Legacy liability (also known as successor liability) in M&A transactions is of key importance as it may significantly impact the value of the acquired target and the overall viability and success of the intended business. Because of this, it is necessary to allocate sufficient resources, time and attention to the analysis and assessment of the activities and matters that may cause legacy liability.
The above is particularly true when a transaction involves the acquisition of a company or assets that are primarily dedicated to, or used in connection with, highly regulated activities such as mining – which is dependent on governmental concessions – permits, licences and authorisations that may be suspended or even revoked.
The existence and treatment of legacy liability differs greatly in countries of civil law rather than common law tradition. Civil law systems are generally less advanced in this regard, since they heavily rely on dated legal provisions and not on dynamic case law. Because of this, is not possible to give an all-encompassing analysis on the subject, and prospective purchasers should always seek the advice of local counsel in the relevant jurisdictions involved in an M&A transaction.
The legacy liability issues included in this chapter are analysed under a civil law perspective with particular emphasis on the Mexican legal system, which may be similar to the legal systems of other civil law tradition countries, mainly those in Latin America.
In the following sections, this chapter will (i) provide a brief overview of the different structures to carry out an M&A transaction, and analyse the general implications of such structures under a legacy liability standpoint, (ii) flag the areas that typically involve legacy liability issues in the mining sector, and (iii) discuss some of the strategies and tools available to minimise legacy liability risks involved in an M&A transaction.
Structures to carry out M&A transactions
In Mexico, an M&A transaction is usually structured and carried out as one of the following:
- share acquisition;
- asset acquisition;
- merger; or
- a combination of the above.
From a Mexican legal perspective, the most relevant distinction between an asset and a share acquisition is that in a share acquisition, the purchaser will assume the entire liability from the target company. In contrast, in an asset acquisition, the purchaser will generally only absorb liability on the assets acquired, unless such acquisition is classified as one of a going concern or business under Mexican tax legislation and precedents, in which case the purchaser may be deemed jointly and severally liable with the seller for past tax obligations of the seller and its business.
Because of the above, asset acquisitions are in themselves a way to minimise the risk of facing legacy liability, and share acquisitions tend to be subject to more lengthy and detailed pre-acquisition due diligence review in order to assess, identify and – when possible – quantify the potential liabilities of the target company that will be assumed by the purchaser.
From a legacy liability perspective, a merger in Mexico entails a universal transfer of all assets and liabilities of the disappearing entity to a surviving or newly formed entity. The surviving or newly formed entity becomes a successor in interest of the disappearing entity; thus, there are no resources to mitigate legacy liability issues, because all outstanding liability of the disappearing entity is transferred to the surviving or newly formed entity.
Areas that may involve legacy liability issues
In Mexico, the mining industry is regarded as a strategic activity owing to its various far-reaching and long-term impacts to the environment, and social and economic landscape, as well as government policy regarding the use of natural resources that are deemed to be originally owned by the government.
Therefore, asset acquisitions focused on mining operations may be prone to facing legacy liability on many fronts, which typically include the following:
- environmental matters;
- real estate matters (ownership, leasehold, temporary occupation and easements);
- permitting matters;
- labour and employment matters;
- social and community impact matters;
- taxes; and
- breach of contractual obligations.
The areas that may pose a risk from a legacy liability standpoint are discussed below.
Owing to the need to protect several ecosystems and some of the most valuable natural resources, many countries such as Mexico require mining companies and operations to observe several laws and regulations intended to protect the environment and to minimise the negative impact that mining exploration and extraction activities may have on non-renewable natural resources, and indigenous animal and vegetal species.
Many of the applicable environmental laws have strict penalties and long-lasting statute of limitations provisions designed to discourage practices that may harm the environment, and to penalise violations. Such provisions may also require the performance of remedial actions to reverse the damage caused to the environment to the fullest extent possible.
In many cases, mining requires the use of explosives and toxic substances, which need special procedures to be stored, handled and disposed of. Mining companies may also have to get special permits to buy, use, store and manage these materials. The incorrect use, storage or management of these substances may lead to lasting environmental damage and penalties that may negatively impact or cripple the continuance of an operation.
