Practice Tip: Evaluating Products Liability Risks at the Corporate Level

Conducting a due diligence review has long been standard practice for anyone considering the purchase of a company's stock or assets or a piece of real estate. In some disciplines, such as environmental law, the potential imposition of strict liability for contamination or the threat of third-party lawsuits has resulted in comprehensive environmental due diligence becoming an essential part of any pre-acquisition review. The same is the case with respect to product liability. Given the proliferation of product liability lawsuits, due diligence should no longer be thought of as a tool used exclusively in mergers and acquisitions (“M&A”). Rather, it should become an integral part of the corporate culture.

Due Diligence: It's Not Just for M&A Anymore

A potential acquisition of a product manufacturer or distributor ' particularly those who market highly regulated or potentially dangerous products ' requires careful consideration by litigation, product liability, and insurance specialists. Such experts also can play a significant role in risk management even when an acquisition is not being contemplated. Consider the following:

SEC Filings. Following the enactment of the Sarbanes-Oxley Act, corporations that file with the Securities and Exchange Commission (“SEC”) are under increased pressure to be forthcoming about their liabilities and risks. Officers of publicly traded corporations must certify that the disclosures made in public filings (eg, offering memoranda, annual reports, etc.) are accurate and that management has systems in place to track, evaluate, and report potential liabilities. To comply, companies should conduct audits and other forms of internal due diligence review to ensure compliance with these reporting obligations.

Emergence of Quality Management Systems. Internationally recognized certification programs, such as the International Standards Organization (“ISO”) 9000 program, have gained considerable recognition in the global economy. Eligibility for certification requires companies to have systems in place to evaluate regulatory compliance and track other liability risks. The corresponding demand for corporate self-awareness has resulted in a need for almost continual due diligence review.

Insurance. Most insurance policies have clauses that relieve the carrier from its obligation to provide coverage for potential liabilities that were not disclosed by the policyholder at the time the application for insurance was made. Far too often, it is only when the carrier denies coverage or issues a lengthy reservation of rights letter that insureds carefully scrutinize the materials provided to the insurer prior to underwriting. Consequently, insureds should conduct an appropriate internal due diligence review in response to the underwriter's questionnaire to ensure that the insurance application adequately describes the risks to be insured against.

Debt Restructuring. The global economic situation of the last few years has resulted in many companies restructuring their debt. Financial institutions – even ones with which the borrower may have long-standing relationships – have become more focused on the potential for product liability, toxic tort, and environmental liabilities to limit a borrower's ability to service the debt or even push the borrower into bankruptcy. If a borrower's credit rating is downgraded as a result of emerging liabilities, lenders also will have difficulty syndicating or securitizing the loan. Similarly, although a debtor emerging from bankruptcy should be “cleansed” of debts arising prior to the filing of the bankruptcy petition, lenders providing financing to the reorganized entity are keenly aware that some potentially devastating liabilities can survive the bankruptcy. Consequently, the level of due diligence review by financial institutions has become increasingly rigorous.

Scope of the Due Diligence Review

Whether the review is in connection with a transaction, one of the other events described above, or just sound risk management, no single due diligence review model is appropriate for all companies on all occasions. Lawyers and company personnel involved in the review must be able to adapt the scope of the review to fit the intended purpose as well as reflect the types of risks faced by the particular company.

When evaluating product liability risks, there is a tendency to focus on the company's current and recent litigation. Reviewing the quantity and substance of known lawsuits helps in understanding the company's risk profile. Because an adequate due diligence review is supposed to help evaluate risks prospectively, however, practitioners should look beyond just facts and status of the known cases. For example:

• Are there identifiable trends in the number of cases filed?
• Has there been a significant event, such as a large judgment or a finding of recklessness, which may influence the likelihood of new cases being filed?
• Are the cases limited to a certain plaintiffs' firm or geographical area?
• Do the cases have factual similarities, such as common failure modes, the same type of personal injuries, or a particularly sensitive population, such as children, who are exposed to the product's alleged defect?
• Is there a discernable relationship between the number of products in distribution and the number of claims?
• Are the products durable goods with a long life expectancy, or do they have a short life cycle?
• Has the available insurance proven adequate for the claims history? Are the insurance carriers cooperating or resisting their coverage obligations? Are the layers of insurance approaching exhaustion?

