UCC Priority Disputes Between Banks, Lenders, and Factors

How Article 9 Ranks Competing Claims

A priority dispute arises when more than one party claims the same personal property and the property is not worth enough to satisfy everyone. The question is not whether each claim is valid, but in what order the claims are paid. In Illinois, the answer for most business collateral comes from Article 9 of the Uniform Commercial Code, adopted at 810 ILCS 5/9-101 et seq., together with a small number of federal statutes that override state law, most importantly the Internal Revenue Code and the Bankruptcy Code.

Priority depends on two prior questions. First, the security interest must have attached under UCC § 9-203 (810 ILCS 5/9-203): value has been given, the debtor has rights in the collateral, and the debtor has signed a security agreement describing the collateral, or another statutory condition is satisfied. Second, the secured party must determine whether and when its interest was perfected, usually by filing a financing statement under § 9-310(a), but in some cases by control, possession, or automatically. The date and method of perfection drive most of the priority rules discussed below.

Banks, factors, and asset-based lenders typically compete with these parties:

• Other secured lenders and factors holding filed or unfiled security interests in the same collateral
• Purchase-money lenders and equipment vendors that financed specific goods
• Creditors that have acquired a lien on the property by attachment, levy, or the like; assignees for the benefit of creditors from assignment; receivers in equity from appointment; and bankruptcy trustees from the petition date, as provided in § 9-102(a)(52)
• The depositary bank where the debtor keeps its operating account
• Buyers of the debtor's inventory and other goods
• The Internal Revenue Service under a federal tax lien

Each category has its own rule. A secured party that is first in time against one competitor may be junior to another. Effective analysis of a priority dispute therefore begins with an inventory of every claimant, every filing, every control agreement, and every relevant date, and then applies the specific rule that governs each pair of competing claims.

The First-to-File-or-Perfect Rule and Lien Creditors

The baseline rule for competing secured parties is found in UCC § 9-322(a) (810 ILCS 5/9-322(a)). It establishes three tiers:

• Perfected against perfected, § 9-322(a)(1). Conflicting perfected security interests rank according to priority in time of filing or perfection. Priority dates from the earlier of the time a financing statement covering the collateral is first filed or the security interest is first perfected, if there is no later period in which there is neither filing nor perfection.
• Perfected against unperfected, § 9-322(a)(2). A perfected security interest has priority over a conflicting unperfected security interest.
• Unperfected against unperfected, § 9-322(a)(3). The first security interest to attach has priority.

The rule is a race to the public record, not a race to fund. Because § 9-502(d) permits a financing statement to be filed before a security agreement is made or the security interest otherwise attaches, a lender that files early can lock in its priority date before it advances. Knowledge generally does not matter: a first filer that knew of an earlier unfiled interest still generally prevails. Because priority runs from the filing date, later advances under the same filing generally share that priority, subject to the limited exceptions in § 9-323. A gap in perfection, such as a lapse for failure to file a continuation under § 9-515, can forfeit the earlier priority date.

Lien creditors are governed by § 9-317(a)(2). Subject to § 9-317(e) and (f), a security interest is subordinate to a person that becomes a lien creditor before the earlier of perfection or the time when a financing statement covering the collateral is filed and one of the conditions in § 9-203(b)(3) is satisfied. A lien creditor includes a creditor that has acquired a lien by attachment or levy, an assignee for the benefit of creditors, a receiver, and a trustee in bankruptcy. Under 11 U.S.C. § 544(a), a bankruptcy trustee holds the rights of a hypothetical lien creditor as of the petition date, which is why an unperfected interest is generally avoidable in bankruptcy. Section 9-317(e) provides a limited grace period for purchase-money interests: if the purchase-money secured party files within 20 days after the debtor receives delivery of the collateral, it generally takes priority over a lien creditor whose rights arose in the interim.

Because these rules turn on the precise filing date, the debtor's correct name, and the correct filing state, in practice a defect in the financing statement can decide the dispute. The UCC filings page explains where and how a financing statement must be filed to be effective.

