If your company is trying to decide whether to purchase another company, it is important to know that the transaction could end up with you having to pay for the sins of another. A recent Seventh Circuit U.S. Court of Appeals decision 1 emphasizes the need to be mindful of potential successor liability under the Fair Labor Standards Act (FLSA).

In the case, JT Packard & Associates (Packard) was sued in a collective (class) action by its employees for overtime violations under the FLSA. Packard entered into a settlement agreement with the class of employees to the tune of $500,000 and subsequently became insolvent, issuing its stock to a third party, which then sold the stock to a bank. Thomas & Betts subsequently purchased the assets of Packard through a receiver’s auction, with full knowledge of the settlement agreement. One condition specified in the transfer of assets to Thomas & Betts was that the transfer be “free and clear of all liabilities” that the buyer had not assumed, and a related but more specific condition was that Thomas & Betts would not assume any liability that Packard might incur in the FLSA litigation. Following the asset purchase, Thomas & Betts continued to run the business as it had been run in the past, with little being changed.

When a company is sold in an asset sale as opposed to a stock sale, the buyer acquires the company’s assets but not necessarily its liabilities; whether or not it acquires them is the issue of successor liability. Most states limit such  liability to  sales  in  which  a  buyer  (the successor) expressly or implicitly assumes the seller’s liabilities. But when liability is based on a violation of a federal statute relating to labor relations or employment, a federal common law standard of successor liability is applied that is more favorable to plaintiffs than most state-law standards to which the court might otherwise look. Since this case involved violations of federal law, the Seventh Circuit applied the federal common law. The federal law considers the following factors:

Whether the successor had  notice of  the  pending lawsuit, which Thomas & Betts unquestionably had when it bought Packard at the receiver’s auction; this is a factor favoring successor liability.

Whether the predecessor (Packard) would have been able to provide the relief sought in the lawsuit before the sale. The answer is no, because of Packard’s insolvency. The answer counts against successor liability by making such liability seem a windfall to plaintiffs. But this depends on how long before the sale one looks.  

Whether the predecessor could have provided relief after the sale (again no—Packard had been sold, with the proceeds of the sale going to the bank, along with Bray’s remaining assets). The predecessor’s inability to provide relief favors successor liability, as without it the plaintiffs’ claim is worthless.  

Whether the successor can provide the relief sought in the suit—Thomas & Betts can—without which successor liability is a phantom (this is a “goes without saying” condition, not usually mentioned).

Whether there is continuity between the operations and work force of the predecessor and the successor, as there was between Packard and Thomas & Betts, which favors successor liability on the theory that nothing really has changed.

The court decided that successor liability is appropriate in suits to enforce federal labor employment laws—even when the successor disclaimed liability when it acquired the assets in question— unless there are good reasons to withhold such liability. Lack of notice of potential liability—the  first criterion in the federal standard as usually articulated—is an example of such a reason. In the end, the court concluded among other things that, if an acquiring employer could contractually disclaim liability in this fashion, the "statutory goals" of the FLSA would be frustrated, and "a violator of the Act could escape liability or at least make relief much more difficult to obtain."

What You Should Do

While the court’s reasoning seems to discourage due diligence. After all, the court referred to the purchaser’s knowledge of the FLSA lawsuit as a factor favoring successor liability.  However, that should not be the take-away. The court also mentioned some instances under which a court might not impose successor liability even if the purchaser had knowledge of the liability. Instead, due diligence should be the course of conduct and if the company to be acquired has any liabilities under federal labor and employment laws, determine whether under the facts of the purchase, successor liability would be found, and whether there is a way to structure the transaction to avoid this type of unexpected liability.