During the pre-acquisition due diligence review, a prospective purchaser should be particularly careful to request all available supporting documents and permits regarding the acquisition, use, storage, management and disposal of any potentially dangerous substances that may cause damage to the environment. It is also advisable for the purchaser to review the environmental impact statement, and conduct business compliance reviews, including Phase I and Phase II environmental site assessments to ascertain whether an actual risk exists, as well the scope and scale of any corrective action that is potentially required to remediate any pollution at the relevant site. These site studies are relevant as environmental damage is not always apparent, and its effects may be suffered over a long period. It is also important that purchasers make sure that the consulting firm entrusted with the issuance of the Phase I and Phase II reports are reputable firms that expressly allow the purchaser to rely upon the conclusions of said reports through the issuance of a reliance letter.
Prospective purchasers can inherit legacy environmental liabilities resulting from past activities performed on a site currently or previously owned by the acquired target company or business, as well as regarding non-compliance with administrative provisions set forth in the corresponding environmental licences or authorisations. In jurisdictions such as Mexico, in some extreme cases the lack of certain relevant environmental authorisations can also lead to criminal liability for certain corporate officers with knowledge of the lack of required permits or authorisations.
Real estate matters
Mining operations usually require the extensive use of real estate property, which must be legally secured either though purchase, leasehold, easement or other temporary use rights. An additional complication is that mining grounds are usually located in a rural setting, which may require additional permitting to allow those lands to be used under a land regime appropriate and consistent with the mining exploration and extraction activities. Filings and requirements for change of land use can be burdensome and take significant time to be completed. Operating without the proper land use authorisation can lead to hefty fines and temporary closure of the site.
Another issue to consider is that some jurisdictions such as Mexico have communal land ownership regimes that may affect the land on which mining projects are located. Those land ownership regimes may require additional due diligence review, and actions to properly secure the use of real estate properties. In some jurisdictions, the procedure to acquire or secure use rights over land subject to communal ownership regimes are cumbersome and time-consuming. Communal land ownership regimes normally function like a corporation (ie, they have a corporate governance body such as a general board of communal owners, which is required to vote and approve significant matters affecting the land, such as long-term leases and disincorporation of portions of land from the communal regime for its subsequent transfer). These approval processes can also be time-consuming and may entail negotiations with a high number of owners with different and occasionally opposing interests. Because of these matters, prospective purchasers are highly encouraged to seek specialised advice for real estate matters from the due diligence review phase and all through the post-closing phase. Other issues such as protected areas and archaeological sites should also be considered and analysed.
A prospective purchaser may face legacy liability owing to omitted payments of real estate taxes, rent or lack of permits in connection with the authorised use of land, as well as for infringement of a third party’s property or leasehold rights owing to unlawful real estate use, or occupation by the target company or business.
Searches of publicly available real estate information are a useful resource to ascertain whether some of these contingencies exist and how to effectively manage them.
Permitting issues are some of the most relevant items to consider in mining M&A transactions, owing to the highly regulated nature of mining operations. A lack of proper permits can lead to material fines, and even to the temporary or permanent closure of the mining operation.
In some countries, mining exploration and exploitation activities require an authorisation granted by the government. This is particularly common in Latin America, with countries such as Argentina, Brazil, Chile, Mexico, Colombia, Peru and Venezuela requiring some form of authorisation or ‘mining concession’.
In Mexico, for example, the relevant authorisation is a mining concession, and it is required based on the premise that some of the minerals located in the subsoil may be deemed as originally owned by the Mexican state.
Some countries may also have additional restrictions on mining activities that must be observed, such as foreign investment restrictions, or owing to the nature of the mineral subject to extraction. For example, in Mexico, any activity or industry related to radioactive minerals is exclusively reserved for governmental authorities and entities, and cannot be performed by private individuals or entities.
Many of the required permits need subsequent renewals or update procedures, which are continuous and recurring obligations of the permit holder, and that may entail payment of significant fees to keep the corresponding rights in good order. The lack of payment of these obligations, or lack of observance of the terms of the relevant permits, can lead to fines, accrual of interests over amounts due and other administrative penalties, such as suspension of the relevant rights or revocation of the corresponding permits.
Purchasers may face legacy liability owing to omitted payments or updates required under acquired permits that were previously granted, as well as for activities carried out within sites currently or previously owned by the acquired target company or business without the proper permit or authorisation.
Labour and employment issues
On a transfer of assets, the scope of labour liability assumed by the purchaser will vary depending on the specific circumstances of the transaction and the method of performing the transfer of employees.
