Apparently for the first time, a Massachusetts trial judge has used a newly decided corporate successor liability theory to hold a newly formed company responsible for the debts of its predecessor, yielding a $2 million judgment for back rent and interest. The plaintiff in the case, Renaissance Worldwide, had leased space to Sitara Networks, a voice-over-Internet (VOIP) company, in a Waltham building. Sitara arranged for a creditor to foreclose on its assets and then bought them back, reopening as a new entity, Converged Access. Converged claimed that it should not be responsible for the hundreds of thousands of dollars in back rent and interest owed by Sitara.
Superior Court Judge Bruce R. Henry said “not so fast,” and ruled that Sitara’s plan to reemerge as Converged Access was improperly designed to shed the company’s unsecured debt, scrubbing the books clean with the transaction. He ordered Converged Access to pay a whopping $1.2 million in back rent plus $800,000 in interest and attorneys’ fees. Judge Henry’s ruling is reportedly the first major decision relying on a year old Milliken decision from the Massachusetts highest court on corporate successor liability. The judge wrote:
“That plan causes me the same concerns as did the similar plan of the defendant in the Milliken case,” Henry wrote. “As the Supreme Judicial Court found in Milliken, ‘Notwithstanding our respect for the integrity of corporate structures, we are troubled by the notion that by merely changing its form, without significantly changing its substance, a single corporation can wholly shed its debts to unsecured creditors, continue its business operations with an eye toward returning to profitability, and have no further obligation to pay such creditors.'”
A Young Company Pursues VOIP Technology But Runs Into Trouble
Sitara, the young company was pursuing voice-over-Internet protocol technology – or VoIP – which essentially allows phone service to work over the Internet. In April 2002, Sitara stopped paying its rent and began talking to Renaissance, the landlord, about renegotiating the lease, but the two never reached a revised agreement. Sitara failed to pay the rent over the next 15 months, accumulating a $1.2 million debt. (Why the landlord let the rent accrue this much is beyond me).
Meanwhile, it owed Lighthouse Capital Partners, a secured creditor, $1.1 million. In 2004, Sitara began working with Argus Management Corp., a consulting firm that specializes in helping distressed companies. Argus tried to negotiate a reduced rent, but the two sides never agreed to terms. In April 2004, one of Sitara’s founders, Malik Khan, sent an e-mail to some colleagues discussing the rent negotiations with Renaissance and outlining several options, including selling the company to Lighthouse and buying the assets back. “We hand the keys to Lighthouse and then purchase the assets back from them,” he wrote. “We have spent time working this last option out with Argus, who have much more experience at this than we do. … Financially, this is a better deal for all of us but more complicated.” In a later e-mail to an investor, Khan spelled out the plan in greater detail: Lighthouse would take over the assets and a new company would buy them, getting “Sitara’s current business, assets, IP, brand names, trade marks and copyrights, with no debt on its balance sheet.” And he noted that, if done “expeditiously,” there would be “a seamless transition from employees, customers and the market, with minimal disruption to business.”
Not So Fast Says The Judge
After several years of litigation, the Judge ruled in a jury waived trial that the plan “engineered by Khan with assistance from Argus and the cooperation of Lighthouse was designed to permit Sitara to continue its business, albeit with a new name, and to shed its unsecured debt.” He ordered the defendants to pay $1.2 million in rent plus roughly $800,000 in interest, as well as attorneys’ fees, which have not yet been calculated.
The take-away from this case is think twice before you engage in an end-game corporate foreclosure strategy under which a new related corporate entity is formed to “cleanse” the debts of the predecessor insolvent company. This applies not only in the real estate leasing context but for all types of corporate debt situations. With the economy still recovering, I would expect to see more of these “loan-to-own” successor liability cases as companies squeezed by the credit crunch look to get rid of debt while avoiding the longer, more expensive bankruptcy process. There is still much distressed corporate debt out there and otherwise sound companies that are victims of the credit crisis.
I’ve been waiting for an opportunity to write about commercial leasing and this new case which just came down provided a great opportunity. The case, Renaissance Worldwide Inc. v. Converged Access Inc., can be read here.