This approach is helpful, but to be effective, an appropriate due diligence review should go beyond merely evaluating the known cases and probe the company's internal systems for risk reduction, such as:

• What policies and procedures are in place to ensure that the manufacturing processes are followed within acceptable tolerances?
• Is there a quality control process to minimize the risk of unsafe products being placed into commerce?
• Are there voluntary industry standards or mandatory government regulations prescribing product performance?
• Does the company have a significant problem with supply-chain management, employee turnover, or worker injuries?
• Does the company outsource any part of the manufacturing, assembly, or packaging process? If so, what controls are in place to ensure compliance with company specifications?
• What mechanisms does the company have in place to keep abreast of new technological innovations, safety enhancements, customer satisfaction, and warranty fulfillment?
• Is management fully aware of all applicable recordkeeping, reporting, and labeling requirements, such as those posed by the Consumer Product Safety Commission, the Food and Drug Administration, the Federal Trade Commission, or comparable state agencies?

These topics generally are best addressed when the reviewer has access to the company's knowledgeable personnel and its internal records. In some cases, such as a hostile takeover bid or an auction, the prospective purchaser may not have access to internal records or personnel. To help offset this gap ' and to supplement or confirm the information even when access is granted ' practitioners should make use of external sources of information, including the primary and secondary legal libraries of LEXIS/NEXIS and Westlaw, government records, as well as publications issued by the relevant trade associations, independent certification and standards institutes, and the insurance industry. Don't forget: The Internet can provide a surprising wealth of information.

Get the Documents

To borrow an expression from Ronald Reagan, “trust but verify.” During the course of a due diligence review, practitioners often must rely on information provided orally by counsel or management, particularly when time and resources are limited. Whenever possible, however, the reviewer should ask for documents to back up the representations. For example, a general counsel may state with all sincerity that a case has been dismissed. A review of the court's order may reveal, however, that the case was dismissed without prejudice, leaving open the possibility that the company could be brought back into the case or sued again. Similarly, settlement agreements usually contain provisions limiting the scope of what is covered by the settlement and often have escape clauses that allow parties to back out upon the occurrence of certain events. Reviewers must overcome their reluctance to “create work for people,” especially during internal audits where colleagues have an expectation that their recollections will be accepted without question.

It is also prudent to make sure the person providing the information has the relevant knowledge. When company representatives start qualifying their responses by “to my knowledge,” it is fair to ask how long they have been with the company. In these days of high turnover, it is not surprising to find that a company representative may only have been with the company for a few years and may not have any reason to know of past practices or events that could lead to liability down the road. Keep in mind that most purchase agreements expressly disclaim any representations not contained within the agreement. As a result, it is critical to verify as much factual information as possible.

Thinking Outside the Box

In some cases, an appropriate due diligence review also must take into account much more than just litigation histories and manufacturing operations. A company's corporate history and the deals it has made throughout its history can have a significant effect on its potential risks. Consider the experience of Sealed Air Corporation and the asbestos liabilities that it unwittingly acquired from W.R. Grace & Co. In 1998, Sealed Air purchased Grace's Cryovac food packaging business. Neither Sealed Air nor Cryovac ever produced or sold products containing asbestos. Furthermore, as part of the transaction, Grace and its subsidiaries expressly retained all liabilities unrelated to Cryovac's operations. This notwithstanding, Sealed Air was named in an alarming number of asbestos lawsuits against Grace. Eventually, after Grace filed for bankruptcy protection, plaintiffs asserted that the sale of Cryovac was a fraudulent conveyance designed by the companies to hide the Cryovac assets from asbestos plaintiffs. After a federal court issued a ruling making it easier for plaintiffs to proceed with their fraudulent conveyance claims, Sealed Air agreed to settle the matter by placing more than $800 million into a settlement trust for asbestos plaintiffs.

