By: Deniz Harrison and Chas Waters
March 26, 2020
The Massachusetts Supreme Judicial Court reinforced the extensive strength of the equitable theory called successor liability. Specifically, in Smith v. Kelley, SJC-12759 (Feb. 2020) the Court determined that successor liability still applies where the liable predecessor professional corporation “continued” as a sole proprietorship, ultimately making the individual owner liable for the former company’s debt.
Kelley Law, P.C. (the “P.C.”) was a professional corporation primarily handling real estate transactions. The sole shareholder was Robert Kelley. One of the (now former) associates at the P.C. was Louis Bertucci. The Plaintiff was a United States Marine Corps veteran. In 2005, the Plaintiff was living out of his car and working as a trash collector. He also suffered from schizophrenia, posttraumatic stress disorder, depression, and was functionally illiterate. During this time, Plaintiff was approached by a participant in a scheme about a “special investment program” that did not require him to invest in any money but promised returns. Plaintiff agreed, and two real estate purchases were affected under his name based on falsified financial information. Bertucci acted as closing attorney for both properties. Several months after the closings both properties went into foreclosure. This ruined Plaintiff’s credit thus preventing him from renting an apartment.
In 2007, the Plaintiff brought an action against Bertucci, the P.C. and Kelley. Bertucci was found liable for fraud while Kelley was found not to be personally liable. On appeal, the P.C. was found vicariously liable for Bertucci’s fraud and the Court entered judgment against the P.C. for over $200,000. The day after final judgment was entered against the P.C., Kelley resigned from the P.C. and voted to wind up the corporation. At the same time, Kelley established a sole proprietorship called Law Office of R. Emmet Kelley (the “Sole Proprietorship”).
The question for the SJC was whether the Sole Proprietorship could be held liable for the final judgment entered against the P.C. The SJC held that, indeed, the Sole Proprietorship was liable for the P.C.’s debts as a successor interest. In reaching this conclusion, the SJC implemented a two part analysis asking: (1) whether the Sole Proprietorship is a mere continuation of the P.C.; and (2) whether successor liability is unavailable because the successor is a sole proprietorship.
First, the SJC found there were many significant similarities and facts indicating that the P.C. became the Sole Proprietorship “for the purpose of eliminating its corporate debt.” Smith v. Kelley, (citing Milliken & Co., 451 Mass. at 558.). For instance, Kelley amended the fee agreements with his clients at the P.C. to bill all future work to the Sole Proprietorship thus transferring his previous clients to the Sole Proprietorship. In addition, the Sole Proprietorship operated out of the same office as the P.C., used the same email address, used the same letterhead, had the same IOLTA account, used the same health insurance with the same named employer, and paid the same creditors and vendors. Kelley also was the proprietor of the Sole Proprietorship, and was the sole shareholder of the P.C. Finally, Kelley admitted in deposition testimony that he dissolved the P.C. because of the judgment entered against it, stating “[t]hat is exactly why I dissolved it.” Based on these facts, the SJC found that the Sole Proprietorship was in fact a “mere continuation” of the P.C.
Next, the SJC considered whether successor liability was available because the successor is a sole proprietorship. It concluded that it was. In so finding, the Court stated that “successor liability is justified where the sole proprietorship is a mere continuation of its predecessor and the purpose of the change is to eliminate the debt” even though it exposes proprietors to personal liability. In its rationale, the Court ultimately relied heavily on Columbia State Bank, 199 Wash. App. at 312, which had nearly identical facts relating to the “mere continuation” analysis, and found that successor liability was warranted between a professional corporation and a sole proprietorship. In addition, the Court borrowed Columbia’s rationale that successor liability is an equitable remedy in finding that the particular circumstances warranted relief given that “the record plainly reflects that the purpose of dissolving the P.C. and establishing the sole proprietorship was to avoid payment of the liabilities at issue.”
To the extent that Kelley will be personally liable as a sole proprietor, but was not previously as shareholder of the predecessor professional corporation, the SJC blamed Kelley himself, stating that the Sole Proprietorship was his choice, and a bad one under the circumstances. However, in balancing the equities, the Court stated that it “favor[ed] such a focus at the damages stage to properly account for, and protect against, undue personal liability and hardship for Kelley.” Thus, “revenues generated by the continuing practice should be used to pay the debt, not Kelley’s other assets.” The Court instructed that in order to implement this approach the lower court should examine Kelley’s income tax returns and identify revenues that were generated by the Sole Proprietorship.
The Court’s decision demonstrates that Massachusetts courts will not countenance efforts to shed corporate liability simply by restructuring the formation of the business, even it turns into a sole proprietorship.