Purchase Money Security Interests: A Powerful Tool for Creditors with Precise Rules to Be Followed

Eric von Helms
evonhelms@kmksc.com
(414) 962-5110

When selling goods to a customer on credit, one tool a creditor can employ to enhance its likelihood of being paid is to obtain a security interest—a lien—in the goods being sold.  Absent a lien in favor of the selling creditor, in a liquidation or bankruptcy scenario, the customer’s lenders often end up being the only creditors that recover any payment based upon their security interests in the customer’s assets.  However, where the creditor extends credit, for the buyer to purchase or acquire goods, the creditor can obtain a security interest in such goods, known as a purchase money security interest or PMSI.  A PMSI allows a seller to obtain a lien with priority over other secured parties including those that already have liens in the buyer’s assets. However, obtaining this PMSI priority requires the selling creditor to closely follow the applicable rules.

The rules for obtaining liens in property, including PMSI liens, and the rules that dictate what liens have priority, are set out in the Uniform Commercial Code, or UCC, which has been enacted in each state.  Although the rules are generally uniform (hence the name of the Code), there can be subtle, but legally important, differences from state to state.  This article describes the generally applicable rules related to PMSIs in inventory and equipment.  We do caution that a detailed discussion of all the rules, procedures, and considerations concerning PMSI liens is beyond the scope of this article.

First, in order to obtain the typical UCC lien in inventory or equipment, including a PMSI, the creditor needs a written security agreement with the customer, where the customer agrees to grant the creditor the security interest in the goods being sold.  The security agreement must provide a complete description of the goods to be treated as the creditor’s collateral.

Step two of the process involves properly perfecting the security interest.  This step includes several facets, including the filing of a UCC financing statement, which, among other things, provides notice of the creditor’s security interest to third parties.

One critical piece of the creditor’s required due diligence is to determine the customer’s location for the purposes of the UCC.  The customer’s “location” dictates where the financing statement is filed, and there is a tricky rule under the UCC:  an organization such as a corporation or LLC is “located” where it is legally organized or formed, which might not be where the company’s business operations are located or where the collateral will be kept.  For example, if the customer’s business operations are in Wisconsin, but the company was formed in Delaware, for purposes of the UCC, the company is “located” in Delaware.  Therefore, critical due diligence includes requesting up-to-date copies of the articles of incorporation and bylaws for the customer (assuming it is a corporation) to verify the name and state of incorporation for the customer.

The PMSI process also differs substantially depending on whether the goods being sold to the customer will be considered the customer’s inventory or equipment.  Broadly speaking, inventory consists of items that the buyer intends to sell or lease to its own customers, while equipment consists of items that the buyer will keep for use in its regular business operations.  For example, if a creditor sells a customer forklifts, and the customer is a forklift dealership that intends to sell or lease the forklifts to end users, the forklifts are considered the customer’s inventory.  However, if the customer has a warehouse where it intends to use the forklifts to haul the customer’s products, the forklifts are considered the customer’s equipment.

If the collateral will be considered the customer’s equipment, then the PMSI process is a bit simpler, but the details are still critical:  the UCC financing statement needs to be filed with the proper state filing office (for the state where the customer is “located”), with a specific description of the equipment being sold, and the filing has to be made within 20 days of the delivery of the equipment to the customer.  If all the rules for a PMSI in equipment are met, then the creditor’s lien in that equipment will have priority over other liens, even earlier filed liens in the customer’s equipment generally.

If the collateral will be considered the customer’s inventory, then different steps are required.  In particular, the creditor must provide a written notice to each of the customer’s already-existing secured creditors with UCC liens in inventory, and this notice must be provided prior to the creditor delivering any of the goods to the customer.  Therefore, the creditor must obtain a UCC search in the customer’s location to see what liens are already filed, and to whom the prior notices have to be provided.

There are also important rules for completing the UCC financing statement.  Whether the lien will be in inventory or equipment, the financing statement must use the exact name of the customer as provided in the customer’s articles of incorporation.  The correct name of the creditor is also required.  UCC financing statements for equipment need to include a detailed description of the equipment with reference to the year, make, and model of the equipment with serial numbers.   UCC statements for inventory, as well as the notices to be provided to the customer’s existing secured creditors, need to describe the inventory items as specifically as possible.  Depending on the circumstances, this might include reference to the total number of inventory items being provided or sold by the creditor.

Another technique that can be employed in a PMSI scenario, to avoid some potential for disputes about lien priorities in collateral, is to request lenders with prior lien rights to enter into an inter-creditor agreement with the selling creditor.  Such inter-creditor agreements provide for the prior secured lender to specifically acknowledge the creditor’s priority lien position in the collateral being provided to customer.

Creditors must also be aware of other potential liens that might not be filed or arise under the UCC.  Many states have statutes that provide landlords or warehouse owners with liens that will not appear on a UCC lien search in the applicable state.  If the customer does not own the premises where the inventory or equipment is to be stored or located, the customer’s landlord could potentially assert its own lien rights in any goods that are at the premises. In that scenario, best practices dictate that, if possible, the creditor provide notice to the landlord that the creditor has a purchase money security interest in the goods, and also seek a landlord’s waiver that acknowledges that the creditor’s liens have priority over any liens of the landlord, statutory or otherwise. 

Purchase money security interests can provide sellers with the substantial benefit of first-priority lien rights in goods being sold to a customer, if all the rules are closely followed.  Therefore, when entering a large sale transaction on credit with a customer, a creditor should consider whether seeking PMSI protections is reasonable or appropriate for the transaction at issue.  However, because of the complexity and procedures to ensure such lien rights, a creditor should engage the assistance of experienced legal counsel when considering and going forward with such secured transactions. If you have any questions about how a PMSI transaction might be helpful in your business or even in a specific transaction, please contact KMK attorney Eric von Helms at evonhelms@kmksc.com or Samuel C. Wisotzkey at swisotzkey@kmksc.com or 414-962-5110 for assistance.