Handling UCC liens in an asset purchase

A common concern for a buyer purchasing a small business is with the seller’s assets. Part of the concern stems from the legal ownership of those assets. For example, a piece of equipment owned by the seller could have multiple liens on it. The multiple liens create possible issues for the buyer, such as gaining proper ownership of the asset, after closing on an SMB acquisition.

What is a UCC Lien?

A UCC (Uniform Commercial Code) filing is a legal document, also known as a UCC-1 financing statement, that gives a lender the right to a borrower’s asset in the case of default. The UCC filing creates a lien on the asset that is used as collateral on the loan to the borrower. In other words, the UCC lien indicates that the lender has a security interest in the asset.

For example, when someone purchases a home, they typically take out a mortgage to finance the purchase of the home. The home is used as collateral to obtain the mortgage and if a borrower defaults, the lender can initiate foreclosure proceedings on the property. The lien used in residential mortgages is similar to the UCC-1 financing statement used in commercial lending (i.e., lending against a businesses assets)

When does a UCC Lien Happen?

Typically, a UCC lien is initiated at loan origination between the borrower and the lender. The UCC lien is placed on the asset that is collateralizing the loan. 

It is important to note that if the lender is the first lender to file a UCC lien on the asset, they are deemed to be the first in line for the borrower’s asset (i.e., a first lien is created). If there is a second lender that places a lien on that same asset, but after the date of the first lender, then the second lender has placed a second lien on that asset. In essence, the second lien is second in line to the borrower’s asset.

Why is it Important to have Assets Free and Unencumbered?

There are multiple reasons to have assets in a M&A transaction be free and unencumbered (i.e., free and clear). One reason is because there could be a claim on that asset prohibiting the sale of the asset or business. Either option can be detrimental to the success of a deal because that asset could be the main value driver for the business or could be an important piece to the future of the business.

Another second reason is that SBA lenders often require assets to be free and unencumbered. The main rationale for this is because the SBA lender will often want the first lien position on that asset. From a risk perspective, an SBA lender wants the first lien because if there is a default the lender has the first right to the asset.

A third issue is that if assets are not free and unencumbered then the assets value could retrieve a lower valuation. Yes, a lower valuation is, in theory, great for a buyer; however, sellers would not appreciate that and may be less willing to sell the business or that piece of equipment or property.

How to Handle Liens in Asset Sale?

There are three common ways to handle liens in an asset sale:

1. Arguably the easiest way to handle liens in an asset sale is to have the seller pay off the lien and obtain a file-stamped termination notice that is provided to the buyer before closing. Paying off the lien allows the asset to be free and clear.

2. Another way is for the seller, buyer and third-party lienholder (typically a lender) to agree to a lien release letter. Where the lienholder is paid at closing with the seller’s proceeds, resulting in the removal of the lien. Within the release letter, the third-party lien holder promises to remove the lien when they are paid by the seller. Often, the buyer agrees to this method because the buyer controls and directs the closing wires (funds used to pay for the purchase of the business or asset).  In short, this strategy allows the seller to pay off the lien (similar to method one) however, this method allows the seller to receive payment for the business (cash) at closing that is then used to pay the lienholder.

3. In rare cases, the buyer agrees to allow the lien to remain in place.

How Detrimental can Liens be to an M&A Transaction?

UCC liens rarely jeopardize a deal; however, UCC liens can easily delay the closing of a deal and create further issues in the deal process. Possible issues are cash flow issues (from pushing out the closing date), legal contracts with lenders, possible delays in products or services for customers, etc. 

It’s important to note that if lien searches are done late in the deal process, it too can delay the closing date because third-party lienholders may not be highly motivated to facilitate the deal and neither the buyer or seller has much leverage over the third-party lienholder.

Therefore, it is imperative that the buyer and seller work on and agree to the handling of liens early on in the process of an M&A transaction. Otherwise, the buyer and seller risk pushing out or jeopardizing the closing of the deal.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.