Recent Decision by NY County Supreme Highlights Potential Pitfall for Business Buyers Seeking to Avoid Their Seller’s Pre-Closing Liabilities.
by: Michael Braunstein
Very often, buyers who are acquiring an existing business will desire to structure their transaction as a purchase and sale of all or substantially all of the assets of the seller. In contrast to a stock or interest purchase, the parties in an asset purchase transaction can specifically designate which assets will be included in the sale and which liabilities, if any, will be assumed by the buyer. In this way, buyers may avoid being held responsible for their seller’s pre-closing liabilities, which very often cannot be easily identified and when they can be identified are not always easily quantified. As the New York County Supreme Court recently pointed out inZmos Networks, LLC v. Momentum Investment Partners et. al., this strategy may not always work out as planned.
In Zmos, the court used the doctrines of de-facto merger and mere continuation to find that Momentum, the corporate defendant-buyer, was not entitled to a dismissal of the plaintiff-creditor’s complaint that Momentum should be held liable for the obligations of its predecessor.
The general rule of successor liability is that a corporation which acquires the assets of another is not liable for the torts or contractual obligations of its predecessor unless:
- it expressly or impliedly assumed them,
- there was a consolidation or merger of seller and purchaser,
- the purchasing corporation was a mere continuation of the selling corporation; or
- the transaction is entered into fraudulently to escape such obligations.
The de facto merger doctrine is an exception to the general rule under which a court will disregard the actual form of the parties’ transaction and treat them as having merged with one another to find successor liability. The court stated that “the hallmarks of a defacto merger include: continuity of ownership; cessation of ordinary business and dissolution of the acquired corporation as soon as possible; assumption by the successor of the liabilities ordinarily necessary for the uninterrupted continuation of the business of the acquired corporation; and continuity of management, personnel, physical location, assets and general business operation… not all of these elements are necessary to find a defacto merger.”
Regardless of the ultimate outcome of the Zmos case, there are a few important lessons to be learned from the decision on the motion. Most of them are not novel but are worth restating here.
First, merely structuring an acquisition as an asset purchase over a stock purchase does not mean that the buyer can always avoid its seller’s pre-closing obligations.
Second, whether a buyer will ultimately be held liable for these obligations is a highly fact sensitive question and creditors will often have a reasonably good shot at pleading a case that survives a motion to dismiss.
Third, although most Asset Purchase Agreements provide indemnities for these kinds of things, an indemnity alone may not be sufficient if the indemnitor does not have the wherewithal to pay claims. Proving at trial that there was no defacto merger or continuation will no doubt be time consuming and expensive. Moreover, an adverse decision will directly influence the outcome of claims by other creditors, which could start to add up very quickly.
All of this leads to what I consider to be the most important lesson: in a deal where any of the above factors are present, it is especially critical that the buyer insist on an escrow fund to back-stop the seller’s indemnity obligations. The amount of the fund should correlate to any identifiable obligations of the seller plus an additional amount for the expense of defending claims and for any unforeseen liabilities. Finally, the escrow should survive long enough for any potential litigation to wind its way through the courts, a period usually stated in years.
We have handled many deals involving these kinds of issues and would be happy to discuss them with you in greater detail should you have any questions.
Read the decision here.