If you are purchasing an existing business or even the assets of a business in California, it is important to consider to what extent your business will have exposure to successor liability following the purchase. California successor liability laws are significantly broader than those in some states, so being informed and taking steps to mitigate your company’s exposure beforehand is critical, especially in higher risk industries.
What is Successor Liability?
Successor liability simply involves the imposition of liability against a successor company for the debts and liabilities of a predecessor. This usually occurs following the sale of a business or a merger of two entities. For example, if your new or existing business purchases the equity interest (shares or LLC membership interest) of a target company, or merges with a target company, the surviving entity will typically be liable for the target company’s past and future debts and other liabilities. See Corporations Code Section 1107(a). While a successor’s liability to creditors can be mitigated in some instances through compliance with California bulk sales laws, most of the obligations of a predecessor will remain with the successor following these transactions. Click here for our discussion on California bulk sales laws.
Ways to Avoid Successor Liability
A purchasing business owner may consider one of several options to avoid the imposition of successor liability, including:
1) The owner of an existing business may create a separate subsidiary to purchase the target business. This option places the acquired liabilities in the subsidiary to avoid exposure to the parent company. This option is, of course, available only for existing companies, not new businesses, and does nothing to prevent successor liability from being imposed on the subsidiary; or,
2) The purchasing company may include certain legal provisions in the purchase agreement which shifts liability back to the seller. This choice is feasible where the selling entity survives the purchase or where a selling company’s owners have the financial ability (and are willing) to indemnify or otherwise compensate the purchasing entity should any predecessor liabilities arise following the sale or merger; or
3) A purchasing business might also avoid the imposition of successor liability by purchasing only the assets of a target business. However, this is not a foolproof solution as discussed below.
Imposition of Successor Liability Following a Sale of Assets
While the general rule is not to impose liability on a successor business following an asset sale in California, there are a number of exceptions, as explained by the Supreme Court of California in Ray v. Alad Corp. (1977), 19 Cal.3d 22:
“[T]he rule states that the purchaser does not assume the seller’s liabilities unless
(1) there is an express or implied agreement of assumption,
(2) the transaction amounts to a consolidation or merger of the two corporations,
(3) the purchasing corporation is a mere continuation of the seller, or
(4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts.”
In the Ray case, the Court added a fifth basis for imposing successor liability–strict tort liability for a defective product. In the context of an asset sale, California courts have been somewhat creative in finding ways to impose liability against a successor where a party has clearly been injured and there is no available remedy against the predecessor, so it is not safe to assume that a purchase of assets alone will provide adequate protection against successor liability.
Successor Liability to Governmental Authorities
Successor entities in California can also be held liable for obligations of the predecessor with regard to various governmental authorities debts, if not already paid by the predecessor. Following are examples of amounts the purchaser may seek to deduct from the purchase price as reimbursement for payments to the appropriate governmental entities.
- Contributions to the California unemployment fund, employment training fund and unemployment compensation disability fund, plus any interest and penalties.
- Franchise and income taxes, plus any interest and penalties
- Sales and use taxes
As an alternative, the purchasing business may seek to obtain, prior to closing of the sale or merger, confirmation from these governmental entities that the predecessor’s obligations have been fulfilled.
In conclusion, individuals or entities who are contemplating the purchase or merger of an existing business must be aware of the real potential for successor liability being imposed on their company following the acquisition of a business or its assets. Often, a combination of the options discussed here will provide the best protection for a purchasing business against the imposition of successor liability. Assessing the level of risk and determining which of the available avenues are ideal in any given situation should be done by an experienced professional. The business law attorneys at Gehres Law Library are adept at identifying these risks and mitigating them as much as possible in a variety of situations. Contact us today for a free evaluation or browse our website for more information.