When expanding business, companies frequently consider whether to establish a branch or a subsidiary. One of the most attractive advantages of a subsidiary over a branch is that it limits the parent’s liabilities. This limitation is grounded in the general rule that corporate entities are presumed to have a separate existence; each is responsible for its own debts. However, the general rule is not without exception. The following non-exhaustive list provides some examples.
A. The Parent Takes the Obligations
The Parent as a Guarantor
A parent company may voluntarily sign itself as a guarantor for the subsidiary’s obligations. For example, it may agree to be a guarantor in a subsidiary’s lease of real property or loans. If the subsidiary defaults on the obligation, the guarantor-parent will have a direct duty to the creditor to pay out. The scope of this duty depends on the contract terms. Thus, the parent company should pay close attention to the terms of the guarantor agreements that it intends to sign.
Assumption of Liabilities
If the parent agrees to assume any liabilities of the subsidiary, it will be directly liable for those claims. Assumption of liability clauses can be extremely broad. For example, a clause may contain language such as, “liabilities of any kind or nature, now in existence or hereafter arising from or relating to the conduct of the business of its Subsidiaries”. The broader the language, the more the parent’s burden of potential liability. The assumption of liabilities language can appear in various contracts, such as a transfer of assets, indemnity, or assignment agreements. Franklin v. USX Corp., 87 Cal.App.4th 615 (Cal. Ct. App. 2001) (concluding that the assumption agreement did not include tort claims). Assumption of liabilities can also be implied from the parent’s conduct.
B. The Parent Is Improperly Entangled with the Subsidiary
Single Enterprise (“Alter Ego,” “Piercing the Corporate Veil”)
The courts will apply the single enterprise concept when the parent and the subsidiary are so entangled that “there is really only one corporation.” Mesler v. Bragg Mgmt. Co., 39 Cal.3d 290, 301 (1985).
The single enterprise liability has two components: the unity-of-interest and the injustice element. The unity-of-interest element is simply a measure of how entangled the parent and the subsidiary are (commingling of funds and assets, identical equitable ownership, use of the same offices and employees, lack of segregation of corporate records, and like factors). Virtualmagic Asia, Inc. v. Fil-Cartoons, Inc., 99 Cal. App. 4th 228, 245 (2002) (listing the unity-of-interest factors).
The injustice element means a kind of “bad faith [that] makes it inequitable for the corporate owner to hide behind the corporate form.” Sonora Diamond Corp. v. Superior Court, 83 Cal.App.4th 523, 539 (Cal. Ct. App. 2000). For example, the injustice element may be found where a company operates its alter-ego companies in such a way that no money flowed to the debtor company. Toho-Towa Co. v. Morgan Creek Prods., Inc., 217 Cal.App.4th 1096 (Cal. Ct. App. 2013).
C. The Subsidiary Acts in Accord with or Under the Authority of the Parent
Aiding and Abetting (Co-tortfeasor Liability)
“Liability may … be imposed on one who aids and abets the commission of an intentional tort if the person (a) knows the other’s conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other to so act or (b) gives substantial assistance to the other in accomplishing a tortious result and the person’s own conduct, separately considered, constitutes a breach of duty to the third person.” Casey v. U.S. Bank Nat. Assn., 127 Cal.App.4th 1138, 1144 (Cal. Ct. App. 2005).
However, “[m]ere knowledge that a tort is being committed and the failure to prevent it does not constitute aiding and abetting.” Id. Aiding and abetting “necessarily requires a defendant to reach a conscious decision to participate in tortious activity for the purpose of assisting another in performing a wrongful act.” Casey, supra, 127 Cal.App.4th 1138, 1146 (internal citations omitted, italics original).
Hence, if a parent corporation knows that its subsidiary commits, for example, a fraudulent transfer, this – without more – will not constitute aiding and abetting. However, if it provides substantial assistance and promotes the transfer, such conduct may constitute grounds for co-tortfeasor liability.
The subsidiary’s dealings may also bind the parent company if the subsidiary acted as an agent. California Civil Code §2330. Notably, the parent can authorize its subsidiary indirectly by creating an appearance of authority so that others rely on such delegation of authority. California Civil Code §2334 (defining “ostensible authority” of an agent). Moreover, the parent may authorize a transaction by ratifying it after the fact. Bowoto v. Chevron Texaco Corp., 312 F. Supp. 2d 1229, 1247 (N.D. Cal. 2004) (“An agency may be created … by a precedent authorization, or a subsequent ratification.”) (citations omitted).
The parent’s control is the central inquiry. If the parent company’s control is so tight and goes far beyond mere control of investments, then it risks taking the subsidiary’s obligations. However, if the parent controls its subsidiary only through the voting mechanism (as a majority shareholder), this will not amount to an agency relationship. See Restatement 2d of Agency § 14 M, cited in Bowoto, supra, 312 F. Supp. 2d 1238; cf. Doe v. Unocal Corp., 248 F.3d 915, 928 (9th Cir. 2001) (considering whether the subsidiary functioned “merely [as] the incorporated department of its parent”; the court characterized the company as a “super-corporation” and not a mere investor in other businesses).
