Avoiding the Hazards of Acquisition: Due Diligence in the Merger or Acquisition of a Product Manufacturer

February 2017Product Liability Law & Strategy

Product liability lawyers are most often asked to apply their skills in the courtroom. While they rarely find themselves negotiating deals in the boardroom, they can be an extremely valuable member of the corporate team as well.

In recent years, we have seen an explosion of activity in the world of mergers and acquisitions. As corporations continue to reshape at a rapid rate, due diligence groundwork concerning product liability issues can be critically important. Experienced product liability lawyers should be asked to assist in evaluating the potential exposure when a target company manufactures a product which has, or may be, the subject of tort and warranty claims.

This article addresses how deals can be structured, and the areas that need to be explored, when evaluating a potential deal from the perspective of product liability.

Deal Structure

Any product liability lawyer involved in advising on due diligence must have a basic understanding of how deal structure affects liability exposure. Whether a deal is structured as a stock or an asset purchase can have enormous ramifications for the buyer and its potential exposure to liability. Whether it is a purchase of the business entity itself (“Stock Purchase” or “Merger”) or a purchase of the business’ assets (“Asset Purchase”), the client will need to construct the contract in a way that best limits exposure to product liability.

Stock Purchase

In a Stock Purchase, the buyer purchases the equity from the owner(s) of the target company and the business is transferred to the buyer. Essentially, the buyer becomes the new owner of the seller. There are a number of reasons why a buyer may want to acquire a product manufacturer in this manner. For starters, the target company may have contracts that are not assignable without the consent of the target company’s counter-party. Another reason might be that the sale of the target company’s assets requires approval of the board of directors and shareholders.

Generally, when a transaction is structured as a Stock Purchase, the buyer assumes responsibility for all of the known and unknown liabilities of the target company. For example, if the target company has sold a defective product prior to the closing of the deal, the buyer may potentially be held liable for that product, notwithstanding the fact that it was sold before the deal was even contemplated.

What may appear to be a slam-dunk acquisition can quickly turn into years of litigation and substantial financial loss if proper due diligence is not effectuated. One way in which buyers seek to limit exposure is by structuring the deal as an Asset Purchase, as opposed to taking complete ownership of the target entity.

Asset Purchase

Unlike the Stock Purchase, where the buyer assumes the target company’s liabilities by law, the Asset Purchase allows for the buyer to purchase specific assets of the target company without assuming liability. Traditionally, a corporation purchasing assets for cash is not liable for the conduct, acts and products of the seller. However, in structuring such a deal, it is necessary for the product liability lawyer to make sure that the express language of the contract is clear about which, if any, liabilities are being assumed by the buyer.

In an Asset Purchase, most of the target company’s liabilities will be known and set forth in representations and warranties. The buyer can then negotiate which liabilities, if any, will be assumed. As for unknown liabilities, such as potential exposure resulting from product liability lawsuits, the buyer in an Asset Purchase can stipulate by contract that no such liabilities are to be assumed.

For the most part, the buyer can take solace in the fact that courts will generally respect the wishes of both parties in an Asset Purchase with regards to the transfer of liability. However, there is an important caveat: In certain circumstances, courts will nevertheless hold the buyer liable for the product liability of the seller, notwithstanding the express agreement of both parties to the contrary.

Successor Liability in Asset Purchases

While the Asset Purchase is the best avenue for avoiding the liabilities of the target company, there are still instances in which a court will impose successor liability despite the express intentions of both parties to the contrary. There are two major exceptions the product liability lawyer must consider — the de-facto merger doctrine; and the “mere continuation” doctrine.

De-Facto Merger

The de-facto merger doctrine came about due to concerns with corporations structuring deals which purported to be Asset Purchases, but in reality were merely mergers designed to look like an Asset Purchase. Courts generally will look to several factors when determining whether a transaction which is purported to be an Asset Purchase is actually a de-facto merger. The factors include continuity of ownership; cessation of business and the rapid dissolution of the purchased company; assumption by the purchaser of the liabilities necessary for the uninterrupted continuation of the business of the purchased company; and continuity of management, location, general business operation, etc. Courts have held that the presence of all factors is not necessary to find a de-facto merger.

Mere Continuation

Similar to the de-facto merger doctrine, the mere-continuation doctrine applies when there is a certain commonality between the buyer and the seller after the acquisition. Specifically, the mere-continuation doctrine may apply when there is a finding of one or both of the following: no adequate consideration was given to the seller for its assets; or one or more of the officers, directors, or stockholders of the seller became an officer, director, or stockholder of the buyer. Essentially, courts applying the mere-continuation doctrine evaluate whether the two entities have significant shared features such that the buyer is substantially the same as the seller. If the court finds that an Asset Sale is a mere continuation of the seller’s operation, the court may hold the buyer liable for the acts of the seller despite any agreement between the parties to the contrary.

