You are buying a business and heard through the grapevine that if you do an asset purchase instead of a stock purchase, it will keep you from inheriting any of the liabilities that may have been incurred before sale. That is a pretty common belief, and generally sound advice.
Stock Purchase v. Asset Purchase Agreements
Under a stock or share purchase agreement, the buyer acquires the seller’s shares. The business’s underlying assets — e.g., equipment, furniture, real estate, inventory, etc. — continue to be owned by the entity, and the entity now owned by the buyer. Under an asset purchase agreement, the business’s assets, and not the entity, are purchased. The seller retains ownership of the entity, and any existing liabilities at the time of sale. One exception to this is the legal theory of successor liability.
Successor Liability
The use of successor liability allows a creditor to hold a buyer accountable for a seller’s debts and liabilities under a legal doctrine called “merely a continuation.” This doctrine requires a creditor to show one of the four conditions existed at the time of sale:
(i) the buyer expressed or implied agreement on assumption of liability;
(ii) the sale amounted to a de facto consolidation or merger between buyer and seller;
(iii) the buyer’s business is merely a continuation of the seller’s business; or
(iv) the transaction is for the fraudulent purpose of escaping liability for the seller’s obligations.
For a buyer, a carefully drafted asset purchase agreement can assist in avoiding liability. As to the first theory of recovery, clear disclaimers in the agreement can insulate the buyer from “express or implied assumption of liabilities.” Similarly, avoiding the fraudulent transaction condition can be avoided in instances where the assets were shown to be purchased for adequate consideration.
The two remaining conditions require a more fact specific analysis. Red flags as to whether these conditions might be met include: (i) retaining the same management, employees, location, branding, and general business operations; (ii) the seller retaining ownership; and (iii) the seller dissolves its operations shortly after the sale.
Exercising Due Diligence to Avoid Successor Liability
While you cannot prevent yourself from being sued should an unhappy creditor appear after the sale, there are some ways to conduct due diligence prior to the closing that may help you avoid post-closing claims.
>> Conduct a Lien Search. Search at the state, local, and federal level.
>> Conduct a Title Search. Conduct a title search for titled assets: real estate, vehicles, and leaseholds.
>> Check with the Local Tax Authority. Your local tax authority will issue a clearance on a company, indicating what its outstanding tax liability is.
>> Draft a Carefully Worded Asset Purchase Agreement. Carefully review the “representations and warranties” provided by the seller. Seek an indemnity clause to hold you harmless for any outstanding liabilities.
>> Consider Escrow Funds. If you are unable to conduct due-diligence before the closing and you feel you must go forward with the sale, consider requesting some portion of the sale funds be put in escrow to pay for outstanding liabilities that arise after the sale.
Takeaway
Need assistance with the purchase, merger or sale of your company? Contact CASHMAN LAW today for a free consultation to see how we might help with your business negotiations.
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