Several good followup questions came up after class on Wednesday, Sept. 22 about the problems we discussed involving the definition of “purchase money obligation” in § R9-103.  After this discussion, it seemed like a memo was in order to review those problems and to elaborate in more detail about some of the “nuance” inherent in the way § R9-103 treats the purchase money lender rather than the purchase money seller.

The definition of “purchase money security interest”

Section R9-103 is a bit cumbersome, but you can work your way through it step-by-step:

•    Step 1:  Under § R9-103(b), a security interest in goods is a PMSI “to the extent that the goods are purchase-money collateral with respect to that security interest.”
•    Step 2:  Under § R9-103(a)(1), goods are “purchase-money collateral” if they secure a “purchase-money obligation” with respect to that collateral.
•    Step 3:  Under § R9-103(a)(2), an obligation is a “purchase-money obligation” if the obligor incurs that obligation
•    as “all or part of the purchase price of the collateral,” or
•    in exchange for value given to “enable the debtor to acquire rights in or the use of collateral, if the value is in fact so used.”
This means there are two types of purchase-money secured parties.  The first is the purchase-money seller who takes a security interest in the goods sold to secure the purchase price of the goods.  The goods sold are the “purchase-money collateral”; the obligation to pay for the goods is a “purchase-money obligation”; and thus the security interest in the goods is a PMSI.

The second type of purchase-money secured party is the purchase-money lender, who takes a security interest in certain goods in a transaction where the lender gives value that both enables the debtor to acquire rights in the goods and that is actually spent by the debtor to acquire those rights.  The goods are the “purchase-money collateral”; the obligation to repay the loan used by the debtor to acquire the goods is a “purchase-money obligation”; and thus the security interest in the goods is a PMSI.

Problems to demonstrate the application of this definition

Problem 1:  On June 30, Debtor decides to purchase a Model X saw from Seller.  The sale price is $50,000.  On July 1, Debtor borrows $50K from Bank to purchase the saw.  That same day, Debtor signs a security agreement granting Bank a security interest in the saw.  On July 2, Debtor
uses the $50K to meet its payroll expenses.  On July 3, Debtor is paid $50K for his services on a prior construction job.  On July 4, Debtor uses this $50,000 to purchase the saw.  Bank does NOT have a purchase-money security interest, because the obligation to repay Bank is not a
“purchase-money obligation” under § R9-103(a)(2).  Although the loan was intended to enable the Debtor to acquire the saw, the loan proceeds were not in fact used to pay for the saw.  Thus, although Bank has a security interest in the saw, it is not a PMSI.

Problem 2:  Same as problem 1, but instead of loaning the money to Debtor directly, Bank issues a check jointly payable to Debtor and Seller and delivers that check to Seller in payment of the price of the saw.  Bank has a PMSI, as its interest secures a “purchase-money” obligation (the money enabled the Debtor to acquire the saw and the money was in fact used to pay for it).  By paying the Seller directly, Bank assures that it meets its burden of proof (see § R9-103(g)) that it holds a PMSI.

Problem 3:  On June 30, Debtor decides to purchase a Model X saw from Seller.  The sale price is $50,000.  On July 1, Debtor purchases the saw from Seller, signing a contract in which Debtor agrees to pay for the saw in monthly installments, with interest, and also grants Seller a security
interest in the saw to secure payment of those installments.  On July 2, Seller assigns the contract to Bank, who pays Seller $50,000.  Bank takes possession of the contract and notifies Debtor to make future payments to Bank.  Bank has a purchase-money security interest in the saw.  Seller initially took a security interest in the saw that secured a “purchase-money obligation” (the Debtor’s obligation to pay the purchase price in installments), and thus Seller’s interest was a PMSI.  By assigning the contract to Bank, Seller assigns this PMSI to Bank.

The Purchase-Money Lender’s “Tracing” Burden

Consider Example 1 again, and suppose that Debtor deposited the $50,000 loan in its general bank account (its “operating” account).  Suppose further that during the four-day period between July 1 and July 4, Debtor deposited other sums into this account and also spent money from
that account to meet payroll and pay utility bills (in addition to paying for the saw).  Under these circumstances, is there any way that the Bank can meet the burden of proving that it has a “purchase-money” security interest in the saw?

On the one hand, we could look at the Bank somewhat harshly and say that once the $50,000 loan was commingled with the rest of the money in the account, it became impossible to know exactly which dollars were used to pay for the saw.  On this view, it would be impossible for the
Bank to qualify for PMSI status because it could never meet its burden of proof.  Because the Bank could have easily addressed this problem by making the check jointly payable to the Debtor and the Seller (as in Example 2), one might make a case for viewing the Bank’s situation harshly and denying the Bank PMSI status.

