This post is also available in: Chinese (Simplified)

By: Kun Zhao, Esq.

In international trade, suppliers of goods often sell on credit to their customers, facing credit risks especially when the customers are experiencing financial difficulties in this economy. Sellers have growing concerns when their customers start to delay payments or even stop payments. How to recover something from the defaulting customer to mitigate the loss is a frequently asked question. The reality is that the delay or failure to pay is often due to the customer’s financial difficulties or even insolvency. If the financially distressed customer files bankruptcy, the seller will probably not receive a recovery, as the customer’s primary lenders normally have earlier-filed security interest in the customer’s assets, including the goods, and therefore have priority in recovery over the seller.

There is a relatively simple protection device that Chinese suppliers have rarely used, called the Purchase Money Security Interest under the Uniform Commercial Code (“UCC”) Article 9 (“PMSI”), which to some extent affords a certain level of protection in securing the seller’s interest in the goods to mitigate the loss if the customer defaults. In some common cases, it could provide Chinese suppliers with superior recovery rights in the goods themselves or the identifiable proceeds from the goods when the customer is insolvent or files bankruptcy. This device is widely used in the sale of large equipment or in a series of sales of goods in inventory for further manufacturing or resale.

A PMSI under UCC §9-103 is defined as a security interest in goods that are taken in collateral to the extent that it secures all or part of the purchase price of the collateral (the goods). In the sale of goods scenario, it is a security interest in collateral created by a seller who secures the obligation to pay the purchase price of goods sold on credit to a customer. A properly perfected PMSI gives the seller of goods on credit with “super priority” in the goods and the identifiable cash proceeds from the goods, trumping other creditors who have a conflicting security interest in the same goods, including those who have earlier-filed security interest in the customer’s assets and inventory in general.

New Jersey and New York have adopted the UCC. The UCC rules for acquiring a PMSI are set out in UCC §9-324. To achieve priority over an earlier-filed security interest in the same goods, the seller and its customer must:

(1)        execute a security agreement, which can be part of the sales agreement. The collateral in the security agreement must relate only to the goods that will be sold to the customer in the future;

(2)        the PMSI must be perfected by filing the appropriate financing statements with the secretary of state or other filing agency in the state where the customer is legally organized when the debtor receives possession of the collateral. In other words, the seller must file the financing statement before the goods are delivered;

(3)        the seller must give written notice to the holder of the conflicting security interest if the holder of that conflicting security interest has filed a financing statement. Any earlier-filed conflicting security interest holder can be found through a UCC filing search at the filing agency in the state;

(4)        This notice must be received by the holder of the other security interest before the debtor receives possession of the purchase-money collateral (the goods), and is valid for a period of five years;

(5)        the notification must state that the person giving the notice has or expects to acquire a purchase money security interest in inventory of the debtor, describing such inventory by item or type.

If sellers have taken proper steps above, they will have priority over earlier, normally superior, security interests that cover the same goods. Sellers will have additional remedies in collecting their receivables, or will have priority to retrieve and resell goods sold on credit for which the customers failed to pay.

Therefore, the PMSI is a valuable tool to help Chinese suppliers in managing credit risks in international trade. It affords Chinese suppliers security rights senior to their customers’ lenders in the goods sold on credit and gives them a better chance to recover at least something rather than nothing.