Potential buyers of businesses should take every possible step to search for and investigate potential liens affecting the acquired company’s assets. Our recent representation of the buyer in the purchase of a local contractor company illustrates the importance of making sure that the target business’ assets are not encumbered by liens. Even if the transaction is structured as an asset sale, a seller’s liens might unknowingly become your problem.
What is a Lien?
First thing’s first: a lien is a legal right or interest that a creditor has in another person or company’s property. If you or your partners are purchasing a business and that company’s assets are encumbered by a lien, a third party may have an interest in the business or the assets you are purchasing.
If that third party happens to be a creditor of the seller, and the lien is still in effect after the acquisition closes, then that could be seriously bad news for you as purchaser.
There are a number of ways that deal attorneys like me try to protect clients from this issue in the language and terms of the purchase and sale agreement. However, as the saying goes, “an ounce of prevention is worth a pound of cure”. Even the finest purchase contract ever drafted can be subject to challenge, and there is really no substitute for tackling and resolving these issues up front, during the due diligence phase of the acquisition. This means searching public records for liens, which generally come in three flavors: UCC, tax, and judgment.
Businesses often require bank financing or trade credit for equipment. As part of the financing, the business will frequently agree to grant the lender a lien on the company’s equipment or inventory as security for such debt or financing.
Here in Arizona, in the case of a lien encumbering personal property of the borrowing business, the lender will often record the lien in the public records of the Arizona Secretary of State (or with the relevant agency in the state in which the debtor is incorporated or maintains is corporate offices).
The purpose of filing the lien in the public records is to put the World–specifically, potential buyers of the personal property–on notice that the personal property is subject to a lien.
The creditor holding the lien “perfects” their security interest by filing a form known as a “UCC-1” financing statement with the Secretary of State. It’s a simple, single page form that includes key information such as the legal names and addresses of the debtor, the identity of the creditor, and a description of collateral encumbered by the lien. UCC-1 financing statements are effective for five years and can be renewed for an additional five years.
As an old commercial real estate attorney, I analogize this process to your mortgage company that lent you the money to buy your house recording a deed of trust with the county recorder. The trust deed is a lien on your property to secure your performance (i.e., payment in full) on your home loan.
When performing a UCC search, it is critical to use the seller’s exact legal name (and, for good measure, any affiliates or subsidiaries of seller). We often recommend using a third-party search company to perform UCC searches, since their reach is wider and far more comprehensive than something most attorneys can do with the Arizona Secretary of State’s online records search. These search companies can also conduct searches for the other two classes of liens at the same time, making things far more efficient.
If the UCC search reveals a lien filing, it should also show you whether or not such lien has been released through the subsequent filing of a termination statement with the Secretary of State.
When a debtor pays off a debt secured by a lien on personal property and perfected by the filing of a UCC-1, the creditor must file a termination statement to document the release of the lien. If (as in the case of my buyer client) the UCC search uncovers a currently active financing statement that has not yet been terminated, it is strongly recommended that you find out more details from your seller and make certain that they obtain a release of the financing statement before you close.
If the UCC-1 is not terminated before you close, the creditor will continue to have a perfected security interest in the business assets purchased after closing. Never a good thing, particularly since it wasn’t your debt to begin with!
Federal and State Tax Liens
The federal government can assert a lien on a business’ property when the company fails to pay its federal income or (as in the case of my purchaser client) payroll taxes in full and on time. Business assets can include the company’s equipment, inventory, accounts receivable and even after-acquired assets purchased after the lien comes into effect.
When a tax lien is asserted by the Internal Revenue Service, they file a Notice of Federal Tax Lien to place all creditors on notice that the federal government has a legal right to the company’s property. Generally, federal tax liens are filed at the place of residence of the taxpayer. In the case of most small to mid-sized business, this is typically the company’s principal place of business.
Keep in mind that Arizona state and local taxing authorities may also place a lien on a target company’s property for unpaid state and local taxes. Arizona tax liens may be filed with the office of the treasurer and recorder in the county where a business is located.
As with UCC liens, it is crucial that you discover any such liens prior to acquiring the target business or some or all of that business’ assets and have them paid off and released on or before the closing.
Last but not least, we have the judgment lien. These are liens that arise from litigation between parties in court (and almost always where money or money damages are involved).
Assuming a civil lawsuit is not settled first, the losing party usually has a judgment entered against them by the court. The winning party can then take that judgment and record it with the office of the recorder of the County in which the losing litigant resides or is located.
More problematic in the case of a purchaser acquiring assets from an existing business is that judgment liens can also attach to personal property, including equipment and after-acquired property of the debtor.
As with above two categories of liens, a buyer of a business or that company’s assets shouldn’t rely solely on contractual mechanisms (e.g., indemnification provisions or seller representations) but should instead strive to discover any legal judgments as soon as possible during the due diligence process and seek or (better yet) condition their duty to proceed with such acquisition upon these liens being paid off by the seller and released as of the closing date.
Ben Bhandhusavee is the Managing Attorney for BHANDLAW, PLLC, a Phoenix business and technology law firm working with start-up companies, creative intellectual property, Internet and digital media matters, and complex corporate M&A and technology transactions. Ben can be reached at (602) 222-5542 or by e-mail at email@example.com