Acumen Law Group, LLC

The Illinois Credit Agreements Act: A Lender’s Best Defense, A Debtor’s Greatest Obstacle

In Illinois, if any aspect of an agreement is deemed to be a “credit agreement” under the Illinois Credit Agreements Act, 815 ILCS 160/1 et seq. , and if the credit agreement is not a writing signed by both parties, then debtors may be barred from asserting certain claims, counterclaims, and defenses against the lender.  Klem v. First National Bank of Chicago, 275 Ill. App.3d 64 (1995).  A credit agreement is defined as any agreement by a creditor to lend money, extend credit, or forbear repayment for commercial purposes.  Under the Act, credit agreements, or amendments thereof, are unenforceable  unless both parties sign the agreement or amendment.  In this regard, the Act has a particularly harsh effect on debtors trying to sue lenders for deceptive  statements or conduct made in relation to a credit agreement.  The Act expressly precludes debtors from asserting claims/defenses like fraud, part performance, and equitable estoppel based on a lender’s oral statements or conduct.

When Does the Act Apply?

The Act applies to any commercial credit agreement or other non-credit agreement that is an integral part of a commercial credit agreement, e.g., a guaranty.  The Act’s requirements can be characterized as a much stricter incarnation of the common law statute of frauds, as the Act requires a writing signed by both parties in order for a credit agreement to be  enforceable.  This requirement not only applies to the initial credit agreement but also extends to any modifications and amendments of such agreement.  Even if only a portion of an agreement involves a credit agreement, the Act still applies.   The application of this Act by Illinois courts provide commercial lenders with significant protection, while leaving debtors vulnerable to unscrupulous lender conduct.  So what does this mean?

Scenario 1: Oral Statements

Let’s assume there is an existing loan agreement between a lender and a debtor, and before the agreement matures, the lender orally agrees to extend it for another two years over the phone.  The lender even sends the debtor an email summarizing the terms of the oral promise.  As a debtor, should you rely on this oral promise?  The answer is no.  The promise has to be in writing and signed by both lender and debtor to be enforceable.   Otherwise, the lender can change its mind and demand that the debtor pay the full amount on the original maturity date.  In this scenario, the debtor would have no recourse against the lender because of the Act.

Scenario 2: Reliance on Oral Statements

Now let’s assume that a lender induces a debtor to execute a $1 million promissory note, payable to the lender.  The lender orally promises that the debtor’s liability on the note will be extinguished upon the lender’s investment in the debtor’s company, which the lender promises it will make.  Relying on this promise, the debtor also invests his own $1 million in the company.  The lender later decides not to invest in the company and demands payment on the promissory note.  Can the debtor claim fraud by the lender?  Breach of contract?  Promissory estoppel?  No, no and no.  Fortunately for the lender, and unfortunately for the debtor, all of these claims/defenses are barred because they relate to a un-memorialized and un-signed credit  agreement, leaving the debtor personally liable to the lender for $1 million.

In Conclusion

If you are a debtor, before entering into any commercial loan or credit agreement, ensure that the agreement is in writing and signed by both you and the lender.  Any amendments or modifications to the agreement — however minor — also must be in writing and signed by both parties.  If in doubt as to whether the agreement is a “credit agreement” under the Act, put it in writing and have both parties sign it.  If you don’t, you risk being denied certain legal protections against the lender.

Conversely, if you are  a lender, ensure that your credit agreements contain a choice of law and venue selection provision mandating that disputes be litigated under Illinois law  in Illinois courts.  Lenders should take advantage of the broad protections afforded under the Act.

If you have any questions regarding commercial loans or credit agreements, please call one of our experienced attorneys at Acumen Law Group.

Authored by Bardia Fard, Esq. and Shoko Asaka, Law Clerk

Keeping Trade Secrets Secret

According to a recent survey conducted by Symantec Corporation (2009), 59% of individuals who were laid off, fired, or quit their jobs admitted to misappropriating company data.  Of those individuals who misappropriated data, a staggering 67% used the data to leverage a new job.  In a time where information can be a company’s most valuable asset, the misappropriation of information by rogue employees poses a very real and significant threat.  While there is no cure-all to prevent information theft, a company can decrease the risk of misappropriation by implementing trade secret policies and procedures.

Trade Secrets?

