Unintentional liabilities: don't let the unintentional assumption of liabilities in asset purchases sink your ship.

Industry pundits have long been trumpeting the benefits, if not the necessity, of consolidation. While the jury is still out as to whether or not consolidation is the key to survival that the experts have described one thing is certain; there has been a lot of consolidation in the industry and it will likely continue.

Mention the "C" word to most wholesalers and their first thought is typically of termination. The truth of the matter is, however, that most consolidation has occurred as a result of arms-length transactions involving the sale of one or more brands by one wholesaler to another. While brewers certainly have "encouraged" a lot of these arms-length transactions, the bottom line is that most consolidations have been negotiated deals as opposed to outright distributor terminations. In previous articles we dealt with some of the more important issues to consider when buying or selling brands. In this article we will discuss one of the most important issues facing a purchaser when acquiring a competitor's entire business--avoiding the inadvertent assumption of the seller's liabilities. Nothing is more frustrating or potentially devastating than winding up with huge obligations that were not contemplated at the time of the acquisition; liabilities which can turn an otherwise profitable deal into one which drains the profit out of your business. The bad news is that there are a number of pitfalls for the unwary which can lead to dramatically adverse consequences. The goods news is that you can protect yourself from such results by doing appropriate due diligence and by drafting appropriate acquisition agreements.

Stock versus Assets

In general there are two different ways to acquire an existing company, purchase the stock or purchase the business assets. Often times, there are significant tax issues which drive the structure of the acquisition. Structuring the acquisition as either a stock deal or an asset deal can have either significant tax benefits or significant adverse consequences depending upon the particular circumstances. As a result, the first consideration of any buyer or seller should be how to structure the transaction to obtain the best result for a tax perspective. Taxes however, should not be the only consideration in determining the appropriate structure; avoidance of unintended liabilities must also be considered.

It is often said that when you buy the stock of a company, you get the company--"warts and all." This is because the purchaser steps directly into the shoes of the seller. All assets of the company remain assets after the sale and all liabilities of the company--whether disclosed or not--remain liabilities of the company after the acquisition. For this reason many astute purchasers prefer to acquire assets. As a general rule, when a purchaser acquires the assets of a company the purchaser only assumes those liabilities which are expressly assumed in the purchase contract. The problem however, is that this just a general role while many purchasers and purchasers' attorneys believe that it is absolute. It never ceases to amaze us, however, we constantly see seasoned professionals virtually ignore investigating the existing liabilities of a target acquisition. A typical response to a question on the target company's liabilities is "Why do we have to worry about liabilities, we are purchasing the assets, not the stock?" The sad truth is that investigating liabilities is always important, regardless of whether you are purchasing assets or stock. Indeed, even if the asset purchase agreement specifically states that the purchaser is not assuming any liabilities of the seller there is significant potential for a purchaser to be liable for the seller's pre-closing liabilities.

Successor Liability in Asset Acquisitions

Historically, the asset purchase agreement did control what liabilities a purchaser would assume. Today, however, things are not as simple. There is a growing judicial trend to impose liability on a purchaser of assets in several important areas. As a result, a purchaser may not simply rely on the express terms of the agreement.

In large part, these judicial theories are based upon the concept that an injured party deserves a remedy, and the owner of the asset which produced the injury--even if the event giving rise to the injury took place while the asset was owned by someone else--is a logical source. Several areas are particularly vulnerable to successor liability theories, although the list is ever evolving.

Products Liability

Broadly speaking, the seller of a defective product that results in injury or property damage is liable for such damages. This scenario is what is commonly known as products liability. Consider the following scenario. Seller sells a defective product to Consumer A on Day 1. On Day 100, Seller sells substantially all of its assets to Purchaser who continues the business operations of Seller intact. The asset purchase agreement specifically provides that Purchaser assumes no responsibility for any of Seller's liabilities including, without limitation, any liabilities which may arise as a result of the sale of defective products by Seller prior to the closing date (Day 100). On Day 150 Consumer A is injured by the defective product sold by Seller on Day 1, i.e. prior to the closing date. Consumer A sues Purchaser. Purchaser defends by asserting that Seller, not Purchaser sold the defective product and, further, Purchaser did not assume any liabilities of the Seller when it acquired selling assets. Who wins? Traditional thinking would suggest that Purchaser wins. Traditional thinking, however, has come under attack. There are a growing number of courts that are now following the so called "Product Line Exception" which originated in California or other closely related doctrines in order to impose liability on the Purchaser. Pursuant to these theories, where the purchaser acquired a business and continues the business virtually intact the purchaser assumes the risk of defective products distributed by the entity prior to the time of the acquisition. The rationale of these decisions is that in acquiring the good-will of the company the purchaser gets not only the benefit of the good-will, but the burdens as well, which includes responsibility for injuries from defective products.

