Introduction to Security Interests
A security interest is the interest that a lender takes in a borrower’s property in exchange for lending money to the borrower. In legal terms, the lender becomes the “creditor,” the borrower becomes the “debtor,” and the property in which the creditor takes an interest becomes the “collateral.” Sometimes the collateral is the property that the debtor purchased with the borrowed funds. Other times the collateral is property that the debtor already owned before borrowing the funds from the debtor. Once a creditor holds a security interest in collateral, the creditor has a right to repossess that collateral if the debtor fails to make timely payments to the creditor of the loan. If the debtor succeeds in repaying the loan in full, the security interest in the collateral may then be terminated by filing a termination statement with the appropriate state authority (usually the Secretary of State).
Sometimes multiple creditors hold a security interest in the same collateral. When this happens, Article 9 of the Uniform Commercial Code (UCC) governs which creditor has priority over other creditors in the collateral—in other words, whose interest is senior, and whose is junior. Think of it this way: the senior security interest is first in line, and the junior security interest only gets the leftovers, if any.
The easiest and most common way for a lender to ensure it will hold the senior interest is to (1) make sure there are no existing security interests in the collateral at the time the lender takes the security interest over the collateral; and (2) file a financing statement with the appropriate state authority (usually the Secretary of State). By filing a financing statement, a creditor gives notice to the world of the existence of its security interest over the debtor’s property (the collateral). That interest becomes searchable by future lenders through what’s called a UCC search.
Application to Mergers and Acquisitions
A commonly misunderstood concept in mergers and acquisitions is how the buyer purchases the seller’s business. It is easy to imagine a wealthy buyer handing over millions of dollars in cash that the buyer just had laying around. In reality, a buyer will need to borrow a lot of money from an institutional lender (like a bank) to purchase the seller’s business. More than likely, the buyer’s institutional lender will be different than the lender the seller has borrowed from and granted security interests to. In other words, the seller’s creditors are usually different from the buyer’s creditors
To make sure it gets repaid by the buyer, the buyer’s institutional lender will want to take a security interest in the assets acquired from the seller, and possibly in other assets held by the buyer. But not just any security interest will do; the institutional lender will demand that it have the senior security interest. Assuming this institutional lender is not a creditor of the seller, there may arise issues of priority over the seller’s assets. Rather than risk taking a junior interest in the seller’s assets, the buyer’s institutional lender will require that any existing liens on the seller’s assets (remember, this will be the collateral for the institutional lender’s security interest) be paid off and a termination statement be filed. In short, the new secured party will require that all prior security interests be terminated.
UCC searches for existing security interests in the seller’s assets are a standard part of due diligence. Sellers are typically required to prepare documentation to pay off and terminate those security interests before closing. Most sellers delegate this responsibility to the closing company involved in the acquisition. The asset purchase agreement between buyer and seller will require the seller to use a portion of the purchase price to pay off those existing security interests. By doing so, the buyer’s institutional lender will become the only secured party over the assets purchased in the acquisition, guaranteeing priority over the buyer’s future creditors.
For more advice on acquiring a business, or for help forming a comprehensive plan to sell your business at the best time, contact one of our Sioux City attorneys, Sioux Falls attorneys, or Omaha attorneys today! Check out our guide which further explainins due dilligence for your business!