Court searches are the best way to reveal the credit risk posed by civil suits and bankruptcy cases. These open court actions threaten to encumber property being pledged as collateral and can seriously impact a debtor’s solvency.
In one example, lenders learned about a potentially large threat by accident. A large conglomerate was acquiring a privately-owned business. During the due diligence process, the business assured legal counsel that it had disclosed everything pertinent for the Litigation Section of the Disclosure Schedule to the Sale/Merger Agreement. However, during casual conversations that occurred as the deal was nearing its final stages, one of the executive officers told an anecdote about an employee who was injured while working on a piece of equipment. Upon further questioning, it was revealed that a suit was pending by the worker. Further, the worker was contemplating pursuing the case as a civil action outside of Workman’s Compensation, which would increase the potential liability.
Rather than hope for casual conversation to reveal information on legal actions, a court search should be conducted. Conducting a court search is reliable and inexpensive “insurance” to uncover the potentially significant risks of any legal actions your borrower may be involved in that could encumber assets. It can also shed light on the nature of the cases and the liability involved. Potential borrowers may indeed believe that they have disclosed everything they know regarding litigation. However, they may have overlooked a case or they simply may have thought that a matter was not important enough to mention.
When conducting court searches, it’s particularly important to include bankruptcy searches. Searches at the U.S. Bankruptcy Courts assist in the evaluation of a debtor’s credit risk. Like pending suits, bankruptcy cases cannot be revealed in the local filing office where liens reside. However, the inclusion of a borrower’s name as a petitioner in a bankruptcy proceeding is a clear red flag. If a company has filed for Chapter 11 bankruptcy, lenders will gain instructive insight into the borrower’s credit issues, whether they successfully executed their restructuring plan, and how creditors were repaid.
Bankruptcy searches—along with litigation searches—are pertinent for many types of lending agreements, from credit agreements to large merger deals. In transactions that involve asset sales, these searches identify whether the assets are controlled by the borrower as they claim they are, that no other secured parties can lay claim to the assets and that there is no pending litigation that could encumber the particular assets.
Check in tomorrow for part 5 in our advanced due diligence series: ordering a “search-to-reflect” after conducting a UCC filing.