Buyer Beware: The Federal Common Law of Successor Liability Can Create Unexpected Liability

Key Takeaways:

• The Third, Sixth, Seventh, and Ninth Circuit Courts of Appeals have recognized the doctrine of federal common law successor liability for claims brought under certain federal labor and employment statutes, including the Fair Labor Standards Act, Title VII, the Family and Medical Leave Act, and the Employee Retirement Income Security Act, among others.

• Federal common law successor liability is broader than traditional state concepts of successor liability in that it does not require commonality of ownership between a predecessor and successor company; substantial continuity of operations can be sufficient to support successor liability.

• Thus, structuring a transaction as an asset sale as opposed to a merger or equity acquisition may not necessarily be sufficient for an acquiror to avoid liability for certain federal claims if key personnel, assets, and general business operations remain the same or substantially similar following the closing of the transaction.

• In Central Illinois Pipe Trades Health & Welfare Fund v. Prather Plumbing & Heating, Inc., No. 20-252 (7th Cir. July 7, 2021), the Seventh Circuit continued to recognize the federal common law doctrine of successor liability, but rejected the idea that it could supply an independent basis for federal question jurisdiction.

• Plaintiffs’ attorneys and others can be expected to test the boundaries of the doctrine by seeking to apply it to other federal causes of action that “arise under” federal law.

The United States Court of Appeals for the Seventh Circuit recently issued a noteworthy ruling in East Central Illinois Pipe Trades Health & Welfare Fund v. Prather Plumbing & Heating, Inc. on the application of successor liability in federal courts.¹ Federal common law successor liability is an exception to the general rule in virtually every U.S. jurisdiction that the buyer corporation (i.e., acquiror) in an asset sale transaction does not assume the seller corporation’s (i.e., acquiree) liabilities simply by acquiring ownership of the assets.² Federal appellate courts, including the Third, Sixth, Seventh, and Ninth Circuits, have carved out an exception to this general rule and recognized that “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.”³ Under this approach, successor liability may be found even in the context of a true asset sale if (1) the successor had notice of the claim, (2) there is “substantial continuity in the operation of the business before and after the sale,” and (3) the predecessor cannot provide the relief sought.⁴ Federal appellate courts have applied this framework to federal labor and employment claims arising under the Fair Labor Standards Act (FLSA),⁵ Title VII,⁶ the Family and Medical Leave Act (FLMA),⁷ and the Employee Retirement Income Security Act (ERISA),⁸ among others.

As a timely example, the district court in Prather Plumbing found the availability of federal common law successor liability to be a “close call” for plaintiffs who had obtained a default judgment on ERISA claims against an asset-selling target company that was left with few assets following a sale transaction and brought a separate action against the acquiror of those assets.⁹ Although the owners of the companies involved in the asset sale transaction were father and son and the son was on notice of his father’s company’s possible outstanding liabilities, the district court saw “a grave inequity in imposing a judgment of nearly US $300,000 due solely to the purchase of only US $25,024 in physical, depreciating assets” and ultimately declined to impose successor liability.¹⁰ Other courts, however, have balanced the equities in the other direction and have imposed successor liability on asset purchasers. Indeed the Seventh Circuit recently reemphasized that “when the successor company knows about its predecessor’s liability, knows the precise extent of that liability, and knows that the predecessor itself would not be able to pay a judgment obtained against it, the presumption should be in favor of successor liability.”¹¹