Generally, a trade secret is any information that makes a company money by virtue of not being publicly know.  Because a trade secret is a legally-recognized asset, one can sue for misappropriation of that asset under a number of common law theories.   In Illinois, a trade secret is entitled to further protections  if it meets the requirements of the Illinois Trade Secrets Act (“ITSA”).  Under ITSA, a trade secret must be:

information, including but not limited to, technical or non-technical data, a formula, pattern, compilation, program, device, method, technique, drawing, process, financial data, or list of actual or potential customers or suppliers, that: (1) is sufficiently secret to derive economic value, actual or potential, from not being generally known to other persons who can obtain economic value from its disclosure or use; and (2) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy or confidentiality.

In deciding whether information is entitled to protection under ITSA, Illinois courts additionally consider: (i) the extent of measures taken to guard the secrecy of information;  (ii) the extent to which the information is known outside of the company’s business; (iii) the extent to which the information is known by employees and others involved in the company’s business;  (iv) the value of the information to the company’s business and to its competitors; (v) the effort and money expended in developing the information, and (vi) the ease or difficulty with which the information could be properly acquired or duplicated by others.  See Liebert Corp. v. Mazur, 357 Ill.App.3d 265 (1st Dist. 2005).

There are a number of benefits to trade secret protection under ITSA.  One such benefit is the ease of obtaining injunctive relief to prevent actual or threatened misappropriation of information.  Additionally, ITSA allows for an award of damages measured in terms of reasonable royalty for the unauthorized disclosure/use of a trade secret.  Such an award is significant if one cannot demonstrate actual damages or unjust enrichment resulting from the misappropriation.  Finally, unlike other forms of IP protection, like patents, trade secrets remain protectable indefinitely, e.g., Coca-Cola’s secret formula.

How to Protect Trade Secrets

Regardless of whether a trade secret qualifies for the extra protection of ITSA, there are a number of measures a company can employ to generally help protect its trade secrets.  These measures include:

  • Written confidentiality policy — at minimum, the policy should: (i) define exactly what information is confidential, (ii) state that all confidential information is the company’s property, (iii) provide a procedure for returning any confidential information at employee’s termination, and (iv) require an employee signature acknowledging the receipt of confidentiality policy and acceptance of its terms.
  • Limited access to physical and electronic confidential information — any given employee should only have access to the information needed to perform his duties (e.g. one’s secretary, salesperson, and financial manager each work with different sets of information, and do not necessarily need access to all the company’s confidential information). For physical information, use locks, security codes, “confidential information” labels, etc.  For electronic information, use passwords on computers and specific files, limited networks, etc.
  • Post-employment restrictive covenant — separate agreement for key employees to sign at termination.  The signed agreement should acknowledge that (i) employee returned all confidential information to company upon termination, and (ii) employee has a continuing obligation to keep trade secrets confidential.
  • Preservation of employee’s computer activity in months leading up to termination — this includes emails, files on the hard drive, etc.

In Conclusion

Trade secrets are only valuable so long as they remain secret.  While laws like ITSA provide trade secret owners with a certain degree of protection, they can not undue damage that has already been done.  For this reason, it is extremely important to take preventative measures to protect one’s trade secrets.

If you have any questions regarding the protection of trade secrets, please call one of our experienced attorneys at Acumen Law Group.

Authored by Dominika Szreder Fard, Esq.

Contracts by Email: Writer Beware

Important business transactions are regularly decided and agreed upon via email these days.   Email is instantaneous, easy, (mostly) secure, and with the proliferation of smart phones, allows big decisions to be made as quickly as one can type on her Blackberry.  Despite the obvious advantages of  email in business, there is a very real danger of inadvertently binding oneself to a contract through informal email exchanges.  If an email or chain of emails contains an offer of a deal by one party, and the other party responds by email accepting the deal, then there’s a good chance that a contract has been formed, despite the fact that no signatures are exchanged (and even if one party had no intention of entering into a contract in the first place).

A Cautionary Tale from New York

A court in New York recently recognized that a series of emails exchanged between two parties constituted a valid modification to one party’s existing employment agreement.  Stevens v. Publicis, S.A., et al., 50 A.D. 3d. 253, 854 N.Y.S. 2d 690 (N.Y.A.D. 1 Dept. 2008).  Specifically, one of the emails exchanged between the parties included a detailed proposal of employment duties, and it was followed by an email from the other party accepting the proposal.  Stevens, 50 A.D. 3d 253.   The court found that the parties had agreed “in writing” to modify one of the parties’ duties under the employment agreement, and the emails were “signed writings” because they included the parties’ names and signature blocks at the end of their emails.  The court reasoned that the parties’ names signified an intent to authenticate the contents and satisfied the requirement of the employment agreement that any modification be signed by all parties.

