Have you ever been in a situation where your subcontractor or fabricator did not have the financial ability to purchase material needed for a project? Have you ever offered your assistance by way of either directly purchasing the material and providing it to the subcontractor/fabricator or advancing funds to the subcontractor/fabricator to allow for the purchase? While this arrangement has its advantages, contractors should be aware of their exposure, particularly if the subcontractor/fabricator has financial issues down the road. Even though a contractor fronts the funds to purchase the materials, it could lose its interest in those materials to the subcontractor/fabricator’s lender, especially if that lender holds a security interest in the subcontractor/fabricator’s inventory.
To minimize this risk, contractors can take certain steps to protect their investment in the material. In general, a contractor can (i) obtain a purchase money security interest (PMSI) in the material, which would have priority over the lender’s security interest, or (ii) establish that it, and not the subcontractor/fabricator, owns the material. Each of these options provide a contractor with some level of protection and may be appropriate depending on the circumstances.
A. Purchase Money Security Interest
If a contractor provides the funding to purchase materials, it can obtain a PMSI. This security interest can give the contractor priority over a lender. A PMSI in inventory requires (a) the filing of a UCC-1 financing statement prior to delivery of the materials, and (b) notice to all lenders that hold a security interest in the inventory. The UCC-1 must be filed in the state of formation or incorporation of the subcontractor/fabricator, if it is an entity, or the state of residency, if the subcontractor/fabricator is an individual. If properly done, a contractor holding a PMSI will have priority over the material in the event the subcontractor/fabricator files for bankruptcy or another secured party claims the materials and attempts to foreclose on its security interest.
B. Establishing Ownership in the Material
Establishing ownership over material that is in the possession and control of a subcontractor/fabricator and is not otherwise distinguishable from the subcontractor/fabricator’s other inventory is a difficult hurdle to overcome. However, having a properly drafted and executed bailment agreement or bill of sale with the subcontractor/fabricator can be an effective tool to evidence ownership. At a minimum, the agreement must clearly identify the material and require that the material be clearly marked and stored separately from the subcontractor/fabricator’s other inventory.
While a PMSI or a bailment agreement can potentially prevent a contractor from losing its interest in purchased material to a secured lender of a subcontractor/fabricator, each option is not ironclad, and drawbacks have to be considered when determining which will best serve a contractor’s needs. Your best option is to consult with an attorney before entering into such an arrangement to ensure that your interests are properly protected.
Marian A. Kornilowicz is a Partner and the Chair of the Business Transactions Group of Cohen Seglias. His practice is concentrated in the representation of clients in varied business transactions and real estate matters.
Anthony M. Bottenfield is an Associate in the Firm’s Construction Group and concentrates his practice on construction litigation.