Untangling Successor Liability Under the False Claims Act

American Hospital Company (“American”) makes a $1.2 billion cash bid for substantially all of the assets of Regional Hospital System (“Regional”), with the expectation that Regional’s hospitals will bolster American’s presence throughout the Southwest. During pre-signing due diligence, however, Regional discloses that a former chief financial officer of a Regional hospital likely filed a False Claims Act (“FCA”) qui tam against Regional.

Despite this disclosure, American executes an asset purchase agreement (“APA”) with Regional. To protect itself, American includes in the APA a provision expressly disclaiming liability for the potential qui tam. Due to a hot market for Regional, however, American is unable to include a provision indemnifying it for costs related to the potential qui tam.

The deal closes, but the month after American begins the integration process, the qui tam is unsealed, the government intervenes, and American is served with an amended complaint which names American and Regional as defendants. What happens next for American?

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Pursuant to the common law and the law of most states, an asset purchaser generally does not assume the liabilities of an asset seller, even when a purchaser buys substantially all of the seller’s assets.¹See
United States ex rel. Jajdelski, 834 F. Supp. 2d 1182, 1185-1186 (D. Nev. 2011). Notwithstanding this general rule of successor nonliability, courts commonly recognize four exceptions when:

(1) the acquirer expressly or impliedly assumes the liability;

(2) the transaction is an attempt to fraudulently evade liability;

(3) the acquiring company’s business constitutes a “mere continuation” of the seller’s business; or

(4) the transaction amounts to a de facto merger.²John H. Matheson, Successor Liability, 96 Minn. L. Rev. 371, 381 (2011).

These exceptions are relatively narrow, however, and many asset purchasers would not be held liable under any of them. The first exception, assumption of liabilities, is really no exception at all; if the purchaser intends to assume the seller’s liability, it will be held liable for them.³ Id. at 384. The second exception typically requires that the purchaser have defrauded the seller’s creditor.⁴See, e.g., Ed Peters Jewelry Co. v. C & J Jewelry Co., 215 F.3d 182, 192 (1st Cir. 2000) (“We have found no evidence of misrepresentation or deceit by the defendants that either induced [their creditor] to act contrary to his best interests or fail to take action that could have resulted in the payment of all or a part of the commissions due.”). Finally, the third and fourth exceptions—which are virtually identical—require, among other things, continuity of ownership between the buyer and seller.⁵See
C.T. Charlton & Assocs. v. Thule, Inc., 541 Fed. Appx. 549, 2013 BL 268424 at *3 (6th Cir. Sept. 30, 2013) (“Under the ‘mere continuity’ exception, courts will look to the totality of the circumstances but only if the ‘indispensable’ requirements of common ownership and a transfer of substantially all assets are met first.”) (citation omitted); Cargo Partner AG v. Albatrans Inc., 207 F. Supp. 2d 86, 104 (S.D.N.Y. 2001) (“[M]y research discloses no case (in New York or other jurisdictions) in which a court has found a de facto merger without at least some degree of ownership continuity — except in the area of products liability (and the other tort areas mentioned … below) where some courts have justified new or expanded exceptions on special policy grounds.”); see also
Patin v. Thoroughbred Power Boats, 294 F.3d 640, 650 (5th Cir. 2002) (“In other words, a ‘mere continuation of business’ will be found where the purchasing corporation is merely a ‘new hat’ for the seller with the same or similar management and ownership.”); Weaver v. Nash Int’l, 730 F.2d 547, 548 (8th Cir. 1984) (declining to find successor liability without unity of ownership). Thus, in our hypothetical, American likely would not be held liable for Regional’s FCA violations pursuant to any of these traditional exceptions.

Under another exception that has been adopted in certain federal law contexts, however, if an asset purchaser continues the business of the seller, the purchaser can be held liable for the seller’s violations of law—even in the absence of continuity of ownership. Under this “substantial continuity” exception, successor liability can attach when: (1) the buyer had notice of the claim before the acquisition; and (2) there are no major changes to the operation of the business after the sale.⁶See
EEOC v. G-K-G, Inc., 39 F.3d 740, 748 (7th Cir. 1994). The substantial continuity exception is distinguished from the “mere continuation” exception in that continuity of ownership is not a required element. Thus, if the substantial continuity exception applies, American likely could be held liable for Regional’s violations of the FCA.

