Successor Liability in Asset Purchase Agreements

When business owners consider buying or selling a business, they often encounter various legal terms and concepts that can be confusing. One such concept is successor liability, which plays a crucial role in the structure of an asset purchase transaction, through which a buyer purchases specific assets of a business such as equipment, inventory, customer lists, or intellectual property, rather than acquiring the stock or other equity ownership of the current company that operates a business from that company’s owners. In this blog post, we'll delve into what successor liability means in the context of an asset purchase arrangement and why it's important for small business owners to understand.

What is successor liability?

Successor liability refers to the legal responsibility that a buyer assumes for certain obligations and liabilities of a seller when acquiring a business. In simpler terms, it means that when a business is sold, the buyer may become liable for the seller's past obligations and liabilities, even if they were not directly involved in those actions or agreements. Successor liability aims to protect the interests of creditors, employees, and other parties who may have legitimate claims against the seller's business. Without this concept, a seller could potentially evade their responsibilities by selling the business and leaving those liabilities unresolved.There are a two primary types of successor liability:

• Contractual Liability: If the buyer expressly agrees to assume specific liabilities of the seller in the asset purchase agreement, they become contractually liable for those obligations. It is essential for small business owners to carefully review the agreement and understand the extent of the assumed liabilities.
• Successor Liability by Operation of Law: In some jurisdictions, successor liability may also arise automatically by operation of law, even without explicit agreement. This means that the buyer may inherit certain liabilities of the seller based on legal principles established in that particular jurisdiction simply by acquiring the business.

Importantly, even where parties have agreed to allocate or assume successor liability via contract, a court might still hold a buyer responsible for certain liabilities of the seller. It would then be the seller’s responsibility to track down the buyer and get that buyer to “indemnify” or reimburse the buyer for that liability. So, even with a thorough asset purchase agreement, it is important for buyers to understand how the structure of the transaction and the ongoing operation of a business can create successor liability risks.

Factors that Influence Successor Liability

There are a few primary factors that influence whether and to what extent a buyer assumes the risks of successor liability:

1. Contractual Assumption of Liabilities: Explicitly assuming the seller's liabilities in the purchase agreement can trigger successor liability by operation of law. If the buyer agrees to assume specific obligations and liabilities of the seller, such as outstanding contracts, pending litigation, or tax obligations, they will become responsible for those liabilities even without a separate legal action.
2. Continuity of Business: Successor liability typically arises when there is a substantial continuity of the business between the seller and the buyer. If the buyer continues the same business operations, employs the same workforce, or uses the same assets and customer base, courts may be more inclined to apply successor liability.
3. Notice to Creditors: In some jurisdictions, providing notice to creditors regarding the sale of the business can affect the extent of successor liability. Failure to inform creditors of the change in ownership may increase the likelihood of the buyer assuming the seller's liabilities.
4. Mere Continuation: If the buyer is a mere continuation of the seller's business, meaning there is a seamless transition from the seller to the buyer with no significant changes in operations or ownership, successor liability by operation of law is more likely to apply.
5. Fraudulent Intent: Successor liability generally does not apply if the sale of the business is intended to defraud creditors or evade liabilities (assuming the buyer was not part of that fraudulent conduct!). Courts are less likely to impose successor liability on the buyer if there is evidence of fraudulent conduct. Instead, litigation would be targeted towards the seller and holding them responsible for their fraudulent conduct. However, if a court found that a buyer was involved in or part of the seller’s fraudulent attempt to evade liabilities, the buyer may be on the hook for certain successor liabilities–as well as other penalties for fraud!
6. Regulatory Compliance: When buying a business in a regulated industry, such as healthcare or finance, successor liability may extend to compliance with regulatory requirements. If the buyer continues the business in the same industry, they must ensure they meet all legal and regulatory obligations associated with the business, including licenses, permits, and ongoing compliance.

It’s also worth noting that certain liabilities may be exempt from successor liability, depending on applicable laws and circumstances. For example, liabilities arising from the seller’s intentional misconduct or environmental violations may not transfer to the buyer.

How to Mitigate a Buyer’s Successor Liability Risks

Buyers can mitigate some of the risks of assuming success liability in an asset purchase transaction by focusing time and resources of important mitigation strategies:

1. Due Diligence: Conducting thorough due diligence is essential to identify potential liabilities associated with the business. This involves reviewing the seller's financial records, contracts, pending litigation, and potential liabilities to identify and assess any risks associated with the transaction. It helps uncover any pending litigation, tax obligations, or potential claims that could impact the buyer. Understanding these risks enables small business owners to make informed decisions and negotiate the terms of the transaction.
2. Structuring the Transaction: Business owners can mitigate successor liability by structuring the transaction appropriately. For instance, purchasing only essential assets instead of the entire business can limit the potential liabilities a buyer assumes.
3. Negotiating and Drafting the Agreement: Business owners should negotiate and draft the asset purchase agreement carefully. Clearly define the extent of assumed liabilities, indemnification provisions, and any representations or warranties related to the seller's obligations.
4. Specific Legal and Tax Advice: Seeking the guidance of an experienced attorney who specializes in business transactions is highly recommended. It is also prudent to involve the owner’s and/or the company’s CPA or tax advisor from an early stage. They can help navigate the complexities of successor liability and ensure that the asset purchase agreement protects the buyer's interests while minimizing potential liabilities.

Conclusion

Understanding successor liability is vital for small business owners involved in buying or selling businesses through asset purchase agreements. Continuity of business operations, notice to creditors, being a mere continuation of the seller's business, and fraudulent intent are all factors that can impact successor liability. By carefully navigating these circumstances, conducting due diligence, seeking legal advice, and structuring the transaction appropriately, small business owners can mitigate potential liabilities and make informed decisions that protect their interests. It's important to work closely with experienced attorneys and professionals who can guide you through the complexities of successor liability, ensuring a smooth transition of ownership and minimizing potential risks.Picture on the top is by Scott Graham and is in the public domain.Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.