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Tenth Circuit Case Points Out the Need for Employment Due Diligence in Merger and Acquisition Deals

    Client Alerts
  • March 18, 2022

We once had a client opine that he was looking to acquire a new business and not a lawsuit to go along with it. The risk of buying a company with poor human resource practices or pending claims should make review of labor practices a crucial part of due diligence when considering whether or not to acquire the business. Even so, purchasers in many deals fail to take a serious look at the target’s human resource history, often due to time or cost constraints. A new decision from the Tenth Circuit Court of Appeals shows the potential downside of this approach.

In EEOC v. Roark-Whitten Hospitality 2, the owner of a hotel sued by the EEOC for discrimination sold the business to a new owner. That buyer in turn sold the hotel again to another purchaser. The EEOC amended its complaint to include the two subsequent owners, alleging that they were “successor employers” liable for the alleged actions of the original hotel owners. In some limited circumstances, purchasers of a business can be liable for the actions of their predecessor if they continue the business essentially unchanged, or if they were affiliated with the prior owner. In this case, the district court dismissed the complaints against the two subsequent owners, and the EEOC appealed to the Tenth Circuit.

On appeal, the Tenth Circuit in a 2-1 decision concluded that one of the two defendants was plausibly a successor employer. The majority decision was based on language in the acquisition agreement that gave the second purchaser the right to conduct due diligence with respect to pending legal matters. Therefore, the purchaser had constructive knowledge of the claim even though it failed to avail itself of the review authorized in the purchase agreement. The dissenting judge noted the irony that the purchaser would have been better off had it not include a due diligence review period in the agreement.

If followed by other federal courts, this decision could impose something close to a strict liability standard on purchasers who buy companies with pending legal claims. Companies involved in potential acquisitions can shield themselves against such claims by (1) conducting meaningful review of the target’s human resource practices and history; (2) including warranties in the agreement that protect the purchaser against costs associated with past employment practices; and (3) structuring the acquisition to make clear that the purchaser is not acting as a successor employer, by running the business in a different manner than in the past. A little advance preparation and review can help avoid unanticipated costs post-closing.