Protecting accounts receivable for inventory sold under the UCC

In the current economic climate, sellers are increasingly seeing their sales on credit for what they are - a gamble on the buyer’s creditworthiness. If the buyer doesn’t pay its invoice, what rights does the seller have against the buyer? How do the seller’s rights compare to those of competing creditors? If there’s not enough money to pay everyone, does seller still get paid?

The Uniform Commercial Code (UCC) dictates the answers to these questions and the answer frequently depends on what steps the seller has or has not taken BEFORE the sale to protect its interests.

The UCC gives special treatment to sales of consumer goods. If the buyer is the end user of the product (the consumer), will not be reselling the product and is using it primarily for personal, family or household purposes, then a seller whose agreement with the buyer on credit (the store credit card agreement, for example) provides for a security interest in goods sold but not yet paid for, obtains an automatically perfected priority lien on the sold merchandise. No steps are required for perfection and seller’s claim to the merchandise will generally trump those of other creditors.

If, however, the goods sold constitute “inventory” in the hands of the buyer, meaning generally that they will be reselling them or will be using them in their business, then perfection is no longer automatic and affirmative steps must be taken to protect a seller’s rights if the buyer fails to pay for the goods purchased.

First, you need to be certain that your sale documents (e.g. purchase orders) contain effective language granting you a security interest in the items sold until such items are paid in full. In UCC terms this effects the “grant” of your security interest and gives you rights in the items sold as against your buyer/debtor. This does not, however, confer “perfection” of the security interest, which determines your priority among competing creditors.

In many if not most cases, you will likely be selling your products to a buyer who already has some form of general corporate financing in place, which financing is typically secured by a “blanket” lien on all assets of the debtor. That means that once you sell your products to buyer/debtor, buyer’s bank will get a lien in those assets in addition to yours. So whose lien comes first?

The answer under the UCC is that the bank’s lien on inventory will trump or prime your lien on your products sold to buyer unless you (1) file a UCC financing statement against the buyer with respect to your products sold BEFORE you sell the products to them AND (2) notify the competing bank creditor of your impending lien BEFORE you sell the products. These steps will allow your lien in products sold by you to your buyer to prime the bank or other inventory lender’s lien.

The burden of both filing the UCC and providing prior notice to an inventory lender before making a sale, as a practical matter, dictates that most sellers will pick and choose which sales and which buyers warrant this level of protection. In most cases, you, as seller, will not know if your buyer has an inventory lender or the identity of that lender, so a UCC search will need to be conducted first, an additional administrative burden. Nevertheless, for large sales and/or for buyers whose creditworthiness may be suspect (a growing group of buyers in these troubled economic times), extra diligence and action may be warranted.

- Jackie Camp