Clearly, choice of law is critical for arms-length asset purchasers like American in our hypothetical. So which exceptions apply to False Claims Act liabilities? Unfortunately, federal courts have divided on the question. Some courts simply apply the traditional state law exceptions, albeit without much explicit rationale.⁷See, e.g., United States ex rel. Pilecki-Simko v. Chubb Inst., No. 06-3562 (D.N.J. Mar. 22, 2010); United States v. Americus Mortg. Corp., No. 4:12-cv-02676 (S.D. Tex. Sept. 10, 2013). Other courts apply the substantial continuity exception, with little analysis or explicit justification.⁸See, e.g., United States ex rel. Fisher v. Network Software Assocs., 180 F. Supp. 2d 192, 195 (D.D.C. 2002); United States ex rel. Geschrey v. Generations Healthcare, LLC, 922 F. Supp. 2d 695, 2012 BL 213119, at *13, (N.D. Ill. Aug. 14, 2012); see also
United States ex rel. Jajdelski v. Kaplan, Inc., 834 F. Supp. 2d 1182, 1186 (D. Nev. 2011). Though the Jajdelski court nominally applied the substantial continuity exception, it granted a motion to dismiss a qui tam where the relator failed to allege that the “[d]efendant continued to conduct the alleged fraudulent activities following its acquisition” of the seller – implying that true successor liability is never available in FCA cases. The government, unsurprisingly, argues for the application of the substantial continuity exception.⁹See, e.g., Mem. Of Law in Opp. To Defendants’ Motions to Dismiss the Second Amended Compl., United States v. Allquest Home Mortg. Corp., No. 4:12-cv-0676 (S.D. Tex. Dec. 21, 2012), at pp. 68-70.

So how should courts decide between state and federal law? The answer is in United States ex rel. Klein v. Omeros. In Klein, the U.S. District Court for the Western District of Washington engaged in a sua sponte analysis of precisely this issue, and it appears to be the only court to have done so in a meaningful way. The Klein court first recognized that federal common law governs questions involving the rights of the U.S., such as under the FCA. In giving content to that federal common law, however, U.S. Supreme Court precedent directs the lower courts to consider “(1) whether the federal program, by its very nature, requires uniformity; (2) whether application of state law would frustrate specific objectives of the federal program; and (3) whether application of a uniform federal rule would disrupt existing commercial relationships based on state law.”¹⁰United States ex rel. Klein v. Omeros, 897 F. Supp. 2d 1058, 1065 (W.D. Wash. 2012).

The Western District of Washington recognized that the Ninth Circuit had applied this framework to successor liability under the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”) and had concluded that the substantial continuity exception was inapplicable to claims under that statute. The Klein court decided the same with respect to the FCA.¹¹Klein, 897 F. Supp. 2d at 1067. The parties settled prior to appeal. Specifically, the court stated that in the absence of a “clear expression of intent on the part of Congress,” the four traditional exceptions to successor non-liability applied to the FCA, in the same way that they applied to claims under CERCLA.¹²Id. at 1066. Indeed, the court strongly suggested that the substantial continuity exception should be limited to suits brought pursuant to labor laws.¹³Id. at 1067 (citing New York v. Nat’l Servs. Indus., Inc., 352 F.3d 682, 686 (2d Cir. 2003) (rejecting application of substantial continuity exception to CERCLA suit)).

As noted above, Klein is the only FCA decision which considers the choice-of-law issue for successor liability. The other decisions referenced in this article—whether applying the traditional exceptions or the substantial continuity exception—simply fail to analyze the appropriate choice of law. Given the perceptive and careful analysis in the Klein decision, other courts should follow it—and potential defendants should be prepared to brief the issue.¹⁴For additional discussion of these issues see Taylor J. Phillips, The Federal Common Law of Successor Liability and the Foreign Corrupt Practices Act, ___ Wm. & Mary Bus. L. Rev. ___ (forthcoming). Note that this analysis may not apply to an acquirer’s liability for overpayments or civil monetary penalties when the seller transfers its provider agreement to the acquirer. See
United States v. Vernon Home Health, Inc., 21 F.3d 693 (5th Cir. 1994); Deerbrook Pavilion, LLC v. Shalala, 235 F.3d 1100 (8th Cir. 2000).