Lending with Confidence: Key Due Diligence Searches Explained

The Role of Due Diligence in Confident Lending

What this is: Conducting due diligence is crucial for assessing whether a borrower represents an acceptable risk to a lender.

What this means: By scrutinizing public records for outstanding liens, litigation, and bankruptcy cases that could impact the assets pledged as collateral, lenders can mitigate risks, foster long-term relationships, and encourage responsible lending practices.  Neglecting these essential searches can result in financial losses, legal and regulatory challenges, reputational harm, and operational disruptions.

In this article, we will thoroughly examine the concept of due diligence, investigate the different types of searches that should be performed, and evaluate the tools available to meet lender’s needs, enabling them to confidently extend loans to potential borrowers.

Understanding Due Diligence in Lending Transactions

To perform the necessary searches and thoroughly evaluate the risks and outcomes of a lending transaction, a lender must first understand the available records and the insights each search offers. The following are essential due diligence search categories that every lender should incorporate into their due diligence process. Discoveries in many of these categories can indicate financial instability or affect the collateral to be held.

Uniform Commercial Code (UCC) Searches – The UCC is a group of statutes that governs secured transactions. A pre-funding UCC search is key for lenders to evaluate the risk correlated with extending credit or entering into financial agreements and to determine if a business’s assets are collateral for a prior debt.

UCC searches are also conducted after filing to ensure the lender’s filing was properly indexed, ensuring the creditor’s security interest is “perfected” and has the intended priority among other creditors.

Tax Lien Searches – Federal and state tax liens are legal claims against property for unpaid taxes. A potential borrower may have hidden tax debt which can be uncovered through a more thorough look into the IRS records. 

Judgment Searches – A judgment is the official decision of a court of law granting or denying a plaintiff’s claim. These judgments could lead to liens, threatening the ability to recover funds in the event of default.

Judgment Lien Searches – A judgment lien is nonconsensual and can be best described as a liability or security interest placed on a debtor’s property to satisfy a judgment issued in court. A judgment lien search uncovers legal claims on a borrower’s property.

Pending Litigation Searches – Pending litigation pertains to unresolved and active legal disputes within the judicial system. A search of these records uncovers active lawsuits or pending legal actions against a seller, borrower or guarantor. 

Bankruptcy Searches – Lenders should search to identify if a prospective borrower has filed for bankruptcy due to an inability to repay their debts.

Another crucial step in a lender’s due diligence is obtaining a Good Standing certificate to confirm that the borrower is properly formed and registered in the states where it conducts business. Additionally, ordering Articles and Amendments is essential to verify the entity’s name, which should be used as the debtor’s name on a UCC1 filing to ensure its accuracy.

UCC Search Fundamentals: The First Line of Defense

UCC searches serve as the first line of defense for lenders. Search results obtained through a thorough UCC search can assist a lender in the following ways:

• Establishing Priority: Accurate UCC searches help determine the priority of security interests. This ensures that lenders know their position relative to other creditors.
• Avoiding Legal Complications: Incorrect searches can lead to legal disputes over the validity and priority of security interests. This can result in costly litigation and delays in enforcing security interests.
• Identifying Existing Liens: Proper searches reveal existing liens and encumbrances on the collateral. This information is vital for assessing the risk and viability of the loan.
• Ensuring Compliance: Accurate searches ensure compliance with UCC Article 9 requirements. This helps avoid penalties and ensures that security interests are properly perfected.
• Preventing Financial Losses: Missing critical information can lead to poor decision-making and significant financial losses. For example, undiscovered liens can affect the value and security of the collateral.

To ensure a UCC search is conducted correctly, a lender should consider the following when determining what name to search, where to conduct the search and search logic for that jurisdiction.

• Correct Debtor Name: Ensure the debtor’s name is searched exactly as it appears on the most recent charter document.
• Jurisdiction: UCC filings are typically filed at the state level, but some filings, like fixture filings, may be at the county level. Make sure you’re searching in the correct jurisdiction based on where the entity was formed, location of the debtor and the type of collateral.
• Search Logic Variations: Different states have different search logic and rules. Searchers should be familiar with the specific requirements and search methods for the appropriate states.