On the other hand, if there was always at least $50,000 in the account at all times between July 1 and July 4, then there is no real “harm” caused by the commingling.  We could indulge the assumption that we had treated the $50,000 deposit as if we had “earmarked” it for use for the
saw.  Then, we could say that as long as the other withdrawals from the account never took the balance of the account below that $50,000 level, we could still identify that $50,000 as having been “earmarked” for the saw — so that when the saw gets paid for, it gets paid for using the
proceeds of the loan and thus the obligation to repay the loan qualifies as a “purchase-money obligation.”  On this view, the commingling shouldn’t really affect Bank’s ability to claim purchase-money status.

As a practical matter, courts would take the latter view, and generally allow the Bank to use “tracing rules” developed by courts in non-Article 9 cases in order to satisfy this “tracing” problem imposed by § R9-103(a)(2).  For example:

Problem 4:  Same as problem 1, except that the $50,000 loan is deposited in Debtor’s bank account.  The Debtor then exhausts the account entirely to meet his payroll, reducing the balance to zero.  On July 3, the Debtor then replenishes the account when he deposits the $50,000 he was paid for the prior construction job.  On July 4, when Debtor buys the saw for $50,000, he does not buy it with the $50,000 obtained from Bank, as that had been exhausted to meet payroll.  Although Bank has a security interest in the saw, it is not a PMSI.

Problem 5:  Same as problem 4, except that following the July 1 deposit of the loan proceeds, Debtor’s bank account contains $300,000.  Between July 1 and July 4, at all times the bank account never had a balance below $100,000.  Under common law tracing rules, the court would
treat the $50,000 loan proceeds as having been “earmarked” for the saw and thus would conclude that those $50,000 were used to pay for the saw on July 4.  Thus, Bank would have a PMSI in the saw.

Problem 6:  Same as problem 5, except than on July 2, the balance in the Debtor’s bank account dropped to $25,000.  On July 3, the Debtor deposited the $50,000 he was paid for the prior construction job, and on July 4, the Debtor then paid $50,000 for the saw.  Under common law
tracing rules, the court would conclude that $25,000 of the funds originally earmarked for the saw had been spent on other bills, and that $25,000 of the funds originally earmarked for the saw had in fact been spent to buy the saw.  Bank has a security interest in the saw, but it will be a
PMSI only to the extent of the $25,000 actually used to pay a portion of the price of the saw.  [Note the “to the extent of” language in § R9-103(b)(1).]

We will discuss these common law “tracing rules” (most notably the “lowest intermediate balance test,” which is demonstrated in Problems 4-6) in more detail when we talk in several weeks about Article 9’s rules governing proceeds of collateral and conflicting security interests in
cash proceeds.

Purchase-Money Priority Rules for Goods Other than Inventory

Generally speaking, a secured party with a purchase-money security interest in goods other than inventory will get priority over conflicting security interests in the same goods if the secured party perfects its PMSI before the debtor takes possession of the goods or within the 20 days after the debtor takes possession of the goods.  § R9-324(a).  If the secured party does not perfect its PMSI within this period, then the priority of the secured party’s interest will instead be resolved by reference to § R9-322(a)(1)’s first-to-file-or-perfect rule.

Problem 7:  Same as Problem 2, except that Debtor has previously granted a security interest in all of its equipment (including after-acquired) to Lender, and Lender has previously perfected that security interest by filing a UCC-1 describing “equipment.”  Debtor takes possession of the
saw on July 4.  On July 10, Bank files a financing statement covering the saw.  Bank will have priority over Lender with respect to the saw under § R9-324(a).

Problem 8:  Same as Problem 7, except that Bank does not file a financing statement covering the saw until August 1.  Bank’s security interest does not qualify for priority under § R9-324(a), as Bank did not file its financing statement within 20 days of Debtor’s taking possession of the
saw.  Thus, Lender will have priority as to the saw under § R9-322(a)(1), as Lender was first to file or perfect.

Problem 9:  Same as Problem 6, except that Debtor has previously granted a security interest in all of its equipment (including after-acquired) to Lender, and Lender has previously perfected that security interest by filing a UCC-1 describing “equipment.”  Debtor takes possession of the
saw on July 4.  On July 10, Bank files a financing statement covering the saw.  Bank will have priority over Lender with respect to the saw under § R9-324(a), but only to the extent of the first $25,000 of the saw’s value, because that is the extent to which Bank’s interest is a PMSI.  After
the first $25,000 of the saw’s value is accounted for, the Bank’s interest would not be a PMSI, but a regular security interest, and thus Bank’s security interest would be subordinate to Lender’s interest under § R9-322(a)(1).  Thus, if Debtor defaulted to Bank and Lender (assume Debtor
owes each $50,000) and the saw sold for $50,000, Bank would be entitled to the first $25,000 of the sale proceeds, but Lender would have priority over the remaining proceeds as first to file or perfect.