Purchase-Money Security Interest Super-Priority

The most important exception to the first-to-file rule is the purchase-money security interest. Under UCC § 9-103 (810 ILCS 5/9-103), a security interest in goods is a purchase-money security interest to the extent the goods secure an obligation incurred as all or part of the price of the goods, or for value given to enable the debtor to acquire rights in the goods, if the value is in fact so used. Equipment sellers that retain a security interest and lenders that finance a specific acquisition are the typical holders. A qualifying purchase-money interest can take priority over an earlier-filed blanket lien on the same goods.

Equipment and other non-inventory goods. Under § 9-324(a), a perfected purchase-money security interest in goods other than inventory or livestock has priority over a conflicting security interest in the same goods, and generally in their identifiable proceeds, if it is perfected when the debtor receives possession of the collateral or within 20 days thereafter. No notice to the earlier lender is required. The 20-day period runs from the debtor's receipt of possession, which may precede the date the debtor signs the financing documents, so the timing of delivery should be documented.

Inventory. The inventory rule in § 9-324(b) and (c) is stricter because inventory lenders rely on a continuing flow of new goods. A purchase-money security interest in inventory generally has priority over a conflicting security interest in the same inventory only if:

• The purchase-money security interest is perfected when the debtor receives possession of the inventory, with no 20-day grace period
• The purchase-money secured party sends a signed notification to the holder of the conflicting security interest
• The holder of the conflicting security interest receives the notification within five years before the debtor receives possession of the inventory
• The notification states that the sender has or expects to acquire a purchase-money security interest in inventory of the debtor and describes the inventory

Under § 9-324(c), the notification requirements apply to a conflicting holder that filed against the same types of inventory before the purchase-money filing or, where the purchase-money interest is temporarily perfected under § 9-312(f), before the beginning of that temporary-perfection period. A purchase-money lender that skips this step generally falls back to the ordinary first-to-file rule.

The inventory priority also has limited reach into proceeds. Under § 9-324(b), it extends to identifiable cash proceeds received on or before delivery of the inventory to a buyer, and to certain chattel paper and instruments, but generally not to accounts. When financed inventory is sold on credit, the resulting account is therefore generally governed by § 9-322, and an accounts lender or factor that filed first will generally have priority in that account over the inventory purchase-money lender. In practice, this distinction can be decisive when a factor and an inventory financier both claim the same receivables.

Proceeds and the Tracing Problem

Collateral rarely stays in its original form. Inventory is sold, accounts are collected, and equipment is traded in. Under UCC § 9-315(a)(2) (810 ILCS 5/9-315(a)(2)), a security interest generally attaches to any identifiable proceeds of collateral. Under § 9-315(c), a security interest in proceeds is perfected if the security interest in the original collateral was perfected. Under § 9-315(d), that perfection generally continues beyond the 20th day after attachment only if one of three conditions is met:

• A filed financing statement covers the original collateral, the proceeds are collateral in which a security interest may be perfected by filing in the same office, and the proceeds are not acquired with cash proceeds
• The proceeds are identifiable cash proceeds
• The security interest in the proceeds is perfected other than under § 9-315(c) when it attaches or within 20 days thereafter

For priority, § 9-322(b)(1) generally provides that the time of filing or perfection as to the original collateral is also the time of filing or perfection as to its proceeds. A lender that filed first against inventory therefore generally holds the same priority date in the accounts and cash produced when the inventory is sold, subject to the purchase-money and deposit account rules. Section 9-322(c) through (e) contain special rules for proceeds of collateral perfected by control or possession, which can change the result for certain categories of collateral.

The practical difficulty is identification. Once proceeds are deposited into a commingled account, the secured party must show that particular funds are proceeds of its collateral. Under § 9-315(b)(2), commingled proceeds that are not goods are identifiable to the extent the secured party can identify them by a method of tracing, including equitable principles, permitted under law other than Article 9. Tracing disputes are fact-intensive and depend heavily on the bank records, the debtor's books, and the sequence of deposits and withdrawals. A secured party that cannot trace generally cannot claim the funds as proceeds.

A factor that has notified account debtors to pay it directly avoids much of this problem, because payment comes to the factor rather than into the debtor's account. The notice of assignment is the tool that redirects those payments.

