Interested in buying a business, or thinking about pulling that trigger and acquiring your labor of love? Before you do, you need to understand what “Successor Liability” is, and how it can ruin everything if you don’t plan accordingly.
Buying a business can subject you to potentially infinite liability …
As attorneys, we often get calls from clients “after the fact,” seeking legal guidance when everything is about to fall apart. For example, we’ve seen clients acquire the retail assets of a business, only to have the IRS swoop in and take all the fixtures and inventory a year-and-a-half after they acquired the business’ assets. We’ve seen clients take over businesses by acquiring their assets, only to be forced to defend themselves in sexual harassment lawsuits from employees they never knew existed — former employees of the previous company they purchased the assets from. And, we’ve seen business owners subject to 6-figure lawsuits from the state for unpaid sales taxes and gross receipts taxes from the previous company from whom they acquired the assets.
Big Exceptions to the General Rule
The general rule is that a successor entity (or person) is not liable for the debts (or acts or liabilities or obligations — I will use these terms interchangeably in this article) of its predecessor. Unfortunately for many purchasers, this general rule is not absolute. There are many exceptions.
Pre-existing liens or successor liability can wreck havoc on your asset purchase, even years later.
If there is a pre-existing lien on the assets of a business, such as in a tax lien or UCC filing, your “purchase agreement” won’t take priority over those previous liens. If such a lien exists, you could lose the very assets you thought you were acquiring. Or, if the circumstances of your asset purchase can be shown to met certain exceptions to the general rule, you can find yourself liable for acts, debts or obligations that far exceed the value of the very assets you acquired. In this scenario, a buyer’s potential liability could be infinite. In many states (including New Mexico, California and Illinois), the purchaser is not liable for the liabilities of the seller, except:
- where the purchaser expressly (or impliedly) agrees to assume such debts/liabilities;
- where the transaction is really a consolidation or a merger (i.e. the “de facto merger exception”);
- when the purchasing corporation is merely a continuation of the selling corporation; or
- where the transaction was fraudulently made in order to escape liability for such debts.
The Agreement Exception
If a Purchase Agreement does not affirmatively state that the purchaser is not assuming any acts, debts, liabilities or obligations, they can be potentially presumed or at least the subject of costly litigation. To prevent this exception from being triggered, the Purchase Agreement should clearly state which, if any, specific liabilities are being assumed. If none, the Purchase Agreement should specifically say this.
The De Facto Merger Exception
The de facto merger exception will trigger if three or more of the following four factors exist for a particular transaction:
- Is there a continuation of the enterprise?
- Is there a continuity of shareholders?
- Has the selling company ceased its ordinary business operations?
- Has the purchasing company assumed the seller’s obligations?
The de facto merger exception is a common-culprit in causing successor liability.
A de facto merger will not necessarily exist, when only two of the four factors exists, especially if it can be shown the purchaser paid fair market value for the assets of the business.
A “continuation of the enterprise” may be shown if the physical location, assets, operations, management, employees, branding and/or clients are the same (or substantially similar) between the seller and the purchaser.
A “continuity of shareholders” means substantially the same (or similar) ownership between between the seller and the purchaser. Minor similarities in ownership may not necessarily trigger this factor, but including the seller as a major partner in the new establishment could.
A “cessation of operations” looks at whether the selling company continued to exist and/or its operations post-sale. If the seller winds up its operations or dissolves shortly after a sale of substantially all its assets, it will trigger this factor.
Finally, an “assumption of obligations” looks at the obligations necessary for the ordinary course of business. This could include customers, contractors, vendor agreements, leases, specific assets that were acquired, phone numbers, websites and domain names, intellectual property, and so on. If the Purchase Agreement isn’t crystal clear on what obligations are and are not assumed by the purchaser, the purchaser may become liable for all of the seller’s obligations.
The Mere Continuation Exception
The mere continuation exception could be met if (1) only one company remains after the transfer of assets, and (2) there is an identity of stocks, stockholders and directors between the two companies. This will generally occur when the owners of the selling company maintain a significant ownership stake in the purchasing company.
