Practical tips and techniques for mass tort liability avoidance

Kevin L. Colbert, Jane Hammond, John Melko, Eunice Song &Tim Spear Gardere Wynne Sewell LLPHouston

By way of introduction, “mass torts” were once thought the province of companies whose products caused injury or were the result of a catastrophic occurrence (such as a release of pollution into the drinking water supply of a city). However, oil and gas companies now face the same perils once reserved for manufacturing entities.

Mass tort litigation emerges when an event or series of related events injure a large number of people or damage their property. A mass tort is defined by both the nature and the number of claims. The claims must arise out of an identifiable event or product, affect a very large number of people, and cause a large number of lawsuits asserting personal injury or property damage to be filed.

Classic examples of mass tort litigation include asbestos litigation, pharmaceutical medical devices (such as breast implants) litigation, and other chemical exposure litigation. While it may not be possible to eliminate every potential mass tort risk in a business transaction, there are a number of issues that companies and their counsel should consider.

II. Liability avoidance technique

A. Due diligence Prior to any acquisition, the buyer should conduct a due diligence review to determine what the buyer is in fact acquiring. Buyers and their counsel should include an analysis of a target’s product lines, assets and property, corporate history and ownership. Additionally, key personnel and current and former trial counsel should be interviewed.

1. Assets and property

A company’s assets constantly change as does property ownership. With the cost–cutting of the 1990s, many companies have discontinued company libraries and historians. Names of companies change as often as the ownership and structure. Despite this, there are a number of strategies the buyer and its counsel can employ to reduce the potential for mass tort litigation.

In acquisitions involving real property, it is imperative to determine the historical uses of real property. Historical means of discontinuing an operation included simply tearing down the structures and burying the debris on site. Contaminants such as heavy metals and asbestos may lurk beneath the surface unbeknownst to the current landowner. Sources of information to consult to determine historical land use include local newspaper archives, Sanborn fire district maps, and local historical society collections.

2. Corporate history

The buyer should conduct a thorough evaluation of the corporate history. Company histories can be a fruitful source of information regarding the company’s growth, prior acquisitions and divestitures, and key people and could be a storehouse of information for counsel conducting a due diligence review to evaluate suspected liabilities.

3. Personnel

One way to determine the existence, nature, and extent of retained, or hidden, liabilities, is to interview key personnel within the target company. Interviews of current employees may result in discovering the existence of previously undisclosed or forgotten obligations or issues that may give rise to potential obligations. Interviewing former employees is more challenging, but buyers should research the records of trade organizations and other similar groups to determine former employees of the target company.

4. Interview trial counsel

Lastly, information regarding the potential for mass tort litigation could be retained by current and former trial counsel for the company. Trial counsel are uniquely qualified to discuss facts and occurrences that may lead to a mass tort and issues that may be revealed during litigation. Additionally, trial counsel may be a source of information regarding corporate history and key people.

5. All appropriate inquiries

Commonly referred to as Phase I or Phase II environmental site assessments, the EPA has established regulations for “all appropriate inquiry.” For real property, EPA regulation requires the environmental site assessments to be conducted pursuant to procedures developed by the American Society for Testing Materials (ASTM). In short, there are 10 criteria that must be satisfied to meet the “all appropriate inquiries” test; those are:

An inquiry by an environmental professional;
Interviews with past and present owners, operators, and occupants of the facility for the purpose of gathering information regarding the potential for contamination at the facility;
Reviews of historical sources, such as chain of title documents, aerial photographs, building department records, and land–use records, to determine previous uses and occupancies of the real property since the property was first developed;
Searches for recorded environmental clean–up liens against the facility that are filed under federal, state, or local law;
Reviews of federal, state, and local government records, waste disposal records, underground storage tank records, and hazardous waste handling, generation, treatment, disposal, and spill records concerning contamination at or near the facility;
Visual inspections of the facility and adjoining properties;
Specialized knowledge or experience on the part of the defendant;
The relationship of the purchase price to the value of the property if the property was not contaminated;
Commonly known or reasonably ascertainable information about the property; and
The degree of obviousness of the presence or likely presence of contamination on the property.

