How to Avoid Seller Liabilities When Buying a Business

When buying and selling businesses (this is generally called “mergers & acquisitions” or, just “M&A”), there are three ways to structure a deal –

  1. The buyer can purchase the assets of the seller
  2. The buyer can purchase the stock (or other equity interests) of the seller directly from the owners, orz
  3. The buyer and the seller can merger themselves together through a process called a statutory merger, which entails making a filing with the Secretary of State

Most businesses sold in the areas in Texas I practice (I represent buyers and sellers of business as their lawyer) are structured as asset sales. I am talking about main street businesses (sales less than $2 million) and lower middle market businesses (less than $10 million). While not common in smaller deals, I see mergers more often with M&A transactions involving large companies, including public companies.

The General Rule Regarding Asset Purchases and Seller Liabilities

One reason (there are many others) that buyers prefer to purchase the assets of the selling business, rather than the stock or other equity interests held by the owners, is to avoid assuming liabilities of the business being sold. Most buyers prefer to cherry pick the assets of the business and leave behind the liabilities.

The purchaser of a business may be willing to accept some liabilities of the seller. For example, a buyer of a business might be taking on the employees of the seller after closing and be willing to pick up the accrued vacation of those employees. Or, a buyer may be willing to pay the accounts payable of the seller in order to maintain good relationships with the vendors it wants to use after the closing.

However, when it comes to other liabilities, such as litigation, most buyers prefer to avoid taking them on. Generally speaking, structuring an M&A transaction as an asset purchase gives the buyer the flexibility to avoid assuming unwanted liabilities. The reason is because the buyer just picks and chooses the assets and liabilities it wants to acquire. In a stock purchase, on the other hand, the buyer steps into the shoes of the selling owners and takes over the company as-is.

Buyers of Business Can’t Always Choose to Avoid Assuming Liabilities

However, as with most areas of the law, there are exceptions to the general rule that asset purchase transactions can be used to avoid assuming liabilities. There are certain circumstances where a buyer will be responsible for certain liabilities of the selling company despite structuring the deal as an asset purchase and despite specifically excluding those liabilities from the deal. This area of the law is called “successor liability” because the buyer, as successor to the seller with respect to the acquired assets, is held liable for certain obligations of the seller by law. It is also sometimes called “transferee liability.”

Until the 1970s, successor liability was not a major concern to M&A players. Courts almost always respected the allocation of liabilities set out in the asset purchase agreement. But since then, courts have developed several new theories of successor liability in order to hold a buyer liable for the liabilities and obligations of sellers.

Most court cases expanding the scope of successor liability arose in a few specific contexts where it simply seemed unfair that the owners of a selling company profited from the sale of assets and walked away from certain liabilities. The courts wouldn’t get too worked about some accounts payable of the seller if those were not paid. However, in the case of product injuries, environmental liabilities and shortfalls in retirement and pension funds, courts got creative and came up with ways to ensure someone somewhere remained on the hook to settle up those type of liabilities.

The Product Line Exception

In the late 1970s, the California courts created the product line exception to successor liability. This carve out to the general rule applies to product injury lawsuits.

The product line exception imposes successor liability on a buyer of a business for pre-closing product liability claims against the purchased business in the event that the following things are true:

  • The plaintiff’s recourse against the seller was frustrated by the buyer’s acquisition of the dissolved seller’s business
  • It is fair to require the buyer to assume responsibility of these liabilities because the buyer acquired the goodwill of the seller, and
  • The buyer continues to manufacture and sell the same products that the seller sold (later California courts have ruled this is not a critical requirement).

De Facto Mergers

Some courts have imposed successor liability on buyers of business assets under a theory known as de facto merger. As the name “de facto merger” suggests, courts determine that in certain cases, the asset purchase is for all intents and purposes a merger. Mergers, like stock purchases, transfer all the liabilities of the seller to the new buyer because the assets and liabilities aren’t actually touched, only the ownership of the company is affected. Courts usually make this determination when the transaction appears to be motivated by a desire to avoid liabilities.

