Successor Liability for Sole Proprietors
Did your sole proprietorship recently acquire all or nearly all of the assets from a corporation? Think you’re immune from the former corporation’s tortious liability? Watch out! A recent decision from the Massachusetts Supreme Judicial Court found that a sole proprietor can have successor liability! Read below for more information.
In Smith vs. Kelley, SJC-12759, (Mass. February 11,2020), the Massachusetts Supreme Judicial Court (“SJC”) found that a sole proprietorship operated by Robert E. Kelley (“Kelley”) could be held liable for a judgment owed to the plaintiff Robert Smith (“Smith”) by Kelley’s former professional corporation (the “Corporation”).
The Prior Judgement
Kelley was a real estate attorney who previously practiced law through the Corporation. Kelley was the sole shareholder, president, treasurer, secretary, and director for the Corporation. Smith is a United States Marine Corps veteran that suffers from schizophrenia, post-traumatic stress disorder, depression, and is functionally illiterate. Id. at 3.
Smith was never a client of the Corporation. But in 2005 Smith was the victim of a mortgage fraud scheme. Under the scheme, Smith’s name and a false financial profile were used for two fraudulent real estate purchases. An attorney from the Corporation was the lender’s attorney and directed Smith to sign loan documentation with contradictory and false owner-occupancy affidavits. Id. at 4. Shortly thereafter, Smith defaulted and both properties went into foreclosure. The foreclosures ruined Smith’s credit, prevented him from being able to rent an apartment, and his mental health deteriorated precipitously. Id. at 5.
Smith filed a lawsuit in 2007 against the Corporation, Kelley, and others. After trial and a subsequent appeal, the Corporation was found vicariously liable for the attorney’s actions in the mortgage fraud scheme. On January 12, 2016 the judge entered a final judgment against the Corporation for more than $250,000. Kelley was not found personally liable because he had no knowledge or involvement in the scheme.
After the final judgement, Kelley resigned and voted to wind up the Corporation. Kelley also voted that the Corporation’s existing clients should be asked to amend their fee agreements to bill all future work to a sole proprietorship that he was establishing rather than the Corporation. Id.at 7.
Smith made a demand on the Corporation for his judgement but the Corporation failed to remit any money to him. Smith filed this lawsuit on July 18, 2016 seeking a declaratory judgment that Kelley was personally liable for the judgement as a successor in interest to the Corporation. Kelley filed for summary judgment which the trial court granted on the ground that the doctrine of successor liability was only applicable to successor corporations and could not be applied where the successor in interest was a natural person. Smith appealed and the SJC transferred the case on its own motion.
The SJC reversed and found that Kelley could be personally liable under the doctrine of successor liability for Smith’s judgement against the Corporation. Id. at 15.
The SJC based its decision on the equitable doctrine of successor liability. A a general rule of corporate law, a corporation’s liabilities are typically not imposed upon its successor. Id. at 15. See also Millikan & Co. v. Duro Textiles, LLC, 451 Mass. 547, 556 (2008). The successor liability doctrine is an equitable exception whereby a successor in interest is held responsible for the predecessor’s liabilities. The doctrine is to remedy the inequitable situation where a corporation attempts to shed its liabilities to an unsecured creditor “by merely changing its form without significantly changing its substance.” Smith, SJC-12759 at 16 (quoting Millikan & Co. v. Duro Textiles, LLC, 451 Mass. 547, 561 (2008).
Successor liability is triggered when a successor entity is a “mere continuation” of its predecessor. Id. at 16-17. To determine whether a successor entity is a mere continuation, courts will examine “the continuity or discontinuity of the ownership, officers, directors, stockholders, management, personnel, assets, and operations of the two entities.” Id. at 17 (citing Cargill, Inc. v. Beaver Coal & Oil Co., 423 Mass. 356, 359 (1997) for relevant factors in continuation analysis).
Kelley argued that his sole proprietorship was not a mere continuation of the Corporation because it only had one employee (Kelley’s wife as office manager); did not have directors and officers like the Corporation; and the Corporation employed twelve to fifteen employees over the course of its lifetime. Id. at 18. The SJC rejected these differences because “the leadership structures of the [Corporation] and Kelley’s sole proprietorship were functionally identical”. Id.
Furthermore, the SJC found that Kelley’s sole proprietorship directly mirrored the Corporation immediately prior to the Corporation’s dissolution. At that time, the Corporation only had one employee (Kelley’s wife as office manager) just like Kelley’s sole proprietorship. Additionally, Kelley’s sole proprietorship and the Corporation had the same physical address, the same email address, the same bank accounts with the same name, the same health insurance with the same named employer, and paid the same creditors and vendors. Additionally, Kelley’s sole proprietorship received fees from the Corporation’s clients and payment from their fee agreements with the Corporation . Kelley also took equipment, inventory and supplies from the Corporation for use in his sole proprietorship without paying the Corporation. Id. at 19.
Consequently, the SJC concluded that evidence was “overwhelming that Kelley’s sole proprietorship amounted to a ‘reincarnation’ of the corporation”. Id. at 20 (citations omitted). Furthermore, the SJC opined that if the Corporation had been dissolved in favor of another corporate form, such as a corporation or a limited liability company, “it would have little difficulty in finding the successor entity liable.” Id.
The SJC expressed some misgivings, however, about imposing successor liability a sole proprietorship. The issue, according to the Court is that the sole proprietor is “much more exposed to personal legal liabilities” than a corporation or an LLC because the sole proprietor is personally liable for “all of the debts of the business.” Id. at 23. Despite these misgivings, the SJC concluded that successor liability should be imposed when the sole proprietorship was formed to to allow the owner to continue operating his business and avoid specific liabilities owed by the predecessor corporate entity.
Lessons from the Case
There are several important lessons to take from the case. First, if your business has a judgment levied against it, don’t try to evade the judgment by setting up a sole proprietorship to continue operating the business. Kelley’s attempt to do so failed spectacularly and only succeeded in creating personal liability for himself, instead of the judgement remaining with the corporation. Instead, consult with a knowledgeable business law attorney to discuss your options, one of which may include business bankruptcy.
Second, if you are a sole proprietor acquiring assets from a dissolving corporation , conduct your due diligence! Investigate why the corporation is selling the assets and whether there are any known outstanding liabilities. If there are, identify these known liabilities in the purchase and sale agreement and have them specifically excluded. Include provisions in your purchase and sale agreement to protect your business, such as indemnification provisions, seller representations and covenants, and other appropriate provisions. Consult with a knowledgeable business lawyer for advice when buying assets from a dissolving corporation.
Third, if you purchase assets from a dissolving corporation , don’t use the assets solely as a continuation of the predecessor’s business. Courts look at a variety of factors to determine whether the business is a continuation such as commonality of ownership, management and operations. Try to vary these as much as possible after purchasing the assets. This may be hard because some of your reasons for buying the assets is to take advantage and replicate the success of the predecessor business. But do your best!
Finally, consider converting your sole proprietorship to a corporation or limited liability company(“LLC”) to purchase these assets or, to the extent feasible, use one of these entities to purchase the tainted assets. Both types of entities are also subject so successor liability, but can act as shields to protect your other personal assets from liability (some exceptions are discussed here). One issue with a sole proprietorship is that all of your other personal assets are at risk from any liabilities associated with the business. Using a corporation or an LLC to buy these assets (or converting your entire business to an LLC or a corporation) can help shield your other personal assets. Consult with a knowledgeable business formation attorney for help.