Thus, simply using the Asset Purchase as a way to avoid liability may end up causing the purchaser to be blindsided by litigation later down the road. Whether the client decides to structure the transaction as a Stock Sale or an Asset Sale, it is crucial for the product liability lawyer to uncover any and all potential product liability exposure before the closing of the deal.

Evaluating Liability Exposure

During the due diligence stage of a potential acquisition, the more information the product liability lawyer can gather about the target company, the better equipped the lawyer will be in assessing the risks involved in the potential purchase.

Here is a list of key questions for the product liability lawyer to consider:

1. What is the target company’s claims history with regard to its products?

Due diligence should uncover the following: a) The allegations made, and outcome, of every claim against the company; b) A list of the type of injuries resulting from (or that might result from) the company’s product offerings — are they immediate (e.g., explosions) or latent (e.g., toxic exposure)? c) The status of any unresolved claims and the potential defenses to those claims; d) The company’s philosophy on settlement; and e) A list of any and all unsatisfied judgments.

2. What is the legal atmosphere surrounding the product?

a) The litigation history of competitors: Evaluating the claims history of competitor companies can be useful in assessing the possibility of lawsuits surfacing post-transaction. Even if the target company has not seen much litigation action, there may be a high likelihood that lawsuits could come in the near future. The claims history of competitors can provide a pattern of product defects and help forecast the likelihood of future claims; b) The success rates of defenses: There may be hundreds of claims filed, but if those claims are being routinely dismissed, the potential exposure might not be as threatening as it seems; and c) The trends in litigation within all potential jurisdictions. The attorney should be aware of how courts are leaning — in terms of tort reform, plaintiff-friendly verdicts and the like.

3. Does the company maintain a written record on all products manufactured and distributed by the company?

It is important for the product liability lawyer to obtain: a) A comprehensive list of all of the company’s product offerings dating back at least six years; b) A summary of the results of all tests, studies and surveys regarding existing products and products under development; c) Any new designs or modifications to the products; d) A record of the manufacturing specifications and designs, and the identities of the individuals involved in the designs; e) A report on the number and models of units sold, by region; f) A list of all product recalls (and the costs involved); and g) A list of all vendors and alternate sources of supply.

4. Is the company carefully vetting the claims it is using on its labels and its advertising?

Words on labels and advertisements can also lead to litigation if found to be false or misleading. It is important to examine the regulations governing the products being manufactured by the target company. For example, a manufacturer in the food business needs to be aware that words like “natural,” “healthy” and “organic” can have legal ramifications if the product itself does not align with regulatory requirements.

5. Does the company have insurance to cover product liability claims?

Due diligence should produce the following: a) Documentation of prior and existing primary and excess insurance coverage; b) Additional documentation if suppliers have added the target company as an additional insured; c) A risk management evaluation — weighing existing insurance against your estimates for potential exposure. Then decide whether additional insurance is necessary. Obtaining an insurance specialist might be useful in complex situations; and d) If additional insurance is needed to mitigate product liability, make sure that the insurance package covers unknown regulatory and product liability issues that may arise — including cyber claims and false advertising.

It may also be necessary to execute an indemnity agreement whereby the buyer will be provided liability coverage for a certain period of time prior to, and after, the purchase. Liability insurance and indemnity agreements can be very useful in situations like the Stock Purchase or de facto mergers, in which the buyer assumes liability by law.

6. How does the company size up in terms of publicity?

It is important to evaluate the target company’s publicity as well as the overall public perception of the company. This is especially important, and perhaps easier, in this new age of information and social media. The product liability lawyer should pay close attention to: a) Any press releases relating to the target company within the past five years; b) Print and online articles, scholarly journals, and blogs mentioning the target company; and c) Social media coverage of the target company. Perusing the target company’s “mentions” and “tags” on social media sites — such as Twitter, Facebook, and Instagram — can provide a unique insight into the public perception of the target company and its products. This may also uncover the threat of litigation before it happens. Some of the first reports of potential claims may appear via social media — as plaintiffs’ lawyers troll for claims against the target company.

Conclusion

There is no single, one-size-fits-all approach to due diligence, as each company presents its own unique set of risks. However, the above recommendations can serve as a guide in developing a comprehensive due diligence program for the analysis of product liability issues potentially affecting an individual buyer. Effective counsel should be able to provide the buyer with advice on how to structure the deal in terms of assumed liability. The lawyer should also uncover as many known and unknown liabilities as possible, and provide advice on how to mitigate those risks moving forward.

What the client wants is not always the same as what the client needs. Lawyers often feel pressured to avoid standing between the client and a deal. With that in mind, product liability due diligence requires a certain level of brutal honesty. It is far more beneficial to have a disappointed client than to hear, months down the line, that the client is on the hook for a multi-million-dollar product liability suit because of your apprehensiveness. It is important to disclose any and all potential liability and perhaps offer solutions — such as a change in deal structure, an indemnification agreement or additional insurance. The future of the client’s company may depend on your due diligence … and your honesty.

This article was published in the February 2017 edition of Law Journal Newsletter's Product Liability Law & Strategy.