B. Deal structure

1. Asset acquisition
Perhaps the most effective deal structure for limiting a buyer’s liabilities is an asset acquisition. In such a deal, the buyer and seller specify which assets will be acquired and which liabilities will be assumed by the buyer. General “successor liability” law provides that an asset buyer does not assume unknown seller’s liabilities unless they have been expressly assumed. There are exceptions to this general principle. The following lists the major exceptions:

The buyer expressly or impliedly agrees to assume the seller’s debts and/or liabilities;
The transaction is a de facto merger or consolidation;
The buyer is a mere continuation of the seller; and
The transaction is an effort to fraudulently avoid liability.

2. Stock acquisition

In a stock acquisition, the target’s shareholders sell their stock to the buyer and the target becomes a subsidiary of the buyer. There are no transfers of property and no assignments of contracts, licenses, or permits. The buyer indirectly assumes all liabilities. Because of the significant risks associated with the buyer’s assumption of all liabilities, conducting thorough due diligence prior to the acquisition is crucial to uncover the extent of the target’s liabilities. If possible, the buyer should also obtain extensive representations and warranties from the shareholders so that in the event of a breach, the buyer has some recourse.

3. Mergers

Similar to a stock acquisition, under a merger, the target’s property, contracts, licenses, and permits are all acquired by the buyer by operation of law resulting in an automatic transfer of not only the target company’s assets but also its liabilities. However, unlike a stock acquisition where the buyer is not directly liable for the target’s liabilities, in a merger the “target company’s liabilities are directly assumed by the buyer as the surviving company.” Consequently, “the surviving company assumes unlimited liabilities from the target company in a merger while the buyer’s liabilities are generally capped at its investment in the target company’s stock in a stock acquisition.”

The merging company should conduct extensive due diligence and request extensive representations and warranties from the target and its shareholders in the merger agreement. As a further protective measure, the merging company could seek a separate agreement with the target’s shareholders, officers and directors providing for their personal liability after the merger.

C. Successor liability

The environmental area has seen significant development regarding potential successor development, specifically under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”). The four exceptions to successor liability mentioned in II(B)(1) above have been recognized under CERCLA. A fifth and controversial exception, the “continuity of enterprise” or “substantial continuation” exception, has also been applied by a few courts under CERCLA broadening the scope of successor liability.

One final notable exception is the “petroleum exclusion” which provides that so long as the substance at issue is found in refined petroleum fractions and is not present at levels that exceed those normally found in such fractions, such substance is not treated as a “hazardous substance” as defined under CERCLA. However, the analysis under the petroleum exclusion is limited strictly to the substance at issue and not whether the business entity involved is in the petroleum industry or is a petroleum company. Under CERCLA analysis, when applying these exceptions, an asset buyer could certainly be liable for the seller’s previous contaminations.

1.Discussion of exceptions

a. Agreement to assume liabilities
Based on general principles of contract interpretation, a court determines whether a buyer has explicitly or impliedly agreed to assume all liabilities.

b. De facto merger

Under this exception, the actual form of the sale is not as relevant as the substance of the transaction. If the substance of the deal appears to be a merger, then the surviving company assumes the debts and liabilities of the subsumed company. The relevant factors in determining whether a merger is deemed to have occurred include:

continuation of enterprise of the seller;
continuation of ownership of purchaser and seller;
dissolution of the seller as soon as possible after the transaction; and
buyer’s assumption of the obligations of the seller necessary for uninterrupted operation of the business.

c. Mere continuation

This exception arises in situations where the buyer appears to be a reorganized version of the seller rather than a separate entity. Some of the significant factors in this evaluation include:

common ownership of buyer/seller;
common identity of officers/directors;
similar control of stock and hiring and function of officers and directors;
one corporation surviving after transfer of assets; and
inadequate consideration for the assets.

d. Fraud

This exception generally relies on state fraudulent transfer statutes to determine whether successor liability should be imposed. At issue are those transfers intended to “defraud, hinder or delay creditors or stockholders of the predecessor company.” For determining the occurrence of fraud, courts look to several factors, such as whether:

the seller was insolvent at the time of transfer;
there was insufficient consideration; and
the seller was inadequately capitalized.

e. Substantial continuation

Substantial continuation is the broadest and most undefined exception; only half of the federal judicial circuits have adopted it. Of those circuits that have, some require that the buyer have knowledge or notice at the time of the transaction or substantial ties with the seller. The determinative factors for this exception are:

continuity of employees, directors, officers and physical location, assets and general operations, business address/office/phone and customers;
manufacture of the same product;
retention of the name;
a buyer holding itself out as the continuation of seller;
contaminating activity which continues even after the acquisition;
the buyer had knowledge or notice of potential liabilities or had substantial ties with the seller;
transaction was not arms–length;
buyer was not previously in same business as seller;
absence of other parties from whom damages could be recovered.