Another Case In Massachusetts

In another case, the court  bound two parties to settlement terms that were exchanged via email by the parties’ respective attorneys.  The first email, written by one party’s attorney, summarized the settlement terms.  This email was followed by a one-word reply from the opposing attorney stating  that the terms were “correct.” Here, the court ruled that the emails constituted a sufficiently complete and unambiguous statement as to the terms of the settlement agreement, and that both parties intended to be bound by that communication of settlement terms.  Basis Technology Corp. v. Amazon.com Inc., 71 Mass App. Ct. 29, 878 N.E.2d 952 (Mass. App. Ct. 2008).

Takeaway

As these two cases demonstrate, although email may be an informal means of communication, the substance of emails is subject to the same level of scrutiny as signed writings.  As such, it is very important to be particularly cautious when discussing a possible business deal in an email.  At bottom, if all you intend is to negotiate issues leading up to a formal written and signed contract, make sure you clearly state that in your emails.

If you have any questions regarding the formation or enforcement of contracts, please call one of our experienced attorneys at Acumen Law Group.

Authored by Dominika Szreder Fard, Esq. and Shoko Asaka, Law Clerk

The Low-Profit LLC: A New Entity in Illinois

On January 1, 2010, Illinois will become one of only 5 states to recognize the low-profit limited liability company (“L3C”).  The L3C is a variation of the familiar limited liability company (“LLC”), and is only available to for-profit entities whose primary goal is to achieve a socially beneficial objective.  Put differently, profits must be a secondary goal of the entity.  This entity form aims to make it easier for social enterprises to attract capital.  Currently, an L3C can only be formed in the states of Michigan, Vermont, Wyoming, and Utah.

The L3C shares many characteristics with a typical LLC – it is a for-profit entity; offers a flexible ownership structure; is treated like an LLC for tax purposes, rather than a not-for-profit entity; and its members enjoy limited liability.  Unlike an LLC, however, the primary purpose of the L3C must be to achieve a socially beneficial objective.  In order for an entity to qualify as a L3C, it must (i) significantly further the accomplishment of one or more charitable or educational purposes, and would not have been formed but for its relationship to the accomplishment of such purpose(s); (ii) not have as a significant purpose the production of income or the appreciation of property (though the company is permitted to earn a profit); and (iii) must not be organized to accomplish any political or legislative purposes.

One of the advantages of the L3C is that it embodies the operating efficiencies of a for-profit entity, while remaining unburdened by the many not-for-profit entity regulations.  This structure also provides the entity with a better chance at recovering its principal investment and potentially realizing a capital gain which, in turn, can be plowed back into the entities’ charitable or educational endeavors.

If you have any questions regarding the Illinois low-profit limited liability company, please call one of our experienced attorneys at Acumen Law Group.

Authored by Dominika Szreder Fard, Esq. and Shoko Asaka

Illinois Home Repair and Remodeling Act: A Cautionary Tale for Contractors

The Illinois Home Repair and Remodeling Act, 815 ILCS 513, is a statute obligating residential contractors to (i) have a written contract, (ii) include certain terms in the contract, such as price, insurance, and dispute resolution, (iii) provide the homeowner with a brochure informing them of certain rights, and (iv) obtain a receipt for giving the brochure.   Recent appellate court decisions involving the Act reveal an inconsistent landscape with respect to a contractor’s ability to recover monies owed where the Contractor fails to comply with the Act’s strictures.  Ultimately, the issue of whether a contractor can recover its fees from a homeowner  may depend on  which judicial district the issue is litigated in.  A map of the various judicial districts may be viewed here.

Fourth District

In 2007, the fourth district in Smith v. Bogard held that a contractor’s failure to comply with the Act is an absolute bar from recovery, i.e., prevents him from recovering any payment including mechanics liens, breach of contract claims, unjust enrichment claims and the like.

First District

In the first district, the court in K. Miller Construction Company, Inc. v. McGinnis provided that a contractor’s failure to comply with the Act still prevents the payment recovery based on a mechanic’s lien claim and breach of contract claim; however, the contractor may recover payment based on a claim for quantum meruit (unjust enrichment, which provides that even if there wasn’t a contract, the owner benefited from the work and should have to pay for that work).

