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Type: Law Bulletins
Date: 06/26/2020

Successor Liability Risks in Asset Purchase Agreements

In theory, asset purchase agreements allow buyers to choose the assets they wish to buy and not assume the seller’s liabilities. In reality, many buyers are being exposed to litigation concerning the debts and tort liabilities of their sellers. Over the past 25 years, courts around the country have issued decisions that have created minefields for asset buyers. The number of successful cases has been steadily increasing as have the settlements to avoid the risk, expense, and uncertainty of litigation. Prudent buyers are enhancing their diligence to identify these risks and negate contractual protections such as escrows, holdbacks, indemnification, seller covenants to maintain its business, and even insurance against claims migrating from the seller to the buyer.

Advising buyers on the risks of successor liability is challenging for transactional lawyers. Case law is of little predictive value because: (a) there are many factors used to determine successor liability; (b) the list of factors which may trigger liability has steadily grown (and may never be set); (c) unknown tort claims such as product liability may be litigated in remote jurisdictions and create a complicated choice of law questions, and (d) both trial and appellate courts have embraced novel theories to benefit claimants who are unable to collect from insolvent sellers. These risks are real and cannot be eliminated by simply structuring the acquisition as an asset purchase. The risks are enhanced when transactions involve a distressed or insolvent seller. 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.

There are four general case law exceptions to the rule of buyer non-liability in asset transactions:

  1. The buyer assumes the seller’s liabilities expressly or impliedly.
  2. The transaction in substance constitutes a merger or consolidation of the buyer and seller (de facto merger).
  3. The buyer is “a mere continuation” of the seller.
  4. The intent of the transaction is to defraud the seller’s creditors.

The de facto merger theories are the most commonly cited by courts. Facts which support those theories include:

  • Continuity of management.
  • Same physical location.
  • Same general business operations.
  • Common equity ownership.
  • Assumption seller’s ordinary course business trade debt.
  • Seller’s dissolution following the sale.

This list is not exhaustive. No particular factor is sufficient to support liability and the absence of any particular factor will not necessarily defeat a claim. But, because those are fact-intensive inquiries, it is difficult or impossible to resolve those cases with summary judgment. 

Identifying Successor Liability Risk

Additional factors that are likely to create or increase successor liability risk include:

(a) the buyer’s exposure to “long tail” claims such as product liability, environmental torts, taxation, employment discrimination, health and safety, and data breach;

(b) the seller’s dissolution or liquidation soon after the transaction;

(c) the seller’s owners’ receiving equity interests in the buyer (either expressly or in consulting agreements or employment contracts whose terms mimic ownership);

(d) the buyer continuing the seller’s business with little change;

(e) the buyer marketing itself as a continuation of the seller or otherwise trading on the seller’s goodwill; and

(f) the buyer’s actual knowledge or imputed knowledge of claims combined with the buyer’s failure to require the seller to make adequate provision for their satisfaction through insurance or escrow.

Managing Risks in a Transaction

The purchase agreement must clearly define the liabilities included and excluded in the transaction as well as the seller’s obligation to indemnify the buyer for retained and non-assumed obligations. Acquisition subsidiaries are useful to trap successor liability claims at the subsidiary level and protect the core business of the buyer. Cash transactions reduce the risk of liability based on grounds of “continuity of ownership” and also create liquidity to satisfy the seller’s current and future creditors. While the risk of unknown liabilities is lower in asset acquisitions than in merger or stock transactions, the strongest defense is robust and organized diligence. Where potentially significant liabilities may be imposed on a buyer long after the transaction closes (such as product liability and environmental clean-up costs) proper pre-closing investigation can identify and quantify the risks. Once identified, the risks can be allocated and mitigated through  measures such as indemnification for liabilities that come to light immediately after closing and insurance coverage for other claims.

Using Insurance

Insurance is an important but often overlooked source of protection (particularly for tort negligence and strict liability claims). Buyers may need to engage experienced insurance advisors to review their seller’s existing and past insurance policies and claims histories. Policies written on an “occurrence basis” will likely remain available to the seller after closing for claims occurring prior to the closing. The buyer may negotiate with the seller to be named as an additional insured on these occurrence-based policies. For policies written on a “claims-made” basis, the buyer may require the seller to purchase tail coverage for the applicable statute of limitations period. So-called “tail coverage” insurance pays claims for pre-closing occurrences that are discovered during the post-closing period. 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 costs), successor liability insurance, fraudulent conveyance insurance, and litigation and contingent liability insurance.

A seller’s creditors are not parties to the asset purchase agreement and are not bound by it. (Sales governed by bankruptcy court orders pursuant to 11 U.S.C. 363 and other judicial sales may be an exception to this rule.) The acquisition agreement alone cannot provide complete protection for the buyer. The asset purchase agreement assigns responsibility between the parties for the seller’s obligations. An indemnification right may be of little value when assets are being purchased from a distressed or insolvent seller. Creditors will seek redress wherever they can make a colorable claim and courts have been open to some very novel theories of recovery. When a seller is distressed or insolvent, this risk must be identified and quantified. The sales price should reflect both the cost of defending these claims and the possibility that they may be successful. In many circumstances, insisting on a sale utilizing a receivership, bankruptcy, or other judicial means to obtain the protection of a court order may be the only prudent option to acquire assets from some companies.

Perhaps the strongest protection for the buyer is to have a viable seller after the transaction to both respond to post-closing indemnification claims raised by the buyer, and to satisfy claims of other creditors (including governmental agencies) that may seek payment from a “successor.” When feasible, buyers should require sellers to remain in existence until applicable limitations periods expire and maintain insurance coverage for current and pre-closing liabilities. When dealing with solvent sellers, buyers should require adequate reserves for pre-closing claims and contingent liabilities, including reserves to cover deductible amounts and self-insured retentions. Unfortunately, sellers able to meet these demands are the least likely to present successor liability issues for their buyers, and the best value for assets are often from desperate sellers.

Warning Signs

The most troublesome evidence in successor liability cases often comes from careless conduct by the parties both during the negotiations and after closing. To preserve relationships with a buyer’s vendors, employees, and customers, parties often characterize the sale as “a seamless continuation” of the seller’s business. These communications may be formal such as letters and website notices or as casual as emails attempting to comfort co-workers worried about termination or customers concerned about their orders being completed. Undisciplined communications may support an implication that a buyer is assuming the seller’s obligations to the recipients, even if the acquisition agreement clearly provides otherwise. The importance of proper characterization of the deal needs to be stressed to all employees and agents of both the buyer and the seller.

Jurisdiction and Forum

The outcome of a case seeking successor liability may be determined by which state’s law applies and what court considers the case. The governing law applicable to the acquisition agreement may not be relevant, 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 requires 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. The factors considered and their relative weight in successor liability cases differ from state to state.

For example, Texas has eliminated successor liability for seller liabilities which are not assumed in purchase agreements. Delaware courts use the doctrine of de facto merger sparingly and only in very limited contexts. But in Indiana, after a state representative’s health club closed, the state adopted a statute which obligates all future operators of health clubs on at a particular address to honor memberships sold by previous tenants. Medicare reimbursement rules and unemployment insurance underwriting rules also may have the effect of making a buyer suffer for the sins of its seller. 

Summary

Purchasing assets rather than equity is not a risk-free way to avoid successor liability. By employing proper planning, robust diligence, and contractual protections (including indemnification, escrows, holdback, and insurance), however, buyers can lower the risk of being liable for the debts and obligations of their sellers. Often the risks are too serious to complete a transaction without the comfort of a court order. In these transactions, the parties should consider using bankruptcy, state receivership, or other judicial sale vehicles. 

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