Uniform Commercial Code Protections Affecting Vendor Claims: Purchase Money Security Interests and Reclamation

Dealing with a financially distressed customer requires both vigilance and creativity.  Vigilance is critical because closely monitoring a customer’s payment history and overall financial situation will signal whether a vendor should take additional actions to protect itself.  Creativity comes into play in deciding what sort of protections are possible and appropriate in a given situation.  This is all especially important if the U.S. economy takes a downturn and financial distress becomes more common for more companies.  The Uniform Commercial Code (the UCC) provides certain creditor protections that can dramatically change a vendor’s chances at full recovery.  Purchase money security interests (PMSIs) can allow a lender to jump ahead of a vendor’s otherwise first priority lien rights.  In addition, reclamation of goods may allow a vendor to curtail its exposure.  

When it comes to maximizing claim recovery, is it is better to have a secured claim than an unsecured claim.  That is, creditors are much better off if they have a first-priority, validly perfected lien on valuable collateral.  A vendor selling on credit to a customer (also known as a debtor) is well advised to consider taking a lien on the debtor’s assets to secure payment.  Such a vendor might consider itself fully protected by obtaining a blanket lien on the assets of a debtor via the execution of a security agreement and the proper filing of a UCC financing statement.  In many situations, such a vendor will have first priority over the debtor’s collateral in the event it becomes necessary to foreclose on the vendor’s security interest or in the event the debtor files bankruptcy and multiple parties assert claims against the collateral.  However, vendors and other parties asserting liens on a debtor’s collateral should be aware that Article 9 of the UCC provides a mechanism for a third party lender to obtain senior lien rights on collateral purchased by the debtor as a purchase money obligation.

UCC section 9-103(a)(2) defines a “purchase money obligation” as an obligation that was “incurred as all or part of the price of the collateral.”  Section 9-103(1) limits PMSIs to goods and certain types of software.  PMSIs allow a debtor to borrow the purchase price of a good from a lender, while at the same time using the good as collateral for the loan.  PMSIs are beneficial to debtors because they allow for the purchase of goods without the debtor using precious cash.  A properly perfected PMSI provides the lender with a first priority lien on the purchased collateral, notwithstanding previously perfected liens by other (i.e., non-PMSI) parties.  A lender seeking PMSI protection must ensure that the transaction qualifies under the terms of the UCC.  For example, the UCC requires that the money provided by the lender must, in fact, be used to purchase the particular collateral.  Lenders frequently ensure this element is met by making the payment directly to the seller of the collateral.  To obtain a first priority PMSI, the lender must also perfect its lien rights in the collateral.  Proper lien perfection depends on the type of collateral.  In the case of inventory and livestock, a PMSI lender must file a UCC financing statement, but must also send an “authenticated notice” to other parties asserting a lien in the inventory or livestock.  As to most other types of collateral, a PMSI lender need only file a UCC financing statement within twenty days of the debtor taking possession of the collateral.

Vendors with lien rights who complacently assume that their UCC financing statements provide them all the protection they need may later find that PMSI lenders are in the first priority position on some of the debtor’s most valuable assets.  Again, while PMSIs in inventory and livestock require the PMSI lender to provide notice to other lienholders, such notice is not required for other types of collateral.  Vendors taking a lien in a debtor’s property should consider taking efforts to ensure they maintain their first position including contractually obligating the debtor to notify the vendor of any PMSIs.  Such vendors should also periodically review filed UCC financing statements to determine whether any other party has asserted PMSI rights over a debtor’s collateral.

In addition to lien rights, the UCC provides another mechanism for vendors to protect themselves.  UCC section 2-702 allows a vendor, under certain circumstances, to “reclaim” goods previously shipped to a debtor.  Where the goods are purchased on credit by an insolvent debtor, the vendor may reclaim the goods upon demand made by the vendor within ten days after the debtor’s receipt of such goods.  Notably, if the debtor misrepresented to the vendor that it was solvent within three months prior to the delivery of the goods, the ten day demand limitation does not apply.  Reclamation rights are a powerful tool to allow a vendor to “snatch back” valuable goods and thus limit the vendor’s exposure.  Such rights, however, are subject to a number of limitations.  First, the UCC provides that reclamation rights are subject to the rights of ordinary course or good faith purchasers of the goods.  Second, in the event the debtor files bankruptcy, the Bankruptcy Code makes clear that reclamation rights are subject to the rights of lienholders in the goods.  In other words, reclamation rights are only valuable in bankruptcy to the extent there is not a properly perfected lien in the goods.  

PMSIs and reclamation rights are by no means the only rights under the UCC that can affect (either positively or negatively) a vendor’s claim and its ability to recover.  But, the assertion of such rights are relatively common in commercial transactions, especially transactions involving financially distressed debtors.  Vendors who wish to maximize their recovery chances are well advised to have a general level of familiarity with these provisions of Article 2 and Article 9 of the UCC.