Successor Liability in Asset Acquisitions

Background
Environmental Liability
Labour
Tax
Product Liability
Contractual Obligations and Liabilities
Comment

Background

In Korea, as in most jurisdictions, executives, financial advisers and lawyers must grapple with a myriad of legal and financial considerations when structuring a business transfer or other acquisition transaction. Among others, the following considerations will be familiar, at least at first glance, to M&A practitioners in other jurisdictions:

• tax consequences;

• assumption of liabilities of the target;

• title transfer issues;

• antitrust laws;

• third-party consents;

• labour issues; and

• regulatory permits and licences.

Among these, assumption of liabilities is a factor that looms large. The 1997 financial crisis in Asia resulted in an explosion in the number and size of cross-border acquisition transactions involving Korean target companies. Crippled by debts, panic-stricken conglomerate members quickly shed non-essential subsidiaries, divisions, captive utilities and other assets. Droves of foreign investors went bargain hunting, but few were eager to assume the pre-closing liabilities of these financially distressed sellers. Thus, many cross-border transactions were structured with a view to minimizing the assumption of liabilities.

In Korea, as in the United States and other jurisdictions, the three fundamental structures for acquisition transactions are:

• statutory business combinations, such as mergers and share exchanges;

• stock purchase transactions; and

• asset purchase transactions.

These structures resemble their US counterparts and, for the most part, offer similar advantages and disadvantages.

In a statutory business combination or purchase of shares, all pre-closing liabilities of the merged or target company, whether known or unknown and absolute or contingent, are assumed by the survivor or purchaser, albeit by differing mechanisms. In the former structure, the surviving entity (or the new entity resulting from the merger) must assume all the pre-closing liabilities of the entity that is merged out of existence. In the latter structure ownership of the target company merely changes hands and so the target company simply retains all its pre-closing liabilities.

In contrast in an asset purchase transaction the seller's liabilities are in principle allocated between the purchaser and seller by agreement, and the legal presumption is that the purchaser assumes only those liabilities which it specifically agrees to assume. However, statutes and the domestic courts have carved out several exceptions to this presumption, by which successor liability may be triggered notwithstanding the terms of any agreement between the transaction parties. Nonetheless, Korean courts have yet to develop non-statutory theories of successor liability such as the de facto merger or substantial continuation doctrines found in US case law.

This update reviews successor liability in five key areas:

• environmental liability;

• labour;

• tax;

• product liability; and

• contractual obligations and liabilities.

Environmental Liability

Korea's environmental protection scheme is generally less comprehensive than those of the United States or other Western industrialized nations. Economic development long took priority over environmental protection, once perceived as a luxury which the nation's nascent industries could ill afford. Although environmental protection laws were in place, enforcement was sometimes lax. Now that Korea has reached levels of industrialization and living standards once thought improbable, the governmental authorities, public and media have become more aware and vocal about environmental concerns, and the government has tightened the regulatory scheme and toughened up on enforcement.

In this scheme liability for environmental matters is largely statutory, with the Ministry of Environment serving as the key regulatory agency. Of the relevant legislation, the Soil Environment Conservation Act and the Waste Control Act, and their respective enforcement decrees, are of particular interest in the context of asset acquisition.

Soil Environment Conservation Act
The Soil Environment Conservation Act contains provisions analogous to those found in the US Comprehensive Environmental Response, Compensation and Liabilities Act 1980 (42 USC Sections 9,601 to 9,675).

Article 23 of the act imposes joint and several strict liability on persons who own, occupy or operate a soil contamination facility for damages, including clean-up costs, resulting from contamination of soil by the facility. The act defines a 'soil contamination facility' as any facility, equipment, building, construction or location that is employed to produce, transport, store, treat, process or dispose of soil contaminants and is suspected of contaminating the soil. A 'soil contaminant' is any substance that causes the condition of soil to be hazardous to health or the environment, with such status being determined by the Ministry of Environment.

Under Article 23(3)(3) strict liability is also imposed on persons who acquire such facilities, as in the case of an asset transaction, or who comprehensively succeed to the rights and liabilities of the facilities' owner, as in the case of a merger or succession by inheritance. Subparagraph 4 imposes similar liability on those who acquire such facilities at public auction (eg, those relating to the liquidation of a bankruptcy estate or the sale of assets seized by customs or tax authorities or other officials).

