Unless a lender that provides a senior secured credit facility to a borrower has explicitly agreed to subordinate its security interest in collateral to another secured creditor, the lender expects (and requires) that its credit facility be secured by a first-priority security interest in all personal property of the borrower (i.e., all property other than real estate). This type of security interest is colloquially known as an “ABA” filing which is shorthand for “all business assets.” Such a security interest is also referred to as a “floating” lien, meaning that it is intended to cover not only personal property owned by the borrower at the time the security interest is granted, but also any personal property acquired by the borrower after the grant of the security interest. Some lenders are surprised to learn that there are scenarios by which another lender that provides a specific type of financing to the same borrower after the senior secured credit facility is put in place can nonetheless obtain a security interest that is senior in priority to the security interest of the senior secured lender in specific personal property of the borrower. This article will describe some of the basic rules applicable to so-called “purchase-money” financing and how senior lenders can address issues that purchase-money financing can create.
Senior Secured Credit Facilities and “All Assets” Liens
For a lender to obtain a security interest in all personal property of a borrower at the origination of a credit facility, the borrower executes a security agreement in favor of the new lender, by which the borrower grants to the lender a security interest in all its personal property. The lender can perfect its security interest in almost all the borrower’s personal property by filing a UCC-1 financing statement in the filing office applicable to the borrower that describes the collateral as “all assets” of the borrower or “all personal property” of the borrower or some other formulation of words signifying that the lender has a lien on all property of the borrower.[1] If the borrower has an existing secured credit facility with another lender at the time the new credit facility is originated, the new lender will require that the preexisting debt be paid off and any existing UCC-1 financing statements that name the borrower as debtor be terminated or, at a minimum, that any such existing secured lender subordinate its security interest to the new lender’s security interest.
Once these steps have been taken, one might think that’s the end of the story when it comes to which lender has superior rights in the borrower’s assets. The world is now on notice that the new lender has a “floating” security interest in all personal property of the borrower, even property acquired by the borrower after creation of the security interest. All other contenders either have been paid off and their liens terminated or have agreed to subordinate their liens to the liens of the new lender. Indeed, Section 9-322(a) of the Uniform Commercial Code (the “UCC”) reinforces this perception with the general rule that conflicting security interests in the same collateral rank according to priority in time of filing or perfection. In other words, the general rule of Section 9-322(a) is that the first secured party in time to perfect a security interest in collateral of a borrower will generally have priority against other secured parties that perfect a security interest in the same collateral later in time. As you will read below, there are exceptions to this rule.
[1] Note that the lender’s security interest in certain types of collateral can, and in some cases must, be perfected by means other than the filing of a UCC-1 financing statement (e.g., to perfect a security interest in a deposit account, the lender must “control” the deposit account).
Purchase-Money Security Interests
Properly perfected purchase-money security interests are an exception to the general “first in time, first in right” rule of Section 9-322(a) discussed above. To summarize Section 9-103 of the UCC, which contains the general definitions applicable to purchase-money security interests, a purchase-money security interest can be created in goods or software owned by a borrower (referred to as a “debtor” under the UCC) when a lender provides the borrower with financing for the sole purpose of purchasing specific goods or software and the borrower uses the loan proceeds for such purpose. A common example of this type of loan is equipment financing. Perfection of a purchase-money security interest is accomplished by all the normal perfection rules of the UCC, with a few caveats described below.
Goods Other Than Inventory and Livestock
Section 9-324(a) of the UCC provides that, subject to a few exceptions, a perfected purchase-money security interest in goods, other than inventory or livestock, has priority over a conflicting security interest in the same goods, and a perfected purchase-money security interest in the identifiable proceeds of such goods has priority over a conflicting security interest in the same proceeds, provided that the purchase-money security interest is perfected when the debtor receives possession of the goods or within twenty (20) days thereafter. The UCC defines “goods” as “all things that are movable when a security interest attaches” and “equipment” as “goods other than inventory, farm products, or consumer goods.” It should be noted that Article 9 of the UCC does not require a purchase-money lender that finances the purchase of goods, other than inventory or livestock, or the borrower for that matter, to notify the borrower’s existing senior secured lender of the purchase-money financing and resulting security interest.
