In the transactional world, lenders strive to ensure that loans are secured by properly perfected liens against the borrower’s collateral. This practice is in line with the “first-in-time” rule of UCC Article 9 and protects secured creditors in the event the borrower defaults on the loan. It also gives the secured creditor priority to recover in bankruptcy.
Now, let’s imagine there is a debtor — a toy manufacturing company called Unique Toys, Inc. — with an existing business loan from Big Bank. The business loan from Big Bank is secured by all Unique Toys’ assets, and helps the company start its business. While the business is profitable, the company is still low on cash. Unique Toys also just received a $1 million purchase order from a major retailer, which would require an upfront payment to the factory of $400,000. Big Bank is not willing to lend the additional funds. While there are other lenders willing to lend to Unique Toys at higher rates, they request a first position lien on the borrower’s assets. The only issue is that Big Bank already has a first position lien. What can Unique Toys do?
This is the type of scenario where a purchase-money security interest (PMSI) can save the day.
What is a PMSI?
A purchase money security interest (PMSI) is an exception to the first-in-time rule. It gives secured creditors who meet its requirements a special advantage to jump ahead in line of other creditors with respect to certain collateral. PMSI creditors can get super priority over third parties who perfected their interests first.
UCC Section 9-103(b)(1) provides a fundamental definition: “A security interest in goods is a purchase money security interest…to the extent that the goods are purchase-money collateral with respect to that security interest.”
In other words, a PMSI is created when a creditor loans money to a debtor to finance the purchase of certain goods. And in return, the debtor grants the creditor a security interest in those goods.
There are different types of collateral in which the creditor may be able to obtain a PMSI, including inventory, non-inventory, farm products, and software. For the purpose of this article, we will focus on inventory and non-inventory, which can be defined as follows:
- Inventory – Under UCC Article 9, inventory is goods that are not farm products and that are (a) leased by a lessor; (b) held for sale or lease or to be furnished under a contract of service; (c) furnished in connection with a service contract; or (d) raw materials, work in process, or used or consumed in a business. This does include current and future inventory.
- Non-inventory – Security interest taken on a specific piece of collateral where the debtor retains the equipment (e.g., copier, refrigerator, forklift, printing press)
The method of assuring that the PMSI takes priority over other security interests in the goods differs in accordance with whether the goods are inventory or non-inventory.
PMSI requirements for non-inventory collateral
To obtain purchase money super priority in goods other than inventory, livestock, and fixtures — such as equipment collateral — the creditor must satisfy two requirements:
- The credit extended by the creditor must be used by the debtor to purchase the collateral; and
- The creditor must properly file a financing statement covering the collateral when the debtor receives possession of the collateral or within 20 days thereafter.
To meet the second requirement, the creditor must determine when the debtor takes possession of the collateral. If the 20-day timeframe is not complied with, the creditor will not obtain super priority for its security interest. The creditor must also consider scenarios where collateral is received in installments.
For instance, courts may consider the 20-day period to run from when most of the collateral was received as opposed to the last installment. In In re Piknik Products Company, Inc., 346 B.R. 863 (Bankr. M.D. Ala. 2006), the court found that the secured party failed to perfect its interest within 20 days after the debtor received possession of the “majority” of the equipment, and rejected the secured party’s argument that the entire installation was not yet complete.
To avoid this situation, the creditor should consider pre-filing before the collateral is delivered.
Perfecting a PMSI for non-inventory collateral
A non-inventory PMSI is perfected by filing a UCC-1 prior to the debtor taking possession of the assets or within 20 days after receipt. This must be done in the appropriate jurisdiction where the debtor is located. For registered organizations, the location of the debtor is the jurisdiction of the debtor’s organization. If the filing takes place after the 20-day period, the filer will not have PMSI priority and will come in line after the prior-perfected security interests.
These are general steps, you should look at state statutes on PMSI perfection since these can vary from state to state.
PMSI requirements for inventory
To perfect purchase money security interests in inventory, Section 9-324(b) requires that:
- The PMSI must be perfected at the time the borrower takes possession of the inventory. As such, the security agreement and value extended must occur before inventory is received.
- The secured party must provide authenticated notification to holders of conflicting security interests before perfection — this includes every known secured party. This notice must be received within five years prior to the borrower obtaining possession of the inventory.
- The notification must state that the person sending the notification has or expects to acquire a PMSI in the borrower’s inventory and describe the inventory.
Furthermore, to constitute a PMSI, the UCC stipulates that a “close nexus” must exist between the acquisition of collateral and the secured obligation. In other words, the borrower cannot acquire collateral and subsequently create a security interest. A “close nexus” would also extend to related obligations, which may include but are not limited to interest, fees, insurance, and similar related expenses.
To meet these requirements, due diligence from the outset is essential. It’s also important to retain copies of all delivery records, including invoices, purchase orders, etc.
Finally, it’s important to note that PMSI in inventory has limited reach into “proceeds”. As such, cash proceeds cannot be reached through a PMSI filing unless the identifiable cash proceeds are received on or before inventory is received by the buyer.
Perfecting a PMSI in inventory
To perfect a PMSI in inventory, filers must take the following steps:
- Conduct a UCC search in the applicable jurisdiction to identify the borrower’s secured creditors and collateral.
- Prior to the debtor’s receipt of the collateral, file a UCC-1 that identifies goods to be sold as collateral.
- Provide written notice to the holders of conflicting perfected security interests in the debtor’s inventory. The notice must be received no more than five years before the debtor receives inventory and the notice must include PMSI language as required under the UCC.
A financing statement must be continued within six months before its expiration date, which for an initial filing is usually the five-year anniversary from the date of the original filing. Prior to filing a UCC-3 continuation, the filer would also need to conduct another UCC search to determine if the statements of the conflicting security interest holders remain effective or have been assigned to someone else. If the statements are still effective, the secured party must send new PMSI notices to those holders to retain its PMSI status.
Again, these are general steps. You should look at state statutes on PMSI perfection since these can vary from state to state.
Priority order can determine whether a loan debt gets repaid or not. Creditors with first priority naturally stand a better chance of being able to collect against a debtor compared to those who file late or fail to secure their claim at all.
However, a creditor with a PMSI can gain priority over previously perfected security interests as long as they properly meet UCC Article 9 criteria.
PMSI is a useful tool for lenders who are looking to help finance a specific purchase. This scenario can be viewed as a win-win for all parties involved:
- The existing lender with first priority benefits from the debtor gaining access to additional funds in order to obtain inventory/equipment essential for the operations of the debtor. This existing lender (e.g., Big Bank in the opening example) would not otherwise have first position to that underlying collateral. Without the PMSI lender, the debtor would not have the ability to purchase that collateral.
- The PMSI lender wins by making the loan and getting first priority to the underlying assets. (It’s common to see alternative lenders here also enjoying higher interest rates.)
- The debtor wins from being able to finance the assets.