One of the primary advantages to acquiring businesses through asset sales as opposed to stock sales is the buyer’s ability to avoid successor liability. There are exceptions to this rule in most states, including: (i) impliedly or expressly assuming the liability in the asset purchase agreement; (ii) fraudulent sales of assets for the purpose of escaping liability; (iii) sales that are de facto mergers; and (iv) where the purchase is a mere continuation of the seller. As a general matter, these exceptions are difficult to prove for parties seeking to establish successor liability.

In Teed v. Thomas & Betts Power Solutions, LLC, the U.S. Court of Appeals for the Seventh Circuit recently addressed the limits of successor liability and ruled that an asset purchaser was liable for the seller’s pre-sale violations of the Fair Labor Standard Act (FLSA). The company, faced with a lawsuit for FLSA violations, defaulted on their bank loan. The company’s subsidiary ended up in receivership and its assets were sold for $22 million. The sale agreement provided that the sale was “free and clear of all liabilities” and expressly excluded any liabilities related to the existing FLSA litigation.

The Seventh Circuit ruled that a determination of successor liability for FLSA claims should be made pursuant to federal common law, not state law. Although the buyer in this case appropriately disclaimed all successor liability for most claims under applicable state law, the buyer was not absolved of successor liability for FLSA claims. Under federal law, unless there is a “good reason” to withhold it, successor liability should be enforced with respect to federal labor and employment laws.

The Seventh Circuit discussed hypothetical examples of “good reasons.” Certain examples are fairly straightforward, such as lack of notice of the claim. The court also discussed the possibility that finding successor liability existed gave preference to litigation creditors over secured creditors because the buyer would have paid less at auction if it knew FLSA claims were being assumed. The court rejected the argument because the buyer clearly priced the transaction assuming that the FLSA claims would be left behind.

While addressing various arguments, the Seventh Circuit discussed sales in Chapter 7 or 11 bankruptcy cases, noting that the estate has obligations to maximize recovery for all creditors and to enforce a rigid statutory priority scheme. The court implied that a sale in bankruptcy could occur free of FLSA obligations. There is substantial authority in other jurisdictions for the proposition that sales pursuant to Bankruptcy Code section 363 can occur free and clear of labor and employment liabilities.

The Teed case serves as a cautionary tale to purchasers of distressed assets. Purchasers should not get too comfortable in the assumption that pursuing asset sales avoids all successor liability and carefully evaluate both federal and state standards for successor liability for all claims, especially labor and employment claims. If substantial risk exists, purchasers should consider requiring that the sale occur pursuant to a formal bankruptcy case.