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Fizzano Brothers Concrete Products, Inc. v. Xln

March 26, 2012

FIZZANO BROTHERS CONCRETE PRODUCTS, INC.
v.
XLN, INC., SUCCESSOR IN INTEREST TO SYSTEM DEVELOPMENT GROUP, INC.
v.
SHORE CONSULTANTS, LTD., GREGG A. MONTGOMERY, DAVID BINDER, AND XLNT SOFTWARE SOLUTIONS, INC. APPEAL OF: FIZZANO BROTHERS CONCRETE PRODUCTS, INC.



Appeal from the Opinion and Order of the Superior Court at No. 1896 EDA 2007, dated May 15, 2009, reversing the Order of the Court of Common Pleas of Delaware County at No. 01-11752 dated September 14, 2007 The opinion of the court was delivered by: Mr. Justice McCAFFERY

CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, ORIE MELVIN, JJ.

ARGUED: November 30, 2010

OPINION

At issue in this appeal is a question of corporate successor liability under the de facto merger doctrine or exception. The trial court concluded that XLNT Software Solutions, Inc. ("XLNT") was liable for a judgment owed by XLN, Inc. ("XLN"), pursuant to this exception. XLNT and XLN lacked common shareholders and higher management; however, the corporations each employed the same two key employees in positions of authority and who, at all relevant times, were principal owners of the essential asset around which the business of the two corporations operated.

The Superior Court determined that the trial court misapplied the de facto merger exception and, hence, reversed. We granted allowance of appeal to determine the following issues:

1. Does the de facto merger doctrine always require proof of continuity of ownership?

2. Did the Superior Court improperly substitute its own fact-finding for that of the trial court?

Fizzano Bros. Concrete Products, Inc. v. XLN, Inc., 994 A.2d 1081 (Pa. 2010) (per curiam).

I. BACKGROUND

Appellant, Fizzano Brothers Concrete Products, Inc., purchased a license for accounting and manufacturing software, known as the XLN Enterprise Management Software ("the Software"), from System Development Group, Inc. ("SDG") sometime prior to 2000. Appellant paid $66,818.25 for the license, Software implementation, training, and sales tax, based on assurances or expectations that the Software would update and streamline Appellant's ability to track sales, maintain accounts receivable, and improve record keeping. However, Appellant was never able to implement the Software.

On April 19, 2000, XLN acquired all of the stock and assets of SDG, in addition to all of its liabilities, pursuant to a stock purchase agreement. Appellant filed a cause of action against XLN on October 25, 2001, alleging breach of contract and breach of express warranty arising from the failure of the Software's implementation. XLN denied Appellant's essential allegations.

On or about September 4, 2004, after securing leave of court, Appellant filed an amended complaint, joining XLNT and its president, Gregg Alan Montgomery ("Montgomery"), as additional defendants. Appellant joined these defendants after learning that on or about August 29, 2003, XLNT had entered into an asset purchase agreement with XLN, pursuant to which XLNT purchased virtually all of XLN's assets. Included in the agreement was the transfer of control over the Software, which was owned by the former shareholders of SDG, subject to payment of two promissory notes. Appellant alleged that the additional defendants had engaged in a fraudulent transfer of assets, and further alleged that XLNT was liable under the original breach of contract and warranty actions as the successor corporation of XLN. Following the trial court's denial of their preliminary objections, XLNT and Montgomery filed an answer denying the critical allegations in the amended complaint.

Although there was no dispute that XLN had assumed all of the liabilities of SDG under the stock purchase agreement, including those liabilities arising from the licensing of the Software to Appellant, XLNT contended that, as mere purchaser of the assets of XLN, it had no responsibility arising from Appellant's lawsuit, as XLNT had not expressly assumed XLN's potential liability concerning Appellant. This contention is supported by a general principle of corporation law that a purchaser of a corporation's assets does not, for such reason alone, assume the debts of the selling corporation, unlike a purchaser of the corporation's stock. See Continental Ins. Co. v. Schneider, Inc., 873 A.2d 1286, 1291 (Pa. 2005) ("Schneider II"). However, exceptions to this principle include circumstances where (1) the asset sale amounted to a consolidation or a de facto merger;*fn1 or (2) the purchasing corporation was merely a continuation of the selling corporation. Id.*fn2 Appellant argued that XLNT was liable under these two exceptions. Because Appellant's contentions are factually based, a more thorough review of the essential transactional background must be undertaken.