Deposit Accounts and Control

Deposit accounts follow their own perfection and priority scheme. Under UCC § 9-312(b)(1) (810 ILCS 5/9-312(b)(1)), a security interest in a deposit account as original collateral may be perfected only by control. Filing a financing statement that lists deposit accounts does not perfect an interest in them as original collateral, although a filed lender may still claim identifiable cash proceeds deposited there under § 9-315.

Under § 9-104(a), a secured party has control if it is the depositary bank; the debtor, secured party, and bank agree in a signed record that the bank will follow the secured party's disposition instructions without further debtor consent; the secured party becomes the bank's customer for the account; or another person, other than the debtor, has control and acknowledges holding it on the secured party's behalf, or obtains control after acknowledging that it will do so.

Priority in a deposit account is governed by § 9-327, which generally provides:

• A security interest held by a secured party having control has priority over a conflicting security interest held by a secured party that does not have control
• Except for the depositary-bank and bank-customer priority rules in § 9-327(3) and (4), security interests perfected by control rank according to the time control was obtained
• A security interest held by the depositary bank has priority over a conflicting security interest held by another secured party, except one that has control by becoming the bank's customer

The control rule means that a first-filed lender can lose collected funds to a later lender that took a control agreement, and both can lose to the depositary bank. Under § 9-340(a), the depositary bank generally may exercise its rights of recoupment or setoff against a secured party holding an interest in the account; under § 9-340(c), a setoff based on a claim against the debtor is ineffective against a security interest perfected by control under § 9-104(a)(3). In practice, control agreements often preserve the bank's setoff rights for its own fees and returned items, so the terms of the agreement matter.

Funds that leave the account raise a separate issue. Under § 9-332(b), a transferee of funds from a deposit account generally takes the funds free of a security interest in the account unless the transferee acts in collusion with the debtor in violating the secured party's rights. A lender that waits too long to act on collected proceeds may find that the funds have been paid out to parties against whom it has no claim.

Buyers in Ordinary Course and Federal Tax Liens

Two competitors fall outside the secured-party framework but often decide the outcome of a dispute.

Buyers in ordinary course of business. Under 810 ILCS 5/9-320(a) (UCC § 9-320(a)), subject to the possessory-interest exception in subsection (e) and the farm-products rules in subsection (f), a buyer in ordinary course of business takes free of a security interest created by the buyer's seller even if the interest is perfected and the buyer knows it exists. A buyer in ordinary course is defined in § 1-201(b)(9) (810 ILCS 5/1-201(b)(9)) as a person that buys goods in good faith, without knowledge that the sale violates the rights of another person in the goods, in the ordinary course from a person in the business of selling goods of that kind. The rule protects customers who buy the debtor's inventory. The inventory lender's recourse is to the proceeds of the sale, which is why the proceeds and deposit account rules above carry so much weight for inventory and receivables lenders. A buyer that is not in ordinary course, such as a bulk purchaser of the debtor's equipment, is generally not protected by § 9-320(a).

Federal tax liens. When a taxpayer fails to pay an assessed federal tax after demand, a lien arises under 26 U.S.C. § 6321 on all of the taxpayer's property and rights to property. Priority between that lien and a security interest is governed by federal law, not by Article 9. At a high level:

• Under 26 U.S.C. § 6323(a), the tax lien is not valid against the holder of a security interest until notice of the federal tax lien has been filed
• Under 26 U.S.C. § 6323(c)(1) and (2), a qualifying commercial transactions financing agreement must be in writing and entered into before tax-lien filing; the loan or purchase must occur before the 46th day after filing or, if earlier, before the lender or purchaser has actual notice or knowledge of the filing, and the taxpayer must acquire the qualifying commercial financing security before the 46th day after filing
• Under 26 U.S.C. § 6323(d), qualifying disbursements made before the 46th day after filing or, if earlier, before actual notice or knowledge of the filing may retain priority only in property already subject to the tax lien when notice was filed and covered by a written agreement entered into before filing
• Receivables and inventory the debtor acquires after that 45-day window are generally subject to the tax lien ahead of the lender

These protections carry additional conditions, including that the security interest be protected under local law against a judgment lien arising out of an unsecured obligation. For a factor or receivables lender funding against a revolving pool of accounts, the 45-day window is critical: after it closes, each newly created account may be primed by the tax lien. Notices of federal tax lien are filed in the office designated by state law, which is not always the same office as the UCC records, so a separate federal tax lien search is advisable both at onboarding and periodically during the relationship.