In Mexico, there are two methods to perform the transfer of employees to an asset purchaser:
- employer substitution; and
- employment contract termination and rehire.
Generally, the method for transfer of employees may be freely determined by the parties involved; however, under certain binding court precedents, if the majority or all of the assets required to carry out the employer’s operations are transferred to the purchaser, an automatic employer substitution occurs, which means that the purchaser will assume significant labour legacy liability. Nevertheless, if only certain and limited assets of the seller are transferred to the purchaser, only the employees whose employment activities are related to those assets may be subject to an employer substitution.
In the employer substitution scenario, the substitute employer (ie, the purchaser of the assets or its designee) will assume liability for salaries, labour benefits, length of service bonuses and all other employment conditions of the employees of the target company.
When an employer substitution takes place, employees are, as a general rule, not entitled to severance pay, as long as the new employer assumes and maintains all of their former employment conditions and benefits. In the event that the substitute employer cannot match all the previous working conditions, the substitution of the employer will not be enforceable, and employees may terminate the employment relationship for cause. In that case, the employees will be entitled to receive the mandatory severance pay provided for in the Mexican Federal Labour Law.
In an employment substitution scenario, both the outgoing employer (seller) and the new employer (purchaser) are jointly liable for labour obligations, including unpaid social security contributions for a period of six months after the effective date of the employer substitution.
The other method of transferring employees in Mexico is the employment contract termination and rehiring of employees, which can also have two variants. The type of variant that is used will also impact the scope of labour liability that is assumed by the purchaser.
The two types of employment contract termination and rehiring of employees are as follows:
- employment contract termination and rehiring without recognition of seniority; or
- employment contract termination and rehiring with recognition of seniority.
If a seller terminates its employment relationship with employees and the purchaser then rehires them without acknowledging their length of service (seniority) with the former employer, the employees would be treated as newly hired employees of the purchaser; thus, the purchaser would be entitled to freely determine new terms and conditions of employment and, in turn, the employees would be free to accept those conditions of employment or not, depending on the prevailing market terms for similar positions or other factors to be evaluated by the prospective employees. However, in that case – and because under Mexican law an employer may not terminate the employment relationship with an employee absent a statutory just cause of termination – the employees will be entitled to mandatory severance as required under the Mexican Federal Labour Law, and the termination agreement is subject to the additional formality of approval by the relevant conciliation and arbitration board.
The alternative to employment contract termination and rehiring without recognition of seniority usually seems very attractive to prospective purchasers since it entails less risk and cost because the purchaser will not assume any legacy liability from the prior employment relationship or the termination costs of the transferred employees. However, sellers tend to be more reserved in using this alternative because payment of mandatory severance can be costly. Because of the above, the parties of an asset deal usually spend a significant amount of time discussing and negotiating which party will pay termination costs, or how the parties will split those costs. An alternative to this somewhat polarising method is the employment contract termination and rehiring of employees with recognition of seniority by the purchaser. In that scenario, the seller would only pay to the employees all unpaid salaries, holidays and bonuses, etc, that accrued with the seller, but not mandatory severance. In this method, the purchaser will assume legacy liability for the mandatory severance calculated based on the total length of service of each employee (including length of service of the employee with the seller as the former employer) whether and when the purchaser decides to terminate the employment relationship with the relevant employee. As described above, this alternative can be viewed as a middle ground, since it requires both the seller and the purchaser to assume a portion of liability in connection with labour benefits, and costs owing to a termination.
In share acquisitions or mergers it is important that the due diligence carefully addresses the number of employees and the amount of salaries and other benefits granted by the target company; labour contingencies to be transferred to the purchaser may be high in cases where the target company has employees with significant seniority who may be entitled to benefits that are above the standards provided by applicable law.
Social and community impact matters
Although social and community impact matters are more present and highly developed in other sectors such as energy generation, in that sector, Mexican legal provisions require developers of energy projects to perform studies to determine the impact of a project. Even in the absence of express requirements in connection with social impact studies, purchasers and developers of mining projects should be mindful of the social and community impact that the mining activities may have upon indigenous communities, the general health and quality of life of settlements near the project site, and potential damage or negative impact to historic or cultural assets.
The concept of social and community impact is far-reaching and may be connected with other matters discussed in this piece, such as environmental and real estate matters.
