In theory, asset purchase transactions should allow buyers to pick and choose the assets they want and leave behind the liabilities. In practice, buyers are finding these deals may expose them to litigation.
As a newly minted corporate attorney almost two generations ago, I was given a very simple instruction – a rule of thumb – by my senior manager: always “buy assets and sell stock.” Why? When representing the buyer, we wanted only to acquire what we wanted – specifically articulated assets and select liabilities – and leave the seller with everything else. Of course, when we sold, the opposite was true: we wanted to part with everything associated with that business – known, as well as yet-to-be-discovered, liabilities. The law at the time permitted this approach, giving some certainty to the principle that liabilities may only move to the purchasing entity if the buyer expressly assumed them. But case law developments have eroded this principle. Now, even seller liabilities expressly excluded from the acquisition may follow the acquired business and come home to roost at a future date.
ABA’s January 2019 Memorandum, “Successor Liability in Asset Acquisition Transactions”
Jon T. Hirschoff, John H. Lawrence Jr. and Daniel H. Peters of the Judicial Interpretations Working Group of the M&A Committee of the American Bar Association’s Business Law Section recently published a comprehensive memorandum on successor liability in asset purchase transactions in the United States. Noting the increasing number of cases over the last 25 years in which a buyer of assets is claimed to be responsible for unassumed liabilities of its seller, the memorandum authors suggest an analytical and practical framework for identifying, evaluating and mitigating successor liability risk where there is no fraud or self-dealing. Not surprisingly, the framework, based on due diligence and pre-transaction planning, identifies and prioritizes particularly troublesome risk areas, contractually negotiated protections such as escrows, holdbacks, indemnification, seller covenants to maintain its business existence, and, perhaps most importantly, insurance.
The ABA memorandum goes a long way to recommending how to give parties the benefit of the contractual bargain despite the patchwork quilt of conflicting cases. The authors recognize that advising clients on the risk of successor liability is a challenging one for transactional lawyers. “[C]ase law is of little predictive value because of the multiplicity of factors used to determine successor liability and the difficulty in some areas, such as product liability, of predicting which law will apply.” The risk is real and not one that practitioners can eliminate by structuring the acquisition as an asset purchase, with the buyer taking only what is expressly targeted and leaving everything else behind. In fact, case law suggests that when a seller has been dissolved or otherwise has insufficient resources to satisfy its retained liabilities, including contingencies, the buyer will face a greater risk of successor liability.
The authors list and briefly describe the four traditional case law exceptions to the rule of buyer non-liability in asset transactions:
- The buyer assumes the seller’s liabilities expressly or impliedly;
- the transaction in substance constitutes a merger or consolidation of buyer and seller (de facto merger);
- the buyer is “a mere continuation” of seller; and
- the intent of the transaction is to defraud seller’s creditors.
The de facto merger is the most commonly cited, particularly where the transaction is characterized by a continuity of management, physical location, general business operations and equity ownership (the purchase consideration is stock of the acquirer), assumption by buyer of seller’s ordinary course business liabilities, and seller’s dissolution following the sale.
Identifying Risk Factors for Successor Liability
The ABA memorandum identifies transaction factors that are likely to increase successor liability risk. These include:
- the likelihood that the buyer will encounter product liability, environmental, tax, employment, health & safety, data breach or other “long-tail” claims in the purchased business (Long tail claims, the authors explain, are the primary source of successor liability risk);
- the seller’s dissolution and liquidation soon after the transaction (Successor liability risk is highest where the seller sells all or substantially all of its assets and then dissolves. It is the most important indicator of a de facto merger – there is only one entity after the transaction);
- the seller’s owners receive equity interests in the buyer in the transaction;
- the buyer will continue the seller’s business with little change;
- the buyer holds itself out as a continuation of seller and trades on seller goodwill; and
- the buyer knew or should have known of contingent claims and failed to require seller to make adequate provision for them through insurance or otherwise.
The presence of three or more of these factors should alert counsel to focus diligence efforts on the identified areas of risk.
Allocating and Managing Risks in a Transaction
Buyers are not without some means to address the risk that successor liability will be successfully litigated. The purchase agreement itself should clearly define the liabilities expressly included and excluded in the transaction as well as seller’s obligation to indemnify buyer for retained and non-assumed obligations. Buyers may use a newly created acquisition subsidiary to “quarantine” successor liability claims at the subsidiary level. In addition, an all-cash transaction reduces the risk that liability will be based on grounds of a continuity of ownership; and it also provides a pool of cash for the seller to pay current and future creditors. Although the risk of unknown liabilities is thought to be lower in an asset acquisition than in a merger or stock transaction, perhaps the strongest defense is an organized and appropriate level of due diligence as part of transaction planning. Where potentially significant liabilities may be imposed on a buyer long after the transaction closes, such as product liability and environmental clean-up costs, due diligence can identify and quantify the risk. The parties may then allocate risk through security measures, such as indemnification for liabilities that may come to light within a reasonably short period after closing and appropriate insurance coverage for longer term claims.
