Assumption of Liabilities in Carve-out Transactions

Barbara L. Becker is partner and co-chair of the Mergers and Acquisitions Practice Group at Gibson, Dunn & Crutcher LLP, and Eduardo Gallardo is a partner focusing on mergers and acquisitions, also at Gibson Dunn. The following post is based on a Gibson Dunn M&A report excerpt by Todd E. Truitt and Taylor Hathaway-Zepeda. The full publication is available here.

One of the most difficult, and therefore most heavily negotiated, issues in carve-out transactions is the division of liabilities between the parent and the carved-out business. Typically, the division of liabilities will follow the business: liabilities attributable to the parent’s business will be retained by the parent, and liabilities attributable to the subsidiary or division’s business will be assigned to the subsidiary or division. As explained below, in the case of an M&A transaction, this application can vary depending on whether the transaction is a stock sale or an asset sale. [1]

  • Stock Sale. In a stock sale, liabilities of the carved-out entity typically pass to the buyer by operation of law. The carved-out entity is acquired “as is” with all of its existing liabilities. However, to the extent the parent is creditworthy, the buyer may be able to obtain protection from certain liabilities through indemnification.
  • Asset Sale. In an asset sale, by contrast, the buyer is contractually responsible only for those liabilities that it specifically assumes as part of the negotiated asset purchase agreement. This flexibility allows the parties to choose from any number of liability arrangements, from “all liabilities resulting from the ownership and operation of the carved-out division” to only specifically enumerated liabilities in a schedule, with the parent typically providing unlimited indemnification for all other liabilities. However, even where the buyer does not expressly agree to assume any liabilities, the buyer should be aware that it may nonetheless be subject to certain successor liabilities arising out of the asset purchase. [2]
  • Applicable Law. No matter what the transaction structure, both parties should be aware that under applicable state, federal or international law, certain environmental, product and employee liabilities may pass to the buyer or be retained by the parent even if the parties have contractually provided for another allocation.

In most cases, both parties would be expected to attempt to avoid assuming or continuing to be liable for as many liabilities as possible. However, there may be significant business reasons why a party may want to retain or assume certain liabilities. For example, the buyer may want to assume certain contingent control liabilities, such as warranty obligations for products sold pre-closing to ensure the business runs smoothly and continues to retain a loyal customer base. Similarly, the parent may wish to retain control of certain disputes if adverse publicity or an adverse resolution of the dispute has the potential to create broader problems for its retained businesses.

Liability allocation can also present a potentially profitable arbitrage opportunity for a party if such party expects the ultimate exposure to be less than the amount that the other party is anticipating. For example, if the buyer estimates it will have to spend $5 million to settle an ongoing litigation claim related to the carved-out business while the parent believes it can negotiate a $2 million settlement, the parent may agree to retain the liability in exchange for an increase in the purchase price in excess of $2 million.

Often, the buyer and the parent will also agree to indemnify the other for any damages or losses that relate to the liabilities assumed or retained by them. These indemnification arrangements are often subject to time limits or caps. Parties also have the option of obtaining representation and warranty insurance to address certain of these risk allocation issues.

Specific Liabilities

(a) Balance Sheet Liabilities

Liabilities on the face of the balance sheet of the entities, because they are known and quantifiable, may be the easiest to address. Whether a stock sale or an asset sale, these financial liabilities, such as payables, can typically be accounted for in the purchase price or purchase price adjustment mechanism.

(b) Environmental Liabilities

Environmental liabilities generally follow the business that generated them. Sometimes, however, the parent may have developed a comparative advantage in handling such liabilities and will agree to retain them or agree to defend such claims in return for reimbursement of any related costs. The parties should also be aware that federal and state laws sometimes impose liability on the parent even if the carved-out business expressly assumes the liability. For example, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) prevents a parent that has owned or operated a hazardous waste facility from transferring liability under the Act to any other entity or person,
including the carved-out business. [3] In such cases, the buyer may seek protection through indemnification to the extent that the parent is creditworthy.

(c) Products Liability

Typically, under state law, products liability follows the business that manufactured or sold the product. However, both the buyer and the seller may have reasons for wanting to assume or retain this particular liability in exchange for a purchase price adjustment. As mentioned above, the buyer may seek to assume such liabilities to protect the customer relationships of the carved-out business. The parent, on the other hand, may be willing to assume these liabilities if it already has insurance to cover them (especially insurance for discontinued products). Regardless, the parties should consider whether the parties’ allocation of liability will be effective to protect against third parties’ product liability claims. If not, the parties will have to rely on an indemnification arrangement for such claims.