The Fraudulent Transaction Exception
The purchaser of a company can be liable for the debts and obligations of the selling company, if it’s determined the asset sale was made in an attempt to escape such debts and obligations. This can arise, when ownership in the purchasing company is awarded to the sellers owners, as payment (or consideration) for the assets. To avoid this exception, stock in the purchasing company can be awarded to the seller itself, not the individual owners, which will help to keep the selling company solvent for the benefit of outstanding debtors and creditors.
How a Purchaser Becomes Liable for a Seller’s Obligations
Please don’t be foolish. It’s so inexpensive to conduct a lien and title search before you buy a business.
We see purchasers falling victim to old debts and obligations of the selling company in several ways. Don’t be a victim. Watch out for:
- Outstanding Liens. In particular, liens (UCC and tax liens) on assets the purchaser thinks it acquired will have superior rights over the purchaser, if the purchaser acquired those assets after the liens have been properly perfected (i.e. filed).
- Triggering an Exception to Successor Liability. If the facts and circumstances meet one of the exceptions (as discussed above), the debts, liabilities and/or obligations of the selling company will come back to haunt the purchaser. This is often the case with unpaid state sales and gross receipts taxes.
How to Avoid the Seller’s Past Debts, Liabilities and Obligations
As discussed above, there are many ways a purchasing company can find itself with the loss of the very assets it purchased (i.e. previous UCC or tax lien on the assets) or bringing about circumstances that trigger one of the successor liability exceptions. BEFORE you purchase a company, make sure that you:
- Conduct a Lien Search. You want to search (i) at the state level (i.e. the Secretary of State), (ii) the county or local level (where the physical address of the company is listed in its Articles or where the business is conducting business, or ideally both), and (iii) at the federal level. (For a comprehensive discussion on UCC liens and how they work, see What Is A UCC Filing & How A UCC Lien Works).
- Conduct a Title Search for Titled Assets. If you are purchasing assets that have a title (i.e. vehicles, real estate and leaseholds), conduct a title search to ensure you are acquiring perfected and clean title to those assets.
- Check in with the Local Tax Authority. In New Mexico, the NM Taxation and Revenue Department will issue a clearance on a company, indicating what its outstanding tax liability is. REMEMBER: Even if there are no outstanding tax liens, an outstanding tax liability can be attached to the successor organization if it meets an exception to the general rule for successor liability.
- Craft a Carefully Worded Asset Purchase Agreement. It’s very important that the Asset Purchase agreement contains “representations and warranties” by the seller, indicating the current liabilities of the seller, and the disposition of those liabilities. The seller needs to indemnify and hold the purchaser harmless for any outstanding liabilities. And, beware of offering stock in the purchasing company as part of the consideration.
- Consider Escrow Funds for Outstanding Liabilities. Nothing beats good due-diligence before committing to a purchase, and if you learn of any potential liabilities, make sure the seller either takes care of those liabilities BEFORE the closing date, or if it can’t be done before the closing, place sale funds in escrow subject to the seller taking care of the liabilities before being paid. BEWARE: Constructing careful escrow instructions is important. You want the right to claim those funds if the liabilities are not fully paid or otherwise new and undisclosed surprises later surface.
- Don’t Let Anyone Rush You, and Don’t Trust Anyone. Don’t get caught up in the moment, and don’t let anyone rush you. There are many outstanding business brokers out there, and there are a few not-so-good ones. It’s difficult to tell which is which, although a sure sign you’re dealing with a not-so-good one, is a broker who tries to rush you or otherwise says they’ve done the due diligence for you and everything checks out. Unless the broker is willing to indemnify you, politely tell them to shut up. Same goes for partners, franchisors or others tangentially involved in the deal, but not on the firing line.
I’m sorry to say that even with all the above, you may still end up with some form of liability if you’re not carefully or you don’t carefully conduct due-diligence. The purchasers who hire a good attorney and CPA, take the above precautions, and conduct careful due diligence, are less likely to be surprised with future debts, liabilities or obligations from a previous asset purchase.