Insurance is an important but sometimes underappreciated source of protection particularly for tort and strict liability claims. In appropriate cases, buyers should engage an experienced insurance advisor to conduct a review of seller’s existing and former insurance policies and claims histories. A seller’s product liability policies that are written on an occurrence basis will likely remain available to the seller post closing (or will respond on behalf of seller) for claims occurring prior to the closing.
For added protection, the buyer should negotiate with the seller to be named as an additional insured on occurrence-based policies. For seller policies written on a claims-made basis, the ABA memorandum authors recommend that the buyer require the seller to purchase tail coverage for the applicable statute of limitations period, preferably three years at a minimum. The tail coverage will cover claims for pre-closing occurrences that come to light during the tail period. Depending on the facts of the transaction, other special insurance coverages may be available, including representation and warranty insurance, which covers losses resulting from a breach of a representation or warranty in the purchase agreement, environmental insurance (pollution legal liability and remediation cost cap), successor liability insurance, fraudulent conveyance insurance and litigation and contingent liability insurance.
The acquisition agreement alone cannot provide complete protection for the buyer. The seller’s creditors are not parties to the agreement and are not bound by it. Of course, the agreement does assign responsibility as between the parties for such obligations, and indemnification is the typical contractual protection for a buyer. But a creditor – whether contractual, tort or statutory – will seek redress wherever it can find or believes it can find it. In addition to suing a responsible seller for a defective product or past environmental event, a complaining party is likely to name the current owner of the business especially where the former owner no longer exists, is insolvent or is difficult to find.
One of the strongest protections for the buyer is to have a viable seller remain in existence after the transaction both to respond to post-closing indemnification claims raised by the buyer, but also to cover claims of other creditors, including governmental agencies, that otherwise might seek recourse from the “successor.” Buyers should seek to require the seller to remain in existence for at least the applicable limitations period and maintain insurance coverage for current and pre-closing liabilities. As part of its diligence, buyer should ensure that the seller has established adequate reserves for pre-closing claims and contingent liabilities, including reserves to cover deductible amounts and self-insured retentions. Finally, if and when the seller dissolves and liquidates, it should be required to utilize any procedures available to dissolving entities to shorten periods within which claims may be made against the entity.
Conduct of the parties during the negotiation process and after the closing of the asset purchase transaction may also increase risks of successor liability. Characterization of the transaction as a continuation of the seller’s business by either party in communications with customers or employees may give rise to an implication that the buyer is assuming the seller’s obligations to such parties or all obligations generally, even if the acquisition agreement clearly provides otherwise.
Jurisdictional Questions and Forum Shopping
A complicating factor is the issue of choice of law – which jurisdiction’s law will ultimately determine liability. The governing law applicable to the acquisition agreement may not be relevant, particularly because the injured or aggrieved party in a successor liability case is not a party to the acquisition agreement. When arising in the context of product liability claims, tort choice of law principles generally call for the application of the law of the location of the injury, and not the location where the product was manufactured or where the seller or buyer may be doing business. At least one state has provided a legislative solution to the problem. In property dispositions, Texas has eliminated successor liability for unassumed seller liabilities. The memorandum authors note that “Delaware courts use the doctrine of de facto merger sparingly, ‘only in very limited contexts,’” suggesting that “[f]rom a liability perspective, a choice of Texas or Delaware law as the governing law of the contract should be considered.”
Other jurisdictions have not adopted this approach. But buyers have an array of tools at their disposal to address the current unpredictability they face regarding successor liability. These include conventional contractual protections as well as modern specialty insurance coverages that can be tailored to the parties’ specific needs.
It is clear that purchasing assets is no longer a failsafe way to avoid liability as a successor; however, with proper planning, appropriate due diligence, traditional contractual protections including indemnification, escrows, holdbacks and insurance, buyers can lower the risk that they will be called upon to respond to unassumed seller liabilities.
The memorandum is a must-read for transactional lawyers who advise client buyers or sellers on negotiating successor liability issues and protections in asset deals. The January 2019 Memorandum, “Successor Liability in Asset Acquisition Transactions,” is posted on the M&A Lawyers’ Library, which is available to members of the M&A Committee of the ABA’s Business Law Section. It is also available to the public on the Shipman & Goodwin website.
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