What is a purchase money security interest (PMSI)?

Why the rule exists

Most senior loans to a business are secured by a blanket lien: a security interest in all its assets, now owned and acquired later. Under the ordinary Article 9 rule, the first lender to file a UCC-1 financing statement ranks first. Left alone, that rule would mean every machine the business ever bought would land under the bank's lien first, and no equipment lender would finance it.

The purchase money rule fixes that. A lender whose money actually paid for a specific asset can take first priority in that asset, ahead of the earlier blanket lien, because without its money the asset would not be there at all. The bank is no worse off than before the purchase: it never lent against the new machine, and it keeps a second lien behind the equipment lender, plus whatever equity builds as the equipment loan is paid down.

Two kinds of creditor qualify. A seller who sells on credit and keeps a lien for the unpaid price has one. So does an enabling lender, one that advances money to let the business acquire the asset, but only if the money is in fact used to buy it. A loan paid to the business's general account and later spent on a machine may not qualify; a loan wired to the equipment dealer against the invoice does. That is why equipment lenders pay the vendor directly.

The requirements: equipment and inventory are different

Article 9 sets stricter rules for inventory than for equipment, because inventory is exactly what a receivables and inventory lender is counting on. The rules below are the Uniform Commercial Code as states have generally adopted it; the lender's counsel checks the state where the business is organized.

The inventory notice has a practical purpose. An asset-based lender advances against eligible inventory every week. Once it receives notice that a supplier or finance company will hold first priority on some of that inventory, it can exclude those goods from the borrowing base before it lends against them. That is the bargain: the earlier lender gets warning, and the purchase money lender gets priority. A supplier that skips the notice loses its priority to the earlier lender, which is the classic way an inventory purchase money claim fails.

The proceeds rule matters for the same reason. When inventory is sold on credit, it turns into a receivable. The purchase money lender's priority generally does not follow the goods into those receivables; the receivables lender keeps them. A supplier or floor plan lender that wants to be paid from the sale has to arrange that separately, usually by an intercreditor agreement.

A worked example

A fabrication shop has a revolver and term loan from its bank, secured by a blanket lien filed years ago. It buys a laser cutter for 500, putting in 50 of its own money and borrowing 450 from an equipment lender that pays the dealer directly.

Had the equipment lender filed on day 25, the bank's earlier filing would rank first on the cutter, and the equipment lender would be second on its own collateral. Deadlines in purchase money lending are not administrative details; they decide who gets paid.

Purchase money priority attaches to the asset financed and nothing else. It does not make the rest of the business the equipment lender's collateral.

How it interacts with the senior lender

Winning the priority contest does not mean the senior lender has agreed to the deal. Two separate questions apply.

• Lien law. Article 9 decides who ranks first on the equipment. A properly perfected purchase money interest wins, whatever the senior lender thinks.
• The loan agreement. The senior credit agreement's negative covenants limit new debt and new liens. Most carve out purchase money debt and capital leases up to a set amount, a basket, and only for liens that cover nothing but the asset financed. Borrowing beyond the basket, or letting the equipment lender take a lien on anything else, is a covenant breach and can trigger an event of default and cross-defaults, even though the new lender's priority is perfectly valid.

So the working sequence is: check the basket, tell the senior lender, and if the purchase is larger than the basket, get a consent or amendment before signing. On an asset-based facility, also expect the equipment component or the inventory that the new lender now ranks first on to come out of availability. Equipment financing alongside senior debt covers how the baskets are sized and how the new debt counts toward the leverage covenants.

Where a single lender provides both the senior loan and the equipment financing, none of this arises. Where the equipment lender wants more than the asset it financed, such as a lien on receivables as additional support, it is no longer purely purchase money lending, and the two lenders need an intercreditor agreement or a subordination agreement to set priority.

Leases, vendors and refinancings

Leases. A lease with a nominal buyout at the end is treated as a sale with a security interest, so the lessor is a purchase money secured party and must file on time like any other. A true lease, such as a fair market value lease, leaves ownership with the lessor, so the equipment was never the business's collateral to begin with; lessors often file a precautionary UCC-1 anyway, to put other lenders on notice. See FMV vs dollar buyout leases.

Vendor credit. A supplier selling equipment on terms, or a manufacturer's finance program, can hold a purchase money interest just as a lender can, provided it files in time.

Mixed-purpose loans. A loan that pays for a new machine and also refinances other debt is purchase money only to the extent of the purchase price. The priority covers that portion; the rest ranks by ordinary filing order.

Refinancing. When a business refinances its whole capital structure, existing purchase money lenders are usually paid off from proceeds, each providing a payoff letter and a UCC-3 termination, so the new lender takes a clean first lien. If an equipment loan is staying in place, the new senior lender will want it inside its permitted debt and will want its lien limited to the equipment it financed. See refinancing equipment loans.

What this means for a borrower

• Read your senior loan agreement's permitted debt and permitted lien sections before ordering equipment on credit.
• Keep a running tally of purchase money debt and capital leases against the basket; small leases add up.
• Make sure each equipment lender's UCC-1 describes only the equipment it financed. A filing covering all assets from an equipment lender will show up on the next lender's lien search as a competing blanket lien and slow the next financing.
• Keep equipment loans on your debt schedule with the collateral each one covers, so a new lender can see at a glance which assets are already spoken for.

A lender reviewing a business with several equipment lenders will pull a lien search and match each filing to a loan on the debt schedule. A clean match, each lender on its own machines, keeps a refinancing simple. Transparent's book holds 244 lenders writing equipment finance; which of them will sit alongside a given senior lender, and on what terms, is one of the things settled before a package goes out.