PRINT THIS PAGE Evaluating Mass Torts in a Private Equity Acquisition02/01/2008. Source: Dechert. Sean P. Wajert and R. Jeffrey Legath 
An important aspect of evaluating the possible
acquisition of the stock or assets of a target portfolio company is the potential litigation liability that may be acquired simultaneously. If a target company is involved or could potentially become involved in complex litigation matters, particularly mass tort litigation, it presents both risk and opportunity to a private equity acquiror, Sean P. Wajert and R. Jeffrey Legath, partners at law firm Dechert say. The existence or threat of this type of litigation may result in the opportunity to acquire a target at a below-market valuation multiple, and the uncertainty and fear caused by mass tort exposure can result in valuation discounts that make the attendant risk acceptable. There are potentially significant risks and complications, however, associated
with mass tort litigation or liability exposure, and thus private equity buyers must proceed carefully.
In the private equity context, mass tort litigation exposure can adversely impact the ability to secure third-party debt financing, and can have an adverse impact on investment exit. Private equity purchasers typically have shorter investment time frames than strategic buyers, and mass tort litigation and/or liability exposure often takes a substantial amount of time to resolve itself.
The general rule of law, and the typical structure of an asset purchase agreement, is that an acquiror of the assets of another corporation for cash does not acquire the liability for prior injuries caused by products sold by the target company prior to closing. Even when, however, the parties purport to allocate such litigation liability to the target, the buyer may find itself responsible for the litigation through the operation of various legal doctrines that are exceptions to the general rule.
These include fraudulent conveyance theories or successor liability doctrines, where the successor’s acquisition is judged to result in the successor becoming a continuation of the predecessor or its enterprise.
A few states also apply the so-called “product line” exception, which allows a plaintiff to recover for injuries caused by a defective product sold by the predecessor corporation in cases in which the successor has continued the predecessor’s product line. Attempting to structure the deal to try to minimize the possible application of such theories will often be the first line of defense.
Although asset sale structures are preferable for buyers, private equity sellers are rarely willing to enter into asset sale transactions, and instead often require stock acquisitions. If an asset sale can be negotiated, the buyer may also want to seek a provision that the seller shall not dissolve for some set period of time—so that the mass tort plaintiffs’ remedies seemingly are not destroyed. Special indemnification by the seller for the underlying exposure is another structuring alternative,
especially where an asset sale structure is not practicable.
The special indemnification should survive for a longer period of time than general representations and warranties, and ideally it would not be subject to baskets or caps, or at least, it would be subject to a special cap higher than is typical for representations and warranties made by a “clean” company. The use of a special escrow to set aside funds for the litigation indemnification is particularly important, especially when the fact pattern reveals a private equity seller who will want to distribute the deal proceeds to its investors.
There are inherent limitations in these “structural” responses. Even in an asset sale, buyers must recognize that the successor liability determination may be made by a state court confronting thousands of tort suits applying the law of the home state of the tort claimant who, absent a finding of successor liability, may be without an adequate remedy. It may not be possible for a buyer to negotiate special indemnification that lasts long enough, or is backed by a large enough escrow, to eliminate material risk to the buyer.
Finally, the perceived risk can impact a private equity sponsor’s ability to exit the investment, regardless of the strength of the structural protections. Thus, it may be a mistake to rely too readily on contractual
safeguards without a clear understanding of the potential future litigation risks.
Understanding Mass Tort Risks
A mass tort’s numerous claims pose incredible financial risks to companies, as evidenced by the multiple bankruptcies of large, otherwise prosperous entities due to mass tort litigation. A simple snapshot of any current mass tort litigation may understate the potential number of claims, especially if there is a long latency period — the time between exposure to the product at issue and manifestation of the disease allegedly caused by the product.
Aggregation of many claims in one procedure, such as a class action, may create an unbearable all-or-nothing risk for defendants, compelling what some courts term “blackmail settlements.” The risk of a damaging outcome is undoubtedly a feature that the buyer would want to address through deal structure and possible discount to the purchase price, but also one that should be evaluated thoroughly to help decide whether to proceed with the acquisition at all.
