Acumen Law Group, LLC

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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