A clear example of legacy liability issues in connection with social and community impact may be archaeological findings. If an acquired site has unreported archaeological findings, the purchaser may face legacy liability, which could jeopardise the continuous operation of a mine.
As previously mentioned, asset acquisitions generally pose a decreased risk for legacy tax liability, unless the acquisition is deemed a transfer of going concern, in which case the purchaser could face joint and several tax liability with the seller in connection with past tax liability related to the acquired assets or business. The risk of facing legacy tax liability may be addressed by breaking down the components of the going concern, and having several entities of the same group acquire the different components.
Share acquisitions and mergers entail full transfer of tax liability to the purchaser.
Breach of contractual obligations
In asset deals, the purchaser will acquire all legacy liability and pending obligations derived from the contracts that are assigned or transferred. It is possible to exclude certain obligations through the partial assignment of rights; however, this structure is uncommon since it is complicated and may lead to conflicts in outlining the obligations retained by each party of the agreement, which could in turn lead to further conflicts and litigation. In asset deals, the due diligence review should carefully analyse the contracts that are required for the operation of the target business or assets, and then exclude all other contracts from the operation, thus limiting the liability assumed through the acquisition.
Tools to manage legacy liability risk
Structure of the transaction
As previously discussed, as a general principle to minimise legacy liability issues, it is advisable to structure the transaction as an asset acquisition rather than as a share acquisition or merger. This should be carefully analysed because even if asset deals may be a good way to minimise legacy liability issues, it is very important to accurately define the scope of the assets to be acquired in order to ensure that the purchaser will have all the assets required to pursue its intended activities.
Asset deals may be harder and slower to implement in Mexico owing to required transfer formalities applicable to certain assets, such as real estate and intellectual property. Share acquisitions are generally simpler and quicker to implement since there is no need to list the assets of the target company or to make a detailed purchase price allocation among acquired assets. Mergers are also a typically slower structure, which is generally chosen owing to the possibility of qualifying for tax exemptions if certain requirements are met.
It is also possible to structure an M&A deal as a debt-free transaction. In that way, the purchaser will avoid assuming legacy liability related to prior economic commitments of the target company, business or assets.
Using a special purpose vehicle
The purchaser may use a separate newly created special purpose vehicle to acquire the assets or even shares from the seller. In that way, the purchaser will insulate itself from the liabilities acquired from the seller subject to applicable corporate veil piercing principles. For corporate restructuring purposes, the purchaser may also set a reasonable period, after which – if no unknown or undisclosed liabilities arise – the special purpose vehicle may transfer the assets directly to an operational subsidiary of the corporate group of the purchaser, or the special purpose vehicle can be merged into the operational subsidiary. The creation of special purpose vehicles in Mexico is inexpensive but could require some additional time, so careful planning and scheduling is always advised.
Pre-acquisition due diligence review
The scope and depth of the pre-acquisition due diligence review varies depending on the transaction structure, where typically asset deals have less in-depth due diligence reviews because the risk of unknown or undisclosed liabilities is generally lower. However, pre-acquisition due diligence reviews for asset deals should be more detailed regarding the areas of concern that may pose significant legacy liability risk highlighted in the preceding section, as well as any other risk area particularly relevant in accordance with the target business. A detailed and comprehensive due diligence review will certainly help the purchaser to identify areas of risk, and might also provide supporting arguments to request and use other tools to minimise the risk – which will be discussed in this chapter – such as insurance policies, or provisions in the purchase agreement such as holdback, escrow and indemnity.
Provisions of the purchase agreement
Provisions of the purchase agreement are the basic and first tool of defence against a legacy liability claim. There are a number of different provisions that can be included and negotiated in the purchase agreement that may help the purchaser to minimise the risk of legacy liability.
These provisions include the following:
- Representations and warranties – comprehensive representations and warranties allow the purchaser to make an indemnity claim against the seller, if legacy liability claims arise in connection with matters stated in such representations and warranties. Areas of concern for legacy liability risk should be subject to strict representations and warranties stating that the seller or the business are in compliance with its obligations under applicable law, permits, authorisations and in-force agreements. In that way, the purchaser will be able to claim breach of representation and warranty, and seek indemnification if a third party initiates action against it in connection with matters such as breach of contract or applicable law that occurred prior to closing.
