I
n this chapter and Chapter 3, I turn to the legal aspects of mergers and acqui- sitions. I will cover rights and responsibilities of successors, creditors, share- holders, boards, controlling parties and employees. I will also look at particular statutory regulatory schemes, as well as employee, antitakeover, securities, antitrust and industry-specific rules.Successors—General, Environment and Sales Taxes
Under English common law, claims against and by a company disappeared on dissolution. Any assets had to be given over to the King. In the United States, the rule was changed. On dissolution, the company’s assets became a trust fund for claims by creditors and shareholders. If the assets had been distributed, creditors could bring claims against former directors and shareholders on the ground that the assets were subject to a lien by creditors. Such claims were subject to the statute of limitations, which required that claims be brought within a fixed time period.
Most present state statutes are based on the 1979 Model Business Corporation Act,1which provides that the dissolution of a company does not cancel claims against the company or its directors, officers and shareholders that existed prior to dissolution. Such actions must be brought within two years of dissolution.
Since the 1979 Act only addresses predissolution claims, there is considerable confusion about what remedies should be available for claims arising after disso- lution. Courts will apply the same two-year limitation, unless they find some rea- son that would cause it to be unfair. An example is self-dealing by target’s directors before dissolution.
This provision was clarified in the 1985 Revised Model Business Corporation Act,2which established a longer period of five years and created different rules for claims known at dissolution and for those not known. However, many state statutes remain based on the 1979 Act.
General Liability
Acquirer’s responsibility for target’s debts and liabilities depends on the structure of the deal and the agreements. If acquirer merges or combines with target, it becomes liable for target’s debts and responsibilities. By law, the rights and obli- gations of target pass to acquirer “as a matter of law.” For instance, under Cali- fornia Corporations Code, the surviving corporation will be liable for the debts of the disappearing corporation in a merger, and all liens on property of either company will continue.3Similarly, any action or proceeding pending against the disappearing corporation can be prosecuted against the surviving company.4 Punitive damages can even be recovered against the surviving corporation.
If acquirer purchases target’s stock, it does not become directly liable for tar- get’s liabilities. Target survives and remains liable for its own debts. Indirectly, acquirer does become liable since it is the owner of target, and the value of that ownership is reduced by target’s liabilities. Those liabilities have presumably been reflected in the purchase price.
If acquirer only purchases target’s assets, it is not responsible for target’s lia- bilities and debts. If it contracted to assume only certain liabilities, it is not responsible for other liabilities and debts of target. There are certain exceptions to this principle of being only subject to what is agreed in asset acquisitions, which I will discuss below.
Perfected Security Interests
The first exception is if the assets are taken subject to recorded or perfected secu- rity interests.5Even if acquirer did not agree, it takes subject to any perfected interests that have been properly recorded.
Assumption
The second exception is if acquirer impliedly agreed to assume the liabilities. The implication could arise from conduct or statements. It is important, therefore, that asset purchase agreements expressly exclude any liabilities other than those specifically listed.6
Consolidation, Merger, Continuation or Alter Ego
The third exception is if the net effect of the transaction is a consolidation, merger or acquirer continuing target’s business.
The courts have found a de facto consolidationif acquirer purchases all of target’s assets without adequate consideration to pay off target’s debts, and soon afterwards target ceases to do business.7
Similarly, courts have found a de facto mergerif the consideration paid is solely in acquirer’s or a subsidiary’s stock, all of target’s shareholders become shareholders of acquirer, acquirer assumes only liabilities necessary to carry on target’s business, and target liquidates after the acquisition.8
Courts are more likely to find a continuationif there is a common identity of directors, officers or stockholders, the same or similar name, location or employ- ees are used, inadequate consideration is paid, and only one company survives.9 Courts feel that if acquirer has reaped the benefits of target’s business, it should be responsible for its liabilities. Since cases in this area involve two corporations having the same or similar shareholders and directors, the mere continuation theory may be avoided if there is no common identity of shareholders or man- agement.10
Target might own a subsidiary that is not being acquired because it has signif- icant claims or risks. Even though the subsidiary was a separate company and was not acquired by acquirer, acquirer may be liable. This could occur if the sub- sidiary’s business was closely controlled by target. In such a case, creditors may be able to argue that the subsidiary was operated as a mere tool of target and was its alter ego. If successful in their argument, target—and therefore acquirer—would be liable for the subsidiary’s liabilities.
