By:   Susan E. Wells   

       If you are negotiating a new business loan, you know that your due diligence investigation on the borrower should include a search of the Secretary of State's records* to confirm that the assets being pledged as collateral are "free and clear" and not subject to the security interest or other lien of another lender, lessor or other secured party.  A UCC lien search of the Secretary of State's records will locate financing statements filed to provide notice that a secured party has a lien on certain of the seller's assets.  If the borrower paid off the loan or other obligation underlying the financing statement, the secured party should have filed a termination statement, which provides notice that the secured party has released its lien on the borrower's assets and therefore, the assets are "free and clear."

       You may not be aware, however, that a termination statement does not have to be signed by the secured party.  Therefore, a dishonest borrower may file a termination statement.  In that case, the termination statement would not be effective to remove the secured party's lien and the assets would not be "free and clear."  The secured party's rights with respect to the collateral would be superior to your rights, even though your loan has funded.  Of course, you would have a claim against the borrower; however, a borrower that would commit this type of fraud would probably not be collectible.    

         What is the best practice to avoid this unfortunate result?  For each financing statement terminated within the past five years (particularly those filed within one year of the loan), you should confirm in writing with the secured party that the termination statement was validly filed.  If the secured party cannot be found or verification is otherwise impractical, you can purchase UCC insurance to transfer the risk to a third party.  Considering the increasing incidence of fraud in business and other transactions, these preventive steps are well advised.

      *In limited cases, the records of the office of the county recorder in which a mortgage would be filed should be searched.

About the author:  Susan E. Wells is a lawyer at the Phoenix based law firm of Jaburg Wilk where she assists both business owners and entrepreneurs.  She can be reached at 602.248.1034 or sew@jaburgwilk.com.

3200 North Central Avenue . Phoenix . Arizona