Purchase Money Security Interests (PMSIs) allow a lender to acquire a security interest in collateral that is senior to other creditors holding prior perfected security interests in the same collateral type, provided that the PMSI creditor strictly adheres to the requirements for perfecting its security interest. The purpose of the “super priority” of the PMSI is to provide debtors with access to money from creditors or suppliers, and to avoid a situation where:

an un-yielding creditor may be able to frustrate future outside borrowing by his debtor, since any future lender will be confronted with the fait accompli of a prior perfected security interest that gives the already secured party priority even for subsequent advances.¹

PMSIs are governed by state law, specifically Article 9 of the Uniform Commercial Code.² They most often arise in the context of purchases, such as floor plan financing, equipment financing and seller financing. Of the categories of purchase money collateral, inventory gives rise to the most nuanced issues in terms of practical application. In general, the rules for establishing a PMSI are strictly enforced by the courts, making proper diligence on the part of the PMSI creditor of utmost importance.

PMSI Rules for Inventory

Generally, goods are inventory if they are leased by the debtor, or held for sale or lease by the debtor or are materials used or consumed in a debtor’s business or work in process; and goods are equipment if they are used in the debtor’s business and are not inventory (equipment can range from the computer or desk to the welding machine). Inventory may include goods called “equipment” in everyday language. Construction equipment held for lease or sale is inventory, even though most people would refer to it as equipment. A purchase money secured party who makes a determination that goods are equipment when they are inventory will follow the wrong steps, and will not get the benefit of purchase money priority.

A perfected PMSI in inventory has priority over a conflicting security interest in the same inventory, or chattel paper or an instrument constituting proceeds of the inventory and in the proceeds of the chattel paper, and also in identifiable cash proceeds that are received on or before the delivery of the inventory if:

1. The PMSI is perfected when the debtor receives possession of the inventory.
2. The PMSI secured party sends a notice to the holder of the conflicting security interest.
3. The holder of the conflicting security interest receives the notification within five years before the debtor receives possession of the inventory.
4. The notification states that the person sending it expects to acquire a PMSI in inventory of the debtor and describes that inventory.³

The notification must be sent to each holder of a conflicting security interest with a financing statement listing the same type of inventory, and whose statement was filed prior to the date of the PMSI creditor’s filing, or if the PMSI creditor’s interest is temporarily perfected without filing or possession, before the start of the applicable 20-day period.⁴ The PMSI creditor is entitled to rely upon the address in the financing statement for notification purposes.⁵ The notice is effective for five years after receipt.

Unique Requirements to Perfect a PMSI in Inventory

The need to notify the holder of a conflicting security interest prior to the debtor taking possession of the purchase money inventory differs from the PMSI rules for other goods, such as equipment, because it requires that notice be given to other secured parties with an interest in the same type of inventory prior to the debtor taking possession of the purchase money inventory. The 20-day grace period for perfection after the debtor receives possession of the collateral that is applicable to goods, such as equipment, does not apply to inventory.⁶ A purchase money security interest in inventory must also be perfected when the debtor receives possession of the inventory.⁷

This requirement reflects the commercial reality of inventory finance, in which a secured party is making periodic advances against incoming inventory and periodic releases of old inventory. The notification requirement protects the existing non-purchase money secured party from making an advance against inventory in which it will be junior to the PMSI creditor.⁸ For example, a manufacturer with an all assets financing statement filed against it by its bank can finance the acquisition of inventory through a supplier or inventory financier on a purchase money basis, so long as the supplier or inventory financier files its financing statement and notifies the bank of the purchase money security interest in the relevant inventory prior to the actual delivery of the purchase money inventory.

A PMSI in inventory also differs from that in other goods, such as equipment or livestock, in that it only extends to identifiable cash proceeds received on or before the delivery of the inventory to the buyer.⁹ It does not extend to accounts, or in some situations, instruments or chattel paper. Therefore, a non-PMSI secured party with a prior perfected security interest in inventory, or a secured party with a perfected security interest in accounts, will have priority over the PMSI secured party with respect to accounts that are proceeds of the PMSI inventory.