Fraud
The fourth exception is if the assets were fraudulently transferred. If target sells its assets in an attempt to defraud or deprive its creditors of payment, buyer will be liable for target’s liabilities.11In applying this test, courts usually look at the consideration paid to see if it was adequate, reasonable or fictitious.
Product Line
At least one state has created another exception for manufacturers. Under Cali- fornia law, manufacturers of defective products are strictly liable, and their lia- bility passes to any acquirer of its assets. The theory is that the “risk of injury can be insured by the manufacturer and distributed among the public as a cost of doing business.”12This is called product line theory.
California will apply product line liability to acquirer in these instances:
• Its acquisition of target’s business had, in effect, eliminated any remedy that an injured plaintiff might have had. This has been interpreted to mean that acquirer actually played some role in the destruction of plaintiff ’s remedies.
This means that all, or substantially all, of target’s assets must have been acquired.
• Acquirer has the ability to assume and spread the risk. The courts have interpreted this to mean that acquirer purchased the physical plant, equip- ment, inventories and technology; and has continued to use target’s pro- duction personnel and managers. The individuals could be retained as employees or consultants.
• It is fair to impose the burden on acquirer as being necessarily attached to target’s goodwill that acquirer purchased and enjoys. Fairness will be found if acquirer purchased target’s trade name, goodwill and product
line; continued to produce the same products; and held itself out as the same enterprise.13
Most federal and state courts have rejected this theory at least in principle. A few states, including the highest courts in New York and Delaware, however, have not ruled on this exception. In reality, however, when plaintiff ’s have no other remedy and acquirer has assumed target’s reputation and goodwill, other courts have found means similar to the product line theory to impose liability on acquirer.
Duty to Warn
A related theory is that acquirer should be liable if it was aware of a potential claim, such as a product defect, or should have discovered the claim or defect during its due diligence but failed to warn customers.14This rule only applies if there is a continuing relationship between acquirer and target’s customers. Taking over target’s customer contracts is clearly an example.
Avoiding and Protecting Against Liability
There are a number of strategies that acquirers can adopt to reduce their chances of being found liable for target’s liabilities. To recap:
• Check for secured claims on all assets being purchased.
• Avoid any express or implied assumption of liabilities.
• Avoid any express or implied agreement to dissolve target after the acquisi- tion. If target survives, the mere continuation theory cannot be applied.
• Have a subsidiary, newly created if necessary, buy the assets. This will isolate the liabilities to one business.
• Buy assets, not stock. This eliminates the chance of a de facto merger or consolidation.
• Do not buy all the assets. This will probably eliminate being treated as con- tinuing target’s business, since it keeps target as an ongoing business after the acquisition.
• Do not reference buying goodwill in acquisition documents. Underlying most court decisions in continuity cases is the belief that if acquirer has taken the goodwill, it should take the bad will (liabilities). This may not be possible, however, if the acquisition includes a trademark or a covenant not to compete, both of which require that some goodwill be acquired. This approach will also mean that the purchase price is only allocated to non- goodwill assets, which will raise their capitalized cost and result in higher depreciation expense.
• Give notices to customers, suppliers and employees that acquirer has pur- chased the business and that it is a separate business from target.
• Pay adequate consideration. This reduces the chance of a mere continuation theory.
• Pay consideration in cash, not acquirer’s stock. This reduces the chance of the de facto merger doctrine being applied. It might also reduce the chance of the mere continuation theory being applied.
• Pay consideration to target, not its shareholders. This accomplishes two things. It means target continues. It also means that acquirer can argue tar- get had sufficient assets. It was the distribution of the consideration to shareholders that deprived creditors of any recourse—not the purchase. In such cases, shareholders, not acquirer, should be liable.
• Change product lines after the acquisition.
• Warn customers of product defects.
Even where liability cannot be avoided, acquirer can protect itself by certain actions:
• Reduce the purchase price to reflect any risks.
• Insure against risks. Make certain target’s product liability policy is in place.
Increase coverage if necessary. If target will not continue to exist, have the policy transferred to acquirer.
• Get an indemnity from target, but make certain there will be assets to back it up. If target will be dissolved, get the indemnity from its principals, par- ent or major shareholders.
