Best practices for conducting a complete due diligence search (and pitfalls to avoid)

In this article, we explore best practices for conducting a thorough due diligence search, how other search types are now essential parts of due diligence, and the perils of failing to conduct an adequate investigation before entering a transaction.

The five-part search: The starting point of due diligence

There are several types of due diligence searches that apply to all entities and individuals, and they are a useful starting point for a comprehensive search. They include the following five areas:

• UCC lien search
• State and federal liens
• Fixture filing liens
• Judgment liens
• Bankruptcy liens

UCC searches are an important starting point. They will reveal whether creditors have filed claims against the assets of a company or individual. But limiting a search to just UCC might create the false impression that the collateral is unencumbered, which can lead to serious consequences. A comprehensive due diligence search should also include tax and judgment liens. That’s particularly important because unlike UCC liens, these are not consensual, so they can be on file without the debtor’s knowledge of their existence.

Uncovering potential risks: search litigation

Searching for liens on a business’ assets is a must, but to get a more complete picture of a company a client is considering acquiring, investing in, lending to, or partnering with, a litigation search of the company and its key individuals is also important. In fact, at C T Corporation, we’ve found that adding a litigation search to a five-part lien search is critical. Over the last decade, this has been our fastest-growing search type, far outpacing any mix without litigation. Our findings suggest that more firms are now including this as part of a more thorough due diligence review.

A comprehensive litigation search identifies the involvement of a specific company or individual in any pending, past, or settled court cases. These may include civil, criminal, or bankruptcy proceedings filed in state or federal courts. This search provides valuable insight into a company and can reveal potential red flags or liabilities that need to be considered before going forward with a transaction involving the company.

New types of asset searches

While litigation searches are important, there are other factors that have increased the complexity of due diligence. For one, as the economy has changed, so have the asset types that companies possess. And because the main purpose of due diligence is an evaluation of a company’s assets, a comprehensive due diligence search must take into account both traditional and newer asset types. This can require a five-part lien search, a litigation search, and searches of the records of certain regulatory agencies.

Although intellectual property assets are not new, the increased number of tech and software deals has resulted in a greater focus on IP-focused due diligence. It’s important, for example, to verify a company’s ownership of its IP assets, their value, and the risks of competing claims to these assets.

A firm conducting due diligence clearly needs to look at other areas - such as EPA, ERISA, OFAC, and mechanic liens to get the complete picture. EPA due diligence, for example, can identify the risk that a company’s properties have hazardous substances – a red flag for any potential acquisition. OFAC checks are also essential these days. An OFAC check ensures that an entity or individual involved in a potential transaction with a client is not listed on the sanctions list maintained by the Treasury Department’s Office of Foreign Assets Control.

Due diligence and digital assets

It’s become increasingly likely that any company a client is considering acquiring, investing in, lending to, or otherwise transacting business with owns digital assets – such as cryptocurrency, tokens, and NFTs. That makes conducting a search to see if there are any legal claims, liens, or competing interests in the company’s digital assets vital.

Determining if there are UCC liens on digital assets had been difficult in the past because digital assets didn’t really fit into the state UCC laws. It was particularly challenging for lenders trying the perfect security interests in a debtor’s digital assets. However, the “2022 UCC Amendments on Emerging Technologies”, which have been enacted by over 30 states changed that. A new UCC Article 12 governs a subset of digital assets called the Controllable Electronic Record or CER. A CER is a digital asset that is subject to control, as that term is defined by Article 12. Under the amendments to UCC Article 9, a security interest in a CER can be perfected by filing a financing statement or by control, with control having priority.

A comprehensive due diligence search should still include a UCC search, since financing statements can still perfect a security interest in digital assets. Digital assets may be included in collateral descriptions that state “all assets” or “general intangibles”, as well as listing the digital asset in more specific terms. Determining who controls the digital assets is also a must, particularly in states that have adopted Article 12.

It’s also important to determine if a company’s digital assets are involved in pending litigation, bankruptcy proceedings, or regulatory enforcement actions.

The imperative of a complete due diligence investigation

Failure to conduct a comprehensive search in a due diligence investigation can have consequences for a corporation, its directors, and others regardless of the type of transaction being contemplated, although it is particularly important for certain transactions including the following:

Statutory merger

In a statutory merger, the liabilities of the merged company vest in the survivor. A failure to learn of any existing judgments or pending litigation against the non-survivor can result in a risky transaction or the survivor paying too much.

It can also mean that the survivor and the board of directors that approved the merger could be sued by the survivor’s shareholders for breach of their fiduciary duties in failing to conduct adequate due diligence, failing to disclose important information about the target acquiring, or wasting corporate assets by paying too much. The corporation might also blame any law firms that it engaged to perform due diligence.

Acquisition

Similarly, in any acquisition, whether accomplished by merger, asset purchase, or otherwise, due diligence is required to learn all relevant information about the proposed target. If the acquisition is made, and it later turns out the assets acquired were encumbered and there was a failure to conduct proper searches, this could also lead to shareholder litigation.

Public corporation

In the case of public corporations, securities laws that protect shareholders could be implicated. For example, the SEC actively monitors SPAC and de-SPAC mergers. The SEC stresses the importance of SPAC directors and sponsors conducting due diligence before choosing their de-SPAC target.

Furthermore, shareholders whose shares lost value after the de-SPAC can allege that due diligence failures led to material misstatements in the disclosure materials and thus claim breaches of fiduciary duty.

Conclusion

While each client matter will stand on its own foundation of facts around what due diligence is required, litigation searching is increasingly included in modern due diligence/risk analysis.

Comprehensive searches that include areas once considered “add-ons” are now mainstays for teams to obtain a complete due diligence picture that can help protect a corporation, its director, and others from legal consequences.

For more information, contact CT Corporation.