Down the Rabbit Hole

by Kenneth P. Weinberg March/April 2014

Weaving in the quirky personalities of Alice in Wonderland characters, Kenneth Weinberg discusses the nuances behind purchase money security interests and discerning the “what” and “when” arguments for filing within the applicable period.

Kenneth P. Weinberg,
Shareholder,
Baker, Donelson, Bearman, Caldwell & Berkowitz

Did you perfect your security interest late … did you miss an important date? People in the equipment leasing and finance industry are generally very familiar with the concept of a purchase money security interest (PMSI). Many companies in our industry rely on them heavily to decrease the administrative expense and funding delays that would result from searching UCC filings for each transaction and obtaining subordinations from any existing lenders with conflicting security interests.
Although this edition of Dispatches from the Trenches provides some basic information regarding purchase money security interests (it is always a good idea to have a refresher from time to time), even those readers who are very familiar with the legal framework are likely to make some interesting discoveries.

So find the bottle that says “drink me,” and take a trip all the way down the rabbit hole as if you were Alice in Wonderland.

The Basics

Before starting any adventure, it is important to pack your bags (or in this case, your mind) with some essentials. First, absent special priority rules in Article 9 of the Uniform Commercial Code, the ranking of security interests amongst perfected secured parties is based on what is commonly called the “first-to-file-or-perfect rule.” For example, if Cheshire Cat files his financing statement against Alice before the Mad Hatter files against her interest in the same collateral, the Cheshire Cat will have a superior claim to that collateral even if the Mad Hatter loans money, tea or whatever to Alice first and “perfects” his interest before that crazy cat. In other words, if a filing occurs before perfection, priority can be said to “relate back” to the time of filing. 1

Second, a PMSI is one of the most famous exceptions to this first-to-file-or-perfect rule. It was created to encourage the financing of newly acquired goods. Absent this super-priority concept, blanket lien holders could create a monopoly-like control over the market, much like the Queen in Wonderland: “Off with their heads!” The justification for PMSI priority is that the debtor would not even have the collateral in question absent the purchase money lender who financed its acquisition. Therefore, existing lenders are not hurt by granting priority to the purchase money lender. In order to prevent “secret liens” that may shake the foundation of secured lending, and in order to protect the existing lender from erroneously thinking to its detriment that PMSI collateral is unencumbered, Article 9 places certain burdens on the purchase money lender to evidence its lien in a timely fashion.

These rules differ based on whether the collateral constitutes “equipment” or “inventory” for purposes of Article 9. In circumstances where the PMSI collateral consists of software that is embedded in the goods, acquired in an integrated transaction with the goods, or acquired for the principal purpose of using with the goods, the software is treated in the same manner as the related goods.2

Prior editions of the Dispatches from the Trenches have more details, but the short version is that: (a) for both equipment and inventory, a PMSI requires that the loan proceeds “enable the debtor to acquire rights in or the use of the collateral;”3 (b) for equipment, the purchase money lender must be perfected either before or within 20 days after the date the debtor receives possession of the equipment;4 and (c) for inventory, the purchase money lender must be perfected when the debtor receives possession of the inventory and the secured party must have provided certain advance notice to conflicting lienholders.5

Curioser and Curioser

For commercial transactions, there are two key sets of PMSI provisions. The first is in §9-103 of the UCC and defines exactly “what” constitutes a PMSI. The second set is found in §9-324 of the UCC and dictates “when” a PMSI has priority over a conflicting filing that would have been superior under the first-to-file-or-perfect rule. In other words, just because you have a PMSI, does not mean you have priority. Similarly, complying with the priority rules in §9-324 will do you no good unless you actually have a PMSI. As the Mad Hatter has said, “Why, you might just as well say that ‘I see what I eat’ is the same thing as ‘I eat what I see!’”
At first glance, the code section establishing “what” is a purchase money security interest seems much like the literary nonsense our dear Alice encountered in Wonderland. Article 9 actually says: (1) a security interest “in goods is a purchase money security interest to the extent the goods are purchase money collateral with respect to that security interest;”6 (2) the goods are “purchase money collateral” if they secure “a purchase money obligation incurred with respect to that collateral;”7 and (3) a “purchase money obligation” is “an obligation of an obligor incurred as all or part of the price of the collateral or for value given to enable the debtor to acquire rights in or use of the collateral if the value is in fact so used.”8