This liability is joint and several with the pre-closing owners and operators of the facilities. However, an affirmative statutory defence is available, akin to the 'innocent landowner' defence under the US Comprehensive Environmental Response, Compensation and Liabilities Act against the imposition of such liability. The acquirer of soil contamination facilities by way of an asset transaction or public auction can avoid liability for soil contaminants by proving that:

• the property was acquired after the release of the soil contaminants;

• at the time of title transfer, the acquirer was unaware that the soil had been contaminated; and

• as of the time of the title transfer, the acquirer had not negligently failed to learn about the contamination.

This defence cannot be raised by a successor, however, and thus cannot be raised by the surviving corporation (or new corporation) in the case of a merger.

The first two elements are self-explanatory but may be difficult to establish since this is an affirmative defence placing the onus on the acquirer. For example, if soil contaminants are found post-closing, it may be difficult to determine when they were released, and tough for the purchaser to prove that the facility released them during the seller's ownership.

Regarding the negligence standard for the third element, there is a dearth of legal authority on the degree of due diligence that should be exercised to establish the absence of negligence. The corresponding element in the innocent landowner defence under the US Comprehensive Environmental Response, Compensation and Liabilities Act is satisfied if the acquirer engaged in an "appropriate inquiry into the previous ownership and use of the property consistent with good commercial or customary practice in an effort to minimize liability". Since Article 23 of the Korean Soil Environment Conservation Act is largely based on the US Comprehensive Environmental Response, Compensation and Liabilities Act, US court precedents might be referred to by the Korean courts.

With respect to certain soil contamination facilities such as petrochemical plants and toxic-chemical storage facilities, owners are required, both periodically and in connection with specified triggering events, to have the soil tested for contaminants, with tests conducted by an institution specializing in soil testing. In the event that operation of the facility changes hands, due to the transfer or leasing thereof or some other reason, a soil contamination test should be conducted during the three months prior to the date thereof (eg, the date of closing in the case of an asset transaction).

Conducting this mandatory pre-closing soil test might be a means of establishing the absence of negligence on the part of the purchaser, as a purchaser could at least make an argument that it exercised due diligence before purchasing the facility. Further, in the asset purchase agreement, satisfactory soil test results could be an express condition precedent to the purchaser's obligation to close, thereby allowing the purchaser to walk away from the deal and giving it leverage for demands (eg, more stringent indemnities or a reduction in purchase price) if the soil is excessively contaminated. The purchaser should beware that if the soil is given a clean bill of health, it may find it harder to prove that contaminants found post-closing were released pre-closing.

Waste Management Act
The Waste Management Act imposes successor liability relating to the discharge of industrial waste from places of business. Article 24 requires that enterprises must (i) properly dispose of industrial waste generated by their facilities, and (ii) minimize the generation of industrial waste during manufacture (eg, through recycling). The term 'industrial waste' encompasses wastes produced by enterprises where waste discharge facilities are installed and operated pursuant to the Clean Air Conservation Act, the Water Quality Conservation Act or the Noise and Vibration Control Act.

Under Article 24(5), when facilities generating industrial waste are transferred or pass by way of succession, or when a corporation owning such facilities is merged out of existence, the transferee, successor or surviving corporation must assume all responsibilities and liabilities relating to industrial waste generated prior to the transfer, succession or merger. Pre-transfer liabilities are similarly assumed when such facilities are acquired through public auction.

The Waste Management Act does not have an equivalent to the 'innocent landowner' defence. Thus, an acquirer cannot avoid liability by proving the absence of knowledge and negligence.

Enforceability of indemnification clauses
Typically, asset purchase agreements used in the Korean context, like those used elsewhere, contain environmental representations and warranties, together with more general 'compliance with law' representations and warranties, and indemnification clauses.

The Soil Environment Conservation Act and the Waste Management Act are silent on the issue of whether a purchaser of soil contamination facilities can shift the risk and financial burdens of pre-closing environment compliance to the seller through such contractual means. However, it seems that as long as the purchaser and seller remain, technically speaking, jointly and severally responsible for the damages and clean-up costs, the legislative intent behind the Soil Environment Conservation Act can be effectuated. Thus, it is reasonably likely that an indemnification clause in an asset purchase agreement would be enforceable with respect to environmental liabilities stemming from either act.

Non-statutory theories of liability
In the environmental context, the Korean courts have yet to develop non-statutory theories of successor liability such as the de facto merger, substantial continuation and fraudulent convenience doctrines found in US common law.

