Buyer beware: Distribution and franchise successor liability examined

By Vanessa L. Miller

In an effort to bolster the weak economy, throughout 2008 and 2009, Congress passed legislation to incentivize mergers and acquisitions. Many distributors and franchisors took advantage of this favorable investment climate and entered into asset purchase deals. Following this uptick in transactions, a trend emerged as more individuals and companies began filing successor liability lawsuits, looking to asset buyers to pay debts and liabilities left by the seller. Across a number of jurisdictions, courts became less inclined to dismiss these successor liability claims at the summary judgment phase. Instead, courts began taking a more probing look at these recent deals. It appears that courts became concerned that many companies facing financial difficulties entered into asset purchase agreements in an attempt to escape debts and liabilities, but did not actually "sell" their assets or cease operations. Under the multi-factor balancing tests giving rise to successor liability, even legitimate asset purchasers will have a difficult time obtaining summary dismissal of successor liability claims.

The Doctrine of Successor Liability

The general rule is that a corporation that purchases the assets of another corporation is not liable for the seller's liabilities. However, this general rule is subject to four exceptions. There is significant overlap among these exceptions, making it likely that a creditor will assert multiple exceptions in a successor liability lawsuit.

The first exception is where there is an express or implied assumption of liability. Like a regular contract, an express assumption of liability generally occurs through a provision in the asset purchase agreement or an addendum to the agreement that lists the liabilities that the buyer agrees to assume. An implied assumption of liability may occur where there has been voluntary payments of certain debts, coupled with other admissions or conduct by the buyer such that a creditor may claim that the buyer implicitly agreed to assume all liabilities.

The second exception is de facto merger of the two companies. Courts examine four independent factors to determine whether the businesses have de facto merged. In the first instance, there must be a continuity of ownership. If this factor is present, then the court will balance the remaining three factors: (a) cessation of ordinary business and dissolution of the acquired corporation as soon as possible; (b) purchaser's assumption of liabilities ordinarily necessary for uninterrupted continuation of the business; and (c) continuity of management, personnel, physical location, assets and general business operations.

Under the third exception, where a purchaser is found to be a mere continuation of the seller successor liability will arise. Courts look at several factors on a case-by-case basis, including but not limited to common ownership, inadequate consideration, and whether only one corporation exists at the end of the transaction.

The fourth exception is fraud. Courts look for certain badges of fraud, including: (a) a close relationship between the buyer and seller; (b) a secret, hasty transfer not in the ordinary course of business; (c) inadequate consideration; (d) knowledge of the creditor's claim and inability of the selling corporation to pay the claim; (e) use of fictitious parties; and (f) continued control of assets by the seller after the alleged conveyance.

Examples of Successor Liability Claims in the Arena of Distribution and Franchise

Under these multi-factor balancing tests, any asset purchaser may be faced with a successor liability lawsuit. The following are just some examples of successor liability claims that may be brought against distributors, franchisors and franchisees.

The most common scenario is after an asset sale, companies and individuals have sought to hold the buyer distributor, franchisor or franchisee liable for the seller's debts and liabilities. Often, a company selling its assets is in dire financial straights, has unpaid bills and even outstanding court judgments, which creditors seek to recover from the purchasing company.

Successor liability claims also commonly arise after distributors purchase a division of a manufacturing company. Individuals and classes of plaintiffs have brought product liability lawsuits against the purchaser, even where the purchaser ceased manufacturing the allegedly dangerous or defective product.

Where the asset sale is from one distributor to another, companies have sought to enforce an exclusive distribution agreement against the purchasing company. This can occur even where the distribution agreement was not included in the asset sale.

Employees have filed lawsuits against the purchaser, seeking damages for alleged discriminatory acts that occurred under the ownership of the prior franchise owner. These claims can arise even if the new owner terminates the employees that were responsible for the discriminatory conduct.

Precautions an Asset Purchaser Can Take

As the old adage goes: an ounce of prevention is worth a pound of cure (or thousands of dollars in attorneys' fees defending against successor liability claims). Conduct thorough due diligence before purchasing assets to identify the seller's potential liabilities. The purchase agreement should unambiguously exclude all liabilities of the seller, other than those expressly identified and assumed. The purchaser also may want to include the following provisions in the asset purchase agreement: (a) an indemnification provision, obligating the seller to defend and hold buyer harmless in the event a successor liability claim is brought against the buyer; (b) a requirement that the seller remain in existence, solvent and collectible for a certain period of time following the asset sale; and (c) a requirement that the seller retain insurance coverage for certain liabilities, like product defects.

After the asset sale, if employees from the selling company are retained, the purchaser should change the ownership structure and replace high-level managers to avoid the perception of a continuity of ownership. The purchaser should treat all continuing employees as new hires, providing them with the purchaser's own set of policies and employee handbooks and requiring them to sign new employment agreements.

These are just some precautionary steps that an asset purchaser in the arena of distribution and franchise, or any asset purchaser, can take. Although there is no way for an asset purchaser to completely insulate itself against successor liability lawsuits, a purchaser that has taken these steps will be better positioned to prevail at the summary judgment phase of the lawsuit because the multi-factor balancing tests will tip in its favor.

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Vanessa L. Miller is senior counsel at Foley & Lardner in Detroit and a member of the firm's Business Litigation and Dispute Resolution Practice. Contact her at (313) 234-7130 or vmiller@foley.com.

Published: Fri, Jun 29, 2012