Second District

In a decision subsequent to K. Miller Construction, the second district held in Artisan Design Build, Inc. v. Bilstrom that a contractor’s failure to provide the homeowner with the brochure required under the Act does not remove the contractor’s right to recover in either equity (quantum meruit) or law (breach of contract, mechanic’s lien, etc.).  So what do these decisions mean for residential contractors and homeowners?

Scenario

Consider the following scenario: a contractor finishes his work under a home-repair contract with a homeowner, and is owed $10,000 for the job by the homeowner, but fails to provide a copy of the brochure, or fails to comply with other provisions of the Act.  In the fourth district, the homeowner will not have to pay the $10,000 even if his house is completely repaired according to the contract.  In the first district, the contractor may recover the payment because the homeowner in fact benefited from the contractor’s work, but the recovery amount may be less than $10,000.  Finally, in the second district, the contractor can recover the payment, either in law or in equity.

Conclusion

Although the judicial decisions in the first and second districts are more favorable to contractors, they are only controlling over law suits filed within these districts.  Given the inconsistency of rulings between the various appellate districts, it is likely that the Illinois Supreme Court will intervene and issue an opinion on the matter.  Until that time, however, contractors  should strictly comply with the Act.

The best way to ensure that you are in compliance is to consult with an Illinois attorney who is familiar with the Home Repair and Remodeling Act.   If you have any questions regarding the Act or construction law generally, please call one of our experienced attorneys at Acumen Law Group.

Authored by Bardia Fard, Esq. and Shoko Asaka, Law Clerk

Enforceable Non-Compete Agreements in Illinois

One of the most litigated issues in employment law is the legality of restrictive covenants like non-compete agreements. A non-compete agreement is a contract between an employer and an employee, in which the employee agrees not to engage in certain activities for a set period of time should she leave the employer. Non-compete agreements are frequently used by businesses to protect legitimate business interests, such as confidential information, trade secrets, and customer lists. Because non-compete agreements restrain trade, they are not looked upon with favor by Illinois courts, especially where the agreements are unreasonable and overly-inclusive.

Illinois Courts on Non-Competes

The general rule in Illinois is that a non-compete agreement is enforceable to the extent that it is reasonable and necessary to protect an employer’s legitimate business interest. There are two situations in which Illinois courts may find an employers’ interests legitimate and protectable: (1) the nature of the business creates a near-permanent relationship between the employer and customers, and the employee had contact with the customers solely because of the employment; and (2) an employer has trade secrets which the agreement is designed to protect, and an employee learned of such secrets during her employment. The “near-permanent” relationship can be established where there is a showing of long-term exclusive relationships, which were difficult and costly for the employer to develop. Other factors, such as the duration or closeness of such relationships, may also be considered. As to trade secrets, Illinois is considerably protective of an employer’s trade secrets and confidential information. Of course, the employer still has the burden of establishing that trade secrets exist in the first place, and that they are treated as “secrets,” i.e., the employer restricts access to such information from outsiders.

Regardless of whether trade secrets or a near-permanent relationships exists, a non-compete agreement will not be enforced unless the restrictions on competition are “reasonable.” Factors in determining the reasonableness of the restriction include the hardship to the employee, its effect upon the general public, and the reasonableness of the time (duration), territory, and activities restrictions.

Tips on Drafting a Non-Compete

Given the general reluctance of Illinois courts in enforcing non-compete agreements, employers would be wise to consider the following narrow-drafting tips which may increase the odds of enforceability:

• Restrictions on a former employee’s activities should not be broader than necessary. If your employee never engaged in marketing activities while she was employed, you generally can’t prevent her from engaging in marketing activities after she leaves your company.

• Territory restrictions should be narrowly tailored. If your employee only handled sales in the Chicago market, you generally can’t prevent her from handling sales in Alaska after she leaves your company.

• Do not restrict your former employee’s activities for an unreasonable time. Although there is no set rule, a restraint lasting between 6 months to 3 years may be reasonable.

• Consider limiting a former employee’s ability to recruit former co-workers by including an anti-raiding clause. Illinois Courts recognize that employers have a protectable interest in maintaining a stable workforce – anti-raiding clauses prohibit solicitation of fellow employees for a set period of time.