Buyers should be wary of the substantial continuation exception because it has been applied quite liberally, “imposing CERCLA liability for historic offsite waste disposal by the selling corporation upon a purchaser of assets at arm’s length that continued the same business, but not the operations that generated the waste, and had no continuity of officer, directors or shareholders and no prior knowledge of the environmental liability.”

2. General recommendations

Given the uncertain landscape of successor liability, the buyer should take every precaution to minimize the likelihood of being liable for the seller’s liabilities such as:

“Provide clearly in the purchase agreement that seller’s known and unknown environmental liabilities remain with seller and consider requiring that seller make some financial provision for such liabilities.
If feasible, clearly identify the new operating entity as distinct and independent from the seller.
Do not install officers, directors and supervisory personnel of asset seller in the same roles in the new operating entity.
Do not pay for the assets, in whole or in part, in stock of the purchaser.
Where appropriate, change locations, employees and aspects of management and manufacturing operations.
Require the asset seller to maintain its corporate existence and a minimum net worth for at least a defined period after the sale.
Where appropriate, change the business address, the office location and the phone number.
Do not adopt the corporate or trade name of the seller.”

D. Indemnification

1. Caps on liability
In M&A transactions, it is very common for sellers to insist upon a limitation on the total liability, or a “cap”, for which the seller must indemnify the buyer upon a breach of the sellers’ obligations under the purchase agreement. Caps are expressed as either (i) a percentage of the total purchase price, generally ranging from as low as 10% (or even lower in some cases) of the purchase price to as a high as 100% of the purchase price or (ii) a total dollar amount, e.g. $25 million.

Thus, in a transaction with a purchase price of $100 million, a seller that had negotiated a cap of 10% would face a maximum liability of $10 million, meaning that even if the buyer incurred $50 million in losses that would otherwise be indemnifiable under the purchase agreement, the seller would only be responsible for indemnifying the buyer for the initial $10 million of those losses.

Oftentimes, breaches of covenants are not subject to the liability cap and certain representations and warranties are also frequently excluded from the cap. For example, the seller’s representation that it owns all of the stock of the target company free and clear of all liens is often not subject to a cap in a stock purchase agreement. Although not as common, buyers sometimes negotiate for reciprocal caps on their liability.

2. Thresholds

Many sellers worry about being “nickeled and dimed” after closing by buyers for inconsequential breaches of the sellers’ representations and warranties. Such sellers often argue that minor claims are apt to arise in any business and that buyers should be willing to accept such minor claims as a cost of doing business.

To avoid dealing with these de minimus claims, a seller will insist upon a minimum amount of aggregate losses, or a “threshold,” below which the seller will not have any liability to the buyer. This aggregate threshold amount is typically characterized as (i) a “deductible,” if the seller is only responsible for indemnifying the buyer for claims in excess of such amount or (ii) a “basket,” if the seller is responsible for indemnifying the buyer for all claims back to dollar–one once the threshold has been met. It is common for the aggregate threshold amount to be part deductible and part basket.

3. Seller’s financial wherewithal

In many M&A transactions, the buyer is concerned about the sellers having the financial wherewithal to fulfill their indemnity obligations after closing. This concern is particularly acute when the seller is an individual. Individuals and their assets may be difficult to locate after closing. Additional concerns arise if the seller is a private equity fund that is selling its sole asset because the fund will likely be dissolved shortly after closing. Protection in these situations can be obtained through the use of holdbacks, promissory notes, earnouts, and escrows.

a. Holdbacks

A “holdback” occurs when the buyer withholds a certain dollar amount or percentage of the purchase price at closing for a defined time period. This offers protection from losses arising from breaches of the seller’s representations and warranties. For example, in a $50 million transaction, there might be a $5 million holdback for one year after the closing. If the buyer incurs indemnifiable losses during the holdback period it can deduct such losses from the holdback amount.

At the expiration of the holdback period, the buyer would be obligated to pay the seller the remaining holdback amount. The holdback is particularly advantageous to the buyer because the buyer would keep the holdback amount in its own bank account during the holdback period and would typically be entitled to all interest earned on the holdback amount during the holdback period.

b. Promissory notes

In lieu of using a holdback, the buyer might instead choose to give the seller a promissory note for some part of the purchase price. The promissory note would include an offset provision whereby any indemnifiable losses incurred by the buyer during the note’s term would be offset against the face amount of the note. Interest may or may not accrue to seller’s benefit on the note.