Parsing through this provision carefully makes it very clear that a PMSI is a security interest in collateral to the extent it secures an obligation that enabled the debtor to acquire that collateral. The Official Comments to this section refer to a “nexus,” stating that “[t]he concept of a ‘purchase money security interest’ requires a close nexus between the acquisition of collateral and the secured obligation.”9 Note that the burden of proving whether a security interest is, in fact, a PMSI is on the secured party claiming such status.10

Assuming a security interest is a PMSI, it is entitled to priority only to the extent provided in §9-324 of the UCC. As noted above, that requires the security interest to be “perfected” within a certain time (referred to in this edition of Dispatches from the Trenches as the “Applicable PMSI Period”). For equipment, the Applicable PMSI Period is when the debtor receives possession thereof or within 20 days thereafter. For inventory, the Applicable PMSI Period is when the debtor receives possession thereof.11 It is essential to understand that before a security interest can be “perfected,” it must first be enforceable against the debtor that is granting the security interest in the first place.12 This concept is often referred to as “attachment” under Article 9. For a security interest to attach, the following events must have occurred: (1) value must have been given by the secured party; (2) the debtor must have rights in the collateral;13 and (3) the secured party must have been granted a security interest in the collateral. If a financing statement is filed prior to attachment, “perfection” does not occur until the security interest actually attaches.14

The key point here is that, unlike the regular priority rules which specifically tie priority to the first to FILE OR perfect,15 super-priority is granted to a PMSI only if “perfected” within the Applicable PMSI Period. The result is that a secured party who prudently files a financing statement early during the diligence process (with proper authorization, of course), who makes sure to pay funds directly to the vendor (thereby establishing that the loan proceeds enabled the debtor to acquire the collateral), and who timely sends out any notices required in the event the collateral constitutes inventory, can still encounter potential problems if the security interest is not granted before expiration of the Applicable PMSI Period.

Methinks We’re in Wonderland

One creative argument that some purchase money lenders have made to address this risk is that the Applicable PMSI Period is measured based solely on when the debtor actually grants the purchase money lender a security interest in the collateral. This argument stems from the fact that, for inventory, the “purchase money security interest [must be] perfected when the debtor receives possession of the inventory” and, for equipment, “the purchase-money security interest [must be] perfected when the debtor receives possession of the collateral or within 20 days thereafter.”16

The term “debtor” is defined to be “a person having an interest, other than a security interest or other lien, in the collateral.”17 The term “collateral” means “the property subject to a security interest.”18 The key to this argument, and indeed the key which opens the door into Wonderland, is that you cannot have a “debtor” until you have “collateral,” and you cannot have “collateral” in the context of the PMSI priority rules until a security interest is granted. Therefore, you do not have to be “perfected” until the security interest is actually granted (with respect to inventory) or until up to 20 days thereafter (with respect to equipment).
The reader first hearing this argument may feel much like Alice when she first saw the floating grin of the Cheshire Cat, “Well! I’ve often seen a cat without a grin; but a grin without a cat! It’s the most curious thing I ever saw in my life!” If a given borrower possesses equipment for a year and then grants a lender a security interest, are people really arguing that the lender can obtain a super-priority security interest merely by filing within 20 days (one year and 20 days after the borrower’s possession)? Not really. Yes, people are arguing that the 20-day clock under §9-324 would not start ticking until the grant of the security interest (one year after the borrower’s possession). However, the priority rules under §9-324 would do the lender no good unless the security interest were actually a PMSI. With one exception (discussed below), it is difficult to imagine a situation where (1) a borrower has possession of goods for a year, and (2) its obligation to the lender can be viewed as “an obligation [incurred] for value given to enable the debtor to acquire rights in or use of the collateral” as required for the security interest to qualify as a PMSI.19