• Consider including a “blue pencil” provision in the non-compete, which would allow an Illinois court to revise an otherwise over-inclusive and unenforceable provision. Blue Pencil provisions are enforceable in Illinois unless the original agreement is extremely unreasonable or unfair.

While these drafting tips do not ensure enforceability of a non-compete by Illinois courts, they can significantly improve the odds of enforceability. If you have any questions regarding non-compete agreements for your business, please call one of our experienced attorneys at Acumen Law Group.

Authored by Dominika Szreder Fard, Esq. and Shoko Asaka, Law Clerk

Employers’ Liability For The Misconduct Of Their Notary Public Employees

Many business owners are unaware of their exposure to liability for the misconduct of their notary-employees.  This legal principle recently cost one Illinois employer $233,000 in damages, and likely a comparable amount in legal fees.

In Vancura v. Katris, the Illinois Appellate Court held that a Kinkos copy shop was liable for the damages resulting from its employee’s notarization of a forged mortgage assignment.  While the facts of the Vancura case make for an interesting read, the court’s explanation of how an employer may be held liable for an employee-notary’s misconduct is particularly instructive for business owners.

In Illinois, employers may be liable for the misconduct of an employee-notary either under (i) the Notary Public Act or (ii) common law.  A notary-employee’s “misconduct” generally includes the wrongful or unlawful exercise of the notary’s power to notarize documents, e.g., notarizing a document where it has not been executed before the notary. 

Liability Under the Notary Public Act
Under the Notary Public Act, employers are liable for a notary-employee’s misconduct where:

  • the notary-employee is acting within the scope of his employment when the official misconduct occurred; and
  • the employer consented to the notary-employee’s official misconduct.

While the above conditions seem simple enough, the dispositive issue in the Vancura case was whether the employer “consented” to its notary-employees misconduct.  The court identified two forms of consent: “active consent” and “implied consent.”  Active consent may be satisfied where the employer directs, encourages, or tolerates the notary-employee’s misconduct.  Meanwhile, implied consent exists where the employer knows of prior infractions but fails to address them.  Although the Vancura court held Kinkos not liable under the Notary Public Act due to its lack of “consent,” employers will be liable where the requirements of the statute are satisfied.

Liability Under the Common Law
Likewise, an employer may be liable for its notary-employee’s misconduct under the common law theories of negligent training and supervision.  Negligence is generally defined as the failure to do something which a reasonably careful person would do under the circumstances.  An employer may be liable under the theories of negligent training and supervision where it knew or should have known that its employee behaved in an incompetent or dangerous manner, and where despite this knowledge the employer failed to supervise the employee or implement preventative measures.

In Vancura, the court held that the Kinkos owed a duty to the general public to train, supervise, and control its notary-employees.  In affirming the trial court’s $233,000 judgment against Kinkos, the appellate court held that the evidence supported a finding that Kinkos failed to properly train and supervise its notary-employees.

Lessons
The lesson of the Vancura case should be painfully clear to business owners – you should have an internal policy that trains, supervises, and monitors the conduct of your notary-employees, or otherwise face potential liability under the Notary Public Act or common law.  If you have any questions regarding your company’s liability exposure for its notary-employees’ conduct, please call one of our experienced attorneys at Acumen Law Group.

Authored by Bardia Fard, Esq.

Electronic Copyright Registration: An Overview

Any time one creates an original work, such as a photograph or musical composition, that work is automatically copyrighted under common law.  With common law rights, a copyright owner can file suit against an infringer in state court and seek actual damages and “disgorged” profits. While copyright registration is not required for copyright protection, it is a prerequisite before a copyright owner can bring an action under the Copyright Act in federal court.  The primary benefit to bringing suit under the Copyright Act is the availability of statutory damages, which can go up to $150,000 per infringed work.  If copyright registration is made within three months after publication/creation of an original work, or prior to an infringement of the work by a third party, statutory damages and attorney’s fees are available to the copyright owner.  Thus, when a copyright owner fails to timely register, it can put him at a significant disadvantage in obtaining compensation for infringement.

Fortunately for copyright owners, the US Copyright Office recently began accepting electronic registration of original works.  The official Copyright Office website, www.copyright.gov, boasts a number of helpful articles and tutorials on how to electronically register copyrights.   Depending on the nature of the work, registration can take as little as an hour to complete and cost a modest $35.