Supplementary Public Record Searches: Filling the Risk Gaps

While UCC searches are a crucial component of due diligence for lenders, relying solely on them can leave significant gaps in the assessment process.  By only conducting a UCC search lenders are not uncovering other types of legal claims or financial obligations that might affect the borrower.  Lenders should include judgment, tax lien, litigation, and bankruptcy searches in their due diligence checklist.  Be aware that when searching these records they can sometimes be missed due to jurisdictional differences, such as varying rules, types of liens filed, and terminology. Additionally, data entry errors, delayed updates to public records, and multiple filing locations (e.g., county, state, federal levels) can impede the due diligence. Below is a list of general guidelines for where these public records can be found.

• Tax Liens:  Can be filed at the federal, state, county or municipal level, depending on the type of tax and the type and location of the property.
• Litigation:  For entities, searches should be conducted in the jurisdiction where the entity has its principal place of business or chief executive office. For individuals, searches should be performed in the state of the debtor’s residence or where their assets are situated.
• Bankruptcy:  Cases for business entities are typically filed in the federal bankruptcy court located in the debtor’s state of formation, principal place of business or where the primary assets are found. For individuals, cases are typically filed in the federal bankruptcy court of the debtor’s state of residence or where their assets are located.

Cross-Border Considerations in Due Diligence

A cross-border transaction involves any business deal or financial activity between parties (individuals, companies, or governments) across different countries or jurisdictions, typically requiring due diligence. International due diligence is essential for these transactions, enabling companies to identify and mitigate risks unique to foreign jurisdictions before committing their resources.  Key components of legal due diligence include corporate searches, as well as lien and litigation searches which are similar to those required in the United States.

The risks associated with cross-border transactions include unreliable corporate structures, hidden litigation or financial liabilities, and non-compliance with local tax, labor, and intellectual property laws. Complexities in cross-border due diligence encompass information availability and accessibility, quality and timeliness of information, confidentiality of tax information, jurisdictional variations in naming, differing timelines and time zones, language barriers, and local business practices, norms, and culture.

Using a service company for cross-border due diligence offers several significant benefits that include expertise in foreign jurisdictions, access to local resources, efficiency, compliance assurance, and dedicated support teams.

Technology and Tools That Support Smarter Lending

Many lenders depend on online platforms for conducting searches and preparing and filing UCC filings. These platforms offer a range of tools that streamline the due diligence process, making it more efficient and accurate. Additionally, various applications can assist with document management and servicing of the loan portfolio ensuring that all necessary documentation is organized and easily accessible. 

Engaging a company that provides online platforms offers numerous benefits, including enhanced efficiency, improved accuracy, greater convenience, better organization, ensured compliance, and robust security. You need a company that has sufficient technological resources to help with your research, for both state records and UCC searching and filing.

Choosing a Due Diligence Partner: What to Evaluate

Choosing the right due diligence partner is essential for lenders who want to make informed and confident lending decisions. A dependable partner can help mitigate risks, ensure compliance, and provide valuable insights.

When selecting a due diligence partner, key factors to look for include expertise and experience, accuracy and reliability, comprehensive services so you have a single source when needing assistance, advanced technology and tools, and effective communication and support. 

A due diligence partner should be large enough to provide coverage across state, federal, and international jurisdictions while offering multiple services, and one that can provide a dedicated team of professionals to assist with your requests.

By focusing on these qualities, lenders can choose vendors who will help them conduct thorough due diligence and manage UCC filings effectively, ensuring the security and success of their financial transactions.

Secure Lending Begins with Informed Decisions

Comprehensive due diligence is the foundation of effective risk management in lending. By thoroughly evaluating all aspects of a transaction, lenders can identify potential risks, ensure compliance, make informed decisions and build strong, long-term relationships between lenders and borrowers.

A service company can equip lenders with the resources needed to confidently conduct due diligence. They offer expertise and experience, comprehensive coverage, access to local resources, advanced tools and technology, and cost-effective solutions for thoroughly assessing the liabilities of potential borrowers.

This article is provided for informational purposes only and should not be considered, or relied upon, as legal advice.