In its appellate decision in Prather Plumbing, the Seventh Circuit panel did not reach the equities of imposing successor liability. Instead, the court addressed whether the plaintiffs’ single claim alleging the federal common law doctrine of successor liability constituted alleging a claim “arising under” federal law for purposes of establishing federal question jurisdiction. In a unanimous opinion, the Seventh Circuit concluded that it lacked subject matter jurisdiction, citing the U.S. Supreme Court’s prior decision in Peacock v. Thomas, 516 U.S. 349 (1996), where that Court had determined that an argument for piercing the corporate veil did not provide “federal question” jurisdiction in the absence of an underlying federal cause of action, such as one arising under the federal labor or employment laws.¹² Similarly, the Seventh Circuit concluded that the plaintiffs in Prather Plumbing did not allege a violation of ERISA against the asset purchaser but merely argued successor liability as a “means of imposing liability based on an underlying cause of action” that they had previously won against the predecessor company.¹³ Although successor liability “implicates federal law[,] . . . it does not necessarily follow that federal law has also created a cause of action to enforce this doctrine in federal court.”¹⁴ As such, notwithstanding the fact that the plaintiffs cited ERISA in their jurisdictional statement, no provision of that statute actually provided for a lawsuit premised on successor liability.¹⁵ Thus, the Seventh Circuit vacated the district court’s judgment and remanded with instructions to dismiss the action for lack of federal jurisdiction. 

Although the Seventh Circuit’s decision in Prather Plumbing may reduce the potential for federal common law successor liability by excluding it as a source of federal question jurisdiction to bring a claim in federal court, this form of liability is alive and well in at least four of the federal circuit courts, including appellate courts that cover important jurisdictions such as Cincinnati, Chicago, Detroit, Los Angeles, Philadelphia, and San Francisco. When conducting acquisition due diligence, businesses and merger and acquisition participants should take note of the potential for successor liability under federal labor or employment statutes even where a transaction is structured as an asset sale, if substantial continuity of operations is a planned outcome. It should also be expected that plaintiffs and others will attempt to expand the doctrine of federal common law successor liability to other federal causes of action that “arise under” federal law. All this serves as yet another reminder of the importance of not only conducting thorough due diligence when undertaking an asset acquisition, but also the importance of seeking adequate representation and warranty coverage (including on matters implicated by federal law), as well as viable and sufficient remedies in the event of breach. 

Footnotes

1) E. Cent. Illinois Pipe Trades Health & Welfare Fund v. Prather Plumbing & Heating, Inc., No. 20-252, 3 F.4th 954 (7th Cir. 2021).

2) William M. Fletcher et al., Fletcher Cyclopedia of Law of Private Corporations § 7122 (rev. vol. 2008).

3) Teed v. Thomas & Betts Power Sols., L.L.C., 711 F.3d 763, 764 (7th Cir. 2013); see also Einhorn v. M.L. Ruberton Const. Co., 632 F.3d 89, 94 (3d Cir. 2011); Pension Benefit Guar. Corp. v. Findlay Indus., Inc., et al., 902 F.3d 597, 609-11 (6th Cir. 2018); Sullivan v. Dollar Tree Stores, Inc., 623 F.3d 770, 780-81 (9th Cir. 2010).

4) EEOC v. G-K-G, Inc., 39 F.3d 740, 747-48 (7th Cir. 1994); see also Teed, 711 F.3d at 765-66.

5) See Teed, 711 F.3d at 765-66.

6) See Wheeler v. Snyder Buick, Inc., 794 F.2d 1228, 1236 (7th Cir. 1986).

7) See Sullivan, 623 F.3d at 786-87.

8) See Einhorn, 632 F.3d at 96-100; Upholsterers’ Int’l Union Pension Fund v. Artistic Furniture, 920 F.2d 1323, 1327-28 (7th Cir. 1990).

9) E. Cent. Illinois Pipe Trades Health & Welfare Fund & Plumbers v. Prather Plumbing & Heating, Inc., No. 1:18-CV-01434, 2020 WL 4060766, at *8 (C.D. Ill. July 17, 2020).

10) Id. at *10.

11) Ind. Elec. Workers Pension Benefit Fund v. ManWeb Servs., Inc., 884 F.3d 770, 783 (7th Cir. 2018) (emphasis added) (quoting Worth v. Tyer, 276 F.3d 249, 260 (7th Cir. 2001)).

12) Prather Plumbing, 3 F.4th at 959-60 (citing Peacock v. Thomas, 516 U.S. 349 (1996)).

13) Id. at 960.

14) Id. (emphases added).

15) Id. at 961.