A classic tension in commercial law is the standoff between (1) a seller who sells goods to a purchaser on credit terms and (2) the secured lender who advances credit to that purchaser and takes a security interest in all of that purchaser’s now owned and hereafter acquired goods. At what point in the sale transaction does the interest of the seller in the sold goods give way to the security interest of the secured lender with a security interest in such goods?

As a general rule, the Uniform Commercial Code (“UCC”) prefers the secured lender in such situations from and after the point in time when the goods are either shipped or delivered to the purchaser, because the seller’s ownership interest in the goods will not survive beyond that point in time regardless of what the sale contract provides.[1] Many supply and manufacturing companies either are not aware of this legal preference or utilize insufficient means to attempt to overcome the preference. For example, it is common for commercial sale contracts to provide that title to the goods does not pass to the purchaser until the purchaser pays for the goods. However, such common contractual provisions are not enforceable and, instead, merely amount to the reservation of a security interest in the sold goods.[2] As expected, the vast majority of commercial sellers utilizing such contracts do not realize that they merely hold a security interest in the delivered goods, and consequently they do not file an appropriate UCC financing statement to perfect that security interest. Thus, such a security interest is unperfected and therefore practically unenforceable.[3]

Similarly, it is not unusual to find commercial sale contracts modified by well-meaning (but ill-informed) drafters to become “consignment” agreements, pursuant to which the seller purports to deliver the goods to purchaser only on a consignment basis, and the “sale” does not occur until such goods are paid for by the purchaser, resold by the purchaser or otherwise utilized by the purchaser. Once again, the UCC sees directly through such contractual sleight of hand. Unless the purchaser is “generally known by its creditors to be substantially engaged in selling the goods of others,” then the sale/consignment transaction will qualify as a “consignment” under UCC Article 9.[4] And the interest of a consignor in goods delivered in a consignment transaction under UCC Article 9 is… you guessed it, a security interest (specifically, a purchase money security interest).[5] As such, without the filing of an appropriate UCC financing statement against the purchaser, such security interest is unperfected and therefore practically unenforceable.

Finally, there are those sales contracts that correctly identify the issue and provide that the purchaser grants to the seller a security interest in the sold goods to secure the payment of the purchase price. Again, however, the seller rarely knows to file an appropriate UCC financing statement against the purchaser, and thus the security interest language in the sales contract is ineffective.

While these results are discouraging to sellers of goods, the situation is not hopeless. A seller of goods who agrees to accept payment for the goods sometime after delivery must look itself in the mirror and acknowledge what it really is: a creditor of the purchaser. As such, the seller needs to take standard steps under Article 9 of the UCC to ensure (1) that the seller obtains a perfected security interest in the sold goods and (2) perhaps more importantly, that the seller obtains priority over any conflicting security interests in the same sold goods.[6]

Creating and Perfecting First Priority Purchase Money Security Interests

A “purchase money security interest” (or “PMSI”) is a concept under UCC Article 9 that serves as an exception to the general priority rules. Generally, security interests rank in priority by time of perfection (usually the filing of a UCC financing statement).[7] A PMSI can benefit from special priority rules set forth in UCC 9-324 and discussed below.

Before we consider the issue of potential priority, however, the security interest first has to qualify as a PMSI. In its simplest form, a PMSI is a security interest in goods that secures the repayment of the obligation incurred to pay the purchase price of the goods.[8] A classic example of a PMSI is a loan advanced to a purchaser and used to purchase a particular piece of equipment. Another example is the sale of goods on credit terms, where the seller is granted in writing a security interest in the goods to secure the deferred payment of the purchase price for such goods. In order to be effective, the PMSI (like any other security interest) must be perfected. In the case of goods delivered to the possession of the purchaser, the only means of perfecting the security interest is to file an appropriate UCC financing statement against the purchaser.[9]

Finally, we come to the issue of priority. Assume that (as is often the case) prior to the sale the purchaser has obtained senior secured financing from a bank or other financial institution, which financing is secured by a perfected security interest in all of the purchaser’s now owned or hereafter acquired personal property. The UCC expressly permits such “floating liens,” whereby the global security interest of a secured party can attach to new collateral automatically and without further agreement or filing upon the acquisition of rights by the debtor in such after-acquired property.[10] Generally, such an “all assets” security interest was perfected well before the seller enters the scene, and thus, even if the seller knows to file a UCC financing statement, the seller would lose under the general “first to file” rule under UCC Article 9.[11]

