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Successor Liability - Collision of Tort and Corporate Law
Monica Williams January 15, 2008 — 3,042 views
What new liabilities will my company face now? This question can haunt buyers of new businesses and keep them up nights. Understanding the legal theory of successor liability may help answer this question.
Successor liability is the legal theory behind imposition of liability upon a purchaser of stock or assets. Clearly, the buyer of an entire company, i.e. through a stock purchase and merger, assumes the former company’s liabilities, known and unknown. It is not always immediately clear but a buyer of assets can be saddled with the liabilities of the former company as well. States have various formulations to measure, define, and determine when an asset purchase becomes enough like a stock purchase to justify imposing liability. Successor liability is ultimately the collision of corporate law and tort law.
Corporate law involves contracts. Liability under tort law does not arise out of contract. A tort arises when there is an injury due to a breach of a duty imposed by the law. Products liability is probably the most familiar example.
The buyer in a stock purchase has several lines of defense to limit and manage liability: due diligence, contract drafting, escrowed funds and insurance.
By the time of closing, the purchaser should have completed due diligence and be aware of not only basic contractual liabilities but also existing or pending litigation. Identifying existing contracts and termination penalties is an important part of due diligence. Due diligence should uncover existing litigation against the seller as well as pending litigation and administrative actions.
Purchase agreements can include a seller warranty there is no existing or pending litigation or administrative actions exist against the company (except those listed on an attached exhibit). Other clauses regarding cooperation in litigation matters, availability for depositions and of transfer of records can also be included. From a financial perspective, an evaluation of future litigation costs and expected outcome should be sought from an outside attorney—not seller’s company counsel. Determining how to account for the seller’s set-asides for litigation is another piece. The nature of the business will influence the decision. Manufacturers open to product liability claims need special attention to litigation history-- which should be provided by seller. A look at the company’s litigation history may reveal a large number of harassment or discrimination suits, environmental actions, or regulatory incidents. Knowledge of any pending state tort reform will be helpful in decision making.
Various financial techniques exist to deal with anticipated litigation costs. Two are price adjustment and an escrow account with a mechanism to reflect litigation costs. Buyers should examine seller’s insurance policies very carefully to determine whether insurance coverage will exist for occurrences prior to sale and review current state law on commercial insurance.
A buyer may seek to protect itself from liability by purchasing only assets. This method is not foolproof. An attorney experienced in this area of business law should be consulted.
The general rule of successor liability followed in Ohio and many states provides that the purchaser of a corporation's assets is not liable for the debts and obligations, including liability for tortious conduct, of the seller corporation. However, there are exceptions. Four of them. Three of the four exceptions to this general rule impose liability without regard to contract. A successor corporation may be held liable when:
(1) the buyer expressly or impliedly agrees to assume such liability;
(2) the transaction amounts to a de facto consolidation or merger;
(3) the buyer corporation is merely a continuation of the seller corporation; or
(4) the transaction is entered into fraudulently for the purpose of escaping liability.
A de facto merger is the common-law method of imposing successor liability even when there has not been an official declaration of a merger. The hallmarks of a de facto merger include:
(1) the continuation of the previous business activity and corporate personnel,
(2) a continuity of shareholders resulting from the sale of assets in exchange for stock,
(3) the immediate or rapid dissolution of the predecessor corporation, and
(4) the assumption by the purchasing corporation of all liabilities and obligations ordinarily necessary to continue the predecessor’s business operations.
There is another approach to successor liability relating to product liability called the product line-rule of successor liability. California and Washington follow this approach. Under this theory, a purchaser of substantially all assets of a company assumes, with some limitations, the obligation for product liability claims arising from the selling firm’s presale activities. Liability is transferred irrespective of any clauses to the contrary in the asset purchase agreement.
Moreover, the buyer should be aware that some statutes impose liability on successor corporations without regard to contract. One of the most important of these is the federal environmental law, known as CERCLA, the Comprehensive Environmental Response, Compensation, and Liability Act. So if a purchase of real estate is contemplated, at least a Phase One environmental audit is necessary. Remediation and a more detailed Phase Two audit may ultimately be required.
Besides environmental liability, buyers may unwittingly assume liability in other areas of state law. For example, there may be issues regarding buyer’s liability for workers compensation claims of the selling company. State workers compensation laws may define “merger” broadly to include asset purchases for purposes of ensuring continued coverage for workers. In the area of commercial insurance, whether transferring insurance coverage for indemnification can be transferred and whether insurance defense can be required by operation of law are hotly litigated topics.
Monica Williams is principal in Monica B. Williams Co. LPA, a firm focusing on business transactions for privately held companies. She works with business owners who want to avoid the legal potholes involved in buying/selling a business. Her experience ranges from a $100,000 sale of a steel service company's assets to a $44M acquisition of a tool manufacturer. She advises on legal aspects of company restructurings, mergers and acquisitions and works with tax and accounting professionals to structure transactions to protect and benefit clients.