to maintain the same customers, and required its predecessor to cease its ordinary business operation and to liquidate its business as soon as practicable.  The Court was not swayed by either the tragic circumstances or the foregoing similarities of the predecessor and successor companies. Rather, it held that a “common identity of the officers, directors, and stockholders in the selling and purchasing corporations is the key element of a ‘continuation’."  Because the Court found that Truxmore Industries’ purchase of all the assets was a bona fide, arm's-length transaction, the "mere continuation" exception did not apply.

A number of cases in Virginia and other States have similarly placed very high emphasis on whether there was common, even absolute, identity of officers, directors and stockholders among the two companies, to the point where it appeared that a creditor could not prevail even in situations where the successor was made up of the debtor’s friends or family members as “strawmen”.  It was sometimes baffling reading, as many decisions contained language which initially made it appear that it would be possible for a creditor to make out a case in such strawman instances, but ultimately the Courts returned to the commonality of ownership requirement. For example, in Dixon Lumber Co. v. Austinville Limestone, 256 F. Supp. 3d 658 (W.D. Va 2017), the Court first noted that “the mere continuation theory requires a common-sense analysis "of corporate realities, not mechanical application of a multi-factor test”. The test for mere continuity has "a common-sense flavor about it", and courts should be careful not to "elevate form over substance" when applying it.  This language would appear to be helpful in the strawman scenario.  Nonetheless, the Dixon Court and others followed up the apparent opening for creditors by observing that courts have consistently held that “identity of ownership is the most important factor”.  Finding no overlap in ownership, the transferee in Dixon was not found to be a successor of the transferor.   Many decisions in effect turned an “important factor” into the only factor which mattered. 

Some Common Sense at the Federal Level

Shortly before La Bella Donna made it to the Virginia Supreme Court the first time, the District Court in the Eastern District of Virginia considered a fact pattern where the first company was formed by and had one person serving as sole manager, chief administration officer, and operating officer throughout its existence, but who had no formal role in the second company. Although there was some, but not total, ownership overlap, the Court also looked at other factors besides ownership, including (i) the winding down of the first company concurrently with the formation of the second, (ii) steps taken to transfer customers from the first to the second, (iii) that both businesses operated the same type of business servicing the same clientele and, (iv) that there was a familial relationship among the owners of the predecessor and successor companies. Refusing to elevate form over substance, and despite not having “perfectly identical formal ownership and management structures”, the Court concluded as a matter of law that the second company was a mere continuation of the first.  Charles Schwab & Co. v. WS Wealth Management., LLC, 2016 WL 7033699 at *19 (E.D. Va. Dec. 2, 2016). 

The Charles Schwab Court included a lengthy footnote discussing transfers among family members, citing several other cases for the proposition that transfers involving entities controlled by family members deserved extra attention.  For example, one Court found “sufficient continuity of ownership where the first company’s sole shareholder owned no shares in the successor corporation but his wife and children owned shares and assumed significant management roles in the second which they had not had in the first”. Another Court cited in the footnote observed that “a reduction in the former shareholder’s interest to two percent and the addition of a new family member as shareholder to the successor corporation does not prevent a finding of continuity of ownership.”  All cases which the Charles Schwab Court cited were in favor of applying established “common sense” rules of analysis used in a variety of circumstances in order to avoid elevating ‘form over substance’ in assessing a transaction.  

La Bella Donna Returns

On its second trip to the Supreme Court, La Bella Donna Skin Care, Inc. v. Belle Femme Enterprises, LLC, 2019 Va. Unpub. LEXIS 20 (Va. Aug. 26, 2019), the Court cited a Federal District Court case in setting out what it deemed relevant in order to find successor liability:

 (i) whether the two companies share the same ownership, a common identity of the officers, directors, and stockholders in the selling and purchasing corporations; (ii) whether the new corporation continues in the same business as its predecessor; (iii) whether transfer of the selling company's assets was done for less than adequate consideration; (iv) whether two corporations or only one remain after the transactions at issue; and (v) whether the new company continues in the old offices with the same telephone number and address as the old company. 

The Court found that almost all of the foregoing factors were met, but none of the owners of the prior corporation became owners of the subsequent one; rather, the son of one of the original owners formed the successor corporation and later the spouses of the owners of the predecessor became members. There was never an express overlap of ownership. Under Harris and several other decisions, La Bella Donna would have lost because common ownership had always been at a minimum a “key element” necessary for a finding of successor liability by virtue of mere continuation. The La Bella Donna Court, however, demonstrated the commonsense analysis the Plaintiff had been looking for and ruled in its favor on the successor liability claim despite the lack of any common ownership. The Court based its decision on several elements not typically noted including (i) ownership by relatives, (ii) lack of consideration for the transfer of assets and, (iii) payment of former owners at minimum wage while their relatives received the true earnings. On those facts, the Supreme Court reversed the Circuit Court and rendered judgment to Plaintiff La Bella Donna as a matter of law, firmly establishing that express common ownership is not required at least in the familial setting.

Subsequent to La Bella Donna, the same Federal District Court which had decided the Charles Schwab case took notice, observing that La Bella Dona Skin Care “further develops the landscape for determining mere continuation under Virginia law, suggesting that some common identity of ownership may not always be required to prove successor liability”.  Easter v. Contech Constr. Prods., 2019 U.S. Dist. LEXIS 170181.  La Bella Donna and the more recent Federal District Court cases represent an important win for creditors and give them additional ammunition when fraudulent and voluntary conveyance actions are not workable in the particular scenario.  These cases stand for the proposition that where the owners of predecessor and successor companies share commonality in the familial setting, which is an often used strategy used to hide income and assets, there will more likely be a commonsense analysis of corporate realities, not a mechanical application of a multi-factor test where one formalistic requirement is determinative.

Richard Biemiller is a Pender & Coward shareholder focusing his practice in the areas of creditors’ rights, banking and financial institutions, commercial transactions and real estate.

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