How to Avoid Hidden Liabilities When Negotiating an Asset Purchase Agreement

In practice, that’s the way most businesses hope an asset purchase agreement will avoid liabilities. In reality, however, avoiding liability can be far more complex. Federal and state courts have carved out several exceptions to the non-liability doctrine. If, after a sale, a buyer holds onto employees, maintains key client contracts, or keeps the acquired assets running as they were under the previous owner, it may discover it’s on the hook for liabilities like debts, licenses, taxes, or claims.

Matters grow more complicated because of the need for speed. Often, buyers are looking to capitalize as quickly as possible on new assets to increase market share, minimize disruption to their businesses, take advantage of possible tax benefits, and reduce the costs associated with doing a deal. Unfortunately, a compressed timeline can increase the odds that certain liabilities may be overlooked. Without thorough legal due diligence and purchase terms that have been carefully structured to minimize risk, buyers may find they have inherited unforeseen liabilities and sacrificed one of the key strategic advantages an asset purchase is designed to provide.

An Asset Purchase Agreement Gone Wrong

How can liabilities materialize after an asset purchase? Let’s explore a hypothetical example: Your fast-growing software-as-a-service platform wants to continue its upward momentum. The biggest obstacle? A competitor whose similar SaaS product includes proprietary features you would like to add to your service.

For buyers, acquiring the company through a stock purchase structure makes little sense. Not only is a stock purchase often less beneficial from a tax perspective, the buyer will be also responsible for all of the target’s disputes, debts, and other obligations. Instead, you focus on the asset you really want—the technology of the SaaS. Your company makes the deal, it closes rapidly, and then integrates the competitor’s software into its platform.

Then comes the surprise. Just after you launch your new-and-improved platform, another company files a patent infringement lawsuit against you. While you believed all of the IP associated with the platform had been the seller’s, one element had, in fact, been licensed from a third-party patent holder and now the owner of the patent won’t provide the same licensing agreement terms that were negotiated with the target company. This would have been caught during a thorough legal due diligence.

Since the license transfer was not covered in your asset purchase agreement, you face some unsavory choices: You can pay licensing fees you hadn’t anticipated, engage in a costly legal battle with the patent owner, or remove the technology—irritating customers who have come to depend on it. Now, the fast, smooth transaction has morphed into a complicated and potentially expensive IP dispute. And you risk a court invoking an exception to the liability protections you thought you enjoyed with an asset purchase.

Non-Liability Exceptions in Asset Purchases

As far back as 1890, the U.S. Supreme Court said non-liability in asset purchases was such a well-established principle that “it is surprising” anyone could believe otherwise. While this is still the general rule, state and federal courts have been increasingly willing to recognize exceptions. The most common are:

1. The Express or Implied Assumption of Liabilities. The most frequent exception is when buyers themselves agree to assume liabilities and expressly spell them out in the asset purchase agreement. This often includes contracts and other obligations that are essential to operating the business. But buyers may also be held accountable if their actions imply that they accept the seller’s liabilities. For instance, a buyer may continue to operate an asset exactly as the seller did, honoring pre-existing contracts, licenses, or client agreements. As a result, courts may view the buyer’s conduct as an implicit assumption of liability.

2. The De Facto Merger Doctrine. If an asset purchase begins to look too much like a merger, the courts may hold the buyer responsible for all of the previous owner’s liabilities. Courts usually look at a few key issues to make this determination: Will the asset operate in much the same way after the sale?; will the employees, board of directors, and management be the same?; will the seller’s company cease to exist?; did the buyer explicitly assume liabilities to keep the business running as usual?; has the buyer retained the same branding, locations, and contact information?

3. A Mere Continuation. The mere continuation exception resembles the de facto merger doctrine. But it is focused on whether the asset is being acquired by a new buyer, or by the seller wearing buyer’s clothing. As one Indiana court noted, “the test for a mere continuation of the seller’s business is not the continuation of the business operation, but rather the continuation of the corporate entity. An indication that the corporate entity has been continued is a common identity of stock, directors, and stockholders and the existence of only one corporation at the completion of the transfer.” If a court finds that a mere continuation has occurred, it may assign all of the seller’s liabilities to the buyer.

4. Fraudulent Transfer. Most states have laws preventing sellers from transferring assets to evade liabilities. As the Wisconsin Supreme Court put it, “the fraudulent transaction exception is a doctrine that prevents successor companies from avoiding obligations incurred by their predecessors.” A court may determine whether the price paid for assets was a “fair consideration,” or whether the asset sale was specifically designed to deceive creditors. This exception occurs most often in cases involving distressed or insolvent companies.

Acquisition-Related State Laws and Successor Liability

When it comes to liability in an asset purchase agreement, location matters. For instance, under state law in Texas, successor companies (i.e., the buyers) “may not be held responsible or liable” for a seller’s liabilities or obligations unless they expressly assume responsibility. In Delaware, the nation’s corporation capital, the courts are reluctant to apply the de facto merger doctrine except, as one court said, l”in very limited contexts.” In New York, by contrast, de facto merger exceptions are relatively commonplace in disputes over asset purchases.

States have also created their own exceptions. The Michigan Supreme Court developed an extension of the mere continuation doctrine called “continuity of enterprise.” Several states have followed its lead. The continuity of enterprise exception focuses solely on whether the asset sale has an impact on the company’s operations. If operations remain unchanged post-sale, a court may assign liabilities to the buyer. Unlike a mere continuation exception, continuity of enterprise can apply to buyers who have no relationship to the seller.