Finally, in enforcing a PMSI interest, it is important that the cash proceeds be identifiable.¹⁰ Commingling of the cash proceeds in a general operating account may impede a diligent PMSI creditor who has a perfected security interest from realizing on that interest.¹¹ Additionally, when the proceeds of the original collateral are deposited in a deposit account, priority in the deposit account is governed by the rules on perfection of deposit accounts, not the rules on perfection of PMSI.¹² Therefore, a PMSI creditor that has a security interest in identifiable proceeds in a deposit account will lose a priority battle with a creditor that has perfected its interest in the account by control notwithstanding the PMSI status.¹³

Strict Application of Article 9 Rules

The PMSI rules under the UCC are clear-cut. They are also strictly enforced. The courts have not hesitated in finding that PMSI creditors, who otherwise would have had priority, have lost that priority as a result of the failure to adhere to the statutory rules, such as the need to provide notice to the existing creditor that contains a statement of the intent to acquire a PMSI and sets forth the relevant purchase money inventory. Examples of notices found to be deficient include delivery of a package of loan documents instead of a notice, even though the documents did have an embedded reference to purchase money,¹⁴ and the failure to explicitly identify the interest as a purchase money interest as opposed to a simple “security interest.”¹⁵ Courts will not look to the parties’ intentions or expectations if the PMSI creditor has failed to adhere to the requirements of Article 9.¹⁶ As the delivery date can be ambiguous, such as when a debtor buys goods and takes possession of them in stages, it is best to file the financing statement as early as possible to ensure that the PMSI creditor is perfected when the purchase money inventory is received.¹⁷

A Powerful Tool

PMSI is a powerful tool for both creditors and debtors in situations where a debtor is in need of funding but already has existing creditors with blanket liens on collateral. However, in utilizing this tool, creditors should take care in properly identifying the collateral type, as different rules apply to inventory, equipment, fixtures, livestock, and to a limited extent, accounts receivable. Inventory is especially nuanced, and a PMSI creditor with expectations of enforcing its rights against accounts receivable generated by the sale of PMSI inventory will be disappointed if no further steps are taken to secure such an interest. Overall, it is important for creditors to be diligent during the process of acquiring a PMSI to strictly adhere to the statutory requirements, and to seek outside assistance if needed.

Michael E. Reyen is associate in the Real Estate & Finance Practice Group at Hodgson Russ LLP.

Footnotes:

<sup>1. Thomas H. Jackson & Anthony T. Kronman, A Plea for the Financing Buyer, Yale LJ, Vol. 85, No. 1-2, at 1 (1975).↩
2. Article 9 of the UCC, §9-103, §9-317, and §9-324. ↩
3. UCC §9-324(b).↩
4. UCC §9-324(c); §9-312(f).↩
5. UCC §9-324(b), Comment 6.↩
6. UCC §9-324(a), (b).↩
7. UCC §9-324(b)(1).↩
8. UCC §9-324(b), Comment 4.↩
9. UCC §9-324(b), Comment 8.↩
10. UCC §9-324(b).↩
11. Tracing of the commingled proceeds may be necessary pursuant to UCC §9-315(b)(2), Comment 3.↩
12. UCC §9-327; UCC § 9-324, Comment 8.↩
13. Douglas Dynamics, Inc. v. Carnegie Body, Ltd., 2011 Ohio Misc. LEXIS 562 (OH Court of Common Pleas 2011) (purchase money inventory lender lost priority once proceeds of inventory were deposited into blocked deposit account established in favor of another creditor).↩
14. In re Sports Publishing, Inc., 2010 U.S. Dist. LEXIS 19078 (D.C.C.D. Ill. 2010); ↩
15. Guaranty State Bank & Trust Co. v. Van Diest Supply Company, 30 Kan. App. 2d 1108 (Kan. 2002).↩
16. In re T & R Flagg Loggin, Inc., 399 B.R. 334, 339 (Bankr. D.Me. 2009).↩
17. UCC §9-324, Comment 3.↩</sup>