Editor’s note: The author served as local trial counsel to Lehman Brothers Holdings in Lehman Brothers Holdings v. Gateway Funding Diversified Mortgage Services.

U.S. District Senior Judge Anita Brody of the Eastern District of Pennsylvania recently presided over a nonjury trial in Lehman Brothers Holdings v. Gateway Funding Diversified Mortgage Services. Brody is expected to render a decision in the coming weeks. Lehman Brothers represents the first occasion for the district court to consider the legal principle of de facto merger under Pennsylvania law following the Pennsylvania Supreme Court’s landmark decision in Fizzano Brothers Concrete Products v. XLN, 42 A.3d 951 (Pa. 2012). In Fizzano Brothers, the Supreme Court substantially modified the application of the de facto merger doctrine allowing trial courts far greater flexibility in the application of the doctrine to a broader set of facts.

Before Fizzano Brothers, Pennsylvania courts were constrained to a mechanical application of four elements: (1) continuation of the enterprise of the seller corporation; (2) continuity of shareholders; (3) cessation of ordinary business operations on the part of the selling entity; and (4) assumption of those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations. In practical application, the “continuity of shareholders” requirement was nearly impossible to satisfy where sophisticated businesspeople with legal representation structured the transaction as a sale of assets to a new entity. Consequently, mechanical application of the continuity of shareholders element was the stumbling block in the de facto merger analysis.

The Fizzano Brothers court substantially modified the analysis by discarding the mechanical application of continuity of shareholders. Citing public policy and recognizing the sophistication of business transactions in the current climate, the court ruled that “where the underlying cause of action is rooted in a cause of action that invokes important public policy goals, the continuity of ownership prong may be relaxed.” The question of successor liability should first be viewed in light of “whether, for all intents and purposes, a merger has or has not occurred between two or more corporations, although not accomplished under the statutory procedure.”

The Supreme Court went on to hold that the shareholders of the predecessor company were no longer required to become shareholders of the successor to meet the requirements of de facto merger. The court concluded such a holding would be “incongruous” with provisions of the Pennsylvania Business Corporation Law, stating, “Because a de facto merger analysis tasks a court with determining whether, for all intents and purposes, a merger or consolidation of corporations has occurred, even though the statutory procedure had not been used, the continuity of ownership prong of the de facto merger analysis certainly may not be more restrictive than the relevant elements of a statutory merger as contemplated by our legislature.”

The court then adopted a more flexible approach. After Fizzano Brothers, cases rooted in breach of contract and express warranty no longer require strict transfer of ownership. Rather, the de facto merger doctrine now requires “‘some sort of’ proof of continuity of ownership or stockholder interest. … However, such proof is not restricted to mere evidence of an exchange of assets from one corporation for shares in a successor corporation.”

The Fizzano Brothers factors are at issue in Lehman Brothers, where Lehman Brothers raised claims of successor liability relating to indemnification agreements with Gateway’s alleged predecessor. At trial, evidence was admitted indicating that Gateway had specifically and intentionally purchased all assets that were necessary to the continuation of the mortgage origination business formerly conducted by the predecessor. Such evidence included direct testimony on the part of Gateway’s management team that the acquisition was designed to acquire not only the current “pipeline” of loans in progress, but also the potential for continued loan origination. Contemporaneously, Gateway also undertook to acquire debt obligations owed by the predecessor that were necessary to loan origination, including securing warehouse lines of credit utilized to temporarily fund mortgage loans until sold on the secondary market. Finally, documents related to the transaction reflected the intention that the business operations of the predecessor entity were to be “wound down.” In that regard, restrictions against competition imposed upon the former principals of the predecessor, now Gateway employees, were permitted to “compete” only for the purpose of effectuating that wind-down.

While evidence was admitted as to each element of the de facto merger doctrine, continuity of ownership was specifically contested. The transaction at issue was characterized by the buyer and seller as an asset transaction with no stock transfers. However, the four shareholders of the predecessor entity were provided compensation in a variety of ways that Lehman Brothers argued were illustrative of ownership. The four shareholders received employment agreements with Gateway that included substantial severance benefits, a right to share in the profits of the same operations as had been conducted by the predecessor, and cash considerations. One former shareholder indicated the cash component was paid, at least in part, as a result of his equity position in the predecessor.

In contrast, Gateway argued that the four shareholders were valuable and experienced revenue-generating employees with corresponding compensation arrangements following the acquisition. Objectively, the four shareholders of the predecessor were not granted stock in the acquiring entity. Further, although certain of the agreements between the four shareholders and Gateway referenced the shareholders’ equity stake in the predecessor, no provision for consideration set forth in the language of the agreements was expressly tied to that equity position.

The Lehman Brothers trial is the first test of the new, more relaxed application of the continuity of ownership prong of the de facto merger analysis. Brody’s decision will provide guidance to both transactional practitioners in structuring transactions where liabilities may remain post-closing, and to litigators when faced with claims against a defunct entity where assets were transferred, leaving a hollow shell.

Tom Donnelly is a partner with Antheil Maslow & MacMinn, based in Doylestown, Pa. His practice focuses primarily on commercial litigation and transactions, employment disputes and personal injury. To learn more about the firm, visit www.ammlaw.com.