In the first part of this series, we discussed how purchase money security interests (PMSIs) in assets could gain priority over previously perfected security interests. In this part 2, we discuss the rules under Article 9 of the UCC relating to PMSIs in inventory under which the holder of the PMSI may gain priority over secured parties with prior perfected security interests in such inventory. These rules are different – and more onerous – than the rules for other types of assets.

PMSI in Inventory

Assume that a lender has made a loan to a borrower secured by all assets of the borrower. The lender properly perfects its security interest by filing a financing statement in the borrower’s jurisdiction of formation. Some months later, the borrower purchases goods to use as inventory from a seller on credit, and the borrower grants to the seller a security interest in those goods to secure its obligation to pay the purchase price. The seller’s security interest would constitute a PMSI, but would it have priority over the security interest of the buyer’s lender that attaches to those goods? In order for the seller’s PMSI to be first in priority over the lender’s previously perfected security interest, the seller, prior to delivery of the goods, must:

  • Perfect the PMSI by filing a financing statement naming the borrower as debtor and seller as secured party, and properly identifying the goods to be sold as the collateral.
  • Perform a UCC search in the appropriate jurisdiction to identify the borrower’s secured creditors and their collateral.
  • Send a notice (a “PMSI Notice”) to each creditor identified in the UCC search as having a competing security interest that would cover the goods, which notice must state that seller has or expects to obtain a security interest in the goods and include a reasonable description of those goods.

Only after each of the foregoing steps have been taken can the seller deliver the goods to the borrower if the seller wants a first-priority PMSI in the goods. If any of the foregoing steps are not taken prior to delivery of the goods, the seller’s PMSI will be subordinate to the lender’s security interest in the goods.

The creditor (be it the seller or other lender that finances the purchase of the goods) that seeks to have a first-priority PMSI in inventory must therefore jump through more hoops than a creditor that seeks to have a first priority PMSI in other types of goods.

Note that the seller must also provide a PMSI Notice approximately every 5 years thereafter, because under the UCC the creditor must receive the notice within 5 years before the debtor receives possession of the inventory.

Consignments

Consignments are treated in the same way under the UCC as PMSIs in inventory, and thus the consignor (the person delivering consigned goods) must jump through the same hoops to protect its interest in the consigned goods in order to obtain superpriority over prior perfected security interests. Accordingly, a consignor must, prior to delivering the consigned goods to the consignee, obtain a UCC search, file a financing statement, and notify earlier filers of security interests of the contemplated delivery of the consigned goods. However, the consignor need not satisfy those requirements if the consignee is generally known by its creditors to be substantially engaged in selling the goods of others.

Addressing PMSIs in Loan Documents

PMSIs are generally addressed in loan documents through negative covenants governing debt and liens. In the case of PMSIs, these negative covenants limit a borrower’s ability to grant PMSIs that might prime the lender’s otherwise first-priority security interest. Although an exception for purchase-money obligations and related PMSIs is not always included, a secured lender will often agree to include exceptions in order to permit the borrower to acquire assets needed to operate the borrower’s business (often available on attractive terms). If included, this exception can be limited in several ways, including by:

  1. generally limiting the amount of other debt the borrower can have outstanding;
  2. specifically limiting the total amount of purchase-money obligations that can be secured by a PMSI;
  3. limiting the debt secured by the PMSI to a certain percentage of the lesser of the cost or fair market value of the asset;
  4. requiring the assets be acquired in the ordinary course of business;
  5. requiring the PMSI to be granted contemporaneously with the acquisition;
  6. prohibiting the security interest from attaching to assets other than the assets purchased; or
  7. some combination of the foregoing.