Buyer beware: Successor liability in asset purchases

September 30, 2014
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Your company recently purchased the assets of another business through an asset purchase agreement, which specifically states the buyer is not assuming any liabilities of the seller. No need to worry about any of the seller’s liabilities coming back to haunt you, right?

The general rule in Michigan is that a purchaser is not responsible for a seller’s obligations existing at the time of the purchase when the purchaser is only acquiring the seller’s assets (as opposed to purchasing the stock of the selling company).

Michigan case law has recognized five exceptions to this general rule: (1) express or implied assumption of liability; (2) de facto consolidation or merger; (3) fraudulent transaction; (4) where some of the elements of a purchase in good faith were lacking or where the transfer was without consideration and the creditors of the seller were not provided for; or (5) transferee is a mere continuation of the transferring entity.

Additionally, certain federal and state statutes provide that a successor may be liable for certain debts of a company that is merely transferring its assets.

Successor liability

Assumed liabilities

A successor corporation may assume its predecessor’s liabilities through express or implied assumption of liability. A well-drafted asset purchase agreement should avoid any potential express or implied assumption of the selling corporation’s liabilities.

Mere continuation

Michigan courts have held that a successor entity can be responsible for the liabilities and obligations of the transferring entity if the successor entity constitutes a mere continuation of the transferring entity. The courts look to whether (1) there is a continuity of management, personnel, physical location, assets and the general business operations of the selling company; (2) the predecessor company ceased its business operations as soon as possible after the sale of assets; (3) the purchasing entity assumes certain liabilities and obligations of the seller in order to maintain the uninterrupted continuation of the predecessor business; and (4) whether the purchasing entity holds itself out to the world as an effective continuation of the selling entity.

State tax obligations

Michigan statute provides that a purchaser may be personally liable for taxes, interest and penalties owed by the predecessor company if certain steps are not taken. The law states that a buyer, when purchasing the assets of a going or closed business, should escrow sufficient funds to cover the amount of taxes due from the selling company until the former owner of the assets can either produce a receipt showing that all taxes have been paid or a certificate stating that there are no taxes due. The parties can obtain information from the Michigan Department of Treasury showing the amount due and owing to establish the escrow amount, but if the escrow requirements are not followed, the statute provides that the purchaser is personally liable for the payment of taxes, interest and penalties unpaid by the prior owner, limited to the fair market value of the business, less amounts of any proceeds from the sale used to pay secured interests which are superior to Michigan’s potential tax lien.

Additionally, a purchasing entity may be found to be liable for the successor entity’s unemployment taxes and interest due to Michigan’s Unemployment Insurance Agency. This is triggered by the acquisition of 75 percent or more of the assets of an already existing business. Requesting the tax liability status of the transferring company not less than 10 days before the acquisition can identify the amount owing from the transferor and provide some certainty that the purchasing entity is not liable for any amounts due from the transferor in excess of the amount determined by the UIA. The selling entity is also required to disclose certain UIA information, including unemployment tax liability, two days before the acceptance of an offer to purchase.

Federal employment obligations

Recent federal case law has held that a company purchasing the assets of an insolvent business at a state law receivership auction was liable for the liabilities of the predecessor arising out of the Fair Labor Standards Act litigation pending against the predecessor company. This rule may also apply to other federal employment claims involving the ADA, ADEA, Title VII or the FMLA. The Seventh Circuit Court of Appeals determined that there was successor liability given that the buyer had notice of the pending lawsuit prior to the asset sale, that the successor entity was being run in substantially the same manner as the successor (by operating the business under the same name, in the same location, and hiring a significant amount of the predecessor’s employees).

Steps to limit impact of successor liability

Due diligence

First and foremost, the buyer must conduct due diligence of the seller to determine the extent and nature of the seller’s liabilities. Is there any pending litigation? Are there any pending or threatened federal employment claims? Are there any outstanding state tax obligations (sales, use, withholding, unemployment and otherwise)? Due diligence should also help determine the amount of liabilities that the buyer could potentially be responsible for after the purchase of the assets from the seller.

Operation of the business

Determine how the buyer will utilize the assets of the new business going forward. If the assets will remain at the same location, the buyer will be using the seller’s former name, and there is a continuity of management and/or employees, successor liability may be more likely. If there are liabilities that are a concern, the buyer may want to consider taking steps to differentiate itself from the predecessor after the purchase of the assets.

Drafting of the purchase agreement

The purchase agreement should specifically state that the buyer is not assuming any liabilities of the seller unless otherwise provided for in the purchase agreement. The buyer should consider a strong indemnification provision protecting the buyer from the liabilities of the seller. Additionally, a buyer should consider an escrow or hold-back provision from the purchase price to protect against those seller liabilities until those potential liabilities are resolved. If the liability of the predecessor is likely, a purchase price reduction may also be appropriate to account for the assumption of that risk by the buyer.

Purchasing only the assets of a business does not always mean that you are leaving all of the liabilities of the seller behind. There are, however, steps to help protect against potential successor liability. While these steps may not alleviate potential successor liability entirely, conducting thorough due diligence and careful drafting of the asset purchase agreement should help adequately protect the buyer from the impact of the potential successor liability.

Neither the list of potential obligations that the buyer may be responsible for nor the list of potential steps to limit the impact of successor liability is exhaustive. This is intended as general information as these issues vary on a case-by-case basis.

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