Written by Craig Billings Miller an associate practicing in the areas of business formations, early stage financing and business transactions.
Buyer Beware: Recent Developments in Successor Liability
For clients of the practicing mergers and acquisitions attorney, one of the central concerns in any deal, whether a small sale or a multimillion dollar merger, is what is my liability exposure post-closing?
Structuring a deal as a purchase of assets, rather than stock, is one of the best tools a buyer has in limiting post-closing liability. However, a recent decision in the United States Court of Appeals for the Seventh Circuit should have attorneys’ and buyers’ attention focused on issues requiring examination and consideration during the due diligence process with respect to successor liability exposure for any asset deal.
In Teed v. Thomas & Betts Power Solutions, LLC, 711 F.3d 763 (7th Cir. 2013), the Seventh Circuit found the purchaser in an asset purchase from a receivership auction in Wisconsin was liable for violations of the Fair Labor Standards Act (“FSLA”) occurring during the period when asset seller owned and operated the business acquired. The court imposed successor liability even though a condition of the transfer of the assets from the receiver to the purchaser was that the transfer be “free and clear of all liabilities” and the more specific condition that the purchaser would not assume any liabilities that the seller might incur under the FSLA. Despite the language in the purchase agreement, which the Teed court conceded under Wisconsin state law would have cut off successor liability, because the claims involved violations of federal labor relations or employment law, a broader federal common law standard for determining successor liability claims was applied.
Under federal law as articulated by the Seventh Circuit, the following five factors are examined in determining whether successor liability will be imposed for acts occurring during the ownership of the predecessor:
(1) Whether the successor had notice of the pending lawsuit.
(2) Whether the predecessor would have been able to provide the relief sought in the lawsuit before the sale.
(3) Whether the predecessor could have provided relief after the sale.
(4) Whether the successor can provide the relief sought in the suit.
(5) Whether there is continuity between the operations and work force of the predecessor and the successor.
Although the result of the Teed case may seem harsh at first blush, when examining the facts of the case against the federal common law standard, it becomes clearer why the court found successor liability against the purchaser. First, the purchaser had notice of the pending lawsuit at the time of purchase. Second, the predecessor would not have been able to provide the relief sought in the lawsuit before the sale because it was insolvent and had defaulted on a bank loan (causing the sale of its assets by the receiver in the first place). The court viewed the predecessor’s insolvency as a factor counting against successor liability, as imposition of such liability would result in a “windfall” for the plaintiff. Third, the predecessor could not have provided relief after the sale as all of the proceeds of sale (along with its remaining assets) went to the bank whose loan it had defaulted on payment. Fourth, the purchaser could provide the relief sought in the suit (the court calls this the “goes without saying” condition). And fifth, there was continuity between the operations and work force of the predecessor and the successor, as the court stated that nothing had really changed in the operations of the business. Even though not all of the factors pointed towards imposition of successor liability, the Seventh Circuit found that successor liability in the Teed case should be imposed given the facts and circumstances of the case.
The Seventh Circuit noted that the idea behind having a distinct federal standard applicable to federal labor and employment statutes is that the statutes “foster labor peace” or “protect workers’ rights” and that the imposition of successor liability is a needed method of achieving the statute’s goals. The court cites an example that without the threat of successor liability, there would be nothing workers could do to head off a corporate sale by the employer aimed at extinguishing that employer’s liability to them for violations of the federal statutes.
Given this articulation of the federal standard by the Seventh Circuit, what should counsel look for during the due diligence period?
First, the party responsible for diligence in any potential deal needs to closely examine these areas of federal labor relations and employment laws for potential claims and what relevant statutes may be applicable. While not exhaustive, the Seventh Circuit cited the Labor Management Relations Act, the National Labor Relations Act, ERISA, Age Discrimination in Employment Act, Family and Medical Leave Act and 42 U.S.C. §1981 (racial discrimination in contracting) as areas where the more favorable federal common law standard is applied in determining whether to impose successor liability. Many of the above cited acts have different thresholds of employee before they are applicable. The reviewing attorney needs to be familiar, or work with another attorney or person familiar with, the applications of these laws in analyzing potential risks.
Second, if a potential issue exists, it is wise to require a holdback of a portion of the purchase price which should satisfy any claim made and/or include indemnification language in the purchase contract. If a potential buyer finds itself in a position similar to the purchaser in Teed, where it is bidding on assets in bankruptcy or a receivership auction, all known outstanding claims exposure should be considered when determining the purchase price of the assets.
In conclusion, the Teed case should be in the back of every attorney’s mind when analyzing potential liabilities that a client may face when acquiring a business, and when issues arise in diligence involving federal labor and employment statutes, the attorney and client should not simply rely upon disclaiming liabilities of the seller in a purchase agreement to protect them from successor liability.