TO: Judicial Interpretations Working Group of the M&A Committee

DRAFT: 1/24/18

M E M O R A N D U M

TO: Judicial Interpretations Working Group of the M&A Committee

FROM: Jon T. Hirschoff,[1] John H. Lawrence, Jr. and Daniel H. Peters

RE: Successor Liability

DATE: January 24, 2018

______

I. Introduction.[2]

A frequently cited advantage of an asset purchase over a merger or stock purchase is the flexibility that the parties have in an asset purchase to agree, as between themselves, on which debts and liabilities of seller will be assumed by buyer and which will be retained by seller. This flexibility is based on the long-standing common law principle that the buyer of the assets of a business does not thereby become liable for the debts and liabilities of seller that were not expressly assumed by buyer. This is commonly referred to as the “rule of non-liability.”[3] The rule is subject to a number of exceptions, the scope of which has expanded dramatically over the past 40 years, to the point where transaction planners can no longer rely on an asset purchase transaction to generally shield the buyer from seller’s liabilities. Indeed, the lack of predictability and the rise in the number of successor liability disputes[4] dictate that due diligence and pre-transaction planning around seller’s retained liabilities in an asset purchase be as comprehensive as it is in a merger or stock purchase transaction. This is especially true in a purchase of all or substantially all of seller’s assets where there is continuity of share ownership and the seller will be dissolved shortly after the transaction. This Memo discusses the rule of non-liability and the state and federal exceptions to that rule and suggests an analytical approach to assessing and minimizing the risk of successor liability in an asset purchase transaction.

The exceptions to the rule identify those circumstances where an asset buyer will be held liable as seller’s successor for the debts and liabilities of seller regardless of any exclusionary language in the purchase agreement. Unfortunately for buyer’s counsel, the courts have taken widely varying approaches in defining and applying these exceptions. The decisions tend to be very fact specific, with courts often using shorthand descriptions in their opinions that do not always accurately describe the application of or weight given to the relevant factors. The exceptions have become so confusing that one commentator described the law of successor liability as so “varied and unpredictable that it is not only a trap for the unwary, but a trap for the very wary, as well. Transactional asset-acquisition planning today faces the worst of all possible worlds: uncertainty as to whether successor liability applies, together with an enormous range of potentially applicable monetary liabilities that may be brought on an asset-purchasing entity after the transaction is completed. . . . More than a century of common law experimentation has resulted in the ‘doctrinal morass and high degree of uncertainty that now surround successor liability.’”[5]

Typically, the buyer of business assets will assume specific liabilities of the seller relating to the ongoing operation of the business, such as trade payables and existing contracts and leases, and will expressly disclaim responsibility for any other liabilities, such as liabilities for products manufactured and sold prior to the closing, seller’s pre-closing tax liabilities, environmental, health and safety liabilities, employee benefit plan liabilities, and other liabilities arising out of the seller’s pre-closing acts or omissions.[6] In the sale of a product line or division the buyer will ordinarily acquire only the tangible and intangible assets related to the acquired line of business and related ordinary course liabilities, and the seller will continue in business after the transaction and therefore be available to be responsible for the retained liabilities.

A corporation that sells all or substantially all of its business assets, will normally dissolve shortly after the sale and distribute the sale proceeds to its shareholders, net of any funds held in escrow or in reserve for contingent liabilities and transaction expenses. Occasionally, the asset purchase agreement will prohibit the seller from dissolving or making any distribution to its owners until the seller has paid or made adequate provision for its debts and other obligations.[7] Creditors of a dissolved entity can generally pursue their claims against a shareholder under the applicable dissolution statute. There are, however, important limitations on a shareholder’s liability. A shareholder’s total liability for all such claims may not exceed the total amount of assets distributed to such shareholder after the dissolution.[8] Moreover, by publishing newspaper notice of the dissolution, the dissolving corporation and its shareholders may be entitled to the benefit of a shorter statute of limitations on post-dissolution claims.[9] All of this may leave a post-closing claimant against the seller without an adequate legal remedy, which can seem particularly harsh in the case of a claim for injury or death where the parties knew or should have known of potential claims and the buyer continues the seller’s business without interruption.[10] The lack of an adequate remedy for injuries and death caused by a defective product under these circumstances has led a number of courts to create additional exceptions to the traditional rule of non-liability.[11]

Where does this leave an M&A lawyer? Advising clients on potential successor liability risk is challenging, not only because of the complex and confusing nature of the case law, but also because of the difficulty in predicting in which jurisdiction the product liability or other injuries might occur and thus which law will govern. This Memorandum is intended to provide a guide to counsel in planning, structuring and documenting asset acquisitions where there are significant successor liability risks. Section II provides a suggested approach for assessing and minimizing successor liability risk based on current successor liability law, Section III presents a brief summary of the common law and statutory rules of successor liability, Section IV summarizes the law of successor liability in specific areas, and Section V discusses choice of law principles in the area of successor liability, all of which should assist M&A lawyers in navigating these tricky waters.

II. Assessing and Minimizing Successor Liability Risk.

Developments in applicable law have rendered the degree of successor liability risk in an asset purchase difficult to predict, and typical deal structures are not well-suited to insulate buyers from that risk. Understanding when successor liability risk is present, what factors increase the risk and what mitigating measures are available are an important part of acquisition planning for the buyer and its counsel.

