In a recent blog entry, I discussed the divergent treatment of name changes and other post filing or registration events under the Uniform Commercial Code (UCC) and the Personal Property Security Act (PPSA). This blog entry continues with our goal of exposing the differences between the UCC and the PPSA—so as U.S. lawyers we can give better advice to our Canadian clients—by explaining the different approach taken by the UCC and the PPSA with respect to purchase money security interests in inventory. That difference is material both to the secured party that holds the purchase money security interest and to the lender who may be living side by side with a third-party vendor with a purchase money security interest in inventory. Our comparison is mostly limited to the Ontario PPSA. We understand there are significant variations among the provinces.

Purchase Money Security Interests in Inventory. As U.S. lawyers, we are asked by clients from time to time to assist with documenting and perfecting purchase money security interests in inventory sold by a Canadian vendor to a U.S. customer. The vendor wants to be able to look to that inventory as collateral if the customer doesn’t pay. Under the UCC, like the Ontario PPSA, the rules for purchase money security interests in inventory include the following three requirements: (a) the customer must grant to the vendor a security interest in the inventory that has been sold to secure the payment of the price of such inventory (in a separate security agreement or the purchase and sale documents, signed by the customer), (b) the vendor must timely file a financing statement against the customer and (c) the vendor must timely send written notice to other secured parties with a potentially conflicting security interest. If the vendor satisfies these requirements, the vendor will obtain a purchase money security interest in the inventory sold by the vendor to the customer that will have priority over another secured party’s perfected security interest in that inventory, even though that other secured party filed its financing statement first. My purpose here is not to discuss the technical details of those requirements or the difference in them under the UCC and the Ontario PPSA. The purpose of this blog entry is to highlight a major difference in the scope of the vendor’s priority purchase money security interest under the UCC and the Ontario PPSA, assuming compliance with the applicable requirements.

The Big Difference. The big difference is that, under the UCC, the priority afforded the secured party with a purchase money security interest in inventory does not extend to the proceeds of sale of that inventory unless the inventory is sold for cash on or before delivery. Under the UCC, the vendor that has a properly perfected purchase money security interest in inventory fully compliant with the UCC rules for purchase money security interests in inventory still has a security interest in the account receivable generated by the sale of that inventory, but that security interest will be subordinate to the security interest of a lender that has previously properly filed a financing statement covering that inventory (or accounts or all assets). In contrast, under the Ontario PPSA, a vendor that complies with the purchase money security interest rules for inventory receives a priority security interest not only in the inventory sold by the vendor to the customer, but also in the proceeds of sale of that inventory, including accounts receivable that result from the sale. (Also by way of contrast, under the British Columbia PPSA, the vendor with a priority purchase money security interest in inventory also receives a priority security interest in proceeds, but there is a significant exception which gives priority to an existing secured party with a security interest in accounts receivable as original collateral, and not as proceeds, if such security interest was “given for new value.”)

Consequences Under the UCC. A secured lender will naturally exclude a vendor’s purchase money inventory from any borrowing base. Such lender may decide, however, to continue to lend against all accounts receivable generated by the sale of that inventory, since the vendor’s security interest in those accounts receivables does not have priority over such lender’s security interest.

From a vendor’s perspective, the priority afforded by a purchase money security interest in inventory under the UCC may have limited value—if the inventory is sold, there may be no collateral in which the vendor has a priority security interest. This result may be not be consistent with a Canadian vendor’s expectation. A vendor may enter into a priority or intercreditor agreement with a secured lender to reverse this result, but there is no guarantee that the vendor can obtain such an agreement, and it may add material expense.

Is the Ontario PPSA Better for the Vendor? The Ontario PPSA appears to provide the vendor with a material advantage over the UCC since the vendor receives a priority purchase money security interest in the proceeds of sale of purchase money inventory, including accounts receivable. But this advantage may cause problems for the vendor’s customer. It may be difficult to identify which receivables are proceeds in whole or part of the inventory sold by the vendor to its customer, so the existence of a potentially competing purchase money security interest in the receivables may taint all the customer’s receivables from another secured party’s perspective. As a result, a secured lender could exclude all receivables subject to a potential vendor purchase money security interest from any borrowing base, create a “reserve” against borrowing availability, require a priority agreement to clarify the relative rights of the existing lender and the vendor, or refuse to consent to the vendor’s security interest altogether if consent is required under the loan documents.

More Certainty Under UCC. The UCC offers more certainty than the Ontario PPSA in its treatment of purchase money security interests in inventory by better avoiding the possibility of conflict between the existing lender and the vendor as to receivables. The revisions to Article 9 of the UCC that were adopted in 2001 also help to promote certainty by resolving various issues. See UCC Section 9-103, which expressly provides for limited “cross collateralization” when a vendor is selling inventory in multiple transactions to a customer and also clarifies the application of payments to purchase money and non-purchase money obligations.