March 4, 2009Client Alert

So You Would Like to Acquire a Financially Distressed Company? Buyer Beware!

Updated March 16, 2010

A buyer desires to acquire a financially distressed business, but does not wish to assume all (or any) of its liabilities. The buyer therefore concludes to purchase assets (not stock) and expressly disclaim liability assumption in the asset purchase agreement. The buyer has successfully accomplished its goal—right? Not necessarily! Due to various judicial and statutory “successorship” laws, such a buyer may not be home free. Indeed, although the proposed structure may result in an attractive price (due to the presumed non-assumption of the business’s liabilities), the buyer should be aware that it might unintentionally acquire the company’s liabilities as well.

Although the general rule in an asset purchase is that the seller’s known and unknown liabilities remain with the seller unless expressly assumed by the buyer, there are exceptions to that rule. These exceptions may be troublesome for the unwary buyer, who may have limited recourse against the selling entity, which was, after all, in a distressed financial position prior to selling. The following are some considerations with regard to acquisitions of financially distressed companies.

Assumption of Liabilities: A buyer can assume, by implication, the seller’s liabilities if the buyer’s “conduct,” during the purchase negotiations or post-purchase actions, indicates its intent to assume the seller’s liabilities and a third party claimant relied on the buyer’s conduct to its detriment.

Successor Liability: In general, a buyer may succeed to the seller’s liabilities when (i) the asset purchase amounts to a consolidation or merger (the de facto merger theory), (ii) the buyer is a “continuation” or “substantial continuation” of the seller, or (iii) the purchase was fraudulently entered into in order to escape liabilities or there is a lack of equivalent value in exchange for the acquired assets (the fraudulent transfer theories). In addition, in certain jurisdictions, the products liability of the seller will become the responsibility of the buyer under public policy theory. Whether any of these successorship doctrines is applicable may depend upon the structure of the asset sale, the form of consideration paid, and the exact assets and employees acquired.

In addition, a buyer may succeed to the seller’s liabilities pursuant to laws and regulations. Below is a brief summary of the laws and regulations commonly encountered in connection with an acquisition that may cause seller’s liabilities to succeed to the buyer.

  1. Environmental. The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA”) is the chief federal law on environmental matters with regard to the acquisition of real property and successor liability issues. CERCLA provides that buyers of real property can be liable for the costs of cleaning up contamination even if the contamination did not occur while the buyer owned the property.

  2. Taxes. In Wisconsin, a buyer is liable for a seller’s unpaid sales and use taxes, and in many states a buyer may be liable for the seller’s unpaid property taxes.

  3. Labor and Employment. A buyer may be required to assume certain union liabilities and/or obligations (including an obligation to bargain with a union) if certain conditions are satisfied. One condition is whether 50% or more of the buyer’s employees were formerly the seller’s bargaining unit employees. A buyer may also be liable for discriminatory actions by the seller under Title VII of the Civil Rights Act of 1964.

  4. Bulk Sales Law. Wisconsin previously had a bulk sales law that required a seller’s creditors be given notice when a substantial part of the seller’s assets were sold outside the ordinary course of business. If an applicable bulk transfer procedure was not complied with, the buyer could find itself owning assets subject to the claims of the seller’s creditors. As of February 19, 2010, the Article 6 bulk sales provisions of the Wisconsin Uniform Commercial Code were repealed pursuant to 2009 Wisconsin Act 110.

In order to minimize its risk of assuming seller’s liabilities, consider the following when structuring and documenting the asset purchase transaction.

  1. Due Diligence. A buyer should perform comprehensive due diligence when purchasing a financially distressed company, though the scope of such due diligence should be considered on a transaction-by-transaction basis depending on the issues, products, liabilities of the Seller, and types of assets being acquired in the transaction.

  2. Structure. A buyer should consult with counsel to determine whether the proposed structure (i.e., the particular asset purchased; the employees retained; the continued use of the seller’s facility, name and goodwill, etc.) of the sale implicates successorship liabilities under any of the theories mentioned above. If so, consider whether the structure can be changed to minimize the risk of successorship.

  3. Purchase Agreement. The purchase agreement should clearly set forth: (i) the assets being acquired; (ii) the liabilities, if any, being assumed; (iii) that no liabilities are being assumed other than the expressly assumed liabilities; (iv) a comprehensive indemnification section to protect the buyer against any damages incurred by the buyer as a result of the transaction or the pre-closing operations of the business (including any successor liabilities).

  4. Guaranty. The buyer should consider obtaining a guaranty from each of the shareholders guaranteeing to the buyer the performance of the obligations of the seller under the purchase agreement (including the indemnification obligations).

  5. Withhold a Portion of the Purchase Price. The buyer should consider withholding a portion of the purchase price for a period of time after the closing (this can be in the form of an escrow agreement) to offset liabilities that are the responsibility of the seller but the buyer pays. The times and amount to withhold depends on the types of issues and the dollars involved.

  6. Third Parties. The buyer may wish to consult, and work, with the seller’s creditors, suppliers, customers and employees to resolve issues prior to consummating the transaction. For example, alternative payment arrangements may be used to avoid supplier delays, bonuses to incentivize the employees to perform, and stay bonuses to maintain the workforce.

  7. Insurance. The buyer should consider obtaining “tail” insurance for products that are manufactured by seller prior to closing. The necessity of such “tail” insurance depends on the types of assets that are subject to the transaction and the likelihood of product liability claims arising post-closing for the products manufactured prior to closing. Note, however, the buyer should examine the underlying insurance policy to insure adequate coverage is obtained with regard to the “tail” insurance.

  8. Obtain Clearance Certificate. The buyer should request a Clearance Certificate from the Wisconsin Department of Revenue to avoid becoming liable for the seller’s sales and use tax liability. Unfortunately, this certificate cannot be received until after the sale. So, the buyer should consider the use of an escrow or reductions in the purchase price to offset possible unpaid sales and use tax liability. Also, a buyer should review a seller’s property tax liability as this type of tax, if unpaid, may succeed to the buyer.

  9. Notice to Creditors. The buyer should consider providing adequate notice to creditors and third parties with regard to the transaction to comply with applicable bulk sales law. Though many states have repealed their bulk transfer laws (including Wisconsin as of February 19, 2010), if the seller has assets located in multiple jurisdictions, a state-by-state review of bulk transfer laws should be conducted to determine compliance with all applicable laws.

For more information on how Michael Best can be of assistance to you in connection with your purchase of a financially distressed company, please contact one of the authors of this alert or any member of the firm’s Business Practice Group.

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