M&A due diligence best practices: Ensure a smooth transaction with the right searches

Experts forecasted high deal activity to continue through 2022. While Q1 has been impacted by high inflation, rising rates, and the war in Ukraine, the outlook for the next quarter looks positive, with many companies exploring multibillion-dollar deals in healthcare, software, energy, logistics, and government sectors.

As deal activity ramps up, so should the due diligence.

When purchasing a business, the acquirer must know what they’re paying for and what liabilities they are taking on. Assets can include intellectual property, cash, real estate, inventory, equipment, and so on. Liabilities can include debt, tax liens, UCC liens, regulatory violations, and lawsuits.

The ramifications of failing to uncover hidden legal liabilities and missing liens in M&A deals can delay or terminate a transaction. Conducting thorough due diligence upfront is therefore critical. Let’s look at some of the key searches and considerations that an acquiring business must take into account, both pre- and post-closing.

The importance of searching for tax liens, UCC liens, and judgment liens

Approaching an M&A transaction always requires a thorough and well-thought-out lien search strategy. Some of the most common liens include UCC liens, federal and state tax liens, and judgment liens. These liens are the obligations that the acquirer will need to weigh into its decision and company value before the deal is closed.

A UCC lien is a public record that a business has borrowed money with collateral and is normally filed by a lender against assets such as equipment. UCC liens are consensual liens and strictly follow the rules of the code. It, therefore, makes it a little more straightforward to search for them. However, one must still be armed with the proper knowledge of what debtor name to use and where to search.

A federal tax lien is filed by the IRS when taxes are due and applies to all the assets of the debtor. State and local agencies can also file a lien for unpaid taxes. Being that tax liens are non-consensual liens, they don’t have to follow UCC rules. This means that they are often more challenging to find. For example, the IRS may file a lien under a variation of the debtor’s name that doesn’t align with the debtor’s true legal name — such as a name that’s listed on the debtor’s income tax returns or employment tax returns. Courts have consistently held that the burden is on the searching party to uncover these liens using variations of the debtor’s name.

Judgment liens are issued when an individual or company loses a court case. This lien can be placed on personal property, bank accounts, real estate, etc. To uncover these liens, it’s important to search under variations of the debtor name and in the correct jurisdiction, usually where the debtor is doing business and where the debtor’s assets are located. In addition, it’s helpful to search for closed litigation in states where there are automatic liens that can attach to real property as a result of a judgment.

Acquiring intellectual property (IP) assets

When IP assets are part of the deal, the acquirer should include lien searches against IP assets as part of its due diligence.

UCC Article 9 suggests that IP assets fall into the “general intangibles” category under §9-102. As such, they’re governed by UCC rules, except where preempted by federal law. Determining whether federal law preempts all types of IP assets is not as straightforward.

Copyrights protect the rights of authors or creators of literary or artistic property and are governed by the Copyright Act. For a registered copyright, a security interest is perfect by recording the security agreement with the U.S. Copyright Office. If a copyright is not registered, then the Copyright Act does not preempt UCC. As a best practice, it is therefore recommended to search both — UCC filings following usual UCC rules and the U.S. Copyright Office.

A trademark, as defined by The Legal Dictionary, is “a distinctive design, picture, emblem, logo or wording (or combination) affixed to goods for sale to identify the manufacturer as the source of the product”.

Registered trademarks are governed by the Lanham Act, while unregistered trademarks are governed by state law. While the Lanham Act provides that certain “assignments” must be registered with the U.S. Patent and Trademark Office (USPTO), courts have found that the term does not include a security interest. A best practice is to search for liens against trademarks in both UCC filings as well as with the USPTO.

Once IP assets have been purchased, it is important to update all relevant ownership records. In addition, if the buyer is purchasing a business that has liens in IP assets, then the related lien filings should be updated.

Real estate as collateral

If financing is used to fund the acquisition, the lender may seek additional liens on real-property assets and inventory. Due diligence must include a review of the seller’s existing title insurance policies and property surveys. This will ensure that any violations, easements, zoning issues, and restrictions that may impact the use of the property are highlighted.

If a lender takes a lien on assets or inventory at a leased location, the landlord may be required to waive the lien. In anticipation of this, the buyer may wish to insist that any waiver(s) are a condition of closing or that the target company seeks these waivers from the landlord in question.

Environmental due diligence (EPA and EPA lien searches)

Although environmental due diligence is a specialized field, the acquirer must recognize when due diligence is required and the best practices for carrying it out.