Another noteworthy case in recent years involved Halliburton Corporation's acquisition of Dresser Industries. Dresser had at one time owned a business, Harbison-Walker, that used asbestos products. Although Halliburton was aware of Harbison-Walker's apparently manageable history of asbestos litigation when it acquired Dresser in 1998, Dresser experienced an unanticipated surge in asbestos claims after Harbison-Walker declared bankruptcy in 2002. Eventually, Halliburton was forced to put Dresser (now called DII Industries) and another subsidiary through a voluntary Chapter 11 proceeding and establish a $4 billion trust to resolve all of the companies' past and future asbestos and silica-related lawsuits.

Although no court ever held that either Sealed Air or Halliburton was a successor to the previous company or that the corporate veil should be pierced, both parent companies' share prices took a significant hit from the “stigma” of asbestos liability. Given that the transactions were handled by sophisticated bankers and lawyers, and given the strong legal defenses each company had, the results seem neither fair nor expected. While the Sealed Air and Halliburton cases are sobering, a moderate view is that such cases are aberrations from well-established legal principles and are unlikely to be repeated except in unusual circumstances. Regardless, both cases illustrate that a proper due diligence review must include a thorough examination of the target company's corporate history and business dealings. In practical terms, this means that when tort lawyers are asked to review litigation files in connection with due diligence review, they should sensitize other members of the team ' such as corporate and financial experts ' to the need for an interdisciplinary approach to understanding the full range of risks.

Put It All in Perspective

Regardless of whether a due diligence review is being undertaken as part of an acquisition or as part of corporate governance, the information and risks must be put into context for business people. In deal making, some risks can be mitigated or allocated by using contractual provisions, such as indemnification or escrows, or by changing the deal structure from stock to assets, reducing the purchase price, or obtaining appropriate insurance. Even when no transaction is involved, however, management can make constructive use of the information by properly reporting to regulators, banks, and insurers and in making tactical and strategic decisions to manage and reduce risk.

Conducting a due diligence review has long been standard practice for anyone considering the purchase of a company's stock or assets or a piece of real estate. In some disciplines, such as environmental law, the potential imposition of strict liability for contamination or the threat of third-party lawsuits has resulted in comprehensive environmental due diligence becoming an essential part of any pre-acquisition review. The same is the case with respect to product liability. Given the proliferation of product liability lawsuits, due diligence should no longer be thought of as a tool used exclusively in mergers and acquisitions (“M&A”). Rather, it should become an integral part of the corporate culture.

Due Diligence: It's Not Just for M&A Anymore

A potential acquisition of a product manufacturer or distributor ' particularly those who market highly regulated or potentially dangerous products ' requires careful consideration by litigation, product liability, and insurance specialists. Such experts also can play a significant role in risk management even when an acquisition is not being contemplated. Consider the following:

SEC Filings. Following the enactment of the Sarbanes-Oxley Act, corporations that file with the Securities and Exchange Commission (“SEC”) are under increased pressure to be forthcoming about their liabilities and risks. Officers of publicly traded corporations must certify that the disclosures made in public filings (eg, offering memoranda, annual reports, etc.) are accurate and that management has systems in place to track, evaluate, and report potential liabilities. To comply, companies should conduct audits and other forms of internal due diligence review to ensure compliance with these reporting obligations.

Emergence of Quality Management Systems. Internationally recognized certification programs, such as the International Standards Organization (“ISO”) 9000 program, have gained considerable recognition in the global economy. Eligibility for certification requires companies to have systems in place to evaluate regulatory compliance and track other liability risks. The corresponding demand for corporate self-awareness has resulted in a need for almost continual due diligence review.

Insurance. Most insurance policies have clauses that relieve the carrier from its obligation to provide coverage for potential liabilities that were not disclosed by the policyholder at the time the application for insurance was made. Far too often, it is only when the carrier denies coverage or issues a lengthy reservation of rights letter that insureds carefully scrutinize the materials provided to the insurer prior to underwriting. Consequently, insureds should conduct an appropriate internal due diligence review in response to the underwriter's questionnaire to ensure that the insurance application adequately describes the risks to be insured against.