The product line exception is a California invention that has also been adopted in a few other states. In 1977, the California Supreme Court ruled that a buyer could be held liable for defective products made by the seller. The court created a three-part test to determine if the exception should apply: 1) Was the original manufacturer liquidated as a result of the asset sale, making it impossible for injured parties to sue them?; 2) Is the buyer able to assume the seller’s role in spreading out risk?; 3) Does fairness justify holding the buyer responsible if it has adopted the seller’s brand and goodwill and continues its product lines?

Liabilities Can Vary By Industry

Asset purchase agreements should also take into account the buyer’s industry and the nature of its business. Certain sectors face unique liability issues that may be relatively rare in others. In a heavily regulated industry like healthcare, an asset purchase agreement may need to grapple with liability for revealing patient information or billing issues involving insurers. Financial services companies may need contract terms involving anti-money laundering risks or data breaches of clients’ accounts.

Consider the technology sector, and back to the software-as-a-service provider in our earlier example. Clearly, liability for intellectual property rights and third-party claims will need to be addressed. Another issues is privacy as relating to asset purchase in the technology space. SaaS companies house terabytes of sensitive client data from their users. If a seller has mismanaged data privacy, the buyer may need liability protections over violations of state, federal, and international data protection laws. And a SaaS provider is likely managing ongoing service agreements with its clients. A buyer should be conscious that it may inherit liability for those commitments if service continues after the asset sale.

The tech sector, in general, has very specific liability issues around intellectual property and licensing that should be flagged in an asset purchase agreement. Software companies, AI providers, and a host of other technology consulting companies routinely use proprietary code, patents, and open-source software, all of which can create unexpected licensing liabilities. The risk of infringement claims and unexpected fees can be compounded if the seller failed to properly document the licenses. During an asset sale’s due diligence process, the buyer may need to conduct a deep review of the seller’s intellectual property to ensure hidden risks are uncovered.

Red Flags in the Asset Purchase Process

To remain liability free, buyers should keep a close eye on triggers that may prompt courts to make an exception. Ambiguous liability provisions are the first, and perhaps most important, warning sign. Buyers should be asking whether the asset purchase agreement’s liability provisions are as clear as they should be. Do they spell out which obligations will stay with the seller and which will transfer to the buyer once the deal is closed? For instance, which party will be responsible if product liability or environmental claims happen to erupt long after the agreement is signed?

Buyers should also be mindful of how much of the seller’s corporate infrastructure they will use after the sale closes. If the management, employees, and core assets remain the same, a judge may view the deal as a merger rather than an asset purchase. Taking on vendor contracts and other routine obligations needed to run the business can also signal that a newly acquired asset is merely a continuation of the previous owner’s business. In both circumstances, a court may decide the buyer must take on the seller’s liabilities.

How the buyer and seller behave with each other after the transaction closes can also create problems. For example, the buyer and seller may be related companies, or the seller may receive equity as part of the transaction. If the two sides share interests and continue communicating post-sale, a court may get the impression that the business is merely continuing operations. Problems can also crop up if a seller closes down overnight once an asset sale closes, or if it accepts payment for significantly less than the true value of the asset. Either scenario may cause courts to question whether the buyer is acting fairly and to allow creditors to pursue their claims.

Minimizing Risk in an Asset Purchase Agreement

To reduce liability risks, buyers should conduct thorough due diligence and meticulously draft the asset purchase agreement. And along the way, they should identify specific liability pitfalls—like industry-centric regulatory requirements—that could create problems down the road.

• Due Diligence. In an asset purchase, the due diligence process gives buyers a fighting chance to unearth hidden liabilities. If the asset purchase agreement is to be as strong as possible, a company’s operations and finances must be reviewed in detail, and potential liabilities and obligations identified and investigated. Among other things, examine claims that may affect the assets, as well as pending lawsuits, contractual obligations, IP licenses, and regulatory issues. It may be tempting in a fast-moving deal environment to skimp on due diligence—or worse, skip it altogether. In a word, don’t.

• Identifying Problems. Special care should be devoted to spotting problem areas and surfacing potential liabilities that may be unique to the buyer. For instance, a deep compliance review may be needed for assets in heavily regulated industries, or an IP audit could help in a tech-related asset sale. Experienced legal counsel with specific industry or state expertise can help pinpoint industry-related liability hazards and potential issues that may prompt state courts to pierce the non-liability shield.

• Drafting the Agreement. The asset purchase agreement itself should be tailored for the specific buyer, with clear and precise language throughout. It should specify which liabilities remain with the seller, and which, if any, will be assumed by the buyer. Representations and warranties should be crafted to hold the seller accountable. For instance, representations from the seller could assure the buyer that IP is fully owned, that contracts with clients have been properly documented, and that no hidden debts are lurking in the shadows. And the buyer should also include a strong indemnification provision requiring the seller to cover any costs related to liabilities that may materialize after the sale closes.

Buying only the assets is no longer a sure-fire way to prevent liability issues for the purchaser. An asset purchase agreement, however, can be carefully constructed to help protect your business as an asset acquisition. To do this requires a solid deal team, but it’s an investment that will help prevent future business disruption and financial stress.

Gouchev Law is a corporate law firm based in New York City with decades of experience negotiating asset purchase agreements. With our mergers and acquisitions expertise, you can confidently enter into purchase agreements knowing your legal and business interests are safeguarded. Discover more about our Merger and Acquisitions practice, or book a call to learn more about how we can help.

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