Another important issue that small business owners should be aware of is the “single business enterprise” (SBE) theory.  In most cases where an investor owns multiple businesses, the various business interests will be separated into different LLCs or other entities.  The primary purpose of that structure is to protect the assets of the other businesses in the event one of the businesses has financial difficulties or faces legal liability.  The SBE theory allows the court to disregard the corporate structure and treat all the entities as one, resulting in all entities being liable for a judgment against single entity.

The SBE theory of liability has been applied in situations where one entity “is so organized and controlled as to make it merely an instrumentality or adjunct” of another entity.  In those cases, the courts have imposed liability on the related entity and rejected the argument that the related entity is free from liability because it is a separately organized or incorporated entity.

In Green v. Champion Insurance Company, the court outlined a set of factors to be considered when determining whether several related entities constitute a single business enterprise:

1. companies with substantial identity of ownership or ownership sufficient to give actual working control;
2. common directors, officers or members;
3. unified administrative control of entities with similar business functions;
4. directors and officers of one entity act independently in the interest of that entity;
5. one entity financing another entity;
6. inadequate capitalization;
7. one entity causing the incorporation or organization of another affiliated entity;
8. one entity paying the salaries and other expenses or losses of another entity;
9. receiving no business other than that given to it by its affiliated entities;
10. one entity using the property of another entity as its own;
11. noncompliance with corporate formalities;
12. common employees;
13. services rendered by the employees of one entity on behalf of another entity;
14. common offices;
15. centralized accounting;
16. undocumented transfers of funds between entities;
17. unclear allocation of profits and losses between entities; and
18. excessive fragmentation of a single enterprise into separate entities.

The court in Green ruled that several related insurance companies could be held liable for the debts and obligations of the others because the entities were operated as a single business enterprise.  The facts the court found important were:

1.     The same family members were the controlling shareholders of all of the corporations;
2.     Two of the shareholders “dominated the affairs of all of the corporations”;
3.     The corporations entered into some transactions without economic justification and solely for the benefit of another related entity;
4.     There was “a tremendous amount of intercompany debt due to the lack of adequate initial capitalization”;
5.     The entities were financed primarily through intercompany debt;
6.     The income of the companies was largely dependent on collecting receivables from the other entities;
7.     There were common employees and at least one entity had no employees;
8.     Some employees received salaries from more than one entity;
9.     Almost all of the business of the entities was given to them by the other entities;
10.  Some employees were compensated by more than one member of the group;
11.  Substantial intercompany debt;
12.  Corporate formalities were not observed;
13.  Centralized offices for the entities; and,
14.  Transactions among the entities were not properly reflected in the accounting records.

All of the entities in Green were liable for the debts and obligations because the court found that the entities “were not operated as separate entities,” but rather “functioned as a single economic entity despite the internal compartmentalization of ownership and operation by means of separate incorporation.”  An important point to note about the factors from Green is that fraud is not identified as a requirement.  Simply operating the entities as one economic unit could be sufficient for the courts to impose liability on all the entities.

The lesson for a small business owner is similar to the lesson learned from understanding the “alter ego/veil piercing” theory (see my previous blog post:  “Why an LLC won’t protect your personal assets (and how to actually protect those assets)”).  While some overlap among related entities is acceptable and obviously efficient, maintaining the distinction among them as truly separate entities is critical to protecting the assets and interests held by the entities. In order to accomplish the ultimate purpose of the corporate structure, keep their dealings separate and treat them as separate companies in all respects.  

As your business grows, you may have the chance to acquire smaller, less profitable businesses as part of your growth strategy.  In most cases, the acquiring entity or newly formed entity intends to purchase only the assets, and not debts and obligations, of the other company.  This is an efficient way to expand operations and increase revenue, but if you aren’t careful, it could lead to unwanted liability related to the business dealings of the company being acquired.  

The legal theory of “successor liability” allows the court to hold  an acquiring entity, or newly formed entity, liable for the debts of the acquired entity if: (a) the new entity expressly assumed the liabilities of the old entity; (b) the formation of the new entity was entered into to defraud the creditors of the old entity; or (c) the circumstances attending the creation of the new company and its succession to the business and property of the old company are such that the new company was merely a continuation of the old company. In Hollowell v. Orleans Regional Hospital, LLC, the court listed eight factors that are used to determine if a new company is a mere continuation of an older company:

1. retention of the same employees;

2. retention of the same supervisory personnel;

3. retention of the same production facility in the same physical location;

4. production of the same product;

5. retention of the same name;

6. continuity of assets;

7. continuity of general business operations; and

8. whether the successor holds itself out as the continuation of the previous enterprise.

The court also pointed out that a finding of fraud is not a prerequisite to establishing successor liability, meaning that the acquiring company could face liability simply by not ensuring that adequate legal measures are taken to distinguish the old company from the new company.

Successor liability was applied in Hollowell to hold a successor company liable based on the fact that it received an assignment of the former entity’s hospital license, medicaid provider numbers, and managed care contracts. The assignments to the new LLC allowed the former entity to avoid an estimated $200,000.00 in liabilities; the new entity hired most of the employees and some of the supervisory personnel from the former entity; and the two entities operated out of the same physical location and used the same phone number. The court ruled that, based on the evidence presented, there was a legally sufficient basis for the jury to find successor liability under Louisiana law.

It’s important for any business considering acquisitions as a growth strategy to be aware of the theory of “successor liability.”  By properly structuring the transaction, you can ensure that your business acquires only those assets it intends to acquire and addresses the outstanding debts and obligations of the old company so they don’t become an unexpected problem as your business continues to grow.