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De Facto Merger Doctrine – Exceptions to General Rule

There are certain exceptions to the basic rule that a buyer of assets buys free and clear of claims against the seller.  Though a transaction is structured as an asset acquisition, in a few isolated cases some courts treated an asset acquisition as if it were a merger or share acquisition under the “de facto merger doctrine.” This doctrine means that although the transaction was structured as an asset acquisition in form, in substance it was no different than a merger or a share purchase because, among other factors, the principal owners of the target corporation became owners of the acquiring corporation, the target corporation was immediately dissolved after the close and the funds distributed to its shareholder without paying trade creditors of the target corporation.

de facto merger doctrine

In assessing the impact of the de facto merger doctrine on potential buyers in an asset transaction it is important to distinguish between strategic buyers and financial buyers. Strategic buyers, normally larger companies in a same or complementary business as that of the target company will typically absorb the target company and will not provide for any of the shareholders of the target company becoming shareholders of the acquiring company. In such a case there is less likelihood that the continuity of ownership would be present to activate the doctrine.

In contrast, to a strategic acquisition by a larger company in a same or complimentary business as that of the target, in a financial acquisition, meaning an acquisition by an equity fund, there frequently will be some minority ownership overlap between the prior company owners and the acquiring company. This follow because by its very nature a private equity fund typically will not have the management expertise and operating personnel who could run the target company unaided by the former owners and managers. Accordingly, in a private equity acquisition of a target company the private equity firm would frequently structure the deal so that the former owners of the target company will, as part of the deal, acquire a 20% share ownership interest in the new company formed in the acquisition. Accordingly, if the de facto merger doctrine is viable, it would be more relevant in the case of private equity acquisition than in a strategic acquisition where there is usually no carry over of ownership from the seller to the buyer.

Product Liability

In de facto merger doctrine cases in which the party acquires a manufacturing business and continues the output of its line of products, the acquiring company, though the transaction is structured as an asset acquisition, might be liable for defects in the products manufactured before the acquisition by the target company. Some courts take the position that a consumer injured by a defective product should have an effective remedy against the acquiring corporation regardless of whether the deal was structured as an asset acquisition or as a share acquisition.

Fraud on Creditors

Aside from the de facto merger doctrine and aside from the tendency of some courts to protect consumers who buy a defective product, the more traditional uniformly accepted doctrine which could impose liability upon a buyer, even in an asset transaction, is the fraudulent transfer on creditors principle. This principle does not exactly impose liability on the buyer but can void the transfer of the assets to the buyer even in an asset acquisition transaction if the transfer or sale of assets is made with the intent to defraud the seller’s creditors, or the transfer leaves the acquired company insolvent or under capitalized and it does not receive reasonable equivalent value for the assets transferred.

Where this may come up as a potential issue, an acquiring company may need to dig into the pro-forma solvency of the target after the acquisition and be reasonably comfortable that what it is paying for the assets is reasonably believed to be equivalent to the value of those assets.

Toxic Properties

There are also other instances where an asset acquisition will not relieve the acquiring company from seller liabilities such as federally imposed liability for polluted or contaminated property. Because of the threat of successor liability for environmental issues, as a condition of the sale where the property may be contaminated, the buyer should conduct an environmental assessment and review before the closing to determine its potential exposure for clean up of toxic conditions on the acquired property.


The buyer of substantially all of the assets of a target company is responsible for the COBRA liabilities of the seller if the seller or any of its affiliates cease to maintain group health plans. In addition, some courts found that asset buyers are responsible for the delinquent pension contributions of asset sellers if there is sufficient continuity of operations and the buyer had knowledge of the seller’s liability. Asset sales general may trigger a seller’s withdrawal liability to a multi-employer pension plan (seller’s pro rata share of the plan’s under funding). Some isolated court cases in the context of retiree health benefits, (“top-hat”) plan (i.e., non-ERISA plans for executives) and fiduciary liability expand ERISA successor liabilities.

