The Art of the (Bad) Deal: Successor Liability in M&A Transactions
Ballard Spahr LLP
Many asset deals have hidden risks that can prove costly for buyers if not addressed prior to closing the transaction, particularly in a distressed transaction where the seller may be unable to satisfy retained liabilities following the closing. As present market conditions present opportunities to acquire distressed businesses, buyers need to be mindful of the risk of successor liability and take steps to mitigate that risk. Such steps include carefully considering sources of potential claims and post-closing business integration, conducting proper due diligence, carefully drafting purchase agreements, and negotiating an indemnification package that provides a source of funds (or other security) to satisfy indemnification claims.
General Rule of Non-Liability
Buyers of businesses will often look to structure the deal as an asset sale transaction in an effort to avoid inheriting liabilities as part of the purchase. The general rule is that a buyer of assets is not responsible for a seller’s liabilities simply due to the ownership of the assets. The Supreme Court in fact declared 130 years ago that this general rule of non-liability is so well settled “that it is surprising that any other can be supposed to exist.”
Exceptions to the General Rule
Over the years, however, courts have carved out a number of exceptions to the general rule against successor liability in a few specific contexts. Buyers can, in certain circumstances, be held responsible for the liabilities of the seller if a court determines that the facts and circumstances support one of the following judicially-created exceptions:
the buyer expressly or impliedly assumes the liabilities;
the transaction in substance constitutes a merger or consolidation of buyer and seller under state law (also known as a de facto merger);
the buyer is a mere continuation of the seller (subsequently expanded by some courts to include the lesser standard of a continuity of the seller’s enterprise); or
the transfer was fraudulent or intended to defraud creditors.
In addition to the traditional common law exceptions to the general rule of non-liability outlined above, courts have also imposed liability in certain other circumstances that include the following:
the buyer continues the same product line of the seller; and
the nature of the particular obligation, arising by virtue of a statute, is such that public policy demands a finding of successor liability.
The scope of the exceptions has expanded dramatically over the years, to the point where predicting the outcome of a successor liability claim with confidence is not possible. Relying on the structure of the transaction alone will not necessarily shield the buyer. Similarly, provisions in the asset purchase agreement stating that the buyer is not assuming any liabilities other than those expressly identified and choosing the state law that will govern the contract may not protect the buyer against a successor liability claim since the claimant is not a party to the agreement. Courts have taken different approaches in applying the exceptions and the cases are very fact driven. Most court cases imposing liability have arisen in situations where it seemed unfair that the seller be allowed to walk away from certain liabilities leaving claimants without any recourse.
The applicable state law matters, as courts in some states are reluctant to hold a buyer responsible for a seller’s liabilities that are not expressly assumed in the transaction. For example, the Court of Chancery of Delaware has noted that, while the general rule of non-liability is not absolute, “[a]bsent unusual circumstances, a successor corporation is liable only for liabilities it expressly assumes.” Further, in certain states, including Minnesota and Texas, state lawmakers have taken action to provide buyers more certainty that they will not be held responsible for liabilities they did not agree to assume.
Assumption of Liability Exception
For the assumption of liability exception to apply and impose liability on a successor, a court must find that the buyer assumed the obligation. When an agreement clearly and expressly disclaims liability, liability based upon the assumption exception normally does not occur. A buyer may agree to assume certain liabilities (such as liabilities accrued as current liabilities in connection with a working capital adjustment) or require the seller to procure insurance for certain potential liabilities without compromising a defense that it did not assume a specified obligation. Clear language in the asset purchase agreement is paramount—if the agreement is ambiguous, a buyer risks being found to have assumed the seller’s liabilities, even if those liabilities were not foreseen at the time of the sale. Moreover, notwithstanding clear language in the agreement, courts may simply conclude that although the parties to the asset purchase agreement have allocated liabilities between themselves and included an express provision denying assumption, such an allocation is not dispositive as to the holders of third-party claims.
De Facto Merger Exception
A court can find that the asset purchase is, for all intents and purposes, a merger, thus concluding—like in any other merger—that all of the seller’s liabilities become the buyer’s liabilities without regard to express language of the asset purchase agreement to the contrary. In making the determination, courts generally look at factors such as a continuation by the buyer of the seller’s operations, continuity of directors, officers, other personnel, location and assumption of those liabilities ordinarily necessary for the uninterrupted continuation of normal business operations. In addition, and significantly, some continuity of shareholders or other owners is often required to impose liability. Often, the selling company ceases operations or dissolves. Loosely stated, the question often asked is “Is it essentially the same people, doing the same thing, at the same place, with the same assets and with the former owners involved in the ownership of the new enterprise?” The buyer’s use of the same business name, phone number, domain name, trademarks and vendors can also increase the likelihood of liability.