At the time of the sale of SDG to XLN, ownership of the Software was transferred from SDG to SDG's shareholders, Daniel T. Fritsch, Jr., Michael R. Hamlin, Phillip C. Theis, and Paul J. Stehlik ("the Shareholders"). XLN purchased SDG's stock for $5,420,000, with the majority of the purchase price being paid to the Shareholders in the form of two promissory notes totaling $5,100,000. The stock purchase agreement provided that the source code for the Software would be placed in escrow, and that the ownership of the Software would remain with the Shareholders until the promissory notes were paid in full. Under both promissory notes, Shareholders Fritsch and Hamlin were each to receive 42.223% of the value of the note.*fn3

The right to license the Software was the primary asset of value acquired by XLN. Two of the developers, who were also the primary owners of the Software, Shareholders Fritsch and Hamlin, were given employment contracts by XLN and worked at the company on a daily basis. However, neither Fritsch nor Hamlin was a shareholder of XLN, nor were the other two Shareholders.*fn4 XLN operated out of the same Lancaster, Pennsylvania location where SDG had conducted its business. On January 17, 2003, XLN terminated Fritsch and Hamlin from their employment as part of an effort to stop cash outlays while XLN attempted to sell the company. Notes of Testimony ("N.T."), 10/24/06, at 82.

On August 5, 2003, XLNT was incorporated in New York. The sole shareholders of XLNT are Montgomery and Richard Alexander. Montgomery, who owns 75% of XLNT's stock, is also that corporation's president. In the month of its incorporation, XLNT entered into the asset purchase agreement with XLN, pursuant to which XLNT purchased virtually all of XLN's assets, including intellectual property, accounts receivable, customer lists, good will, licenses, trademarks, trade names, and copyrights; XLN retained only two workstations and servers and an undeveloped derivative of the Software. XLN also assigned its lease of the premises in Lancaster to XLNT, which thus further obtained all leasehold improvements from XLN. The two aforesaid workstations and servers retained by XLN were to remain at this business location. Under the agreement, XLN also retained two customers, but was required to change its corporate and business name.*fn5

As with XLN's stock purchase from SDG, the "key asset" acquired by XLNT was the right to license the Software. Trial Court Opinion, dated 4/11/07, Finding of Fact No. 27. The trial court credited testimony that (1) the right to license the Software was the only asset of XLN of significant value; (2) a software company "lives and dies" by its software; (3) XLNT's purchase of XLN's assets without the inclusion of the right to license the Software would have been meaningless; and (4) without the right to license the Software, XLN would have had difficulty remaining in business. Id., Findings of Fact Nos. 29-31. Indeed, the asset purchase agreement was expressly contingent upon XLNT coming to a contemporaneous agreement with the Shareholders whereby the Shareholders would ultimately transfer their ownership of the Software to XLNT, again contingent upon the satisfaction of promissory notes held by the Shareholders.*fn6

The asset purchase agreement was also contingent upon the execution and delivery, simultaneous with the closing, of employment contracts between XLNT and Fritsch and Hamlin. These individuals had independently negotiated with XLNT, with XLN's consent, the value of the source codes for the Software, and the terms of conditions of their employment with XLNT. They were to perform the same duties for XLNT as they had for XLN. XLNT also hired from XLN its sole remaining employee.

A schedule to the asset purchase agreement listed five existing claims against XLN, both those in litigation, including Appellant's cause of action, and those not yet in litigation. XLNT agreed to assume liability only for one claim not in litigation. Further, the agreement required XLN to refrain from competing with XLNT by engaging in any activity involving the Software or any similar product. Following the sale, XLNT's website, which Hamlin helped to create, identified XLNT as the successor company to XLN. Id., Finding of Fact No. 43.

II. TRIAL COURT PROCEEDINGS

Appellant filed a motion for summary judgment against XLN, which did not file a response. Indeed, on September 23, 2005, XLN's counsel was granted leave to withdraw from the case. Because of the non-response, the trial court granted Appellant's summary judgment motion against XLN in the amount of $114,105.

The case against XLNT and Montgomery then proceeded to a three-day bench trial. Following the trial's conclusion, the court entered a verdict for Appellant and against XLNT for $114,000, consistent with the court's extensive findings of fact and conclusions of law. More specifically, the trial court concluded that XLNT was liable to Appellant under the "de facto merger" and "mere continuation" exceptions to the general rule of corporate non-liability following a purchase of assets, pursuant to the following rationale.

With respect to the de facto merger exception, the court noted that four factors are generally examined to determine the existence of this exception:

(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, this stock ultimately coming to be held by the shareholders of the seller corporation so that they become a constituent part of the purchasing corporation.

(3) The seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible.

(4) The purchasing corporation assumes those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation.

Id., Conclusion of Law No. 5 (quoting Philadelphia Electric Co. v. Hercules, Inc., 762 F.2d 303, 310 (3d Cir. 1985)).