A promissory note is particularly attractive to the buyer because it would not be required to have funds necessary to pay the entire purchase price at closing. The seller might prefer a promissory note to a holdback because it could sue the buyer on the note rather than under the purchase agreement.

c. Earnouts

The term “earnout” refers to a provision in a purchase agreement whereby the seller receives additional proceeds after closing based on the performance of the acquired business for some limited time period following closing. The buyer will typically insist that it have the ability to offset any indemnifiable losses it suffers under the purchase agreement against amounts that would otherwise be owed to seller as a result of the earnout.

d. Escrows

In an escrow arrangement, the buyer places a portion of the purchase price into escrow generally with an independent escrow agent. The escrow agent agrees to hold the escrow amount for a certain time period after which it will pay the escrow amount, and any accrued interest, to the seller unless the buyer has notified the escrow agent that the buyer has suffered an indemnifiable loss under the purchase agreement for which the buyer seeks recovery out of the escrow amount.

III. Bankruptcy

A. Cleansing assets through bankruptcy sales
For years, many purchasers of assets from companies experiencing product liability claims sought to “cleanse” the assets of any trailing liability by requiring the seller to file bankruptcy and then seek authority to sell its assets with the approval of the bankruptcy court. There were several reasons for this. First, the creditors of the seller/Chapter 11 debtor were required to assert their claims to the bankruptcy court. But more importantly, the bankruptcy code contains a provision that the court may order the assets of the bankruptcy estate sold “free and clear of any interest in such property,” with any such interest attaching to the proceeds of the sale.

As long as the debtor or trustee can prove that the sale is at the best price attainable under the circumstances, the property may be sold and the parties claiming an “interest” in the property, such as liens, claims, or co–ownership, will have those interests attach to the proceeds of sale. There are exceptions to this general rule. The underlying principle is for a bankruptcy estate to realize the highest possible value for the benefit of creditors. The money is brought into the estate, where co–ownership and lien priorities can be sorted out among the creditors with the court’s oversight. By freeing the buyer from entanglement in inter–creditor disputes, the buyer will not discount the price it is willing to pay for a “litigation premium” and the estate and all creditors will be better off.

This “cleansing” process functions well for claims that are known. The problem arises where claims from a defective product do not become apparent until years later. While the parties claiming injury may not have a lien or security interest in the asset being sold in these circumstances, there will be a claim “arising from” that product. Because the claim was not known at the time of the bankruptcy, the claimant could not have filed a claim against the bankruptcy estate, and due process prevents such claims from being discharged.

These claims are usually brought against the buyer under one of the successor liability theories discussed above. Buyers of assets from bankruptcy sales routinely returned to the bankruptcy court for an injunction or other protection from such suits alleging that the plaintiff bought or came in contact with the product prior to the sale, and that any claim should be against the bankruptcy estate of the seller, not the buyer which bought the assets “free and clear” of all claims.

As these cases found their way to the appellate courts, the law became clear that successor liability was a state law issue focusing on the buyer, not the bankrupt seller, and thus the question was outside of the bankruptcy court’s jurisdiction. If the state courts decided that the buyer was a “successor” to the debtor or its product line under the relevant state’s successor liability law, the buyer could be held liable.

As a result of these rulings, and in an effort to maximize value to the bankruptcy estates, debtors’ lawyers established, subject to court approval, special future claims trusts against which any later arising claim must be filed. These are effective only when coupled with an injunction preventing future claimants from pursuing purchasers of the assets of the debtor.

In the asbestos area, the bankruptcy code was amended to specifically provide for trusts of this type, but those amendments apply only to asbestos cases. In non–asbestos cases, the format is often copied, but there is no statutory basis for it. The practical effect of a trust in non–asbestos cases is thought to be one of practicality – i.e., providing a recovery fund for a plaintiff to look to will at least diminish suits against buyers of assets.

IV. Conclusion

The cardinal rule in mergers and acquisitions in the oil and gas industry is the same as for any other business transaction – due diligence. Knowing the assets to be acquired and the history of the seller and the product is key. If there is any risk of successor liability claims, the buyer should insist on mechanisms to provide relief from future claimants and claims, protect the buyer, or adjust the purchase price to account for successor liability risk.