This form of due diligence can arise when the target company owns or leases property. Liability can arise if landowners or employees cause environmental damage and can be costly, especially if the damage extends into neighboring parcels.

If the M&A involves high-risk businesses, such as industrial plants, legal counsel must consider the risk for environmental damage and any potential liability. If damage is suspected, specialists can assist with due diligence.

Apart from actual environmental damage, the buyer should also be aware of potential hidden EPA liens. The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), codified in 42. U.SC. § 9601 et seq. (1980) provides for a federal “superfund” to clean up uncontrolled or abandoned hazardous-waste sites and other environmental contaminants. Under CERCLA, a federal lien is created which attaches to all real property on which the government spent money.

There are three categories of EPA liens that may affect the target’s property. The primary CERCLA lien can be imposed on an owner of property where hazardous material was disposed or possessed, regardless of the owner’s fault or involvement. A windfall lien can be imposed on property where the owner benefited from the cleanup and there are unrecovered response costs that enhanced the fair market value of the property. Lastly, there is the maritime lien which is imposed on a vessel.

EPA liens last until the liability is satisfied or becomes unenforceable through other law. More importantly, is the date of attachments. The EPA lien arises at the later of:

• the time costs are first incurred by the U.S., or
• the time that the person is provided with written notice of the potential liability

Therefore, it’s important to ask whether the target property has been involved in any environmental clean-up and/or whether the owner or any previous owners have ever received written notice of the potential liability. The location of where these liens are indexed is governed by state law, which means rules will vary — it can be at the state level, county level, or at the District Court.

Litigation searches

Litigation searches can uncover any litigation involving the target company. Conversations with the seller and a review of audit response letters from the target company’s law firm to outside auditors can also reveal information about litigation.

Because there is no single centralized repository of information regarding pending lawsuits, legal counsel must determine which jurisdictions to investigate the seller’s litigation profile and conduct separate searches in each. As a rule of thumb, counsel must focus on three jurisdictions:

1. The seller’s location of formation
2. Its main offices
3. The location(s) where the target company has significant business operations and/or where its assets/real property is located

Successor liability in M&A transactions

If the buyer is purchasing assets in an out-of-court foreclosure sale, they must consider whether an unsecured creditor may seek to collect any of the debtor’s unpaid liabilities. Typically, in this scenario, a buyer is not liable for the debts and liabilities of the target company, unless the following conditions apply:

• The purchase agreement stipulates that the buyer is liable
• There was a merger or consolidation of the two companies
• The purchaser is a “mere continuation” of the seller
• The transaction was entered into fraudulently with the goal of escaping liability

This yet again highlights the importance of proper due diligence, including thorough litigation searches.

UCCs: What needs to be done?

On the face of it, it may seem that little needs to be done. Following a merger or acquisition, the Uniform Commercial Code does not require the acquiring business (now the secured party) to alter UCC documents. Given that UCC indexing is done under the debtor’s name, having an incorrect secured party name on the UCC-1 form would not make the financing statement “seriously misleading” as contemplated by UCC § 9-506. However, a closer read of Comment 2 to § 9-506 further provides that having the wrong name of the secured party “may give rise to an estoppel in favor of a particular holder of a conflicting claim to the collateral.”

There are also other risks associated with failing to update the secured party’s information. For one, the secured party of record has the power to amend the financing statement. Therefore, the new secured exposes itself to unnecessary risk. Another serious ramification is if the debtor files for bankruptcy, the secured party may not receive the necessary notification in time since it will go to the address listed on the financing statement. As a result, the secured party may miss the deadline to file its claim and risk losing its place in line.

Pay attention to purchase money security interest (PMSI)

A purchase money security interest (PMSI) is a special right that enables certain creditors to jump ahead in line of other creditors with respect to certain collateral. Usually, it comes up in the context of where the debtor is looking to acquire certain inventory or equipment, and the PMSI lender seeks a lien on the assets being acquired. Provided the PMSI lender meets the necessary requirements under the UCC, they will be able to secure their lien.

While the PMSI lien generally doesn’t affect existing creditors’ interests in existing collateral (since the PMSI lien extends to collateral the debtor is about to acquire), there is another issue. Oftentimes loan agreements deem obtaining another loan or lien without the existing lender’s written consent as a breach of contract. If the new secured party does not update its information on the financing statement, it would not know about the PMSI lien and the related breach, since the notice would go to the secured party on record.

Learn more

There’s no need to go it alone. The right partner can manage the process and ensure your due diligence is successfully completed. Read more about CT Corporation’s thorough and simplified approach to Due Diligence, UCC Searches, and M&A Compliance.

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