When Does an Asset Acquisition Become a De Facto Merger?

The De Facto Merger Doctrine: Exceptions to the 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 have treated an asset acquisition as if it were a merger or share acquisition under the ‘de facto merger doctrine.’

A de facto merger 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. This is because a) the principal owners of the target corporation became owners of the acquiring corporation, b) the target corporation was immediately dissolved after the close, and c) the funds were distributed to its shareholders without paying trade creditors of the target corporation.

Strategic vs. Financial Buyers: When Does the Doctrine Apply?

In assessing the impact of the de facto merger doctrine on potential buyers in an asset transaction, it is essential to distinguish between strategic buyers and financial buyers. Strategic buyers, usually larger companies in the same or complementary business as the target company, will absorb the target company and will not provide for any of the target company’s shareholders to become 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 like that mentioned above, 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.

By its very nature, a private equity fund typically will need more management expertise and operating personnel to run the target company without the assistance of 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 acquire a 20% share ownership interest in the new company formed in the acquisition. If the de facto merger doctrine is viable, it is more relevant in private equity acquisitions than in strategic ones. In the latter, there is usually no carryover of ownership from the seller to the buyer.

Product Liability

In de facto merger cases, an acquiring party buys a manufacturing business and continues its product line. The deal is an asset acquisition. It might be liable for defects in products made before the acquisition. Some courts believe that a consumer hurt by a defective product should have a remedy against the acquiring corporation. This is true regardless of whether the deal was an asset or a share acquisition.

Fraud on Creditors

Aside from the de facto merger doctrine, some courts protect buyers of defective products. The more traditional doctrine is the fraudulent transfer on creditors principle. This could impose liability on a buyer, even in an asset transaction. This principle does not strictly impose liability on the buyer.  It can still void the asset transfer if: a) the sale was to defraud the seller’s creditors, or b) it left the acquired company insolvent and it got no value for the assets.

If this occurs, an acquiring company may need to investigate the target’s pro-forma solvency (i.e., past transactions) after the acquisition and be reasonably comfortable that the price of the assets is reasonably equivalent to their value.

Toxic Properties

Sometimes, an asset acquisition won’t relieve the buyer of seller liabilities. This includes federal 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 the acquired property in the interest it’s deemed a de facto merger.

COBRA/Pension

The buyer of substantially all of a target company’s assets is responsible for the seller’s COBRA liabilities if the seller or any of its affiliates cease to maintain group health plans. COBRA, or the Consolidated Omnibus Budget Reconciliation Act, gives workers and their families the right to continue the group health benefits provided by their group plan for a certain period of time after job loss.

Also, some courts found that asset buyers are liable for the seller’s unpaid pension contributions. This is true if the buyer knows of the seller’s liability and there is enough continuity of operations. Asset sales generally 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 expand ERISA (Employee Retirement Income Security Act) successor liabilities.

Labor Laws

In labor relations, an asset acquisition may not protect the buyer from some labor law obligations. A successor that hires most of the union’s employees and operates mostly the same business must recognize and bargain with the union. However, the successor need not accept the existing collective bargaining agreement, even if it has 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 is one who buys the employing enterprise. If they know of unfair labor practice claims and back pay risks, they may need to reinstate the predecessor’s employees. The purchaser may also be liable with the predecessor for back pay under the NLRA.

To ease the burden on the buying company, the US Supreme Court, in addressing NLRA ’successor employer’ liability cases, stressed the need for advance notice of the potential liability to the successor. The successor may negotiate with the seller about the sales price. It may also seek an indemnity clause or a transfer of risk.

Successor liability also arises in asset sales. This is where the target company faced 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 following:

• The charge or pending lawsuit
• The ability of the predecessor to provide relief
• Whether there has been a substantial continuity of business operations
• Whether the new employer uses the same or substantially the same workforce

Recently, a US appeals court imposed successor liability on an asset purchaser for the predecessor’s wage claim violations, even though such claims were expressly excluded in the purchase agreement. The court used a ’federal common law’ standard for successor employer liability. It was similar to the EEOC cases.

Family and Medical Leave Act (FMLA)

The FMLA requires a ’successor in interest’ of an employer. They must give newly hired employees from the predecessor protected leave rights. They are deemed continuously employed by the successor, without the 12-month wait for new hires.

WARN Act

Sometimes, a buyer must worry about the WARN Act. This applies even if the acquisition is an asset sale. The WARN Act is a federal labor law. It protects employees, their families, and communities. It requires most employers with 100 or more employees to give 60 days’ notice of layoffs, as defined in the Act.

The WARN Act entitles notice to employees, including managers, supervisors, hourly workers, and salaried workers. The WARN Act requires notice to be given to:

1. Employees’ representatives (i.e., a labor union).
2. The local chief elected official (e.g., the mayor).
3. The state dislocated worker unit.

Structuring the Asset Purchase Agreement to Deal with De-Factor Merger Liabilities

As shown, even in an asset purchase agreement, some seller’s liabilities may be passed on to the buyer. The buyer will seek indemnity from the selling corporation and its main shareholders against potential third-party claims.

Hence, the buyer will often require a 1% to 10% deposit of the purchase price. This must go into an escrow for about a year or longer, depending on when pending third-party claims are expected to arise. If they do, the buyer can use the proceeds in the escrow account to satisfy those claims without having to dig into the buyer’s resources. 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 seller’s ability to compensate him for breach of the reps and warranties.

Typical representations and warranties in an asset purchase agreement would include the following:

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

By insuring against these liabilities, the buyer can avoid taking on these liabilities under a de facto merger.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Understanding Risk Management Basics for Business Owners
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This article was originally published on April 3, 2015 and updated on December 4, 2022. This article was most recently updated by the Financial Poise Editors.] 

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