Why should I search for UCC, tax, and judgment liens before buying a business?

The list of items sellers give to buyers during the diligence process is long. Dozens and dozens of items go back and forth. And there’s one item that deserves special attention: Liens on the seller’s assets. Even in an asset sale, they can become the buyer’s problem.

A lien is a creditor’s legal interest in the property of another party, and liens are a high priority matter for buyers. You want to get the keys to this thing by Closing, not learn someone else still has a stake in it afterwards. If you buy assets with a lien on them, a third party retains an interest in the property. You can protect yourself with language in the purchase agreement, but you are taking a risk buying a business with a lien on it. An unreleased lien discovered after closing is a serious headache.

I would not count on language in the contract alone. Instead, I would rely on having performed good due diligence and getting to the table with a clean seller. No matter what you see in the contract, do your own search of the public record to see if there are any existing liens.

3 Different Types of Liens

Be on the lookout for 3 different types of liens: UCC liens, tax liens and judgment liens.

UCC stands for Uniform Commercial Code. It’s a set of rules for commercial transactions in the United States, and a UCC lien is named for that code. Just like the other liens, it’s a creditor’s security interest, and it’s normal and common in business. Still, it’s important to know it’s there.

It happens when a seller signs a security agreement pledging assets to a lender. Say the seller takes out a loan to buy a machine and the bank puts the lien on the machine as collateral for the debt. The bank has an interest in the machine until the debt gets repaid.

Once the security agreement is signed, the lender files the lien. First-in-time means first-in-line: the bank that files first gets paid off first if there’s a default. It stops borrowers from taking the same asset down the road and pledging it to another bank.

In the old days, someone who owned a machine could go to three different banks and borrow against that machine. No one knew the other was doing it. Now public records show who has liens on which assets. There are two kinds of UCCs: Specific Collateral, where only named collateral is pledged to the lender (in the contract), and blanket, where everything of the seller’s can be pledged. A blanket lien would be a lien against every asset a company has, no matter what it is or where it’s kept.

A specific collateral UCC lien, like it sounds, is collateral taken to finance a specific thing - say a business loan to buy a piece of equipment. It goes with that thing being purchased. A blanket lien covers all the assets. With a bank or SBA loan, for example, the business pledges its assets as collateral. That ties up all the seller’s assets. It may keep the seller from getting new financing, until the loan’s repaid.

Lenders generally prefer blanket liens because they hit every single asset. For borrowers, the upside can be flexible underwriting and maybe faster time to money. Lenders “perfect” their claim with a UCC-1 financing statement, which names the debtor, the creditor and the collateral. It’s a tidy way to do business, but be careful about what you buy.

If you can, maybe look at a sample UCC-1.

Whereas UCC liens should not alarm you as the buyer, tax liens should alarm you very much. The IRS files a tax lien on a company when they don’t pay taxes in full or on time. And this lien is usually attached to all the company’s property, all the company’s receivables, all the company’s assets, and all the company’s assets acquired after the lien was filed. There are also state and local liens, of course, and they’re filed at the location of the company’s executive offices.

On the other hand, the UCC liens are filed in the state of incorporation.

Judgment liens come from court judgments after someone loses a lawsuit. They can attach to the losing party’s real estate, personal property, cars, and even property the party acquires after the judgment, too. But a judgment on real estate is confined to the county where the lien was recorded or entered.

If you’re buying a business with an active jobsite, check for mechanic’s liens too. In many states, mechanics’ liens take priority from the day work begins, not from the day the lien is filed. In other words, a single lien filed after closing can override a construction loan recorded months before. If you’re buying a construction company, it’s a good idea to run that as a separate search.

Third-party Search

First, do you have enough experience to conduct the search yourself? Unless you do, I recommend paying for a third-party search. It’s hard enough running a business without figuring out another area of expertise, too. However, if you’d like to do it yourself you can access many state UCC records online. You can also file Form UCC-11 using the seller’s exact legal name.

Make sure you use the seller’s legal name from the Secretary of State corporation database for the state of incorporation. You want to do your diligence on exactly who’s in the deal. Also, since you’re paying for a third-party search anyway, make sure to run one for tax and judgment liens at the same time. They aren’t expensive and you will need the time for other due diligence.

You’ll be glad to have the peace of mind once the search is done, and if a lien turns up, you’ll be glad you found it. You don’t want surprises after closing. Check to see whether the filing is terminated (debts repaid), or still active.

If there’s an active lien in the public record, you can go back to the seller and try to get it released before closing. That’s what I would do. Otherwise you risk the creditor having a security interest even after closing, which you don’t want.

Risk of UCC Lien Filing on a Business

Overall, the effect of a UCC filing on a business is usually insignificant or nonexistent unless it borrows more money or defaults on its debts. But there are a few risks to know before you proceed.

One risk of UCC lien filing on a business is the reduction of chance that the business will be able to secure future funding. A lien can lower odds for traditional as well as alternative lending. The lienholder with priority (having filed first) will take precedence. They’re unlikely to consent to share collateral.

All of the UCC liens filed in the last five years should show on the business credit report. While the UCC filing does not change the business’s credit score, loan and payment history does. The UCC can still factor into a lender’s thinking. Keep it on your radar.

Then there’s the risk of default. Since the assets were pledged, they’re still subject to seizure. Until the loan is paid off, the assets aren’t in the clear. That’s the nature of liens in the world of buying and selling. They can be a major hazard for buyers who don’t do their homework. And yet another reason to do your due diligence and search every UCC, tax and judgment lien before closing.