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8:00pm EDT July 26, 2009

One of the most significant reasons for structuring an acquisition as an asset transaction is to clearly outline the liabilities the buyer will assume after closing. Under theories of successor liability, however, the buyer may be found to have assumed liabilities not expressly agreed to by the parties. The buyer can reduce the chances that it will acquire unanticipated liabilities in its asset acquisition by appropriately structuring the acquisition transaction and definitive acquisition agreement.

Smart Business learned from Louis A. Wharton, Esq., senior counsel at Stubbs Alderton & Markiles, LLP, about what companies need to know to reduce the risk of liability during an acquisition.

What is successor liability?

Successor liability generally describes the result of a court’s application of various legal theories to an acquisition transaction to hold the buyer responsible for liabilities the buyer did not explicitly agree to assume. Two of the significant theories of successor liability include the de facto merger doctrine and the continuity of enterprise doctrine.

The de facto merger doctrine holds the buyer responsible for liabilities not expressly assumed under the theory that the result of the acquisition is essentially a merger of the buyer and the seller. The elements of a de facto merger are 1) continuity of management, personnel, physical location, assets and general business operations, 2) continuity of shareholders, 3) cessation of the seller’s ordinary business operations and its dissolution as soon as legally possible and 4) the buyer’s assumption of the seller’s obligations ordinarily necessary for the uninterrupted continuation of the seller’s normal business operation.

The continuity of enterprise doctrine does not require proof of the continuity of shareholders. Instead, this doctrine holds the buyer responsible for liabilities the buyer did not explicitly agree to assume under the theory that the buyer has essentially continued the seller’s business. The elements of a continuity of enterprise finding are 1) continuity of the outward appearance of the seller’s enterprise, management, personnel, physical plant, assets and general business operations, 2) the seller’s prompt dissolution following the transfer of assets and 3) the buyer’s assumption of the seller’s liabilities and obligations ordinarily necessary for the uninterrupted continuation of the seller’s normal business operations.

Some courts have also found buyers strictly liable for defects in products previously manufactured and distributed by sellers under a variation of the continuity of enterprise doctrine that, in essence, holds that responsibility for such liabilities was the price the buyer had to pay for the seller’s good will and the buyer’s ability to enjoy the fruits of that good will.

What structural steps can the buyer take to minimize the likelihood of a successor liability finding?

The buyer should obtain guidance regarding the development and treatment of theories of successor liability under the laws of jurisdictions that could potentially govern the acquisition transaction to select a reasonable jurisdiction with less expansive successor liability doctrines. The buyer should also analyze and implement potential acquisition structures with the aim of avoiding elements that contribute to a successor liability finding. The buyer may, for example, significantly reduce or eliminate common personnel and business locations since continuity of the seller’s business into the buyer’s period of ownership is a common theme in current successor liability doctrines. In addition, the buyer could require the seller to delay liquidation proceedings for a reasonable period of time to avoid a finding of prompt dissolution. While business considerations will significantly impact the acquisition structure and the integration of the acquired assets into the buyer’s operations, the buyer should remain mindful of structural components under the buyer’s control that can minimize a successor liability finding.

What contractual provisions can the buyer include to reduce the risk of successor liability?

The buyer should negotiate for an unambiguous listing of the liabilities the buyer is acquiring through the inclusion of clauses in the acquisition agreement specifically setting forth the liabilities assumed by the buyer (i.e. at the closing, the buyer shall assume and agree to discharge only those liabilities of the seller set forth on Schedule 1) and clauses explicitly providing that liabilities not assumed by the buyer are retained by the seller (i.e. every liability of the seller not assumed by the buyer shall remain the sole responsibility of and shall be retained, paid, performed and discharged solely by the seller). The terms of the acquisition agreement should clearly state that unexpected liabilities are the seller’s responsibility.

In addition, the buyer should seek to incorporate provisions in the acquisition agreement requiring the seller to comprehensively indemnify the buyer for unexpected liabilities, including liabilities accruing to the buyer as a result of a finding of successor liability (i.e. the seller will indemnify and hold harmless the buyer for any loss, liability, claim, damage or expense, whether or not involving a third party, arising from or in connection with any liability arising out of the ownership or operation of the acquired assets prior to the closing other than the assumed liabilities). The buyer should also consider including an arrangement whereby the parties will place a portion of the acquisition consideration in escrow to meaningfully support the seller’s indemnification obligations.

The buyer should consult with appropriate counsel on a case-by-case basis regarding additional and/or alternative contractual provisions to include in the acquisition agreement to further reduce the risk of successor liability.

Louis A. Wharton, Esq., is a senior counsel at Stubbs Alderton & Markiles, LLP. Reach him at lwharton@biztechlaw.com or (818) 444-4509.