Successor liability risk is typically covered in the purchase agreement by a provision excluding non-ordinary course liabilities and an indemnification obligation of the seller covering any excluded liabilities, with no basket or cap. The indemnification obligation is typically secured by an escrow deposit or offset rights against the seller and its shareholders under the purchase money note or any earn-out payment. This is not an effective remedy, however, where the seller dissolves promptly after the sale and the indemnification claim is made after the seller’s assets are distributed to its shareholders, any escrow funds have been released or the purchase money note has been paid. The risk of successor liability claims has been heightened by the expansion of successor liability theories during the past forty years. Although the common law of successor liability has developed primarily by case law in the areas of product liability, environmental claims and labor law, the principles of successor liability are applied generally across all areas of the law, including contractual and statutory liabilities. Unfortunately, as explained in Section III the case law is of little predictive value because of the multiplicity of factors used to determine the existence of liability and the difficulty in some areas, such as product liability, of predicting which law will apply.

Practitioners representing buyers in acquisitions should engage in early client discussions that include a warning that the risks of successor liability cannot be fully eliminated by simply structuring the transaction as an asset purchase. Ideally, this discussion should take place prior to negotiations regarding the purchase price, however, in practice this is rarely possible because successor liability risk is often apparent only after the due diligence process is well underway. However, as we discuss below, there are certain indicia of successor liability risk that can be known relatively early in the acquisition process and the areas of most significant risk can be identified and addressed fairly early in the negotiation process. The preliminary client conversation should include an assessment of the elements of the transaction that create successor liability risk and the steps that can be taken to identify and minimize that risk. Specifically, the client should be advised that it is no longer prudent to rely on the rule of non-liability where the seller will not be in a position to satisfy all of the retained liabilities, particularly where other risk factors are present that cannot be avoided. Accordingly, where there are multiple successor liability risk factors present, the scope of due diligence in an asset purchase should be just as comprehensive as in a stock purchase or merger.

The numerous theories of successor liability, conflicting judicial decisions and difficulty in predicting which law will govern successor liability claims make it impractical to use any single theory or look to any single governing law to evaluate successor liability exposure. The following is our suggested approach to assessing and minimizing successor liability risk regardless of the theory of successor liability that may be applied or the choice of law.

A. Factors Increasing Successor Liability Risk.

The risk of successor liability increases as the number of the following factors in any potential transaction increases:

1. Claims That Are Likely to Be Made After Expiration of the Escrow or Survival Period, Such as Product Liability and Environmental Claims. The risk of successor liability is generally greater if the acquired business involves manufacturing or product distribution because much of the expansion of common law theories of successor liability has involved product liability claims made long after the product was manufactured and sold. For this reason, product liability claims are known as “long-tail” claims because they arise only when the defect is discovered or the injury occurs, which can be long after the product is sold. Environmental liability and data breach claims are similarly long-tail claims. One of the difficulties of planning for such long-tail claims is that they often arise long after the expiration of the typical one to two-year escrow or indemnification survival period. Service businesses, other than health care and construction, typically do not present the same long-tail claim risk as a manufacturing business.[12] Another reason that successor liability risk is higher for product liability is the product line exception to the rule of non-liability, which imposes liability on a successor manufacturer without reference to any of the indicia of a de facto merger or other exceptions to the rule of non-liability. A similar risk exists for environmental claims which follow the owner or operator of the property, without regard to any of the typical exceptions.

2. Liquidation of Seller after the Sale Without Adequate Provision for its Creditors. Successor liability risk is highest where the seller sells all or substantially all of its assets and ceases doing business, dissolves and distributes its remaining assets shortly after the closing. Cessation of business and dissolution of the seller after the transaction is one of the most important indicia of a de facto merger, i.e. the existence of only one corporation at the end of the transaction.[13] As one court succinctly stated: “There is no continuation of the seller’s business and thus no successor liability where the seller continues in existence as a completely independent business entity subsequent to the sale, with its own officers, directors and shareholders.”[14] Successor liability risk decreases significantly if the seller continues in business as a viable entity after the sale. For this reason, carve-out or divisional sales where the seller continues in business after the sale present a lower risk of successor liability because the courts construe that the seller is still around to satisfy indemnification obligations?

3. Use of Equity Securities of Buyer as Purchase Consideration. Successor liability risk increases if the transaction is not an all-cash transaction and the consideration includes shares or other equity securities of the buyer or its parent, such that seller’s shareholders or other equity owners will become equity owners of the business after the transaction. Ownership of as little as twelve percent of the buyer’s equity may be sufficient to support a finding of de facto merger, especially when seller’s upper level executives continue in the management and operation of the acquired business.[15] However, counsel should take note that it is unlikely that a court would find continuity of ownership for successor liability purposes the equity were granted outside of the sale transaction, for example, but as stock options awarded after the closing and not contemplated by the transaction documents.

4. Continuation of Seller’s Business by Buyer with Little Change. The risk of successor liability is increased if the buyer continues to operate the acquired business after the sale using some or all of the management and employees of the seller and uses the same physical plant and equipment. Other indicia of a de facto merger are the assumption by the buyer of liabilities ordinarily necessary for the continuation of the seller’s business, such as trade payables and the seller’s contractual and lease obligations.[16]

5. Buyer’s Holding Itself Out as a Continuation of Seller. Successor liability risk increases where the buyer holds itself out as a continuation of the seller and benefits from the seller’s name and goodwill. This continuation element may be sufficient standing alone under the product line exception (which has been adopted only in California, Washington and New Jersey), the rationale being that the continuing sale of the product using the name and goodwill of the seller puts the successor in the best position to spread the risks associated with the continuing sale of the product.[17]

6. Buyer’s Prior Knowledge of the Successor Liability Claims. Successor liability risk increases where the buyer knew or should have known of any potential claims or claimants and did not ensure that the seller made adequate provision for payment of claims though insurance or otherwise.[18]