• Set aside some of the purchase price to cover potential claims. An inde- pendent escrow agent can hold the amount set aside if target wants more assurance that the set-aside money will ultimately be available to it.
Environment
Environmental liabilities raise special considerations. Unfortunately, the rules are not clear. Most environmental laws do not clearly address the responsibility of acquirers for target’s environmental liabilities.
The Comprehensive Environmental Response, Compensation and Liability Act15(CERCLA) was passed in 1980 and requires companies to clean up haz- ardous substances they generated, transported or disposed. The Environmental Protection Agency (EPA) or any injured person can sue. CERCLA also created a Superfund for cleaning up hazardous substances where the polluter cannot afford to or cannot be found.
Since CERCLA liability can be significant, it is important for acquirers in their due diligence to look carefully for environmental risks. For instance, a landowner can be liable for hazardous materials found on its land unless it was caused by an
unrelated third party. In due diligence, acquirer must look for hazardous materials found not only on property owned by target but also on nearby and adjacent land.
The EPA has taken a very aggressive position on successor liability. Its position on the liability of successors under Superfund appears in a 1984 memorandum.16 In a merger or consolidation, the EPA stated that the surviving company assumes the Superfund liabilities of both companies. In a stock purchase it recognized that the company remains in existence, with only its owners changing. Therefore, there should be no change in CERCLA underlying liability. In an asset purchase, the EPA will apply the traditional approach described above as modified by the continuity of business exception. In some instances, the EPA has argued that the product line theory should apply.
Some states have not been willing to go as far as the EPA in assessing environ- mental liabilities, and limited themselves to the traditional approach without applying the continuity of business exception. Of course, if acquirer continues target’s practices that gave rise to environmental liabilities, it will be liable.
Sales Taxes
There are several reasons why sales of assets in a merger or acquisition should be exempt from state sales taxes:
• Exempt: most states exempt from sales taxation transfers of property pur- suant to a merger or consolidation.
• Intangibles: states that impose sales taxes on property sales generally exclude the sale of intangibles such as stock, bonds, notes and intellectual property. This means that stock for stock acquisitions will generally be exempt even from the sales taxes in states taxing property transfers. Harder questions arise for sales of assets embodying intellectual property, such as sale of computer software stored on a disc.
• Not in ordinary course of business: many states exempt transfers outside the ordinary course of business, which should include the sale of assets as part of a merger or acquisition.
• Resale: most states also exempt sales of property that the buyer intends to resell. Purchases of inventory, for instance, in such states should be exempt.
• Manufacturing: many states exempt transfers of property used or con- sumed in manufacturing. This should include raw materials and equipment used by a target manufacturer.
• Transaction: other states exempt property sold as part of particular transac- tions, including incorporations, liquidations and reorganizations.
Employers
As a general rule, acquirers are not liable for target’s obligations to its employees in a sale of assets transaction. In stock purchases, target, as in previous cases, remains liable, since only its shareholders have changed, while its obligations have not changed. In mergers and consolidations, the surviving company may be liable in certain circumstances for the dissolved company’s obligations to its employees.
Discrimination Claims
What effect does the acquisition have on target’s liability for discrimination claims? As with general liability, a stock acquisition will have no effect—as long as target continues in existence. More difficult are cases where target is the sub- ject of a merger or asset sale and ceases to exist. The basic principle of general lia- bility is that, having ceased to exist, it can no longer be liable for claims, including discriminatory ones. This can impose a hardship on employees who have been discriminated against. They may be deprived of assets to recover against, since they have been transferred to a new owner, with value paid to the former share- holders. The courts are willing to impose general liability in certain instances to prevent such injustice.
Will they do the same in discriminatory claims? Courts have looked at two previously discussed factors before imposing such liability—substantial conti- nuity and notice to acquirer of the potential liability.17
Collective Bargaining Agreements
There are two issues under collective bargaining agreements that acquirers must consider. First, can target’s employees block the proposed sale? Target’s collective bargaining agreements may be silent or specifically address the issue. When silent, most cases have not implied a right of unions to object.18
Express language will usually state whether the union’s approval must be obtained for asset sales, mergers or consolidations. The approval may be blan- ket—that is, covering all such transactions—or may be limited to instances where a certain number of employees will be laid off as a result of the transac- tion. Although federal law controls questions concerning union rights, state law governs interpretations of whether there has been an assumption.19
In some cases, employees are awarded a tin parachuteif control of the com- pany occurs without board of directors’ approval. The parachute is usually worth
several month’s of salary. While this provision does not mean acquirer must obtain consent of target’s employees, it does mean that the acquisition will be considerably more expensive.