Mere Continuation/Continuity-of-Enterprise Exceptions
A court may apply the mere continuation exception when it finds that the buyer is merely a continuation of the seller, taking into account, for example, the ownership structure, directors and officers of both the buyer and the seller. The United States District Court for the District of Delaware has summarized the requirements this way: “[i]n order to recover under this theory in Delaware, it must appear that the [seller] is the same legal entity as the [buyer]; that is, ‘it must be the same legal person, having a continued existence under a new name.’ The test is not the continuation of the business operation, but rather the continuation of the corporate entity.”
The continuity of enterprise exception, which is an extension of the “mere continuation” exception, has been recognized in some jurisdictions to impose liability on a buyer even if the shareholders or other owners of the buyer and seller are completely different. In essence, this exception, which focuses on a substantial continuation of the seller’s enterprise, is substantially similar to the de facto merger and “mere continuation” exceptions, but is distinguished in that there is no continuity of ownership requirement. Liability will be imposed when the purchaser “is merely a ‘new hat’ for the seller . . . .” Where there is continuity of control or a buyer holds itself out as a continuation of the previous entity, a court can more readily find it equitable to impose continuity of liability.
Fraudulent Transfer Exception
Buyers and sellers of businesses are not allowed to structure a transaction solely to avoid liabilities. Where a transaction is structured with an actual intent to defraud creditors or where the amount paid in the deal is less than “fair consideration”, the law provides recourse and will subject the buyer to liability. This exception is particularly relevant in the context of a distressed transaction where compressed timelines and enhanced leverage may allow a buyer to negotiate a much more favorable purchase price as compared to a non-distressed transaction.
Product Line Exception
The product line exception was created by the California Supreme Court in the 1970s and has since been adopted in certain other states. This exception operates to impose successor liability on a buyer of a business for defective products sold by the seller pre-closing where the buyer acquires the goodwill of the seller and continues to manufacture and sell the same products. This is a meaningful exception to the general rule of non-liability, since these types of claims may involve products that were sold by the seller many years ago. In creating this exception, the Supreme Court of California justified its decision based on (1) the injured party’s loss of remedies against the original manufacturer, (2) the successor’s ability to assume the seller’s risk-spreading position (meaning to spread the cost of satisfying the liability among current purchasers of the acquired product line), and (3) the perceived fairness of requiring the successor to assume responsibility for defective products as the burden of liability is necessarily attached to the seller’s goodwill being enjoyed now by the successor in the continued operation of the business.
Statutory and Regulatory Exception
In addition to products liability cases, a buyer in an asset deal can be liable for the seller’s liabilities that arise under federal and state statutes without regard to any of the typical exceptions. Such liabilities include those relating to unpaid sales, use and payroll taxes and labor violations, as well certain environmental and unfunded pension liabilities. Over the last few decades, courts have in fact expanded successor liability theory to impose liability on a buyer for seller’s pre-closing violations of, and obligations under, certain statutes.
Identifying Risk Factors for Successor Liability
There are a number of factors in a transaction that are likely to increase the risk of successor liability. These include:
the purchase agreement does not speak specifically to the liability at issue;
the nature of the business involves manufacturing or product distribution such that certain claims may arise many years after the closing (including claims relating to product liability and environmental matters);
the buyer will continue to use some or all of the management, employees and physical plant and equipment of the seller;
the buyer conducts no independent operations from those acquired from the seller;
the buyer assumes liabilities ordinarily necessary for the continuation of the seller’s business, such as trade payables (and other current liabilities) and contractual obligations;
the buyer uses the same business name, tradenames, trademarks, phone numbers, website and otherwise holds itself out as substantially the same business as, and trades on the goodwill of, the seller;
communications between the parties prior to or following the closing (including emails) that are inconsistent with language in the purchase agreement relating to any particular liability;
the buyer has actual or constructive knowledge of the potential claims;
the seller’s owners acquire equity in the buyer or one of its affiliates as part of the transaction (a common feature in private equity transactions);
the buyer and the seller are related parties;
the seller ceases doing business and dissolves shortly after closing;
the seller does not receive reasonably equivalent value for the assets transferred; and
the seller has substantial obligations (both in terms of size and number) that will not be satisfied after the closing of the transaction.