Debt Restructuring. The global economic situation of the last few years has resulted in many companies restructuring their debt. Financial institutions – even ones with which the borrower may have long-standing relationships – have become more focused on the potential for product liability, toxic tort, and environmental liabilities to limit a borrower's ability to service the debt or even push the borrower into bankruptcy. If a borrower's credit rating is downgraded as a result of emerging liabilities, lenders also will have difficulty syndicating or securitizing the loan. Similarly, although a debtor emerging from bankruptcy should be “cleansed” of debts arising prior to the filing of the bankruptcy petition, lenders providing financing to the reorganized entity are keenly aware that some potentially devastating liabilities can survive the bankruptcy. Consequently, the level of due diligence review by financial institutions has become increasingly rigorous.

Scope of the Due Diligence Review

Whether the review is in connection with a transaction, one of the other events described above, or just sound risk management, no single due diligence review model is appropriate for all companies on all occasions. Lawyers and company personnel involved in the review must be able to adapt the scope of the review to fit the intended purpose as well as reflect the types of risks faced by the particular company.

When evaluating product liability risks, there is a tendency to focus on the company's current and recent litigation. Reviewing the quantity and substance of known lawsuits helps in understanding the company's risk profile. Because an adequate due diligence review is supposed to help evaluate risks prospectively, however, practitioners should look beyond just facts and status of the known cases. For example:

• Are there identifiable trends in the number of cases filed?
• Has there been a significant event, such as a large judgment or a finding of recklessness, which may influence the likelihood of new cases being filed?
• Are the cases limited to a certain plaintiffs' firm or geographical area?
• Do the cases have factual similarities, such as common failure modes, the same type of personal injuries, or a particularly sensitive population, such as children, who are exposed to the product's alleged defect?
• Is there a discernable relationship between the number of products in distribution and the number of claims?
• Are the products durable goods with a long life expectancy, or do they have a short life cycle?
• Has the available insurance proven adequate for the claims history? Are the insurance carriers cooperating or resisting their coverage obligations? Are the layers of insurance approaching exhaustion?

This approach is helpful, but to be effective, an appropriate due diligence review should go beyond merely evaluating the known cases and probe the company's internal systems for risk reduction, such as:

• What policies and procedures are in place to ensure that the manufacturing processes are followed within acceptable tolerances?
• Is there a quality control process to minimize the risk of unsafe products being placed into commerce?
• Are there voluntary industry standards or mandatory government regulations prescribing product performance?
• Does the company have a significant problem with supply-chain management, employee turnover, or worker injuries?
• Does the company outsource any part of the manufacturing, assembly, or packaging process? If so, what controls are in place to ensure compliance with company specifications?
• What mechanisms does the company have in place to keep abreast of new technological innovations, safety enhancements, customer satisfaction, and warranty fulfillment?
• Is management fully aware of all applicable recordkeeping, reporting, and labeling requirements, such as those posed by the Consumer Product Safety Commission, the Food and Drug Administration, the Federal Trade Commission, or comparable state agencies?

These topics generally are best addressed when the reviewer has access to the company's knowledgeable personnel and its internal records. In some cases, such as a hostile takeover bid or an auction, the prospective purchaser may not have access to internal records or personnel. To help offset this gap ' and to supplement or confirm the information even when access is granted ' practitioners should make use of external sources of information, including the primary and secondary legal libraries of LEXIS/NEXIS and Westlaw, government records, as well as publications issued by the relevant trade associations, independent certification and standards institutes, and the insurance industry. Don't forget: The Internet can provide a surprising wealth of information.