Mass Tort Due Diligence: Goals and Methodology
The due diligence analysis to help answer the question “What am I buying into?” will involve, when available, actual numbers, data, and dollars. But it also requires perceptions and judgments about the future litigation environment, and therefore may not result in a hard and-fast numerical estimate of risk. Rather, the best due diligence analysis may be a range of estimates based on certain assumptions. The buyer would ultimately make a business judgment about the range of risks that are
acceptable in light of numerous factors, including assets available to cover the risks and the financial benefits of the deal.
Experience has shown the optimal approach to the mass tort due diligence inquiry is to approach the risk question from numerous distinct perspectives, and then combine the learning from the various approaches. Specifically, due diligence for product liability litigation should try to examine the claims history, the product dimension, and the medicine/science underlying the possible mass tort litigation.
If the target company has been involved in the tort litigation, three aspects of the claims would be analyzed: the current claims status; the past claims history; and the trends that may be emerging. Together, the claims picture will be a useful, albeit imperfect, predictor of future litigation risks. It is imperfect because mass tort claims are plaintiff-attorney driven. New waves of plaintiffs or target defendants, new scientific studies, and new revelations from internal industry documents are not unusual features that can morph mass tort litigation and impact the number of claims made—in either direction.
There are any number of references/sources that may be consulted for the claims information, beyond information from the seller’s deal counsel. These include publicly available information such as SEC filings, annual reports, company press releases, court filings and dockets, and published case reports. Many mass torts have specific
published trade “reports” commenting on the specific litigation. Another useful set of resources may include the in-house counsel managing the litigation, the outside defense attorney on behalf of the target, and the seller’s insurance company.
A second, complementary way to assess the potential scope of future litigation is to gain an understanding of the product involved, its uses, marketing, and warnings; the nature of the alleged or potential defects as suggested by its hazards; and the regulatory environment governing such products. Product usage and sales can help drive an estimate of the population from which actual claimants may arise. If the regulatory environment offers some type of safe haven—even if there is current or looming litigation—it should help hold down future litigation. Part of this step is also to look at the target’s customers. The chain of distribution may be traced to figure out who the target or its distributors sold to, and thus who potential future plaintiffs might be.
The ultimate end users may be among identifiable groups. The customers, because of the sales history or other factors, may be part
of an older population that is diminishing actuarially, or a younger group from which potential plaintiffs could be drawn for years in the future, depending on any latency period associated with the product hazards. Similarly, it may be provident to assess how claimants allegedly were or could have been exposed to the product, with an eye to the credibility of such allegations of exposure scenarios. Beyond end users, other potential plaintiffs may be involved, including installers, repairers, and possibly bystanders.
The third recommended approach begins with the proposition that the science and medicine of plaintiffs’ claims or potential future claims can dramatically impact the litigation in either direction. For example, even if a company has stopped selling an allegedly defective product, or the defect has been designed out of the product, if the latency period (the time between exposure and the actual manifestation of the disease) is 30 years, the company can theoretically see claims for three decades after stopping sales.
Thus, a careful due diligence process will lead to an understanding of the medicine and science underlying the claims. For many mass torts, a fundamental issue will be an understanding of the probability that someone exposed to the hazardous product will develop disease as a function of the intensity and duration of exposure to the hazard. One issue may be “general causation,” the ability of the product to cause the injury in some people. Beyond that, there will be a need to assess the status of “specific causation” in the litigation.
That is, even if a product is capable of causing a disease, it does not necessarily mean that all product users will get the disease, or that all
product users with the disease got it from the product. The due diligence inquiry may also include an investigation of the assets and resources available to respond to possible litigation costs, including defense costs.
This may involve contractual indemnification for the benefit of the seller that covers the liability at issue and is transferable to the buyer. The analysis may include possible contribution or indemnification claims available as a matter of statutory or common law against others in the product’s chain of distribution. It may include a review of insurance and the status of any coverage litigation.
Conclusion
The various structural steps that may address potential litigation impact should be explored in any deal involving acquisition of mass tort risk, but thorough due diligence is essential in light of the potential deficiencies in structural and contractual protections and the attendant adverse impact they can have an investment exit. The inherent uncertainty in predicting future mass tort claims calls for a multidimensional approach that minimizes the impact of data or information gaps and maximizes the reliability of any assessment of future mass tort liability risks in the private equity acquisition context. Such due diligence is best conducted by counsel with experience in the mass tort arena and the ability to apply a thorough understanding of the forces driving product liability claims.
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