It is unlikely that the Korean courts would hold an asset purchaser generally responsible for the environmental harm arising out of the pre-closing activities of the seller or for related clean-up expense costs, except as discussed above. However, the definitions of the soil contaminant or industrial waste are broad enough to cover almost every pollution event. In the context of labour, the Korean courts tend to look at the economic reality of the asset acquisition and to apply reasoning resembling the mere continuity doctrine.

Labour

In Korea, acquisition-related issues concerning labour are sometimes thorny and a little background is necessary to understand successor liability in this area. In the past, Korean conglomerate members, like their Japanese counterparts, tended to promote a paternalistic relationship with their employees, and claimed to offer life-time employment in exchange for loyalty. While the shocks reverberating from the 1997 crisis caused a partial breakdown of this employment culture, Korean companies are generally still less likely than Western companies to dismiss employees. Further, Korean labour unions can be aggressive, and have been known to voice their opposition to cross-border acquisition transactions that they fear may lead to the dismissal of employees at the behest of foreign investors.

Moreover, Korean labour laws generally permit termination of employment only for cause, although a narrow exception exists relating to restructuring. It can be difficult, though, to meet the following requisite elements for restructuring dismissals:

• There must be urgent managerial need for such dismissals whereby the employer's business and operation would be jeopardized without them;

• The employer must have attempted to avoid the restructuring by various means (eg, temporary layoffs, suspending the recruitment of new employees, improving management or operations, voluntary early retirement);

• The employer must establish and adhere to fair and rational standards for the dismissals; and

• Prior to the dismissals, the employer must confer in good faith with the employees or labour unions.

Issues of successor liability in the context of labour disputes may arise in a variety of situations.

It is likely that a purchaser will be bound by the terms of an existing collective bargaining agreement (CBA) between the seller and its labour union. The Labour Standards Act and other labour-related statutes have no specific sections regarding the assumption of liabilities by the purchaser relating to employer-employee relationships established prior to closing, including the assumption of obligations under a pre-existing CBA between the seller and its labour union. In addition, the courts have not rendered a decision directly focusing on whether a purchaser in an asset transaction is required to assume, and is bound by the terms of, such a CBA. However, most legal commentators agree that the purchaser is bound by existing employer-employee relationships and by the terms governing existing employment relationships between the seller and its labour union, including any outstanding CBA.

It appears, based on Supreme Court decisions, that a purchaser cannot terminate employees of the seller or restructure the seller's labour force after closing merely on the basis that it is the new employer. Similarly, a purchaser may be ordered to remedy unfair labour practices committed by the seller prior to the closing.

In Song Koo Kim v Dongjin Metal Co(1) the Supreme Court held that a purchaser of a business should assume liabilities relating to the pre-closing employment relationships between the seller and its former employees. The plaintiff was a former employee of Saehwa Co. The plaintiff filed an unfair labour practice charge against his former employer, alleging wrongful termination, and the petition for reinstatement was successful. While the plaintiff awaited reinstatement, Saehwa Co sold its business to Dongjin Metal Co and transferred only part of its labour force to the purchaser. The plaintiff then filed a lawsuit against the purchaser for back pay allegedly owed by the seller. Upholding the lower court's ruling that the purchaser constituted a mere continuation of the seller, the Supreme Court held that if any specific agreement between the seller and purchaser of a business provides for the scope of employees to be transferred, such agreement would contravene the legislative intent of the provisions of the Labour Standards Act requiring just cause for termination.

As a related issue, it seems that a purchaser is required to maintain the labour union of the seller after the closing; this can be effectuated through a simple amendment of the applicable union rules. In Omron Automotive Electronics Korea Ltd v Donghae Labor Union(2) the Supreme Court ruled that, in the context of a business sale transaction, a seller's labour union continues to exist even after the transfer of the business, and may continue to exercise its rights under a CBA between the union and seller. Donghae Company transferred its business to the plaintiff in 1998; the purchaser in turn requested that the seller's labour union cease using office space used by it pursuant to the terms of a CBA between the union and seller. The court ruled that the union was entitled to use the office pursuant to the CBA.

One issue raised by this decision is whether multiple labour unions (ie, the purchaser's own union and the seller's union) may co-exist with respect to a purchaser in a business acquisition transaction. Many commentators agree that, after the closing, multiple labour unions can exist with respect to the purchaser.