Under UCC 9-324, a PMSI may have priority over a conflicting security interest, notwithstanding that the conflicting security interest was perfected first.[12] PMSIs come in two varieties: equipment and inventory. “Inventory” means goods that, in the hands of a particular debtor, are leased or held for re-sale or lease (or are raw materials incorporated into products that are sold or leased).[13] “Equipment” means goods that are not inventory,[14] and equipment is generally understood to mean goods that are used or utilized by the debtor but not re-sold or leased (e.g., capital assets such as furniture, machinery, office supplies, etc.).

The distinction between equipment and inventory is important because the priority rule for PMSIs in equipment is different than the rule for PMSIs in inventory. It is easier to establish purchase money priority in goods consisting of equipment. The UCC simply requires that the PMSI in equipment be perfected (i.e., an appropriate UCC financing statement be filed) before the debtor receives possession of the goods or within 20 days thereafter.[15] Thus, for a seller who is selling goods to a debtor who will use those goods itself as equipment, the seller simply needs to file an appropriate UCC financing statement before or within 20 days after delivering the goods to the purchaser.

Establishing purchase money priority in inventory is more complicated. As a matter of policy, the UCC is mindful of the interests of inventory financers who advance funds to debtors secured by the value of the debtor’s inventory on a rolling basis. It would be burdensome to require inventory lenders to continually search the UCC records to look for new filers claiming purchase money priority. Therefore, a PMSI in inventory will only be entitled to purchase money priority over a previously filed security interest in after-acquired inventory if the following conditions are satisfied:

  1. the PMSI must be perfected (i.e., an appropriate UCC financing statement be filed) at the time the debtor receives the goods (not within 20 days after, as is the case with equipment);
  2. the party claiming the PMSI must (i) search the appropriate UCC records for any UCC financing statements filed against the purchaser and disclosing a conflicting security interests in inventory and (ii) send written notification to the secured parties named in any such financing statements (preferably by certified mail with return receipt requested);
  3. the holder of the conflicting security interest must receive the written notice before the inventory is delivered (but not more than 5 years before[16]); and
  4. the written notice must state that the sender expects to obtain a PMSI in inventory and must describe the inventory with reasonable specificity.[17]

PMSIs in inventory are also limited by the fact that the PMSI priority only extends to identifiable cash proceeds and instruments or chattel paper proceeds of the inventory; the PMSI priority does not extend to accounts receivable that are proceeds of the inventory.[18] On the other hand, a seller holding a perfected, first priority PMSI in inventory owned but not yet sold by the buyer when the buyer files for bankruptcy will have the first-priority security interest in any post-petition accounts receivable generated by the buyer’s sale or other disposition of that inventory after the bankruptcy filing.

Best Practices

If a seller of goods intends to take a PMSI in the goods to secure the payment of the purchase price for those goods, the written sales contract must expressly grant such a security interest. Further, the seller should always file against the purchaser an appropriate UCC financing statement in the applicable jurisdiction prior to delivery of the goods. Finally, the seller should determine how the goods will be used by the purchaser. If the goods will be used by the purchaser as equipment, then the filing of an appropriate UCC financing statement alone is sufficient to afford the seller purchase money priority. If the goods will be (or may be) used by the purchaser as inventory, then the seller will need to take the additional steps of running UCC record searches and notifying all secured parties with a conflicting security interest in after-acquired inventory.

One caveat to keep in mind is that senior secured lenders are acutely aware of the rules permitting PMSIs to prime earlier-perfected security interests. Consequently, senior credit agreements typically contain covenants that limit a borrower’s ability to grant PMSIs in goods (and in fact, PMSIs in inventory are often prohibited). Such covenants do not impact the priority of a seller’s properly created PMSI. It is advisable, however, that a seller confirm with a buyer whether a proposed PMSI (in equipment or inventory) is permitted under the purchaser’s senior credit agreement (if any). Clearly, a seller would prefer to be paid the purchase price for the goods sold rather than simply recovering the goods themselves, and defaulting under a senior credit facility is one way that a purchaser can quickly find itself unable to continue business and pay its obligations.