At bottom, copyright owners should at all times prioritize timely registration.  If you are interested in learning more about copyright registration or infringement, please contact one of our attorneys at Acumen Law Group.

Authored by Bardia Fard, Esq.

Implied Copyright Licenses: A Last Resort For Unwritten Agreements

Consider the following scenario: A small business owner finds a graphic designer on Craigslist to design a logo for his business cards. The graphic designer designs the logo, the business owner pays the graphic designer, and both parties happily go their separate ways. No agreement is ever put into writing. Months later, the business owner launches a national advertising campaign featuring the business card logo created by the graphic designer. Upon seeing the advertising campaign, the graphic designer contacts the business owner, claims that she owns the copyright to the logo, and demands that the business owner pay for a license to use the logo on a national scale. Is the graphic designer’s demand legitimate? If so, what can the business owner do in this situation? More fundamentally, who actually owns the copyright in the logo?

Copyrights Ownership

Generally, copyright ownership in a creative work is vested in the author(s) of the work itself. Thus, in the scenario above, the graphic designer is in fact the author and rightful copyright owner. There is an exception to this rule, however: in the case of a work made for hire, the employer is considered the legal author of work created by his/her employees. There are really only two scenarios in which a work for hire can exist: (1) work created by an independent contractor, and (2) work prepared by an employee within the scope of his employment. For work created by an independent contractor, two important conditions must be met to invoke the work for hire doctrine: (1) the work is commissioned; and (2) there is a written contract memorializing the arrangement as a work made for hire.

So what does this mean for the business owner in our scenario? The graphic designer was not his employee, and there is no written contract, so the doctrine of work for hire does not apply. Is our business owner entirely out of luck? Fortunately for him, the doctrine of implied license may create the contract he failed to obtain.

The Implied License

Each copyright author generally has five exclusive rights: (1) the right to reproduce the copyrighted work; (2) the right to prepare derivative works based upon the work; (3) the right to distribute copies of the work to the public; (4) the right to perform the copyrighted work publicly; and (5) the right to display the copyrighted work publicly. Copyright authors are free to license all or a portion of their rights to third parties.  While the ownership of the copyright stays with the author, a licensee may be permitted to distribute copies of the copyright, or use it publicly, etc. In the absence of an actual written agreement between the parties, an implied license to use the copyright may arise based on the conduct of the parties. Ultimately, an implied license provides the licensee (the business owner in our scenario) some nonexclusive rights to use the copyrighted work to the extent that the copyright author would have allowed had the parties initially negotiated and signed an agreement.

Generally, courts create implied nonexclusive licenses where (1) the licensee requests the creation of the work, (2) the licensor makes that particular work and delivers it to the licensee, and (3) the licensor intends that the licensee copy and distribute his work. See I.A.E., Inc. v. Shaver, 74 F.3d 768, 772 (7th Cir. 1996). In our initial scenario, the graphic designer owns the copyright to the logo. However, the conduct of the parties clearly demonstrates that the logo was created for use by the business owner. As such, an implied license may be created based on what the parties would have agreed to had there been a written contract. Nonetheless, courts analyzing the same scenario would still consider to what extent and for what purposes the graphic designer created the logo in the first place. Is its use in a national campaign advertisement outside the scope of the implied license, which may have been limited to use on a business card? Is it reasonable to assume that the business owner can use the logo so long as it is used for the purpose of his business? While the implied license may be an effective gap-filler in the absence of a written agreement, it does not absolve our business owner from liability for unfettered use of the logo.

The best way to avoid such ambiguity is, of course, to negotiate the terms of the agreement and put everything into writing: who owns the logo, what the business owner can do with the logo, what rights, if any, does the graphic designer have in the logo after the business owner pays, etc . If you are interested in learning more about implied licenses or have a copyright dispute,  please feel free to contact us to speak with one of our attorneys at Acumen Law Group.

Authored by Dominika Szreder Fard, Esq. & Shoko Asaka (Law Clerk)

Purchasing A Business: How To Avoid Successor Liability

In purchasing a business, buyers typically have 2 options: either a stock or asset purchase agreement. Under a stock purchase transaction, the buyer acquires a majority of the seller’s shares or, if an LLC, membership units in the business. The business’s underlying assets — e.g., equipment, furniture, real estate, inventory, etc. — continue to be owned by the entity, and the entity owned by the buyer. Conversely, under an asset purchase deal, only the business’s assets are purchased, with the seller retaining ownership of the entity. Most business owners and attorneys alike are familiar with the maxim that when a business sells its assets, those assets are transferred to the buyer free and clear of all liabilities. This general rule, however, is not without exceptions like the successor liability doctrine.

