“Successor liability” is a phrase that strikes fear in the hearts of would- be distress buyers. Why? The goal
of most distress sales is for the buyer to
acquire assets at less than the value of
all of the obligations owed by the seller.
Successor liability threatens this goal,
because it allows unpaid creditors to
pursue the deep pockets of the buyer
in the attempt to get paid in full.
When it comes to the world of mergers
and acquisitions, there are three
primary ways to acquire a company:
the merger, the stock sale, and the
asset purchase. Existing liabilities of
the seller transfer with the company
in a merger or stock sale, so the
acquisition method of choice in most
distress sales is the asset purchase.
An asset purchase allows the buyer
to acquire specific assets and exclude
liabilities. The idea is simple: the buyer
pays fair value for the assets, and the seller
then uses the proceeds from the sale
to pay its liabilities, or some portion of
them if the company is insolvent. When
creditors are not paid in full, however,
successor liability is often the theory they
will use to attempt to collect the shortfall
from the buyer. It is an exception to the
general rule that an asset purchaser can
exclude liabilities and allows creditors
to override the language of the asset
purchase agreement to attach liabilities
to the buyer in some circumstances.
Successor liability was originally a
creation of the courts and developed as
a way to prevent owners of corporations
from playing shell games with corporate
assets to commit fraud on creditors.
This original goal is apparent in
the four traditional theories of
successor liability. They consist of:
1 Assumed Liabilities. A buyer is liable to third-party creditors for
liabilities that it assumes (expressly or
implicitly) as part of its asset purchase.
2 Fraudulent Transfer. The buyer can be liable to third-party
creditors (and the sale can even be
unwound) if the sale was intended as a
fraud to defeat creditors, or if the buyer
paid less than fair value for the assets
when the seller was insolvent.
3 De Facto Merger. Liability attaches when an asset sale has mimicked
the results of a statutory merger except
for continuation of liability. The
elements are often described as
( 1) continuity of the selling corporation
evidenced by the same management,
personnel, assets, and physical location,
and ( 2) continuity of stockholders,
accomplished by paying for the acquired
corporation with shares of stock.
4 Mere Continuation/Substantial Continuity. Similar to the de facto
merger doctrine (and often confused
with it), liability attaches under the mere
continuation theory when the buyer is
continuing the business of the seller
with little change. The primary elements
include use by the buyer of the seller’s
name, location, and employees; a
common identity of stockholders and
directors; and dissolution of the seller
following the transaction. While the
central element in a de facto merger is
ownership continuity through the
transfer of stock, the central element in
mere continuation is the continuation of
the corporate identity.
In the last several decades, a fifth basis
for successor liability has developed
and is known as the product line theory.
This theory finds its genesis in 1977
in the Ray v. Alad1 case in California.
Under the product line theory, when
the buyer continues to manufacture
the same product line(s) as the seller,
and the seller is no longer available to
pay the claims of consumers injured
by goods previously manufactured by
the seller, the buyer can be liable for
product liability claims that otherwise
would have been owed by its seller.
The elements of the product line theory
are often described as: ( 1) the virtual
destruction of the plaintiff’s remedies
against the original manufacturer caused
by the successor’s acquisition of the
business, ( 2) the successor’s ability to
assume the original manufacturer’s
risk spreading role, ( 3) the fairness of
requiring the successor to assume a
responsibility for defective products that
was a burden necessarily attached to
the original manufacturer’s goodwill
being enjoyed by the successor
continued on page 46
BY BOBBY GUY, SHAREHOLDER, POLSINELLI P.C.
Avoiding Successor Liability
in Distress Sales