To summarize, a purchase-money lender can obtain a security interest in certain goods (including equipment) acquired by a borrower with financing provided by the purchase-money lender that has priority over a prior existing floating “all assets” lien of a senior secured lender, provided that the purchase-money lender properly perfects its security interest within the time frame required by Section 9-324(a). This is true even if the purchase-money lender is aware of the senior lender’s prior “all assets” UCC-1 financing statement filing. Obtaining a purchase-money security interest in inventory, however, is a bit different, as discussed below.
Inventory
A purchase-money lender that seeks to obtain a first-priority security interest in inventory of a debtor, as opposed to other types of goods, is required to take a few additional steps that are protective of a senior lender that has properly perfected a security interest in the debtor’s inventory. Pursuant to Section 9-324(b) of the UCC, for a purchase-money security interest in inventory to obtain priority over a preexisting security interest in inventory (e.g., in our scenario, the senior secured lender with the floating “all assets” security interest):
- the purchase-money security interest must be perfected when the debtor receives possession of the inventory,
- the lender seeking the purchase-money security interest must send a written notification to the holder of the conflicting security interest,
- the holder of the preexisting security interest must receive the notification within five (5) years before the debtor receives possession of the inventory, and
- the written notification must state that the person sending the notice has or expects to acquire a purchase-money security interest in inventory of the debtor and describe the inventory.
The notice requirement above applies only if the preexisting security interest is represented by a financing statement covering the same type of inventory that was properly filed before the filing of the purchase-money UCC-1 financing statement.
Practical Considerations for Senior Lenders
We often encounter questions regarding purchase-money security interests when amending existing senior secured credit facilities for our lender clients. The issue can arise when, as part of normal due diligence, a UCC search for the borrower reveals that the borrower has incurred debt to another lender and secured that debt by granting a security interest to the other lender, which the other lender has perfected by filing a UCC-1 financing statement covering specific equipment, inventory, or other goods, or a blanket lien covering goods financed by the lender.
Credit agreements for senior secured credit facilities typically contain limitations on a borrower’s ability to incur other debt or create liens on its property, therefore, the first step is to revisit the underlying loan or credit agreement to determine whether the incurrence of the debt or the creation of the lien constitutes a default by the borrower. Savvy borrowers sometimes negotiate carveouts to the debt and lien covenants in their credit agreements that permit them to incur a certain amount of other debt and liens. These are often referred to as “Permitted Liens” or “Permitted Indebtedness” in credit agreements.
If there are no applicable carveouts in the credit agreement, the senior lender may be surprised to learn that, not only has the borrower breached the terms of its credit agreement, but as a result, the senior lender’s security interest in the specific goods that were the subject of the purchase-money financing is now a subordinate security interest. The senior lender must then determine how to address the breach, whether through a waiver or an amendment to permit a certain amount of other debt or specific liens. In any event, what may have started out as a simple amendment or extension of a credit facility can sometimes turn into something more substantive when other security interests are discovered through due diligence.
It should be noted that whether a purchase-money security interest was properly perfected, and therefore, takes priority over the senior lender’s security interest, often is a question of fact,e.g., was the purchase-money lender’s UCC-1 financing statement filed prior to the debtor obtaining possession of the collateral or within twenty (20) days thereafter? Typically, counsel for the senior lender will not have access to all the facts necessary to know the answer. Furthermore, given that the UCC does not require that UCC-1 financing statements provide information regarding the amount of debt that they secure, counsel for the senior lender also will not necessarily know whether creation of the security interest violates the borrower’s covenants if there are thresholds, carve-outs, or baskets in the credit agreement that allow the borrower to incur a certain amount of purchase-money debt and related liens. The practical result is that the senior lender must now follow up with the borrower to gather more information regarding the other debts evidenced by the UCC filings to determine how to address the issue.
Purchase-money security interests are a quirk of Article 9 of the UCC that generally run counter to the general “first in time, first in right” concepts that many non-attorneys think apply to all secured lending. Lenders should work with knowledgeable and experienced counsel to analyze the issues presented by purchase-money security interests and craft their credit agreements accordingly to address these issues.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances. In addition, the firm undertakes no obligation to update the information discussed in the foregoing article.
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