D. The Parent Improperly Acquires Subsidiary’s Assets
De Facto Merger
If the parent company decides to buy its subsidiary’s assets, the general rule is that the acquiring corporation (parent) does not assume the debts and liabilities of the seller (subsidiary). Yet, there are some exceptions, including the exception of “consolidation or merger of the two corporations […].” Ray v. Alad Corp., 19 Cal.3d 22, 28 (Cal. 1977).
The consolidation or merger exception applies when the buyer does not give adequate consideration (to satisfy seller’s creditors’ claims) or when the consideration consists wholly of shares of the purchaser’s stock which are promptly distributed to the seller's shareholders in conjunction with the seller’s liquidation. Ray, supra, 19 Cal.3d 28-29. In Marks v. Minnesota Mining Manufacturing Co., 187 Cal.App.3d 1429 (Cal. Ct. App. 1986), the court set forth five often-quoted factors that indicate a de facto merger: “(1) was the consideration paid for the assets solely stock of the purchaser of its parent; (2) did the purchaser continues the same enterprise after the sale; (3) did the shareholders of the seller become the shareholders of the purchaser; (4) did the seller liquidate; and (5) did the buyer assume the liabilities necessary to carry on the business of the seller?” Marks, 187 Cal.App.3d 1429, 1436.
Importantly, although all factors are relevant to the de facto merger exceptions, “the common denominator, which must be present … is the payment of inadequate consideration.” Franklin, supra, 87 Cal.App.4th 615, 627.
The Parent Is a Mere Continuation of The Subsidiary
Another exception from the successor non-liability rule is when one company is a “mere continuation” of the other company (to be distinguished from the alter-ego liability). This exception applies when the buyer-corporation (1) pays inadequate consideration (not enough to satisfy the claims of predecessor’s unsecured creditors) or (2) one or more persons were officers, directors, or stockholders of both corporations. Ray, supra, 19 Cal.3d 29.
The courts usually interpret these requirements narrowly. For example, in Franklin, supra, 87 Cal.App.4th 615, 620, the court found that having a single officer with minimal ownership interest remain in the office did not amount to the “mere continuation” exception. Franklin, 87 Cal.App.4th 615, 620 (comparing with other cases where buyer and seller had substantially same ownership).
Thus, when the parent decides to close its subsidiary and acquire its remaining assets, it should be careful to provide an adequate consideration to satisfy the creditors’ claims.
Product Line Successor (Product Liability Cases)
There is another exception specific to product liability cases. A company that acquires a manufacturing business and continues the output of its product line may potentially assume strict tort liability for defects in the same products as previously manufactured and distributed by the seller-corporation. Ray, supra, 19 Cal.3d 22, 34.
For example, in Ray, the court found a successor liability of the manufacturer’s successor where the injured plaintiff had no viable remedy against the then nonexistent manufacturer, the successor to the manufacturer continued to manufacture the same product line as its predecessor, retained the same personnel, used the same designs and customer lists, gave no outward indication of the change in ownership and had opportunities to evaluate production risks and pass on the cost of meeting those risks almost identical to its predecessor’s. Ray, supra, 19 Cal.3d 22.
Therefore, if a company acquires another manufacturing business, it should carefully assess potential liability for the product lines that it intends to continue.
Fraudulent Transfer of Assets
In California, there is a statutory and common law remedy of voiding a fraudulent transfer. The statutory remedy is codified in the Uniform Voidable Transaction Act (“UVTA”), California Civil Code §3439 et seq. Under the UVTA, a transfer can be voided if there was no reasonable consideration for the transfer, and the debtor (seller) was or became insolvent by the transfer. §3439.05. Another type of voidable transfer is when the debtor (seller of assets) made the transfer with actual intent to hinder, delay, or defraud its creditors and without receiving a reasonable consideration for the transaction. §3439.04. The UVTA lists eleven factors for determining the actual intent to hinder, delay, or defraud (transfer to an insider, undisclosed transaction, the debtor absconded or removed the assets, the debtor became insolvent after the transfer, and the like). California Civil Code §3439.04(b).
The common law fraudulent transfer claim existed long before the UVTA. Adams v. Bell, 5 Cal.2d 697 (Cal. 1936). The courts in California held that both remedies, under UVTA and under the common law, are cumulative. Cortez v. Vogt, 52 Cal.App.4th 917 (Cal. Ct. App. 1997), see also Macedo v. Bosio Revocable Trust, 86 Cal.App.4th 1044 (Cal. Ct. App. 2001). The difference between statutory and common law remedies matters especially in the statute of limitations issue. Id.
In sum, the general rule is that separate entities do not inherit each other’s liabilities, however there are critical exceptions. To avoid a subsidiary’s liabilities, the parent company should carefully examine the agreements it signs, the authority it provides to the subsidiary, how closely it controls its subsidiary, how closely it becomes entangled with the subsidiary, and whether it provides an adequate consideration for the assets it acquires. Among many other considerations.
This article contains no legal advice. This list is non-exhaustive and contains general information only.