Successor Liability Considerations When Buying or Selling Colorado Distressed Entities

By Eric L. Kintner, Marissa Kazemi and Courtney Pidcock¹

COVID-19 and the resulting economic uncertainty are adversely impacting businesses worldwide. Colorado companies that are financially distressed may be unable to survive alone and may consider reevaluating consolidation strategies. For strategic buyers, financially distressed companies can represent favorable acquisition opportunities. Acquiring or selling financially distressed companies is often unique and can also be more difficult than acquiring a financially healthy company through the normal merger and acquisition process.

In this Legal Alert, we discuss potential successor liability issues for buyers and sellers under Colorado law and some practical steps the parties can take to mitigate that risk. In an upcoming article, we will review Colorado’s Assignment for the Benefit of Creditors (ABC) statute and the pros and cons of an ABC transaction.

Successor Liability

Under Colorado law, a buyer of the business can be held liable for the seller's debts if one of the following exceptions applies: (1) the buyer expressly or implicitly assumes liability; (2) the transaction results in a de facto merger or consolidation of the entities; (3) the buyer is a mere continuation of the seller; or (4) the transfer is for the fraudulent purpose of escaping liability. In addition, buyers should be aware that federal common law often has a lower bar for successor liability, including claims under the Fair Labor Standards Act. Nevertheless, there are several practical steps that buyers can take to mitigate the risk of successor liability. 

Express or Implied Assumption of Liabilities

Buyers may be held liable for successor liability under Colorado law when the buyer expressly or implicitly assumes the seller’s liabilities. Determining whether there has been an express or implied assumption of liability is a fact-driven analysis. Colorado courts will review both the terms of the purchase and sale agreement and the successor’s conduct in assessing whether a corporation may be found liable under this exception. For example, a court may find evidence of intent when the buyer pays, or assumes, the seller’s debts or liabilities, such as maintaining the seller’s liability insurance.

Merger or Consolidation

The determination of whether a de facto merger or consolidation has occurred will depend upon the structure of the transaction and the specific transaction documents. A merger involves the absorption of one entity by another, in which the surviving entity retains its name and corporate identity with the added capital, franchises and powers of the merged entity. A consolidation is a transaction that results in the creation of a new entity and the termination of the existing entities. Colorado courts look at the structure of the transaction and the parties’ course of conduct.

Mere Continuation

The mere continuation exception applies when there is a continuation of directors and management, shareholder interest and, in some cases, inadequate consideration. Courts look to whether the successor company: (1) acquires all of the assets of the previous company; (2) shares the same management team and employees; (3) shares the same business name; or (4) shares the same ownership and control. For example, Colorado courts have found a mere continuation where the successor company had the same owners, both companies had the same business purpose, the successor acquired all assets of the prior company and the prior company was left unable to pay its debts.

Fraud

A buyer may be liable for the selling corporation’s debts and liabilities when the transaction was entered into fraudulently to escape liability. Colorado courts will look to the Colorado Uniform Fraudulent Transfer Act (CUFTA) when analyzing whether a transaction constitutes a fraudulent transfer. CUFTA provides that a transfer is fraudulent as to a creditor if (1) the debtor made the transfer with actual intent to hinder, delay or defraud any creditor of the debtor, or (2) if the debtor made the transfer without receiving reasonably equivalent value in exchange for the property, and the debtor’s remaining business would be unreasonably small, the debtor incurred debts beyond its ability to repay, or was insolvent or became insolvent due to the transfer. Applying these principles, a buyer or seller cannot structure an asset sale for the purpose of escaping liability to their creditors. 

Product Line and Continuity of Enterprise

Colorado courts have declined to expand successor liability beyond these four exceptions, including imposing so-called “product line” successor liability on buyers for contract-based product warranty claims and tort-based product defect claims (e.g., personal injury) arising from products and services sold by the seller before closing. However, other states, including New York and California, recognize this product line exception, so care should be given as to the governing law of the transaction documents.

Similarly, Colorado courts have declined to adopt the so-called “substantial continuity” exception, which would effectively expand the mere continuation exception and impose successor liability even though the sale of assets is for cash and there is no continuity of shareholders.

Successor Liability Under Federal Common Law

Federal courts have invoked federal common law to find successor liability under various federal statutes, including environmental and labor laws. For example, the Third, Seventh and Ninth Circuits of the Federal Court of Appeals have imposed successor liability on buyers for pre-closing claims under the Fair Labor Standards Act.

Practical Ways to Minimize Potential Successor Liability

The chances of minimizing successor liability risk will improve if buyers identify potential problem areas early in the transaction and structure the asset sale accordingly. In reviewing potential successor issues, buyers should consider the following:

• Conduct Due Diligence – Performing detailed due diligence of the target’s assets, business, credit history, and business activities is important to understanding the current creditors and existing business practices so buyers can realistically gauge potential exposure.
• Asset Purchase Documentation – It can be important to have a properly drafted asset purchase agreement that specifically details the liabilities of the seller and expressly allocates responsibility for such liabilities, and to expressly exclude all liabilities that are not being assumed by buyer, along with corresponding indemnification obligations for those excluded liabilities. In addition, buyers may want to consider paying for or requiring the seller to pay for so called a “tail” insurance policy that would cover pre-closing claims made after the closing.
• Avoid Common Ownership or Management – Due to the broadly worded “mere continuation” exception described above, it can be important to avoid or minimize to the greatest extent possible any common ownership or common management between the buyer and seller.
• Corporate Formalities – By maintaining corporate formalities post-closing, including operating both companies as distinct entities, buyers can further mitigate the risk of successor liability.  For example, any transition services offered by seller to buyer after the closing can be documented in writing and executed at arm’s length with a clearly stated purpose that such services are merely to provide short-term assistance to the buyer and not to imply any continuation of the business by the buyer. 
• Tax Status Letter – When the economy is struggling, states and municipalities often take a greater interest in collecting tax revenue that is owed, and it is generally easier for government agencies to seek payment from the current owner of the business than attempting collection from a former owner. In Colorado, buyers can mitigate potential successor tax liabilities by requiring that the seller obtain a Tax Status Letter from the Department of Revenue that confirms whether any taxes are owed by the seller.
• Post-Closing Unemployment Insurance Tax Rates – Under Colorado law, a buyer who purchases substantially all of the assets of a business from a seller may “assume” the pre-closing unemployment insurance tax rate of the seller, even if the buyer does not hire any seller employees. As a result, buyers may want to confirm the seller’s pre-closing unemployment insurance tax rate and consider whether Colorado will treat the buyer as a new employer or a successor to the seller for purposes of the unemployment insurance tax rates.