In making a de facto merger determination, courts generally look at a few factors. First, there must be a continuation of the selling company operation, with continuity of management, personnel, physical location and general business operations. Second, there must be some continuity of shareholders, partners, members or other owners. Originally, the de facto merger doctrine required that the selling company shareholders become shareholders of the buyer after the transaction was closed. Third, the selling company must cease its business operations and dissolve. And fourth, the buyer must assume the selling company’s normal obligations necessary for continuing operation of the business.

In recent decades, courts in some jurisdictions have relaxed some of these elements and applied the de facto merger doctrine to impose successor liability without requiring, for example, continuity of shareholder ownership interests or immediate dissolution of the selling entity.

To avoid falling prey to the de facto merger doctrine, a buyer should confirm the asset purchase agreement is carefully drafted to specify exactly which liabilities of the selling business are being assumed by the buyer and which ones are not. Broad language to the effect that the buyer is purchasing the entire business of the selling company raise the risk of this issue. That said, there are reasons (in Texas, at least) that a buyer should make it clear that they are acquiring all of the assets of the selling company, so navigating this issue can be challenging and is an area where your legal counsel can add value.

To avoid falling prey to the de facto merger doctrine, a buyer should confirm the asset purchase agreement is carefully drafted to specify exactly which liabilities of the selling business are being assumed by the buyer and which ones are not. The parties should avoid broad language to the effect that the buyer is purchasing the entire business of the selling company, instead stating that the buyer is purchasing only certain specified assets of seller.

I realize that business considerations generally drive how buyers and sellers structure M&A deals. However, to the extent possible and solely for purposes of considering the de facto merger implications, it’s preferable that the buyer pay in cash rather than its stock, change the names of the products it sells (i.e., makes efforts to show changes to the selling business), and make as many other changes to the management of the business (both the people and the business methods) as possible.

How significant an issue this is to a buyer will depend, to a large degree, on the state law that applies to the deal. As I mentioned earlier, most of my M&A practice is representing buyers and sellers of businesses in Texas. If you are buying or selling a business in Texas, you don’t need to worry about the de facto merger doctrine. Courts don’t recognize it. Sometimes they impose successor liability in a way that looks like de facto merger, although it’s because there is evidence of fraud in the deal (we will talk about fraud later on in this article). It’s more or less the same situation in Delaware, another state where I am licensed. On the other hand, last I checked, the de facto merger doctrine was alive and well in Massachusetts.

Bulk Sales

Successor liability also shows up in the case of bulk sales. A bulk sale is the sale of most of the assets of a business outside the ordinary course of business. Most bulk sales acts apply only to a seller whose principal business is the sale of inventory from stock, including those who manufacture what they sell. Service businesses are not subject to the bulk sales act. Neither are software as a service companies and other companies that don’t sell products out of inventory in the way that a retail store does.

The bulk sales law is contained in the Uniform Commercial Code, which has been adopted by all states (although only partially in Louisiana). Nevertheless, many states have now repealed their bulk sales laws for the simple reason that the bulk sales law doesn’t do all that much to protect creditors.

The purpose of the bulk sales law where it survives is to reduce the likelihood that the owner of a business will sell all or most of the assets of a business and then disappear with the money, leaving unpaid creditors holding the bag. In most cases, creditors must be given notice of a bulk sale transaction. If the buyer doesn’t comply with the bulk sales law, the buyer will be liable to the seller’s creditors to pay the seller’s debts.

Of course, a buyer who gets stuck paying the seller’s debts when that is not part of the deal is likely entitled to be reimbursed by the seller per the terms of the asset purchase agreement. But, if the seller’s creditors haven’t been paid by the seller, the likelihood is fairly high that the seller is not going to pay the buyer either. So, buyers should comply with bulk sale laws when they are applicable.

Product Liability

Some courts have created a duty imposed on a buyer of the assets of a business to warn customers of defects in the seller’s products. This is a little different than the product line exception discussed earlier. In general, this doctrine has two prongs. First, the buyer must know about the defects in the seller’s products, and second, there must be some continuing relationship between the buyer and the customers of the selling business, e.g., an obligation to service the products manufactured or sold by the seller. Buyers often purchase the goodwill of the seller. In some cases, the purchase of goodwill may be deemed to include an obligation to assume liability for unforeseen product liability claims that arose before the closing of the deal.