Managing Risks in Purchase Transaction
Buyers should understand that the risk of successor liability, which is enhanced in distressed transactions, cannot be fully eliminated. With that said, there are steps a buyer can take to mitigate the risk of successor liability, including the following:
acquire the seller’s assets through a newly-formed subsidiary with the goal of insulating the buyer’s other businesses from successor liability claims down the road—while a future claimant may attempt to “pierce the veil” to impose liabilities on the buyer’s parent(s), succeeding on such a claim is typically difficult to do;
perform focused due diligence on areas that involve enhanced risk, such as products liability, environmental conditions, employment/union issues and tax obligations;
work with a qualified insurance broker to review the seller’s insurance policies, claims history, etc., and explore insurance products that may provide coverage for certain risks, such as an environmental liability policy, an intellectual property defense policy or a representation and warranty policy, keeping in mind that insurance only covers unknown liabilities (leaving the buyer to look solely to the seller for satisfaction of any known liabilities);
require the seller to obtain tail coverage under claims-made insurance policies;
consider having a Phase I environmental site assessment (and, if warranted, a Phase II) performed to obtain more certainty with respect to the environmental condition of any owned or leased real estate that is part of the transaction;
if the seller participates in a multiemployer (union) pension plan, (i) be mindful of withdrawal liability, (ii) work with the seller and the pension plan to quantify the amount of withdrawal liability and (iii) either require the seller to satisfy the liability or, if the buyer intends to continue to participate in the union plan following the closing, explore whether the exemption available under ERISA Section 4204 would be appropriate in the context of the transaction;
recognizing that unpaid taxes are an area of heightened risk for successor liability claims, (i) perform searches for tax liens and (ii) if available, obtain tax clearance certificates from relevant state taxing authorities;
in the purchase agreement, (i) clearly identify the purchased assets, the excluded assets, the assumed liabilities and the excluded liabilities and (ii) avoid overly broad, ambiguous or imprecise language that may create confusion post-closing as to the parties’ intent with respect to a particular liability or obligation;
further to the above, include in the purchase agreement a list of specific types of liabilities that are included in the excluded liabilities, as opposed to simply relying on a statement that all pre-closing liabilities are excluded excepting only the assumed liabilities;
work with counsel and other advisors to support and, where possible, preserve the privilege of appraisals, valuations, reports and opinions that may later become a material piece of evidence in litigation;
be prepared to support the price paid for the assets to avoid claims of inadequate consideration, which support may include (i) a fairness opinion or (ii) in the absence of a fairness opinion, some other independent third-party support;
avoid issuing equity to the owners of the seller as part of the transaction to ensure that there is no continuity of ownership (recognizing that for some buyers, especially private equity funds, the benefit associated with requiring the seller’s owners to rollover equity in the transaction may outweigh any related successor-liability risk);
require the seller to (i) remain in existence for a period of time following the closing, and (ii) not distribute a specified portion of the sale proceeds for a period of time post-closing to demonstrate that the parties specifically considered that liabilities could arise following the closing and provided a mechanism to ensure that the seller would be able to satisfy them;
in structuring the transaction, recognize that the closer the identity between the seller and the buyer in terms of ownership, management, employees, location, tradename and customers, the greater the risk that successor liability will be imposed;
draft press releases and other marketing communications understanding that statements in such communications could be used to attempt to support a claim of successor liability; and
recognize that, in many distressed transactions, a contractual right to indemnification is of little value unless it is supported by some form of security—understanding this fact, buyers should prepare for the possibility of successor liability by negotiating a meaningful indemnification package that includes one or more forms of security to ensure a source of funds is available to satisfy post-closing indemnification claims (this security may include escrows, holdbacks, deferred payments, earnouts and set-off rights).
Distressed M&A transactions can present enhanced risk for successor liability claims. Although buyers in those deals cannot completely eliminate successor-liability risk, tailored transaction structuring, focused due diligence, clear drafting in the purchase agreement relating to assumed and excluded liabilities, thoughtful use of available insurance products and a meaningful indemnification package can help mitigate risk and ensure that remedies are available in the event a successor liability claim does arise following the closing.
 Fogg v. Blair, 133 US. 534, 538 (1890). The general rule preventing liability for buyers developed in response to the need to protect bona fide purchasers from unassumed liability in order to maximize the transferability of corporate assets.
 Mason v. Network of Wilmington, Inc., 2005 Del. Ch. LEXIS 99, at 18 (Del. Ch. July 1, 2005) (quoting Corporate Prop. Assocs. 8, L.P. v. Amerisig Graphics, Inc., 1994 Del Ch. LEXIS 45, at 4).
 See, e.g., Minn. Stat. § 302A.661 subd. 4 (providing “[t]he transferee is liable for the debts, obligations, and liabilities of the transferor only to the extent provided in the contract or agreement between the transferee and the transferor or to the extent provided by this chapter or other statutes of this state. A disposition of all or substantially all of a corporation’s property and assets under this section is not considered to be a merger or a de facto merger pursuant to this chapter or otherwise. The transferee shall not be liable solely because it is deemed to be a continuation of the transferor.”). Accord Texas Business Organizations Code § 10.254 (providing that “[a] disposition of all or part of the property of a domestic entity . . . is not a merger . . . for any purpose” and the acquirer “may not be held responsible or liable for a liability or obligation of the transferring domestic entity that is not expressly assumed” except as may otherwise be provided by another statute).
 Elmer v. Tenneco Resins, Inc., 698 F. Supp. 535, 542 (D. Del. 1988) (quoting Fountain v. Colonial Chevrolet Co., 1988 Del. Super. LEXIS 126, at 24).
 Patin v. Thoroughbred Power Boats, 294 F.3d 640, 650 (5th Cir. 2002).
 Ray v. Alad, 550 P.2d 3 (Cal. 1977).
 Id. at 9.