AVOIDING LEGAL SURPRISES

How to Reduce the Risk of Successor Liability when Purchasing a Company

By Brian Bailey, Esq.
Becker Meisel LLC

Bailey

Even beautifully wrapped packages can hold some unpleasant surprises. That is most certainly the case when purchasers of New Jersey companies learn they are being sued or held responsible for costs (financial and otherwise) arising under previous ownership.

The legal term is “successor liability” and it can mean big trouble for purchasers that have not properly structured the transaction nor done the due diligence to protect themselves from potential problems and a day in court. It is an easy trap to fall into but one that may be avoided with some care and planning. Avoiding successor liability is a matter of a purchaser knowing what needs to be identified and what needs to be steered clear of.

The following article provides on overview of successor liability, potential consequences a purchaser subject to successor liability may face and a few tips on how to avoid successor liability in New Jersey.  The purpose of the article is to examine successor liability under New Jersey law only.  Purchasers of entities should reference federal laws (i.e. federal labor laws) and the laws of other states (i.e. bulk sales laws) where the entity being acquired is located prior to entering into transactions where successor liability is possible. 
           
Common Signs of Successor Liability
In the majority of cases, purchasers prefer buying a company’s assets rather than its stock. Generally, it is the case that in these types of transactions the buyers are not responsible for the liabilities of the seller. Generally is the key word because there are some interesting and significant exceptions to the presumption against successor liability.

Under the five following scenarios, a purchaser may find itself a legitimate target for successor liability: (1) the purchaser expressly agrees to assume certain debts and liabilities of the selling company, (2) the transaction results in a consolidation or merger of the two companies, (3) the buying company essentially becomes a continuation of the selling company, (4) fraud is employed as the seller attempts to escape responsibility for its debts and liabilities, and (5) in a products liability context, the acquiring company continues to manufacture the same products.

Of the five scenarios, the appearance of a merger and a continuation of the existing business are the two most common pitfalls that can make a purchaser vulnerable to successor liability. Under New Jersey state law, weighing four independent factors helps courts decide the existence of a merger or consolidation. These factors include (1) if there is continuity of the same management and personnel at the same location, (2) how soon after the transaction does the selling company cease operation, (3) whether the purchaser assumes the selling company’s liabilities needed to keep the business running as it had been, and (4) if there is continuity of ownership or shareholders.

A Classic Example of Successor Liability
Proving successor liability means clearing the hurdles of the presumption against holding purchasers liable for acts of the seller. A classic example is a signature 1997 case, Woodrick v. Jack J. Burke Real Estate Inc. In that case, Bradford and Donna Woodrick sued Jack J. Burke Real Estate Inc. for issues regarding the sale of their house. After the lawsuit was filed but prior to the trial, the assets of Jack Burke were purchased by a company, Fox & Lazo Realtors. Four months after Fox & Lazo’s purchase of Jack Burke, nobody on behalf of Jack Burke Real Estate showed up to the trial and as a result the court entered a default judgment in favor of the Woodricks. As Jack Burke Real Estate’s successor, Fox & Lazo were ordered to pay this judgment of nearly $115,000.

Judge David J. Schroth determined that Fox & Lazo’s purchase was a de facto merger that resulted in a continuation of Jack Burke’s business. That ruling had the effect of making Fox & Lazo liable for the entire default judgment. Fox & Lazo immediately filed an appeal.

In filing the appeal, Fox & Lazo argued against the application of successor liability; contending that Jack Burke received no stock and thus had no ownership interest in Fox & Lazo; there was no continuity of management; and Fox & Lazo did not assume the obligations necessary for the uninterrupted continuation of the business.

The Woodricks countered each argument, responding that Fox & Lazo utilized the management, personnel, physical locations, assets and business operations of Jack Burke following the acquisition; Jack Burke’s operations ceased to exist; and Fox & Lazo had assumed all of the liabilities needed to continue the business.

The Appellate Division was not impressed by Fox & Lazo’s arguments, affirming the lower court’s decision in full and finding that “a corporate successor can no longer avoid liability by simply structuring a cash-for-assets sale.” It was a finding that not only undercut Fox & Lazo’s claim to insulation from successor liability but also served notice that corporations in New Jersey would henceforth be held to a higher standard in such transactions.

Although Woodrick v. Jack J. Burke Real Estate Inc. certainly puts New Jersey firms on notice of a higher standard in order to insulate from successor liability, this does not mean that purchasers of companies in New Jersey cannot successfully avoid the grasp of successor liability.

The Necessity of Proper Planning
Proper planning and execution of purchase agreements and transaction documents is critical. The first and most essential step in shielding against successor liability is conducting proper due diligence. Purchasers must do their research. They need to make sure the company they are buying is not subject to any irregular outstanding liabilities or legal action that could possibly come back to haunt them. If any such liabilities or legal actions do exist, the purchaser should not continue with the purchase until they are settled. If the purchaser does want to continue with the transaction and risk being liable for known potential issues, a security measure the purchaser can take is to require the seller to put money in escrow until the issue is completely resolved.

Other tips for avoiding the possibility of being held responsible for the wrongs of an acquired company include setting up the transaction as an asset purchase rather than a buy out or stock purchase and putting a disclaimer in the purchase agreement which expressly indemnifies the purchaser from successor liability. Although neither one of these can guarantee the purchaser is completely protected, taking these steps do weigh heavily against extending successor liability on the purchaser. In addition, the purchasing company should make sure it has insurance that will cover successor liability. The purchaser should also ensure that the seller company is current on its insurance, and that the seller’s policy will provide ongoing coverage for liability due to events that took place during the predecessor’s ownership.

Finally, and most importantly, the purchaser’s lawyer should be an essential and meaningful part of actually structuring the deal and the documents, rather than just acting as a conduit to finalize the deal. Purchasers should not choose just any attorney. They should make sure to use an experienced transactional attorney. Corporate transactional attorneys are trained not only to spot issues that the average businessman may not in these situations, but also to develop appropriate solutions that can save purchasers from a lot of emotional and financial heartache that is inherent in successor liability.

Brian Bailey, Esq. is an associate in the corporate/transactional law practice group of the Livingston, N.J.-based law firm of Becker Meisel LLC. Bailey concentrates his practice on business mergers and acquisitions, start-ups and other business development or wind down structuring.