Liability Issues To Consider When Selling A Company

June 2014       Download PDF      Print

When a business owner sells his company, it's common for some of the liabilities that originated under his ownership to be passed on to the buyer. Because some of these liabilities may be unexpected and very costly, buyers perform due diligence before acquiring a company.

During due diligence the buyer will assess risk factors associated with the target company, especially those relating to environmental, product, and employee liability issues. A business owner should be mindful of these liabilities before selling his company as they can have a significant impact on the success of a transaction.

Deal Structure & Liabilities

If a buyer uncovers potential liabilities during due diligence, it may influence whether a deal is structured as an asset sale or a stock sale. Deal structure in turn influences how liabilities are transferred during an M&A transaction. Deal structure can also have significant tax implications for some business owners. (We've addressed this in our article Asset Sale vs. Stock Sale: What's the Difference?)

In a stock sale, the buyer acquires the seller's legal entity. Consequently, all of the target company's liabilities are transferred to the buyer unless negotiated otherwise, including contingent and unexpected future liabilities.

In an asset sale, on the other hand, the buyer specifies which assets it will acquire in the purchase agreement. The buyer also enjoys protection by being able to choose which, if any of the seller's liabilities it will assume. Buyers often prefer asset sales for this reason. However, it's important to note that there are federal and state "successor liability" exceptions that vary by jurisdiction and can hold buyers responsible for liabilities under certain circumstances.

Terms of the Purchase Agreement

In a typical purchase agreement, some of the most heavily negotiated and most important terms are related to liabilities: representations and warranties, and indemnifications.

Representations & Warranties

From a buyer's standpoint, representations refer to statements and assertions about the target company—both past and present—that are influencing their decision to purchase. Warranties are assurances from the seller that these statements are factual.

This section includes details such as who is making the representations on behalf of the seller and for what period(s) they are being made. Information supporting the representations made by the seller is provided in disclosure schedules. The information and language in this section must be accurate and clearly worded. Otherwise, the buyer may delay or terminate the deal, or the seller may be forced to indemnify the buyer.

Indemnifications

Indemnifications in M&A transactions typically refer to payments that the seller must make to the buyer to compensate for breaches of representations and warranties. Specific points addressed when negotiating indemnifications include the actions to be indemnified, size of the indemnification, who indemnifies whom, the length of the indemnification period, caps, and materiality thresholds.

Unknown Liabilities

Buyers expect sellers to ensure through representations and warranties that all liabilities have been represented, that all contracts and employment agreements have been disclosed, and that all taxes, wages, and insurance policies are current. However, buyers and sellers sometimes get blindsided by liabilities arising from unexpected issues or problems that have been overlooked. We discuss some of the most common examples below.

Environmental Liabilities

Environmental issues come in various forms, including ground contamination, water pollution, or asbestos. In recent years, these have become a growing M&A liability concern due in part to increasingly complex laws and regulations that dictate successor liability.

The assumption of environmental liability is generally dictated by the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") and applicable state laws. Environmental liabilities may include penalties or fines resulting from noncompliance with environmental laws or regulations. They may also include clean-up costs from contamination or expenses related to litigation or ongoing compliance obligations.

Sophisticated buyers in certain industries may seek protection from unexpected environmental liabilities by obtaining a Phase I report and by consulting with various environmental professionals.

Product Liabilities

One of the greatest sources of liability risk for buyers in M&A transactions is product liability. This is particularly true for firms in the manufacturing and consumer products industries. When performing product liability due diligence, buyers typically review all of the company's existing and past product offerings.

Product-related liabilities may arise from breaches of warranty, misrepresentation, defective product, negligence, or personal injury claims. Therefore, buyers typically review any related insurance policies, claims histories, and pending or prior lawsuits. While sellers should disclose any contingent and potential litigation under representations and warranties, buyers must also consider the possibility of new lawsuits surfacing post-transaction.

Employee-Related Liabilities

Buyers should be wary of a variety of employee-related liabilities in M&A transactions. In stock sales, the buyer will assume all of the target company's employees' severance agreements, pension plans, health benefit plans, and incentive plans. Liabilities may also include obligations arising from unresolved labor and employment law violations or ongoing litigation. New complaints filed by former employees could potentially arise as well.

Some employee benefit-related issues are difficult to identify, and as a result, are sometimes overlooked. These types of liabilities may unexpectedly arise if the seller did not maintain its benefit plans in accordance with compliance obligations or failed to fulfill its fiduciary duties.

Unexpectedly Assuming Liabilities

State and federal successor liability exceptions and laws such as CERCLA include rules that expose buyers to unknown liabilities. Under certain circumstances, a buyer can be held responsible for a liability, even if he did not choose to contractually assume it in the asset purchase agreement.

Additionally, buyers can potentially be held liable for obligations arising from events occurring under previous ownership. This may occur in the previous owner is insolvent, bankrupt, or no longer exists. This most commonly occurs in situations where an unexpected environmental or product liability issue surfaces post-transaction. For these reasons, indemnification provisions are some of the most heavily negotiated items in the purchase agreement.

Negotiating a Successful Deal

During due diligence, buyers may uncover unexpected risks that could delay or ruin a transaction. Therefore, it's important for sellers to work with their financial experts and attorneys to assess potential liabilities ahead of the sale process.

Understanding the source of potential liabilities can help sellers negotiate favorable deal terms. This will ultimately help the seller execute his succession plan more efficiently and help him maximize the net proceeds through the sale of the company.