How can a purchase-money lender get priority over a senior lender’s all-assets lien?

Commercial borrowers usually assume a senior lender has the best priority claim on everything on their shop floor. Most of the time, that’s true. A bank lender may be your biggest creditor and have the first lien on all of your personal property, or everything but your real estate. It filed that lien as an “ABA,” (all business assets) that is a floating lien that applies to everything you own now and in the future. But a new lender coming along to loan the money on specific property can get a priority over the senior lender in that property, even though everyone assumes that the senior lender has first dibs on everything. Seniority means who gets their hands on the collateral first in case you don’t pay off the loan.

Your senior lender does a few things at closing that get it a first lien on virtually all your personal property, or on everything but your real estate. First, you sign the security agreement that grants the lender a lien on all your personal property or on everything but your real estate. Next, it files a UCC-1 that says either “all assets” or “all personal property.” That perfects a lien on virtually every kind of personal property. As your stuff comes and goes, it stays attached to the inventory and equipment you already have when you take out the loan, and attaches to whatever you buy afterwards. All existing secured debt was paid off at closing and old UCC-1s terminated, or the old lender subordinated to the new one.

It’s not hard to understand why lenders and owners would think the order’s fixed and the arrangement is carved in stone once the bank files. It seems like that should be the case, but it’s not a complete picture. So it seems the senior lender has a claim of first dibs on everything in the store, right? That is generally the case. Everyone takes notice from the filing; Uniform Commercial Code 9-322(a): Whoever files or perfects first generally wins. However there are exceptions.

(Note: a filing of a UCC-1 does not actually perfect a lien on every type of collateral: some must be perfected another way, e.g. deposit accounts must be under lender control to be perfected.)

New PMSI in Principal Collateral Is a Prior Lien

Suppose some new lender is making a loan on a piece of equipment, a tractor, in particular. Not on everything else. How’s the new lender get a priority over the old one, which still has that blanket lien on (presumably) everything? Well. This new loan on a tractor is what’s called a PMSI: the “purchase-money security interest.” The purchase money security interest, or PMSI, is an interest in goods or software. So, with equipment financing, you borrowed to buy the machine and used the loan for that. The loan is said to have been used to pay for the collateral (the equipment) (see UCC 9-103). (UCC calls borrower the debtor.) A PMSI is perfected the same way, with usual caveats.

(Note: for purposes of this post the term “principal collateral” means collateral is not inventory or livestock; e.g. an excavator.) Under Section 9-324(a), the new PMSI in principal collateral is a prior lien to the other one, provided that it is perfected at the time the borrower takes possession or within 20 days after. Basically, the new PMSI beats a contending interest in the equipment (excavator), and “goods” are defined as movables. Nobody needs to send the senior lender a notice to let the senior lender know what’s going on. So what? The lender who loans the money on the excavator in your shop gets a superior lien on the excavator, even though the blanket lender filed first, and can take first dibs on the piece of equipment, without your bank even taking notice of it.

Although the new lender knows about the senior lender’s UCC-1, a timely perfected PMSI in principal collateral beats the floating lien. It works like an exception to “first come, first serve” or “first to file, first to perfect.” The equipment lender knows about the bank’s all-assets filing before the time of the deal. Does that help the bank? No. Knowing is not the test; perfecting the lien at the right time is the test. PMSI on inventory is different.

PMSI in Inventory

This exception works great, at least for deals that involve principal collateral (not inventory) - lenders can finance equipment and rely on the PMSI exception to beat out the earlier floating lender. A lender seeking first priority in inventory (the collateral) through a PMSI needs to take additional steps to protect the lender perfected before, here the “senior lender” that perfected in everything at the outset. UCC 9-324(b) sets these out.

The four conditions:

• The PMSI in inventory is perfected by the time the debtor receives the collateral.
• The new PMSI lender sends written notice to the earlier lender (the one with the floating lien).
• The earlier lender receives the notice within five years before the debtor receives the inventory (the collateral).
• The new lender’s notice must say the sender has or expects to have a PMSI in the inventory and describe the collateral (the inventory).

But the new PMSI lender only has to give notice to the earlier if the earlier has a properly filed statement concerning the same type of inventory and filed it before the PMSI filing. It basically looks like this: with a bank who took all assets with a UCC-1, the inventory lender must send that notice; the equipment lender need not.

A UCC Search Reveals a Previous Filing

A good diligence UCC search can turn up a UCC-1 filed by another lender with a lien on the equipment, or goods, or on a particular inventory item or class of inventory. Or their UCC-1 is a blanket lien on goods that the other lender financed. How this bites lenders in real life: the senior lender is about to extend you money, but when it does a UCC search, the senior lender finds out there’s another lender that filed a UCC-1 in equipment, inventory or goods. Now what?

A lender’s first step is to review the credit agreement. It typically limits extra debt and liens. Does the new debt cause a default? But sometimes borrower can incur fresh debt and that’s OK, because they negotiated carveouts, like Permitted Liens and Permitted Indebtedness. Before you finance equipment, look in your credit agreement for those carveouts and how much other debt they allow.

If there is no carveout then borrower has breached its contract, and, if the PMSI was properly perfected, the senior lender finds that it has a second priority on those goods. That’s bad. So now what? The two usual answers. One, the bank waives the default. Or, two, the senior lender agrees to amending the credit agreement to permit the new debt or lien. Once a UCC search reveals a previous filing, a routine deal can become a real negotiation.

Most times, the hardest part of the priority analysis is proving the facts. Whether the priority exception (e.g. the PMSI) is perfected before possession or within 20 days afterward is an issue of fact. A lawyer would not know that by just looking at the UCC search. In UCC-1s lenders generally do not state how much money is owed, so lawyer cannot usually tell, just by reading, if baskets or carve-outs are exceeded. Thus, a senior lender doesn’t know if another loan is fine. They don’t usually know the terms of the debtor’s other debt. So senior lender has to ask debtor. What this means for you as the debtor: once it comes time to do another loan or extend your loan with the senior lender, be prepared for it to ask about any other loans, and have papers on the financing of your equipment and inventory, and the filing and delivery dates of the inventory and the equipment, at hand.

At the end of the day, the “purchase money security interest” is a crazy exception to the rule that the first in time is first in line. A lender with a floating lien on either goods or collateral that someone’s financing should consult with counsel who understands the nuances of Article 9 and drafting credit agreements. So a purchase-money loan may outrank your bank in the thing it buys, but for you as a business owner short on cash, know that it can also put you in default with your bank.