The exception, which is near and dear to the heart of readers in the equipment leasing and finance industry, is found in the Official Comments to §9-324:

“[One] issue concerning the time when ‘the debtor receives possession’ arises when a person acquires possession of goods under a transaction that is not governed by this article and then later agrees to buy the goods on secured credit. For example, a person may take possession of goods as lessee under a lease contract and then exercise an option to purchase the goods from the lessor on secured credit. Under §2A-307(1), creditors of the lessee generally take subject to the lease contract; filing a financing statement against the lessee is unnecessary to protect the lessor’s leasehold or residual interest. Once the lease is converted to a security interest, filing a financing statement is necessary to protect the seller’s (former lessor’s) security interest. Accordingly, the 20-day period in [this section] does not commence until the goods become ‘collateral’ (defined in §9-102), i.e., until they are subject to a security interest.”20

The above factual example is somewhat narrow in that the “debtor” was originally a lessee without any ownership interest in the leased equipment. It is only when the lease is converted to a secured financing and the lessor “retains a security interest” as part of the sale that the “debtor” obtains an ownership interest in the equipment and it constitutes collateral. However, the rationale which purports to support the result (that the 20-day period does not commence until the goods are subject to a security interest in favor of the purchase money lender because it is not until that time that “collateral” or a “debtor” come into existence) can have much broader applications.

Some practitioners may be sufficiently comfortable with the above reasoning to proceed full speed ahead with this argument in cases other than the financing of a purchase option under a true lease or rental agreement. Others (the author included) feel more uneasy. While the above interpretation can be fairly viewed as consistent with the statutory language and the above Official Comment, it can be unsettling for other reasons in other scenarios.

Consider, for example, the impact of hyper-technical use of the term “debtor” in other sections of Article 9. For example, §9-509 allows a potential lender to file a financing statement against a potential borrower prior to the borrower’s execution of a security agreement (sometimes called pre-filing). According to this section, pre-filing is permitted so long as the “debtor authorizes the filing in an authenticated record.”21 If the use of the term “debtor” in this section also requires a grant of a security interest (under the same reasoning set forth above with respect to §9-324), this section has no meaning — a person cannot, as a “debtor,” authorize you to pre-file since it is not a “debtor” until the grant of the security interest.

In addition, the theory that the Applicable PMSI Period is measured by when the debtor grants the purchase money lender a security interest can be viewed as inconsistent with the purpose of §9-324. After all, §9-324 is a “priority provision,” which is intended to address the rights between competing secured parties. Existing lenders, with prior filings covering the collateral, find themselves in a subordinate position in the event the purchase money lender perfects within the Applicable PMSI Period. The reason for the timing requirement is to protect the reliance interest of the existing lenders. The time period is shorter for inventory since it turns over more quickly and thus could impact existing lenders more dramatically. An interpretation that allows the perfection clock to start ticking only when the security interest is granted could lead to filings made after the time that filing would otherwise have been required, stretching time in a most Wonderland-like way. As the Mad Hatter says, “No wonder you’re late. Why, this watch is exactly two days slow.”

Also, it seems strange for a provision that is designed to protect existing lenders to measure the Applicable PMSI Period based on the grant of the security interest to the purchase money lender (something generally under the control of the purchase money lender and debtor but invisible to other secured parties). It makes more sense to focus on “possession” of the property, which is something that is usually easier for an existing lender to discern. Indeed, the Official Comments to Article 9 state, “normally, there will be no question of when the debtor receives possession of the collateral,” before addressing the rarer circumstances of: (1) a financed purchase option under a true lease noted above; and (2) when goods are delivered in stages and then assembled and tested at the debtor’s location.22

The argument that the Applicable PMSI Period is tied to, the grant of a security interest to the purchase money lender, also puts significantly more pressure on the “nexus” concept contained within the PMSI definition. Consider the example above where the borrower owned and possessed equipment for exactly one year before granting a lender a security interest. It would be only the failure to qualify as a PMSI that would prevent the lender from having priority since, if the lender had a PMSI, it would have had one year and 20 days to actually perfect it under this particular set of facts and the proposed interpretation of the statute.