Get the Documents

To borrow an expression from Ronald Reagan, “trust but verify.” During the course of a due diligence review, practitioners often must rely on information provided orally by counsel or management, particularly when time and resources are limited. Whenever possible, however, the reviewer should ask for documents to back up the representations. For example, a general counsel may state with all sincerity that a case has been dismissed. A review of the court's order may reveal, however, that the case was dismissed without prejudice, leaving open the possibility that the company could be brought back into the case or sued again. Similarly, settlement agreements usually contain provisions limiting the scope of what is covered by the settlement and often have escape clauses that allow parties to back out upon the occurrence of certain events. Reviewers must overcome their reluctance to “create work for people,” especially during internal audits where colleagues have an expectation that their recollections will be accepted without question.

It is also prudent to make sure the person providing the information has the relevant knowledge. When company representatives start qualifying their responses by “to my knowledge,” it is fair to ask how long they have been with the company. In these days of high turnover, it is not surprising to find that a company representative may only have been with the company for a few years and may not have any reason to know of past practices or events that could lead to liability down the road. Keep in mind that most purchase agreements expressly disclaim any representations not contained within the agreement. As a result, it is critical to verify as much factual information as possible.

Thinking Outside the Box

In some cases, an appropriate due diligence review also must take into account much more than just litigation histories and manufacturing operations. A company's corporate history and the deals it has made throughout its history can have a significant effect on its potential risks. Consider the experience of Sealed Air Corporation and the asbestos liabilities that it unwittingly acquired from W.R. Grace & Co. In 1998, Sealed Air purchased Grace's Cryovac food packaging business. Neither Sealed Air nor Cryovac ever produced or sold products containing asbestos. Furthermore, as part of the transaction, Grace and its subsidiaries expressly retained all liabilities unrelated to Cryovac's operations. This notwithstanding, Sealed Air was named in an alarming number of asbestos lawsuits against Grace. Eventually, after Grace filed for bankruptcy protection, plaintiffs asserted that the sale of Cryovac was a fraudulent conveyance designed by the companies to hide the Cryovac assets from asbestos plaintiffs. After a federal court issued a ruling making it easier for plaintiffs to proceed with their fraudulent conveyance claims, Sealed Air agreed to settle the matter by placing more than $800 million into a settlement trust for asbestos plaintiffs.

Another noteworthy case in recent years involved Halliburton Corporation's acquisition of Dresser Industries. Dresser had at one time owned a business, Harbison-Walker, that used asbestos products. Although Halliburton was aware of Harbison-Walker's apparently manageable history of asbestos litigation when it acquired Dresser in 1998, Dresser experienced an unanticipated surge in asbestos claims after Harbison-Walker declared bankruptcy in 2002. Eventually, Halliburton was forced to put Dresser (now called DII Industries) and another subsidiary through a voluntary Chapter 11 proceeding and establish a $4 billion trust to resolve all of the companies' past and future asbestos and silica-related lawsuits.

Although no court ever held that either Sealed Air or Halliburton was a successor to the previous company or that the corporate veil should be pierced, both parent companies' share prices took a significant hit from the “stigma” of asbestos liability. Given that the transactions were handled by sophisticated bankers and lawyers, and given the strong legal defenses each company had, the results seem neither fair nor expected. While the Sealed Air and Halliburton cases are sobering, a moderate view is that such cases are aberrations from well-established legal principles and are unlikely to be repeated except in unusual circumstances. Regardless, both cases illustrate that a proper due diligence review must include a thorough examination of the target company's corporate history and business dealings. In practical terms, this means that when tort lawyers are asked to review litigation files in connection with due diligence review, they should sensitize other members of the team ' such as corporate and financial experts ' to the need for an interdisciplinary approach to understanding the full range of risks.

Put It All in Perspective

Regardless of whether a due diligence review is being undertaken as part of an acquisition or as part of corporate governance, the information and risks must be put into context for business people. In deal making, some risks can be mitigated or allocated by using contractual provisions, such as indemnification or escrows, or by changing the deal structure from stock to assets, reducing the purchase price, or obtaining appropriate insurance. Even when no transaction is involved, however, management can make constructive use of the information by properly reporting to regulators, banks, and insurers and in making tactical and strategic decisions to manage and reduce risk.