The Law Says It Is Inventory

Most goods financed by the equipment finance industry spend at least part of their existence as “inventory” as defined by the Uniform Commercial Code (UCC). Failing to understand when goods constitute inventory can have disastrous consequences for equipment lenders and lessors. Differing rules of perfection, priority and protection of security interests for goods deemed to be inventory place equipment finance companies in an uncomfortable and unusual spot compared to most other areas of their business. The UCC provides an expansive definition of inventory beyond the moment the goods are sitting on a dealer’s floorplan financing line. The growth of rental and pay per use/service businesses will cause more transactions to fall into the inventory categories as discussed below. This article uses a crane as an example to illustrate this issue.

What constitutes “inventory” under the UCC? 

Four broad categories of goods constitute “inventory”: (1) goods being leased by a lessor, (2) goods being offered for sale, lease or furnishing as part of a contract for service, (3) goods being furnished as part of a contract for service or (4) raw materials, works in process and goods consumed as part of a business. A crane could be inventory under all four definitions during different stages of its life. 

The crane would start its existence as raw materials that become a work in process for a manufacturer. After completion, it might end up being offered for sale by a manufacturer and/or a dealer. While these are more obvious examples of the crane being “inventory,” a good might also constitute inventory in the hands of a buyer in other contexts. The buyer of the crane might lease it to others or furnish it as part of a contract for service to those needing a specific crane for a project with an operator and other support. This latter category is one of the more poorly understood possibilities for goods to be considered inventory and a category likely implicated by the growth of pay per use or service businesses.

Why does this matter? 

How one perfects, obtains and maintains priority and protects its security interest in the crane differs in several key aspects if it is treated as inventory instead of equipment under the UCC. Most importantly in the equipment finance industry, goods being considered inventory are impacted by the rules for obtaining purchase money security interests, how proceeds are treated and the rights of buyers of goods in the ordinary course. Further, in the case of motor vehicles, the relevance of titling laws offers unique challenges for even experienced equipment finance teams. Understanding when these rules apply and being able to shift between financing goods considered inventory and goods considered equipment is one of the biggest operational challenges for the equipment finance industry. 

In the example of the crane, whether the state UCC system or the motor vehicle title laws govern the perfection of security interests could vary if the goods are considered inventory or equipment. When it comes to having a first lien on the crane, as shown in the table on the next page, the process and timing for obtaining priority differs drastically for inventory and equipment. Funders need to also be aware of concerns unique to inventory regarding long-term rental arrangements and the rights of buyers in the ordinary course.

Tips for avoiding the “inventory” trap

Equipment finance teams can avoid some of the issues associated with financing goods treated as “inventory” by taking a few pro-active steps. First, understand the customers, the goods being financed for them and how they intend to use these goods. Acquiring these details should be standard practices for anyone in the equipment finance industry and is critical in identifying when goods should be treated as inventory or not. 

Second, properly train all team members to identify potential transactions treated as inventory. Training in advance will assist in assuring that transactions are properly identified. This is not just a sales or credit function, but something that all team members including sales, credit, documentation, booking and collections should be aware of and understand. 

Third, understand the UCC requirements for inventory and properly train and equip operations to handle inventory transactions. 

Fourth, set internal and external expectations accordingly. The perfecting and obtaining priority in inventory can be more time consuming if not done right out of the gate. Customers and vendors need to understand this to avoid customer and vendor conflict.

Conclusion

The UCC rules for inventory can be a hiccup for even experienced equipment finance teams who do not regularly finance goods considered inventory. The varying rules for inventory and equipment under the UCC are one of the hardest concepts for teams to understand. The UCC has a broad definition of inventory that captures many transactions that might occur in an end-user equipment finance business regardless of the terms of the financing. The growth of rental and pay per use / service industries will lead to more transactions falling into the inventory categories. Understanding early in the financing process that transactions can be considered inventory can prevent problems for a finance company’s business, its customers and the vendor of the goods throughout the process.