- Extended survival period of representations and warranties – as a complement to having strict representations and warranties in the purchase agreement, it is suggested that the purchaser includes extended survival periods regarding key representation and warranties, in order to have more time to seek an indemnity claim. The duration of extended survival periods is a matter of negotiation, but in areas such as tax liability, the survival period normally extends to match the applicable statute of limitations of actions of governmental agencies seeking payment of omitted taxes.
- Indemnification security provisions – in transactions where legacy liability risk is high, it is advisable that the purchaser looks to include methods of securing funds to cover any eventual breach of representations and warranties, such as escrow or hold-back provisions. Hold-back provisions are not usually favoured by sellers because the release of the hold-back amount is highly dependant on the purchaser. Escrow provisions, however, are normally better received by sellers since they usually include detailed and objective mechanisms for the release of funds, but the use of escrow agents may add complexity and cost to a simple transaction; thus, it should be analysed considering the specific circumstances and needs of the parties.
As a general comment, insurance policies linked to all kinds of M&A-related liabilities are not widely available or used throughout Latin America, especially in Mexico. Most of the comments included in this section are based on products available and contracted in the United States. However, non-Mexican or non-Latin American companies may obtain ‘umbrella’ coverage extending to subsidiaries in other jurisdictions.
There are different types of insurance policies that can be used to mitigate some matters arising from legacy liability, such as product liability insurance, completed operations insurance, pollution legal liability insurance, and representation and warranty insurance.
The pre-acquisition due diligence review should focus on reviewing the existing insurance coverage of the target company to properly assess the risk, and whether such risk might be mitigated by the existing insurance policies. The review will directly impact the need to use other tools to minimise the risk derived from legacy liability.
The due diligence review should also focus on the possibility of assigning, or otherwise transferring, the rights of the policy holder to the purchaser, and whether the existing policies will provide coverage for liabilities assumed by the acquiring company – it is common for liability insurance policies to terminate upon a change of control, or to be cancelled upon a sale of the business. In those cases, the purchaser is advised to request the seller to purchase extended coverage to address and cover any potential claims that may arise post-closing but related to losses or injuries that occurred prior to closing. The duration of the extended coverage should be analysed considering the applicable statue of limitations.
There are many other issues that should be considered during the review of existing insurance coverage such as insurer solvency, choice of law, trigger of coverage and policy limits. All these factors are relevant since they might limit the coverage and leave the purchaser exposed to risk. The choice of law is a particularly important provision since the availability and scope of recovery under policies will vary greatly depending on the governing jurisdiction.
Owing to its relevance for M&A transactions, its usefulness to address legacy liability for matters related to breach of representations and warranties that expressly refer to compliance by the seller, and its increasing use, this section will pay special attention to representation and warranty insurance. Representation and warranty insurance covers damage and losses that might be caused to the purchaser by breach of the seller of one or more of its representations and warranties included in the relevant purchase agreement. The terms of a representation and warranty insurance policy can be customised to meet the needs of a particular client in a specific transaction, with certain clauses typically varying from operation to operation, such as the amount and duration of the coverage. Representation and warranty insurance is typically structured in such a way that the purchaser achieves the same economic and financial result that would be obtained from a more traditional escrow or indemnity structure.
Representation and warranty insurance can cover all the representations and warranties included in the purchase agreement, and may be effectively used in connection with representations and warranties given by the seller about matters that pose high legacy liability risk. Representation and warranty insurance may also help smooth the negotiation process between the purchaser and the seller since it limits the seller’s indemnity obligations while serving as the purchaser’s sole source of recovery. The agreement between the purchaser and the seller to contract representation and warranty insurance should not prevent the purchaser from performing a detailed pre-acquisition due diligence review. The underwriters of the representation and warranty insurance policy will require a review of the due diligence report that was prepared, and will likely not issue the policy if the review is not sufficiently detailed. Also, the policy will not cover matters that were disclosed to the purchaser during the due diligence review or in the disclosure letter prepared by the seller. The underwriters of representation and warranty insurance will also likely request a reliance letter from the firm that issued the due diligence report in order to grant the coverage.
In some jurisdictions, specific coverage for legacy or successor liability is available, but it is rare and can be expensive owing to the increased exposure of the underwriter.
 Jorge Alberto Ledesma García is a senior associate and Jorge Ruiz is a principal at Baker McKenzie.