The argument that one measures the Applicable PMSI Period based on when the purchase money lender has been granted a security interest has been raised in the courts many times. Not surprisingly, the results are quite mixed. In many cases where the courts have been persuaded by the argument, the factual situation is more like the financing of a purchase option under a true lease, in that the starting point of the time period appears to be tied to when the “debtor” actually acquired ownership of the collateral (including circumstances where the goods were provided “on approval” or when the security agreement was signed in connection with the sale of the goods).23 Some cases have, however, applied this concept outright irrespective of whether the debtor had an ownership in the goods at a much earlier date.24

On the other hand, many cases have completely rejected this argument.25 The reasoning of these cases is not always on point either. Many focus solely on the date the property is first “possessed” by the debtor. That approach clearly contradicts the example in the Official Comment which addressed the financing of a purchase option under a true lease.

The approach this author thinks yields the most appropriate results would be to focus on when the debtor has sufficient possession of the collateral that it can grant a security interest to the existing lender or the purchase money lender. The PMSI priority section, by its very nature, is designed to address conflicting liens between more than one secured party. In fact, the applicable provisions for both inventory and non-inventory state that “a perfected purchase-money security interest in [the applicable goods] has priority over a conflicting security interest in the same [applicable goods]” if certain PMSI priority rules are followed. In other words, the provision only applies if there is a conflicting lienholder. The fact that there is an existing lienholder means that it has been granted a security interest in the goods, thereby meaning that there is a “debtor” and there is “collateral.” Nothing in the statute requires one to look solely from the perspective of the purchase money lender. After all, §9-324 affects both the purchase money lender and the existing lender — what it gives to one, it takes from the other.

Looking at this issue from the perspective of the existing lienholder is also consistent with the Official Comment, which addressed the financing of a purchase option under a true lease and the other cases that focus on when the “debtor” actually acquires ownership of the collateral. After all, until the debtor owns the goods, it cannot have granted a security interest in them to either the existing lender or the purchase money lender (and the goods therefore cannot be collateral).26

Regardless of which way you lean, one thing is clear: there is room here for vigorous debate. A secured party who argues that the Applicable PMSI Period for super-priority is tied to the date upon which it is granted the security interest may win some of its battles. However, it is by no means a fail-safe argument and, as Alice would say: “[i]f you drink much from a bottle marked ‘poison’ it is almost certain to disagree with you, sooner or later.”

Kenneth P. Weinberg is a shareholder at Baker, Donelson, Bearman, Caldwell & Berkowitz and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.

Footnotes:

1. UCC §9-322, Official Comment No. 4, Example 1.
2. UCC §9-324(f).
3. UCC §9-103(a)(2).
4. UCC §9-324(a).
5. UCC §9-324(b).
6. UCC §9-103(b)(1).
7. UCC §9-103(a)(1).
8. UCC §9-103(a)(2).
9. UCC §9-103, Official Comment 3.
10. UCC §9-103(g).
11. Remember, there are other requirements for purchase money priority in inventory as well (most noticeably providing notice to the holders of conflict security interest within five years before the debtor receives possession).
12. UCC §9-308(a): “[A] security interest is perfected if it has attached and all of the applicable requirements for perfection … have been satisfied.” (emphasis added”); See also UCC §9-322, Official Comment 4 (“Perfection” refers to the acquisition of a perfected security interest, i.e., one that has attached and to which any required perfection step has been taken.”)
13. UCC §9-203.
14. This concept is well established in both statute and case law interpretation. See UCC §9-308(a) (“A security interest is perfected when it attaches if the applicable requirements are satisfied before the security interest attaches.”) See also Owen v. McKesson & Robbins Drug Co., 349 F. Supp 1327 (5th Cir. 1973); In re Page, 6 U.C.C. Rep. Serv. 250 (Bankr. W.D. Ky. 1968); Albion Nat. Bank of Albion v. Farmers Co-op. Ass’n of St. Edward, 422 N.W.2d 86 (1988); In re United Thrift Stores, Inc., 424 F.Supp. 714 (3d. Circ. 1966); Taxas Oil & Gas Corp. v. U.S ., 466 F.2d 1040 (5th Cir. 1972).
15. UCC §9-322(a)(1).
16. UCC §9-324(a) and 9-324(b)(1), respectively (emphasis added).
17. UCC§9-102(a)(28)(A).
18. UCC§9-102(a)(12).
19. UCC §9-103(a)(2).
20. UCC §9-324, Official Comment No. 3.
21. UCC §9-509(a)(1).
22. UCC §9-324, Official Comment 3.
23. See e.g., Rainier Nat’l Bank v. Inland Mach. Co., 631 P.2d 389 (1981) (financing purchase option under true lease); Coastal Bank v. Douglas Asphalt Co. (In re Galbreath Clearing and Grading, Inc.), 258 B.R. 859 (Bankr. S.D. Ga. 2000) (goods previously possessed under short term rental); Commerce Union Bank v. John Deere Industrial Equipment Co., 387 So.2d 787 (Ala. 1980) (financing of purchase option under true lease); In re Prior Bros., Inc., 632 E2d 522 (1981) (goods possessed “on approval”); In re Hooks, 40 B.R 715 (Bankr. M.D. Ga. 1984) (goods delivered and “under inspection to see whether [the debtor] wanted to purchase them”); Ford Motor Credit Co. v. First State Bank, 674 S.W.2d 437 (Tex. App. 1984) (bill of sale not executed until security agreement was signed and loan funded even though goods possessed earlier); and In re Ultra Precision Industries, Inc., 503 F.2d 414 (9th Cir. 1974) (timing tied to execution of sales contracts).
24. See e.g. Brodie Hotel Supply, Inc. v. United States, 431 F.2d 1316, 1319 (9th Cir. 1970); In re Miller, 44 B.R 716 (Bankr. N.D. Ohio 1984); and Hunter v. McHenry (In re McHenry), 71 B.R. 60 (Bankr. N.D. Ohio 1987);
25. See e.g. In re Henning, 69 B.R. 348 (Bankr. N.D. Ill. 1987); North Platte State Bank v. Production Credit Association of North Platte, 200 N.W2d 1 (Neb. 1972); Mark Products U.S., Inc. v. InterFirst Bank Houston, N.A., 737 S.W2d 389 (Tex. App. 1987) (The Texas UCC does not make the semantic distinction urged by [the proposed purchase money lender]. “Collateral” is defined as “the property subject to a security interest….” A “debtor” is one “who owes payment or other performance of the obligation secured. …” However, the Texas UCC actually uses the term “collateral” not only to identify property subject to a security interest but also to identify property that ultimately becomes the subject of a security interest. Likewise, the Texas UCC actually uses “debtor” to refer to that person or entity that is obligated, or ultimately becomes obligated, to a creditor); In re Michaels, 156 B.R. 584 (Bankr. E. D. Wis. 1993) (court viewed the use of the terms “debtor” and “collateral” as “words of identification only” and “not used in the statute to fix the time within which the 20-day period for perfection is to commence.”) and NBD-Sandusky Bank v. Ritter, 446 N.W.2d 340 (Mich. Ct. App., 1989 (reversed on other grounds).
26. Of course, the debtor can grant a security interest to the existing lender in its leasehold interests under a true lease but that is not a security interest in the goods themselves (or any related software) — the collateral subject to the PMSI priority rules.

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