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Your customer is slow to pay, but still wants to buy on credit. His assets are subject to a blanket lien held by his financier. He appears to be on shaky financial ground. But if he can’t buy inventory, he won’t be able to pay your overdue invoices. Do you cut him off and risk not getting paid or do you ship to him and hope he doesn’t end up in bankruptcy? As a vendor, a service center can have its cake and eat it too with a properly prepared and perfected purchase money security interest or PMSI.

A PMSI is a type of security interest in property that allows a vendor who provides a customer with credit for the purchase of inventory to hold a priority lien in the inventory ahead of other secured creditors. Not only does a PMSI allow the vendor to “cut to the front of the line,” but under the correct circumstances it permits the vendor to assert a lien interest in the identifiable proceeds of the inventory. As a result, the vendor is converted from an unsecured to a secured creditor.

The uniform commercial code governs PMSIs, and state law determines what transactions qualify for PMSI treatment. To qualify, a vendor must provide value to a customer that enables the customer to acquire rights in or the use of the inventory—for example, shipping on credit. To obtain the priming lien that is the key to a PMSI, the vendor must first execute an agreement with the customer that grants the vendor a security interest in the inventory. Next, the vendor must ensure that the PMSI is “perfected” by filing a UCC-1 form in accordance with state law. The vendor must also provide authenticated notice of its PMSI and a description of the inventory to any parties holding conflicting security interests, such as the customer’s financier. If done properly, this notice continues to be valid for five years if the vendor continues to ship inventory to the customer. Finally, all of these requirements must be completed before the inventory is delivered to the customer.

While the requirements of a PMSI may seem burdensome, the results are worth it for a vendor whose client becomes insolvent. If the customer defaults on payment but still has the inventory, the vendor can seek to recover the inventory. If the inventory has been sold, the vendor has a priority lien in the chattel paper (ex., title papers) or an instrument (ex., a check or a bond) that are the proceeds of the sale.

Enforcing a PMSI in cash proceeds is trickier and requires more care on the part of the vendor. A PMSI in inventory does provide a security interest in its cash proceeds. But the security interest is limited to the identifiable cash proceeds and only to the extent they were received before or when the inventory was delivered to the buyer. The PMSI does not extend to cash deposited into an account that is subject to a blanket lien. Therefore, it is strongly recommended that a vendor obtain the cash proceeds before they are comingled with other funds or placed into an account. If they are, then the cash proceeds are subject to any prior security interest in the account and may require a tracing analysis in order to make them “identifiable” for collection.

Finally, a vendor should consider using other creditor protection techniques along with the PMSI to maximize its protections. For example, a vendor can require a customer to segregate the vendor’s inventory from other inventory. This enables the vendor to quickly and easily identify its collateral. Likewise, a vendor can require a customer to track its inventory and sales by supplier, so that any inventory subject to a PMSI can be identified for collection purposes. A vendor may also require that any payments resulting from the sale of the identified inventory be made directly to the vendor. A vendor may also take a blanket security interest in the customer’s other inventory at the same time it secures its PMSI. Finally, a vendor may negotiate an intercreditor agreement with the customer’s other lien holders; such an agreement would provide the vendor with protection in the event of a dispute over ownership of collateral or proceeds.