Subordination, Double-Debtor, and New-Debtor Priority

Subordination by agreement. Under UCC § 9-339 (810 ILCS 5/9-339), Article 9 does not preclude subordination by agreement by a person entitled to priority. In practice, lenders use this rule to reorder statutory priority. A bank holding an earlier blanket lien may agree to subordinate its interest in accounts to a factor, or two lenders may divide collateral so that one holds first priority in receivables and the other in equipment. The agreement controls only to the extent of its terms, so the collateral description, the treatment of proceeds, standstill and turnover provisions, and the effect of a bankruptcy filing should all be addressed expressly. The factoring and security agreement page discusses how prior liens are addressed when a new client is onboarded.

Double-debtor problems, § 9-325. A double-debtor dispute arises when a debtor acquires collateral that is already subject to a security interest created by the seller or other transferor. Under § 9-325(a), a security interest created by the debtor is generally subordinate to a security interest in the same collateral created by the transferor if the debtor acquired the collateral subject to that interest, the transferor's security interest was perfected when the debtor acquired the collateral, and there is no later period in which it is unperfected. This is true even if the debtor's own lender filed first against the debtor. A lender financing an acquisition of assets should therefore search against the seller as well as the buyer.

New-debtor problems, § 9-326. A new debtor is a person that becomes bound by another person's security agreement, by contract or by operation of law, such as through a merger, under § 9-203(d). Under § 9-508, a financing statement filed against the original debtor is generally effective against collateral of the new debtor, but if the difference in names makes the filing seriously misleading, it is generally not effective for collateral the new debtor acquires more than four months after it becomes bound unless a new financing statement is filed within that period. Subject to § 9-326(b), a security interest created by the new debtor and perfected solely by a filed financing statement that would be ineffective but for § 9-316(i)(1) or § 9-508 is subordinate to an interest in the same collateral perfected other than by such a filing. In practice, a lender that already financed the surviving entity will often prevail over the lender of the merged entity as to the survivor's collateral. Section 9-326(b) supplies separate rules where competing interests both depend on § 9-508.

How Priority Disputes Are Litigated and Resolved

In practice, priority disputes usually surface after a default, when the collateral is being collected or sold and there is not enough to go around. They are typically resolved in one of several ways.

• Interpleader. Under 735 ILCS 5/2-409, a stakeholder exposed to double or multiple liability by claims arising from the same or related subject matter may join the claimants and require them to interplead.
• Declaratory judgment. A secured party may seek a declaration of the parties' relative rights under 735 ILCS 5/2-701 when an actual controversy exists, often joined with claims for turnover, conversion, or an accounting.
• Enforcement proceedings. Priority is frequently decided in the course of enforcement. A secured party may collect from account debtors under § 9-607, apply collections under § 9-608, and take possession of collateral after default under § 9-609. A secured party that disposes of collateral must generally give notice to the debtor and to certain other secured parties and lienholders under § 9-611, and § 9-615 governs the application of disposition proceeds, including to subordinate interests. A senior party that disregards these rules may face liability under § 9-625.
• Bankruptcy. If the debtor files bankruptcy, the dispute usually moves to the bankruptcy court, where the automatic stay applies and the trustee may challenge unperfected or late-perfected interests under 11 U.S.C. §§ 544 and 547.
• Negotiated resolution. Many disputes end in an intercreditor agreement, a stipulated division of collected funds, or a subordination under § 9-339, once each party has assessed its filing dates, control position, and tracing evidence.

The strength of a priority position depends on documents assembled long before the dispute: the security or factoring agreement, the financing statements and search results, control agreements, purchase-money notifications, notices of assignment, and the bank records needed to trace proceeds. Early review of those documents generally identifies whether the position should be pressed, defended, or negotiated. When the dispute arises in the course of pursuing a defaulted client, account debtors, or guarantors, the factoring collections and recovery practice coordinates the priority analysis with collection of the underlying obligations.