Environmental Issues

Environmental law has been one of the most rapidly developing areas in American jurisprudence over the last several decades. These laws have had dramatic impact in all areas of commerce, not the least of which has been in mergers and acquisitions. Since many business acquisitions also involve the acquisition of the real estate upon which the business operates, liability for environmental matters typically represent the largest risk for the unwitting assumption of liability. This is because, again regardless of express contract language to the contrary, statutes relating to liability for remediating environmental contamination, and in particular, the Comprehensive Environmental Response Compensation and Liability Act of 1980 ("CERCLA"), provide that the current owner of contaminated land is responsible for remediation even though the current owner is not the responsible party for the contamination.

Indeed, under certain circumstances liability may be imposed on the current tenant of contaminated premises even though the tenant did not cause the contamination. While this may sound inequitable or even illogical, the goal of theses laws is to assure that environmental contamination is remediated; the burden is placed squarely on the purchaser to determine its exposure prior to the acquisition.

Labor

The issue of successor liability in the context of labor laws has three separate elements: (1) Is the purchaser bound to bargain with the existing union? (2) Does the purchaser have to assume an existing collective bargaining agreement? and (3) Is the purchaser liable for previous unfair labor practices and/or failure to pay benefits etc.?

A thorough discussion of these issues could easily, and may very well be the topic of an entire future article. For our purposes here, however, it is sufficient to note that under appropriate circumstances all three of these questions can be answered in the affirmative. Many of the same factors which have led the courts to hold successors liable in the products liability context apply in the labor context. These issues include whether or not the purchaser is a "mere continuation" or "substantial continuation" of the seller. In the labor context however, there are many more variables such as whether the predecessor's employees make up a majority of the workforce, whether the purchaser had or should have had notice of the union contract and whether the purchaser had knowledge of the unfair labor practice prior to signing the contract to purchase.

The important point to remember, however, is that regardless of a contractual provision which specifically states that the purchaser will not be liable for liabilities relating to labor unions or unfair trade practices, a purchaser of assets may inherit significant labor problems and liabilities. Indeed, under these same theories, a purchaser of assets may also be responsible for employment discrimination practices of the seller.

Unassumed Contracts and General Liabilities

Almost every asset purchase agreement that you see will specify exactly what contracts and liabilities will be assumed by the purchaser. Does that mean, however, that a purchaser need not be concerned about the nature and extent of unassumed contracts and liabilities? The answer is, resoundingly, no. Just as is the case with products liability, environmental and labor issues there are circumstances where a purchaser may be held liable for unassumed contracts and liabilities. Fortunately, these circumstances are more limited and often require an element of either fraud or intentional avoidance of obligations such as where a going concern transfers its assets to a new entity owned by the same owners who assume only those obligations which are essential to continue the operations. Some courts, however, are not as restrictive and will impose liability on the purchaser solely on the basis of a substantial continuity of the business operations of the seller, without regard to substantial identity of ownerships between the seller and the purchaser. Furthermore, many states have Bulk Sales statutes which, if not complied with, will enable the seller's creditors to assert their claims against the purchaser. The point is that each transaction is unique and must be examined in the light of the laws that are applicable to the particular transaction.

Apply a Little Elbow Grease

So what does it all mean? It is inevitable that asset acquisitions will result in the unintentional assumption of significant liabilities by the purchaser? The simple answer is no, but you have to be diligent to avoid the pitfalls. The first key to the success of any acquisition is due diligence--both by your business people and your professionals. Regardless of whether you decide to buy stock or assets, you must have a clear understanding of what it is that you are buying--warts and all--even if you are buying assets and not stock. The second key is the drafting of the contract. All of the issues that we have discussed can effectively be handled through the due diligence investigation and the drafting process. If done properly you can, to the greatest extent possible, reduce the risk of the unintended assumption of liabilities. If your professionals respond to your questions about the seller's liabilities with a simplistic statement to the effect that you don't have to worry because you are not assuming liabilities, we suggest you retain other professionals.

Remember, that glittering light that you see in the distance may be a diamond in the rough or the sun reflecting off the tip of an iceberg. The key is finding out which it is before your ship is sunk.

Gary Ettelman and Keith Hochheiser are partners in the law firm Ettelman & Hochheiser, of Graden City, NY. Inquiries can be directed via e-mail to Gary at [e-mail]