The trial court determined that, with respect to the asset transfer between XLN and XLNT, all of the above elements had been met, save for the second one regarding continuity of shareholders. With respect to the first factor, the court observed that there was a continuity of management because "key personnel from SDG and XLN," namely Fritsch and Hamlin, were also key personnel at XLNT: Hamlin, as Chief Operating Officer, controlled XLNT's day-to-day operations, and Fritsch, as Chief Technology Officer, controlled XLNT's technology issues. Id., Conclusion of Law No. 11. The court further noted that XLNT hired XLN's sole remaining employee, thus evidencing a continuation of employees.

The court then noted an undisputed continuation of physical location, passed from SDG to XLN to XLNT. Further, XLNT acquired all of the assets of XLN, except for two customers, two computer servers with workstations, and XLN's stock. With respect to the primary asset involved, the court observed that the Software continued to be owned by the Shareholders under both XLN and XLNT until the purchase price was fully paid. See id., Findings of Fact Nos. 39-40. Finally, the general business operations of XLN and XLNT were the same, involving the same essential personnel, key asset, customers (except for the two retained by XLN), and office location.

With respect to the third factor, the court observed that because of the asset purchase agreement, XLN "essentially ceased operating." Id., Conclusion of Law No. 17. Although XLN had changed its name and retained two customers, it had ultimately become "dormant," in the words of its CEO and one of its shareholders, David Binder, and, as determined by the trial court, "can be considered out of business." Id.

Concerning the last factor, the court concluded that "XLNT clearly assumed all of the obligations of XLN that were ordinarily necessary for the uninterrupted continuation of normal business operations." Id., Conclusion of Law No. 18. These obligations included the lease of the work premises, payment of salary to the same key employees, servicing the same clients, assuming a debt owed to one of the clients, and taking "responsibility for XLN's accounts receivable." Id., Conclusion of Law No. 19. Further, the court noted that the most significant obligation of XLN that was assumed by XLNT was the debt owed for the Software, which asset was vital to the operation of XLNT's business. Id., Conclusion of Law No. 20.

For the above reasons, the court determined that "it is clear that there was a de facto merger [arising from] the asset purchase agreement between XLN and XLNT." Id., Conclusion of Law No. 21. In arriving at this determination, the court explicitly rejected XLNT's argument that all four de facto merger factors or prongs must be present in order to find corporate successor liability under this doctrine, noting that no Pennsylvania appellate decision has ever required such.

The trial court went on to determine that XLNT was also liable under the "mere continuation exception" to the general rule of no corporate successor liability where there is a transfer of assets. The court noted that many of the considerations concerning this exception are identical to those of the de facto merger doctrine, which the court had already determined to be substantially present. However, citing U.S. v. Keystone Sanitation Co., Inc., 43 ERC 1404, WL 672891 (M.D. Pa. 1996), the court observed that the mere continuation exception places significance on the new company holding itself out to be the continuation of the predecessor company. Here, the evidence showed that XLNT specifically held itself out to be the "successor" to SDG; hence, the trial court determined, XLNT was therefore necessarily the successor to XLN. Trial Court Opinion, Conclusions of Law Nos. 22-26.

Finally, the court rejected Appellant's claims that either XLNT or Montgomery was responsible under a fraudulent transfer of assets because Appellant failed to carry its burden of proof on these claims. However, because the court determined that the evidence supported the existence of both the de facto merger and the mere continuation exceptions to the general rule of no corporate successor liability where there is a transfer of assets, the court entered judgment for Appellants and against XLNT.

III. SUPERIOR COURT DECISION

The Superior Court reversed the judgment against XLNT, determining that (1) the record did not support the trial court's findings that three of the four factors for the de facto merger exception had been met; and (2) the purportedly absent fourth factor --continuity of ownership between XLN and XLNT -- was indispensable for establishing the de facto merger exception.*fn7 Regarding this latter determination, the court held:

With regard to continuity of ownership, the trial court acknowledged that none of the owners of XLN became owners of XLNT. This finding, by itself, should have ended the trial court's consideration of XLNT's potential successor liability. Continuity of ownership is a key element that must exist in order to apply the de facto merger doctrine, since in the absence of a transfer of stock for assets the consequence of the transaction is not the functional equivalent of a merger. Instead, where there is no continuity of ownership[,] the transaction is merely an arms-length transaction between two corporations and not in any sense a merging of two corporations into one. As one federal court of appeals put it, without "continuity of shareholder interest, the two corporations are strangers, both before and after the sale."

Fizzano Bros. Concrete Products, Inc. v. XLN, Inc., 973 A.2d 1016, 1020 (Pa.Super. 2009) (quoting Travis v. Harris Corp., 565 F.2d 443, 447 (7th Cir. 1977); emphasis ...


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