Second, can acquirer avoid responsibility for target’s collective bargaining agreements? A buyer of assets is generally not bound by target’s existing collec- tive bargaining agreements.20There are two exceptions:
• Acquirer expressly or impliedly agrees to assume the contract.
• Acquirer hires a majority of target’s employees.21
Often, these are described in the terms discussed above as a continuity of target’s business by acquirer. Therefore, if acquirer is not assuming target’s employment con- tracts, at the time of the closing it should announce this fact to the employees.
State Protections
Many states have passed legislation protecting employees in acquisitions.
Delaware, for instance, allows employees to sue for unpaid wages. The state department of labor is also given the right to sue on behalf of employees injured by the acquisition.22Under California law, accrued but unused vacation time is the seller’s retained employment obligation.23
Worker Adjustment and Retraining Notification (WARN) Act
The WARN Act24is a federal plant closing statute. It applies to employers with 100 or more employees that intend to close a plant, have a mass layoff, or have an employment loss.Plant closingis a permanent or temporary shutdown of a sin- gle employment site if it results in an employment loss for 50 or more employees.
It also applies to mass layoffs, which means a reduction in force of 33 percent of the employees and at least 500 employees.Employment lossis a layoff for more than 6 months or a 50 percent reduction in work.
Under WARN Act, employers must give 60-day notice before a plant closing or mass layoff.25Exception is granted to companies actively seeking capital dur- ing that period, if the notice would eliminate any chance of raising the money.
Employers who order plant closings or mass layoffs in violation of the law are liable to injured employees for one day of back pay for each day of violation, plus benefits under employee benefit plans. Back pay is calculated at the higher of the average wage during the last three years or the final wage. Employers are also liable for a civil penalty of up to $500 for each day of violation.26
In cases of acquisitions, target is responsible for giving notice of any plant closing or mass layoff but only up to the closing. Thereafter, acquirer is responsi- ble. Employees of target on the sale date are considered employees of acquirer.
Pension Plans
The Employee Retirement Income Security Act of 1974 (ERISA)27 contains detailed rules on successor liability for pension plans. ERISA covers defined ben- efit pension plans and defined contribution plans.
Defined benefit pension plans reflect promises to pay retiring employees a stated accrued sum. The amount is usually an annuity paid monthly and calculated in accordance with a formula. Contributions are based on actuarial calculations reflecting salary levels, estimated investment return, mortality and turnover. Any investment risk remains with employer.
Defined contribution plans reflect promises to pay workers at either retire- ment or earlier termination of employment the amounts accumulated. Any investment risk is borne by participants.
If the defined benefit pension or contribution plan meets certain require- ments under Internal Revenue Code (IRC),28 it is tax-qualified. This means employees do not have to recognize taxable income until benefits are distributed, including investment income on their contributions. Employers, on the other hand, can deduct when they made any contributions to the plan—up to certain maximum levels. These rules enable employers and employees to enjoy the tax advantages.
Acquirers must evaluate target’s pension plans before completing the transac- tion. Defined benefit pension plans are liabilities of target and can be significant, if not fully, funded at closing. Target may also be liable for tax penalties if it has not adequately funded its pension plan, since the plan would not have been qual- ified and its deductions for contributions would not have been eligible.
To protect employees of terminated plans, the Pension Benefit Guaranty Cor- poration (PBGC), a federal agency, guarantees vested benefits. If the plan has not been adequately funded to pay the amounts due, the PBGC has the right to sue employers to recover any shortfall that it funded.29
Unless target’s collective bargaining agreement provides otherwise, acquirers have a choice on whether to assume target’s plan or not. If acquirer decides not to assume the plan, what it must do depends on the type of acquisition. In a merger or stock acquisition, target terminates the plan prior to the closing. In an asset acquisition, target terminates its plan after the acquisition.
For the most part, acquirers not assuming target’s pension plan are not liable.
There are exceptions. In statutory mergers and stock purchases, if the pension