Tax

Asset purchase transactions are a means by which purchasers may avoid the seller's liabilities for unpaid taxes. From a tax perspective, they may be a more attractive structure than a merger. According to the Framework Act on National Taxes, when corporations are merged the surviving or newly created entity must assume the liabilities relating to national taxes (together with penalties and collection fees for arrearages) of the entity that is being merged out of existence. This provision does not apply in the case of an asset acquisition transaction.

Asset acquisitions carry certain tax disadvantages. Depending on the situation, an asset acquisition may lead to a heavier overall tax burden on the purchaser than other transaction structures, mainly due to the imposition of transfer and acquisition taxes. In asset purchase transactions the purchaser must pay acquisition and registration taxes with respect to certain classes of acquired assets, and the aggregate tax rate may exceed 2% of the purchase price of these assets. In contrast, in share purchase transactions a securities transaction tax of 0.5% of the purchase price of the acquired shares is imposed on the purchaser.

One consideration is the deemed acquisition tax, which is levied when 51% or more of the shares of an unlisted company are transferred. In such cases the stock purchase transaction is treated as an asset purchase transaction for the purposes of the acquisition tax. In addition, the purchaser is still required to pay the 0.5% securities transaction tax.

Furthermore, in a business transfer transaction the purchaser is secondarily liable for the national taxes (together with penalties and collection fees for arrears) payable by the seller if (i) the seller's assets are insufficient for the discharge of such liabilities, and (ii) such liabilities accrued prior to the closing of the transfer transaction. Secondary tax liability is also imposed on the purchaser with respect to the local tax liabilities of the seller.

Product Liability

Korean courts have developed special variations to the general torts law that relate to causation and the burden of proof in product liability cases involving allegedly defective products. These variations are similar to the strict products liability doctrines developed by US courts.

Furthermore, a statute entitled the Product Liability Act entered into effect on July 1 2002. The most important feature of this statute is that it shifts the burden of proof from the plaintiff to the defendant - that is, the manufacturer, processor or importer of the allegedly defective product. Thus, defendants now have the burden of proving that the product at issue is not defective.

As this statute is still quite new, it is unclear at this stage whether Korean courts will impose liability on a purchaser of a business that manufactured, processed or imported a defective product prior to the closing. Korean courts might choose to impose successor liability by adopting the mere continuity doctrine in this context, at least in cases where the seller ceases to exist or becomes defunct.

Contractual Obligations and Liabilities

A particularly attractive aspect of asset acquisitions is that purchasers can generally select the specific contractual rights to be transferred and the specific contractual obligations to be assumed. Under the Civil Code, the assumption of liabilities between the initial debtor and the new party which will assume the debt is valid only if the creditor consents to such assumption. Without such consent, the initial debtor is required to continue to bear the liability. Likewise, a transfer of rights by the creditor is valid against the debtor only if it consents or receives a notice of such transfer. Without such consent or notice, the transferee cannot require the debtor to discharge the liability.

Statutes and judicial precedents have carved out several exceptions to this rule. One such exception is that if an asset acquisition is fraudulent and thus invalid, or if the contract's language can be interpreted to cover implied assumptions of liabilities, then successor liability will arise.

One relevant issue is the bulk transfer rules under the Commercial Code. Under Article 42 of the Commercial Code, if a purchaser of a business uses the trade name of the seller, the purchaser is liable for the seller's obligations for two years after the closing of the acquisition, unless (i) no liability of the successor is registered on the company register, or (ii) the seller and the successor notify the third party that there are no liabilities.

Comment

The scope of successor liability is a major factor to be considered when structuring a business acquisition transaction. Successor liability still stems largely from statutory sources, although the courts have begun to adopt the mere continuity doctrine in the labour context.

A purchaser's exposure to successor liability may be reduced through risk-shifting mechanisms in the acquisition documentation, such as tight and extensive seller's representations and warranties, and strong indemnities. Further, the asset purchase agreement should clearly set forth the liabilities to be assumed by the purchaser and the liabilities to be retained by the seller.

For further information on this topic please contact Young-Cheol Jeong at Woo Yun Kang Jeong & Han by telephone (+822 528 5200) or by fax (+822 528 5228) or by email ([email protected]).

Endnotes

(1) 93 DA 33173, dated June 28 1994.

(2) 2000 DA 3347, dated March 26 2002.