What Is Successor Liability?
Under the successor liability doctrine, a buyer who purchases the assets of a business may be held accountable for the seller’s debts and liabilities where:

(i) there is an express or implied agreement of assumption;

(ii) the transaction amounts to a de facto consolidation or merger of the buyer or seller corporation;

(iii) the purchaser is merely a continuation of the seller; or

(iv) the transaction is for the fraudulent purpose of escaping liability for the seller’s obligations.

Of the foregoing bases for successor liability, the 1st and 4th predicates are the easiest to understand, and therefore the easiest to avoid. With respect to express or implied assumption of liabilities, careful drafting of the asset purchase agreement should ensure that unwanted liabilities are not transferred to the buyer. Similarly, transactions satisfying the fraud standard are avoidable, especially where the assets are purchased for adequate consideration, and where there are no interested (or related) parties to the transaction.

The remaining two predicates for successor liability — de facto merger and mere continuation — require a more nuanced analysis of the circumstances surrounding the asset purchase. The de facto merger doctrine is usually implicated where (i) the buyer retains the same management, employees, location, and general business operations as the seller; (ii) the seller becomes a shareholder of the buyer; and (iii) the seller dissolves its operations shortly after the sale. Illinois courts have opined that the continuity of shareholder element is the most important, as it would appear unjust to force a buyer to assume the liabilities of the seller when a substantial price has already been paid for the seller’s assets.

The mere continuation predicate for successor liability, unlike de facto merger, applies where a corporate reorganization has taken place such that the corporation has simply put on a “new coat”; thus, there is no combination of two existing entities into a single successor entity. Illinois courts will invoke the mere continuation doctrine where there is continuity of same management, corporate organization, and ownership.

How To Avoiding Successor Liability?
Buyers and their counsel should consider the following measures before, during, and after the consummation of an asset purchase agreement:

Request insurance. Buyers should request sellers to maintain their corporate existence post-closing, or to retain insurance policies covering pre-closing liabilities, like product defects. These issues should be negotiated while drafting the asset purchase agreement, and any associated costs can be easily built into the purchase price.

Due diligence. And more due diligence! Buyers should conduct a thorough review of sellers business to identify practices or products that may give rise to post-closing liability. Particular attention should be paid to the sellers’ industry, as some industries have higher occurrences of certain types of claims, e.g., car dealerships frequently deal with state/federal lemon laws.

Separate good assets from bad assets. Buyers should consider establishing a separate entity to hold any problematic asset they deems risky or susceptible to legal claims. This way, the entire investment is not lost if a bad apple gives rise to successor liability.

Draft a clear purchase agreement. The asset purchase agreement should expressly state that buyer is not assuming any of seller’s debts or liabilities. Additionally, the agreement should contain a comprehensive indemnification provision, obligating seller to defend and hold buyer harmless should a post-closing liability arise. Holding a portion of the purchase price in escrow – for a set time – is an effective way of buttressing an indemnification provision.

Structure a deal that contemplates Illinois successor liability precedent. To the extent possible, buyers and sellers should ensure that there is no continuity of management, employees, and especially shareholders post-closing. Buyers would also be well advised to obligate sellers to maintain their corporate existence for a period of time post-closing. Implementing these measures will appreciably reduce the risk of a court invoking the successor liability doctrine to the buyer’s detriment.

Prudent buyers to asset purchase agreements should heed the old adage that “an ounce of prevention is worth a pound of cure.” The involvement of competent counsel in the negotiating and drafting of an asset purchase agreement can significantly reduce the risk of post-closing litigation, and the implication of the successor liability doctrine. Indeed, buying a business through an asset purchase is no longer a sure way of acquiring the business free and clear of all debts and liabilities. In the vast majority of cases, the financial cost of litigating an asset purchase agreement post-closing will dwarf the costs that should have been incurred initially to draft a comprehensive asset purchase agreement.

If you are interested in learning more about successor liability or more generally about asset purchase agreements, please feel free to contact Acumen Law Group to discuss what types of contractual provisions will best protect you when purchasing a business.

Authored By Bardia Fard, Esq. & Brian Afshar (Law Clerk)

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