(d) Litigation

Litigation liabilities often present difficult issues because their contingent outcomes may materially affect the valuation of the spun-out business by whichever party assumes the liability. Parties can address litigation liabilities in a number of manners:

  • The parties may allocate the liability to the business that gave rise to the litigation;
  • The parties may agree to share joint and several or proportionate liability with respect to liabilities of the spun-out business, which will also include deciding which party will manage the litigation and what rights the other party will have with respect to approving a settlement;
  • The parties may single out specified liabilities of the spun-out business and establish special indemnification arrangements for specific matters;
  • The parent may agree to retain the litigation liability, control the litigation and indemnify the buyer; or
  • The parties may agree to certain purchase price adjustments depending on the final resolution of specified litigation matters.

(e) Employee, Employee Benefits and Related Liabilities

The parties need to consider allocation of employee-related liabilities, if any, that arise under state and federal law and any contractual obligations (e.g., the parent’s severance policies, employee benefit plans, employee agreements, collective bargaining agreements, etc.). As part of its due diligence, the buyer should determine whether it expects to lay off employees. If so, the buyer should analyze whether the proposed reductions will create issues under the federal Worker Adjustment and Retraining Notification Act (WARN Act) [4] and analogous state laws. Additionally, the parties should consider who will bear the severance costs for terminated employees. In addition, where the transferred business is subject to employment contracts with change of control provisions, severance costs can sometimes be triggered even when an employee continues to be employed by the acquired business. It is also worth noting that with respect to employment liabilities, both parties often have reputational interests at stake. Some parent entities, seeking to protect their reputational interests, require the buyer to maintain an enhanced severance program for transferred employees for a period of time following the closing (usually one year). An often-adopted strategy is to give the buyer responsibility for liabilities related to the employees it seeks to hire while the seller retains the liabilities for the employees that will not be transferred with the carved-out business.

If any international operations are involved in the transaction, the parties should also consider any relevant foreign labor and employment laws. For instance, many foreign jurisdictions impose statutory severance obligations or require consultation or notice. In the European Union, the parties cannot contractually exclude certain employees from the transfer of the carved-out business without the employees’ consent. [5]

The parties should recognize, however, that although these agreements may be effective between the parties, they may not be enforceable against third parties, including employees or the government. This is especially the case where employees have been exposed to health risks during the course of their employment, in which case third parties may claim that the parent retains liability even if it has been expressly assumed by the buyer.

(f) Contractual Obligations in General

The parties should make sure to obtain any required third-party consents for any significant contracts to be transferred between the parent and the carved-out entity. It is also worth noting that unless the contract provides otherwise, third-party consents are required to release the assigning party from liability.

Another important consideration relates to contracts, guarantees, insurance and credit support that the parent has obtained or entered into for the benefit of the subsidiary or division to be carved-out. For example, the parent may have obtained insurance for the subsidiary or division, or entered into a lease of facilities used by the subsidiary or division. Where these arrangements are not transferrable—either because they are part of a broader corporate structure that the parent intends to retain or because it is not economical for the carved-out business to assume them—the parties will have to consider substitute arrangements. It may be necessary for the parties to enter into a transitional services agreement whereby the parent will provide certain post-closing services to the carved-out business on a temporary basis.

Unidentifiable Liabilities

Unidentifiable liabilities are those liabilities that typically arise after the transaction is complete, but are not clearly traceable to the parent or to the carved-out business. For example, liabilities may arise following a post-carve out change in law that creates liability for pre-carve out actions, or on-going activities, both pre- and post-closing, such as Foreign Corrupt Practices Act (FCPA ) violations. Many purchase agreements fail to address such liabilities, either by neglecting them altogether, or by assuming that they will be addressed by the dispute resolution mechanisms delineated in the agreement.

Parties that do address unidentifiable liabilities typically do so pursuant to the following methods:

  • One party—usually the party most able to bear the liability—agrees to take responsibility for all unidentifiable liabilities;
  • The parties agree to share responsibility for all such liabilities on a joint and several or proportionate basis; or
  • The parties agree to establish a committee consisting of representatives from both the parent and the carved-out subsidiary or division, which will determine the allocation of any unidentifiable liabilities that arise after the transaction is complete.

The Importance of Specificity

No matter how the liabilities are carved up, the agreement should precisely define which liabilities are being assumed, which are being retained and the mechanisms for protection from such liabilities, if any. These issues are likely to be heavily negotiated, and care must be taken to ensure that the stock or asset purchase agreement clearly reflects the parties’ understanding.


[1] In addition, we note that even for carve-outs structured as initial public offerings or tax-free spin-offs, the same issues must be addressed in the separation or distribution agreement.
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[2] See, e.g., Teed v. Thomas & Betts Power Solutions, L.L.C., 713 F.3d 763 (7th Cir. 2013) (extending successor liability for an asset acquiror to suits brought under the Federal Labor Standards Act despite an express disclaimer in the sale contract).
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[3] 42 U.S.C § 9607(e) (2012).
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[4] 29 U.S.C. §§ 2101 to 2109.
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[5] See, e.g., EU Transfer of Undertaking Directive 2001/23/EC.
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