Successor liability You get what you pay for

August 27, 2012
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It's 1895, and, being the enterprising individual you are, you decide to purchase a telephone company.

Wave of the future, they said. Connect the world, they said. But what they didn't tell you is that the company you purchased had an employee get injured on the job a few months earlier.

Now, four years later, you find yourself in front of the Michigan Supreme Court being sued by an employee whom you never employed. Could your company be held liable?

The answer, unsurprisingly, is "It depends." The case discussed in the previous paragraph is a brief summary of Chase v. Michigan Telephone Company, where the court held that simply purchasing the assets of another company was not enough to automatically transfer liability to the new company.

The law has transformed immensely in the last 100-plus years, but this general principle of successor liability remains the same, subject to five exceptions.

These five exceptions are: (1) an express or implied assumption of liability; (2) the transaction amounts to a consolidation or merger; (3) the transaction was fraudulent; (4) the transfer was not entirely in good faith, or was not at adequate value, to the detriment of the transferor company's creditors; or (5) the transferee company is a mere continuation or reincarnation of the old corporation.

Express or implied assumption

When a company agrees to cover the liabilities of the previous organization, then it has made an express assumption of liability and will owe all debts arising under its agreement.

If, on the other hand, the purchasing company’s conduct or representations display an intention to assume the old corporation's liabilities in whole or in part, then an implied assumption of liability is created. The danger with an implied assumption is that purchasers assuming even one obligation beyond those specified in an agreement may be found to have impliedly assumed all of the predecessor's liabilities.

Consolidation or merger

Here, only one company emerges from combining entities, which legally become one. The new entity has all of the rights and interests of each of the constituent entities, and the new entity becomes legally responsible for the liabilities of each of the merged organizations.

Courts also apply the second exception for successor liability when the transaction “amounts” to a consolidation or merger, giving the courts greater flexibility to identify transactions that for all intents and purposes evidence a merger, often called a “de facto merger.”

Fraudulent transaction

If you wouldn't want to explain the motivation for the acquisition to a judge, then you probably shouldn’t go through with the deal. And if you or your lawyer aren't adept at distinguishing what constitutes fraud, a court may be so kind as to help you see the light.

Lack of good faith

The policy behind successor liability law seeks a balance between protecting the interests of corporate creditors while also respecting the independence of distinct corporate entities. When a transaction is seemingly made to avoid paying creditors, either through a lack of good faith or an absence of adequate consideration, a court may apply this exception to hold the successor liable for those debts.

Mere continuation

Perhaps the most interesting of the five exceptions is the "mere continuity" exception. In 1976, the Michigan Supreme Court created the “continuity of enterprise” test. This test goes beyond asking whether there is a continuation of the corporate entity and instead sets a lower standard by focusing on whether there was a continuation of the seller's business operations. The latter question is broader, effectively expanding the circumstances where a successor can be held liable.

Different liability obligations tend to be applied depending on how the purchase was made, such as through a stock or cash purchase, even though the purchasing company is essentially in the same economic position no matter which route it takes.

However, if the predecessor business is still in existence as a viable source of recovery for plaintiffs, successor liability rules usually don’t apply. This is because if plaintiffs can recover damages from the business that actually played a role in their injuries, there is no benefit to society in making the innocent successor liable for those same injuries.

It is also important to recognize that there are considerations that go beyond the balance sheet. Injuries, even when the lawsuit hasn't been filed at the time of the acquisition, can add to the burden of a transaction. This is true even if the acquired assets are dwarfed by the future liability, so that a $50,000 purchase could lead to millions in liability. Of course, that liability all depends on how the transaction is made. For that, hiring a lawyer can be a shrewd investment.

Jeff Gilson, who will be a second-year law student at the University of Chicago Law School this fall, is a summer associate with the law firm of Varnum LLP.

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