Implied Assumption of Liabilities

Another theory of successor liability is called “implied assumption.” Implied assumption primarily arises due to sloppy contract drafting or an alleged ambiguity in the asset purchase agreement. Using this approach, a court may decide that a buyer implicitly assumed certain pre-closing liabilities of a selling business by agreeing to assume all its liabilities in the asset purchase agreement, even if the liabilities were unforeseen by the parties at the time of the sale.

Liabilities Involving Fraud

Courts have always held that transactions entered into for the purpose of avoiding liability may not be used by the parties to dodge their legal responsibilities. This means that buyers and sellers of businesses are not allowed to structure a deal solely to avoid liabilities. In order to prove fraud, a creditor will need to demonstrate fraudulent intent. One common attribute of fraud causes is a lack of appropriate consideration, i.e., the purchase price is unreasonably low.

Successor Tax Liability

Another area of successor liability that buyers should guard against is in the case of certain taxes. In California, for example, a buyer of the assets of a business can be liable for unpaid sales and use taxes, employment taxes and franchise taxes. While California is particularly aggressive on this issue, it is not the only state to get aggressive on finding someone to settle its tax bills. Illinois and Pennsylvania, for example, both have statutes that make asset buyers liable for the income tax of sellers under certain circumstances. These state tax liability examples are the exception, not the rule, although be on guard for it.

Environmental and Retirement Liabilities

Some courts have imposed successor liability based on the broad language in certain statutes. Two such statutes include the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA”) and the Employee Retirement Income Security Act of 1974 (“ERISA”). CERCLA involves environmental cleanup, while ERISA generally shows up in the case of underfunded pensions and retirement plans. While these are both federal statutes, some states have imposed successor liability on buyers of businesses in similar contexts.

Tips for Avoiding the Unwitting Assumption of Seller Liabilities

To avoid or minimize the potential of successor liability in asset purchase transactions, the buyer and its advisors should carefully conduct due diligence regarding the selling company’s business operations. Buyers should keep in mind that just because a particular state court has not adopted a specific theory of successor liability doesn’t mean they won’t. Courts can be creative when they are sympathetic to a plaintiff that has no other remedies available.

Buyers should consider including additional protections in the asset purchase agreement when the context warrants it. Besides fulsome representations and warranties from the seller, a buyer might consider requiring the seller to escrow a portion of the purchase price for a number of years as security for successor liability risks. Strong contractual language is great, although it’s only as good as the company or person that signs off on the language. In the case of a sale of a small main street business, it’s not unheard of for sellers to disappear into retirement or simply not later have the money to back up the things they represented in the asset purchase agreement.

There are also insurance products available for seller liabilities that arise after closing, although for smaller deals insurance may not be practical in that the underwriter may be challenged to form an intelligent opinion on the risk the transaction presents and/or require a disproportionately high premium for the risk.

The asset purchase agreement should be carefully drafted to specify exactly which liabilities of the selling business are and are not being assumed by the buyer. Broadly based assumption language in an asset purchase agreement may give a court an opportunity to find in favor of a sympathetic plaintiff by using the implied assumption theory. To the extent possible, it is advisable to avoid including language in the asset purchase agreement to the effect that the buyer is purchasing the entire business of the seller, stating instead that the buyer is purchasing only certain specified assets and assuming only certain specified liabilities.

Nothing is ever 100% in the law, although successor liability is an area that buyers of businesses can manage and control to the point where they feel confident that there will not be any unwelcome liability surprises.

What Next

If you are thinking about buying a business, exploring new markets or expanding your product lines give me a call at 512.888.9860. I help clients all over, including Texas and Delaware, the hub of US corporate law and take an active role in every step of the M&A process- everything from preparation to due diligence to closing.

 

Author: Brett Cenkus

Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.

2019-08-22T14:26:19-06:00