Labor Laws

In the area of labor relations, there may also be circumstances where an asset transaction does not insulate the buyer from certain labor law related obligations. For example, a successor that hires a majority of the employees represented by a union and who continues to operate substantially the same business will have a legal obligation to recognize and bargain with the union. However, the successor does not have to accept the prior existing collective bargaining agreement even if it contains a successor clause.

The concept of “successor employer” has also been extended to existing liability claims under the National Labor Relations Act (“NLRA”). A bona fide purchaser, acquiring the employing enterprise with knowledge of the existing unfair labor practice claims and potential back pay liability, and then operating a “continuing business enterprise,” may be required to reinstate employees of the predecessor and also held to be jointly and severally liable with the predecessor for payment of backpay awards under the NLRA.

To alleviate the burden this places on the acquiring company, the U.S. Supreme Court in addressing NLRA “successor employer” liability cases emphasized the importance of advance notice to the successor of the potential liability so the successor may negotiate with the seller regarding the sales price or negotiate for an indemnity clause.

The issue of successor liability also arises in asset sales where the target company was involved in equal employment opportunity discrimination claims (“EEOC”). In such EEOC cases, the courts have adopted a nine-part test, including whether the successor company had prior notice of the charge or pending lawsuit; the ability of the predecessor to provide relief; whether there has been substantial continuity of the business operations; and whether the new employer uses the same or substantially the same workforce.

Recently a U.S. appeals court imposed successor liability on an asset purchaser for the wage claim violations of the predecessor, even though such claims were expressly excluded in the purchase agreement. The court applied a “federal common law” standard for determining successor employer liability similar to the EEOC cases.

Family and Medical Leave Act (“FMLA”)

The FMLA requires a “successor in interest of an employer” to provide protected leave rights to newly hired employees from the predecessor as if continuously employed by the successor without the normal 12-month waiting period for new hire employees.


In certain cases a buyer, regardless of whether the acquisition is structured as an asset sale, must concern himself with the Worker Adjustment and Retraining Notification Act (WARN Act). The WARN Act is a federal labor law which protects employees, their families, and communities by requiring most employers with 100 or more employees to provide 60 calendar-day advance notice of layoffs of employees, as defined in the Act.

Employees entitled to notice under the WARN Act include managers and supervisors, hourly wage, and salaried workers. The WARN Act requires that notice also be given to employees’ representatives (i.e., a labor union), the local chief elected official (e.g., the mayor), and the state dislocated worker unit.

Structuring the Asset Purchase Agreement to Deal with Liability Issues

As seen above, even in an asset purchase agreement there are some circumstances in which the seller’s liabilities and problems may pass on to the buyer. For this reason the buyer will seek indemnity from the selling corporation and primarily from the principal shareholders of the selling corporation against potential claims made by third parties. Hence, the buyer frequently will require a certain percentage of the purchase price (ranging from 1% to 10%) to be deposited in an escrow for approximately one year or longer depending upon what time it is expected that third party claims that are pending will come to the surface. If they do the buyer will be able to use the proceeds in the escrow account to satisfy those claims without have to dig into the buyer’s own resources to deal with the claim. Alternatively or in tandem with escrows, “M&A Insurance” may be used to protect both the buyer and the seller. By using M&A Insurance, the amount in escrow can be reduced and the buyer may not need to worry about the ability of the seller to compensate him for breach of the reps and warranties.

Typical representations and warranties in an asset purchase agreement would include that there are no undisclosed liabilities (despite the fact that such liabilities would not normally pass to the buyer) that all consents, as noted above, have been obtained from third parties and the seller has paid all federal and state taxes including use tax and sales tax, there is no violation of law on the part of the seller, no violation of labor employment and environmental matters and if necessary, a tax clearance certificate has been obtained to confirm that the seller has paid all taxes due, that all assets are in good working condition and are sufficient to run the business, that seller has good title to its assets, that they are not subject to lien, that the accounts receivable are collectible in due course and there are no defaults under material contracts.

About Leib Orlanski

Mr. Orlanski helps companies go public. He also represents companies seeking to find underwriters for an IPO or a follow on public offering or a PIPE financing, structures the terms of the public offering, and represents either the issuer or the underwriter in public stock offerings. He was named a Southern California "Super Lawyer" by…

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