Dealing with a client in financial difficulty requires both vigilance and creativity. Vigilance is essential, as close monitoring of a customer’s payment history and overall financial position will indicate whether a supplier needs to take additional steps to protect themselves. Creativity comes into play in deciding what kinds of protections are possible and appropriate in a given situation. All of this is especially important if the U.S. economy is slowing and financial hardship becomes more common for more businesses. The Uniform Commercial Code (UCC) offers certain protections against creditors that can significantly affect a seller’s chances of full recovery. Purchase Money Collateral (PMSI) can allow a lender to advance on a seller’s first priority lien rights. In addition, recovering the goods can allow a seller to reduce their exposure.
When it comes to maximizing debt collection, is it better to have a secured debt than an unsecured debt. That is, creditors are much better off if they have a validly perfect first priority lien on a security of value. A seller selling on credit to a customer (also called a debtor) is well advised to consider taking a lien on the debtor’s assets to secure payment. Such a seller could consider himself fully protected by obtaining a general lien on the assets of a debtor through the execution of a collateral agreement and the proper filing of a UCC financing statement. In many situations, such a seller will take precedence over the debtor’s collateral in the event that it becomes necessary to seize the collateral from the seller or in the event that the debtor goes bankrupt and more than one party claims the collateral. However, sellers and other parties asserting liens on a debtor’s collateral should be aware that UCC Article 9 provides a mechanism for a third party lender to obtain first lien rights over the collateral. purchased by the debtor as a purchase obligation.
UCC Article 9-103 (a) (2) defines a “purchase money obligation” as an obligation that has been “incurred as part or all of the price of the collateral”. Section 9-103 (1) limits PMSI to goods and certain types of software. PMSIs allow a debtor to borrow the purchase price of an asset from a lender, while using the asset as collateral for the loan. PMSIs are beneficial for debtors because they allow the purchase of goods without the debtor using valuable money. A properly implemented PMSI gives the lender a first priority lien on the collateral purchased, notwithstanding any liens previously set up by other parties (i.e. non-PMSI). A lender seeking PMSI protection must ensure that the transaction complies with the terms of the UCC. For example, UCC requires that the money provided by the lender actually be used to purchase the particular collateral. Lenders often ensure this element is met by making payment directly to the seller of the collateral. To obtain a first priority PMSI, the lender must also perfect its lien rights on the collateral. The appropriate perfection of the lien depends on the type of collateral. In the case of inventory and livestock, a PMSI lender must file a UCC funding statement, but must also send a “certified notice” to other parties asserting a lien on the inventory or livestock. As with most other types of collateral, a PMSI lender only needs to file a UCC funding statement within twenty days of the debtor taking possession of the collateral.
Sellers with lien rights who graciously assume their UCC funding statements provide them with all the protection they need may later find that PMSI lenders are first priority 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 lien holders, such notice is not required for other types of collateral. Sellers taking a lien on a debtor’s property should consider making efforts to ensure that they retain their first position, including by contractually requiring the debtor to notify the seller of any PMSI. These providers should also periodically review filed UCC financing statements to determine whether another party has asserted PMSI’s rights to a debtor’s security.
In addition to lien rights, UCC provides another mechanism for sellers to protect themselves. UCC Article 2-702 allows a seller, in certain circumstances, to “recover” goods previously shipped to a debtor. When the goods are purchased on credit by an insolvent debtor, the seller may claim the goods upon request made by the seller within ten days of receipt of such goods by the debtor. In particular, if the debtor made a false declaration to the seller that he was solvent in the three months preceding the delivery of the goods, the ten-day limitation period does not apply. Reclamation rights are a powerful tool in enabling a seller to “recover” valuable goods and thus limit the seller’s exposure. These rights are, however, subject to a number of limitations. First, UCC provides that reclamation rights are subject to the duties of the ordinary course or of the bona fide purchasers of the goods. Second, in the event of a debtor’s bankruptcy, the Bankruptcy Code makes it clear that the rights of reclamation are subject to the rights of lien holders over property. In other words, the rights of reclamation have value in bankruptcy only to the extent that there is no properly established lien on the goods.
PMSI and claim rights are by no means the only rights under UCC that may affect (positively or negatively) a supplier’s claim and its ability to recover. But, the assertion of such rights is relatively common in commercial transactions, especially transactions involving debtors in financial difficulty. Sellers who wish to maximize their chances of recovery are well advised to have a general level of familiarity with these provisions of Section 2 and Section 9 of the UCC.