Successor Liability – Not Your Problem, Or Is It?

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[author: Timothy R. Deckert]

 

When negotiating the sale of a business, tax considerations typically drive the structure of the sale. After taxes, however, liability issues are one of the most significant factors in how a deal is structured. From a liability perspective, a buyer prefers to acquire assets, which allows it to assume only certain negotiated liabilities, while the seller would rather sell the company as a whole (i.e., stock or LLC membership interests), which would saddle the buyer with all liabilities that are associated with the selling entity. While the buyer can protect itself in a stock purchase through indemnification provisions, escrowed funds and other techniques, there are limits (particularly time limits) to those types of defenses, which is why an asset sale is generally preferable for a buyer.

 

The Pennsylvania Supreme Court recently addressed the issue of successor liability in the case of Fizzano Bros. Concrete Products, Inc. v. XLN, Inc., 42 A.3d 951 (Pa. 2012). In this case, the Court noted the following five exceptions to the general rule that a purchaser of assets is not responsible for liabilities of a seller:  1) the liabilities are expressly or implicitly assumed, 2) the transaction constitutes a de facto merger (i.e., a transaction that is not legally structured as a merger, but the end result is the same), 3) the purchaser is merely a continuation of the selling entity, 4) the transaction is a fraudulent attempt to escape liability, and 5) there is inadequate consideration and no provisions are made for the creditors of the selling entity.

 

The Fizzano case focused on the application of the de facto merger test. A software company, System Development Group, Inc. (“SDG”), sold its stock to XLN, Inc. (“XLN”), with the bulk of the consideration consisting of two promissory notes. The two majority shareholders of SDG (the “Shareholders”), who together were entitled to approximately eighty-five percent of the promissory note payments, were employed by XLN and retained the ownership of the software (which was licensed to XLN) until the promissory notes were paid in full by XLN. Subsequently, XLN sold substantially all of its assets, including the right to license the software owned by the Shareholders, to XLNT, Inc. (“XLNT”), which also employed the Shareholders and maintained the same business location. The dispute in Fizzano stemmed from a lawsuit filed against XLN for breach of contract by SDG (XLN was responsible for this breach of contract claim due to the stock acquisition). While XLNT only acquired the assets of XLN, the plaintiff asserted that XLNT was liable under the de facto merger exception.

 

The trial court examined each of the following factors of the de facto merger exception, before ultimately determining that XLNT was in fact liable:  1) continuity of the enterprise (i.e., management, personnel, physical location, assets and general business operations); 2) continuity of ownership; 3) cessation of selling corporation’s business as soon as practically possible; and 4) purchaser’s assumption of the obligations ordinarily necessary for the uninterrupted continuation of the normal business operations of the seller. The trial court determined that three of the four factors were present, and held XLNT liable even though the continuity of ownership element was not met. On review, the Superior Court reversed the trial court ruling, holding in part that continuity of ownership was “indispensable” in order to establish a de facto merger.

 

In reviewing the de facto merger exception, the Pennsylvania Supreme Court considered a number of different issues. First, the Court noted that other jurisdictions were split on the question. The Court acknowledged that the cases where the continuity of ownership requirement had been relaxed typically involved criminal or tort law, or some other “overarching matter of public policy”, as opposed to the contractual/corporate law dispute that arose in Fizzano (the thought process being that in more “serious” cases, it is appropriate to lower the threshold for finding a purchaser liable). The Court was swayed in particular by the statutory merger language contained in Pennsylvania’s Business Corporation Law of 1988. Specifically, the Court noted that in several places, the statutes referred to an exchange of shares/securities or obligations. Focusing on the “or obligations” language, the Court concluded that since a statutory merger does not always require an exchange of shares, it did not make sense to create a broad rule that a de facto merger always have a continuity of ownership interest.

 

Ultimately, the Supreme Court reversed the Superior Court ruling, but declined to adopt a broad ruling. Instead, the Court limited its holding to cases involving breach of contract and express warranty. The Court did hold that the de facto merger exception requires “‘some sort of’ proof of continuity of ownership or stockholder interest.” While the Shareholders received promissory notes from XLNT (which were renegotiated from the promissory notes issued by XLN as part of the initial stock acquisition of SDG), the Court did not make a determination as to whether these notes constituted a sufficient continuity of ownership; instead, the case was remanded for further proceedings to make that determination.

 

While the threat of successor liability may not be present in many legitimate business transactions, the Supreme Court’s holding in Fizzano does underscore the importance of heightened awareness in structuring transactions. With some careful planning, the risk can be further reduced or outright eliminated.