September 1, 2017
A buyer of a business is often concerned about whether the buyer will be faced with liability for legal claims arising from past operations of the business. Under state law this “successor liability” is often minimized by structuring the sale of the business as a sale of assets alone, coupled with a declaration that the buyer is not assuming the liabilities of the business. Recently, Judge Gregory H. Woods of the U.S. District Court for the Southern District of New York joined other federal jurists in adopting a federal standard for asserting successor liability for claims arising under federal labor statutes, a standard which makes it more difficult to avoid successor liability through an asset sale. However, in applying the federal standard, he nevertheless held that the plaintiff in the case before him could not assert a claim of successor liability.
In Xue Ming Wang v. Abumi Sushi Inc., 1:15-CV-9860, 2017 WL 3504859 (S.D.N.Y. Aug. 14, 2017), plaintiff Xue Ming Wang alleged violations of the federal Fair Labor Standards Act (“FLSA”) and related state statutes in connection with his employment by a Japanese restaurant in New York City. In June 2015, the owner of the restaurant sold the restaurant’s assets to defendant Abumi Sushi Inc. The agreement of sale provided for a sale of the assets only, “free and clear of any debts,” and included a representation by the seller that the business was “operated in accordance with all laws, ordinances and rules affecting said business.” There was no assumption of liabilities made in connection with the sale. Moreover, there was no evidence that the buyer or its principals had any actual notice of any violations of labor law prior to the sale.
Plaintiff contended in his lawsuit that prior to the sale of the business assets, the owner had engaged in wholesale violations of FSLA, by, among other things, failing to pay minimum wage and overtime. Plaintiff represented to the Court that he was unable to locate the seller of the business, which left the defendant buyer and its owners as the only viable sources of recovery. Nevertheless, the buyer defendants moved for summary judgement to dismiss plaintiff’s claims on the grounds that the buyer defendants had no successor liability for events preceding the sale of the assets.
The Court first examined the facts under the common law test for successor liability under New York law which provides generally that a corporation that purchases the assets of another corporation without assuming its liabilities is not liable for legal claims arising from the business’ operations prior to the sale. The Court proceeded to examine two pertinent exceptions to the general rule: (a) where the sale transaction was conducted “to defraud creditors,” and (b) where the new business is a “mere continuation” of the old business. As to the first exception, the Court found no evidence of any attempt to defraud plaintiff or any other creditor. As to the second exception, the Court noted that under the common law standard, the “mere continuation” exception requires that there be (among other requirements) a “continuity of ownership” in the business – in essence, a transaction where the buyer and the seller are the same entity or under common control. The Court found no evidence of any such “continuity of ownership” between the buyer and the seller of the restaurant’s assets. This, however, did not end the Court’s inquiry.
The Court proceeded to address the emerging standard for assessing successor liability under federal employment statutes in connection with an asset sale. This federal doctrine is designed to serve the remedial policies of federal labor legislation, and is broader than the traditional common law test. In particular, unlike the common law test, the federal “substantial continuity” test does not require continuity of ownership between the selling and purchasing entities. The factors are as follows:
(1) whether the successor company had notice of the charge or pending lawsuit prior to acquiring the business or assets of the predecessor; (2) the ability of the predecessor to provide relief; (3) whether there has been a substantial continuity of business operations; (4) whether the new employer uses the same plant; (5) whether he uses the same or substantially the same work force; (6) whether he uses the same or substantially the same supervisory personnel; (7) whether the same jobs exist under substantially the same working conditions; (8) whether he uses the same machinery, equipment, and methods of production; and (9) whether he produces the same product.
Xue Ming Wang, 2017 WL 3504859 at *6, citing Musikiwamba v. ESSI, Inc., 760 F.2d 740, 750 (7th Cir. 1985). Three U.S. Circuit Courts (the Third, Seventh and Ninth Circuits) have adopted this test. Judge Woods, however, notes that the federal courts consider the first two factors—notice and the ability of the predecessor to provide relief—to be “indispensable.” That is, a plaintiff cannot succeed on the theory unless the plaintiff proves that the buyer had actual notice of the legal claims at issue and unless the seller of the business is unable to satisfy the liability for the wrongdoing at issue. Xue Ming Wang, 2017 WL 3504859 at *6. In the case before him, Judge Woods found that there was no evidence of actual knowledge on the part of the buyer as to the federal law claims prior to the sale. Accordingly, he dismissed the claims against the buyer defendants.
Plaintiff attempted to convince the Court that “constructive” notice of the claims, as opposed to “actual” notice of the claims, should be enough to satisfy the test. A “constructive” notice test would impose liability upon the buyer if the buyer could have discovered the illegal conduct through an investigation conducted with “due diligence.” The Court held that liability based on constructive notice alone would constitute an unwarranted obligation upon the buyer. However, the Court noted that the presence of “red flags,” such as a “suspiciously low” sales price, might trigger a duty to investigate. Id. at *9. The Court found no “red flags” in the case at hand.
There are a number of upshots from the growing acceptance of the federal “substantial continuity” test. A potential buyer of business assets faces a greater risk that they will be saddled with liability for labor law claims associated with those assets – especially if the buyer is on notice of the liability prior to the sale. Potential buyers may seek contractual indemnification from sellers, but must be assured that the seller will have the resources necessary to make good on such an indemnification. This might be accomplished by a “holdback” in escrow of some of the purchase price for a limited period of time in case such claims arise after the sale.
Moreover, plaintiffs seeking to assert claims of successor liability against buyers of assets must investigate and seek discovery concerning all of the factual issues surrounding the “substantial continuity” test. This is particularly important with respect to the “actual notice” standard. Finally, a plaintiff about to assert claims against a business, upon learning of a potential sales transaction, might consider notifying potential purchasers of the plaintiff’s claims, so as to provide the necessary notice under the federal standard.
This article is intended only as a general discussion of these issues. It is not considered to be legal advice or relied upon. We would be pleased to consider providing additional details or advice about specific situations. For additional information on this topic, please feel free to contact Mark H. Moore, who regularly counsels and litigates for clients in connection with business disputes.