For businesses that require customized equipment, purchasing capital improvements can create a substantial liability. So, too, for vendors that manufacture the customized equipment – often investing significant manufacturing costs over a production period that can last several months. Vendors who cannot (or who will not) agree to carry the manufacturing costs will demand prepayment for its work and materials. What is the legal risk of prepayment?

A business owner in this situation might assume that, by virtue of the prepayment, the business automatically acquires ownership interest in the final product. Not so. First, as a general rule, Article 2 of the Uniform Commercial Code provides that title to the equipment does not pass to the business until delivery. Second, in the hands of the vendor, the equipment is nothing more than the vendor’s “work in progress” that is routinely encumbered by a lien in favor of the vendor’s primary lender. It would be exceedingly rare for a vendor not to have a general line of credit secured by all of the vendor’s assets. Assuming that the vendor’s primary lender has perfected its lien, the lender will have a priority security interest in the very equipment that the vendor was producing for the business.

The situation gets even more grim if the vendor files for bankruptcy protection before it delivers the equipment to the business, in which case the trustee (in addition to the lender) will claim a priority interest in all the work in progress. So what is the business to do?

If the prepayment is substantial, a business can protect itself by demanding that the vendor sign a security agreement in favor of the business granting the business a security interest in the equipment. The written agreement must specifically identify the equipment and otherwise comply with both the attachment and perfection rules of Article 9 of the Uniform Commercial Code. If another creditor (for example, the vendor’s primary lender) has already filed a lien, the best practice is to also obtain a subordination agreement in which that lender acknowledges and subordinates to the business’ security interest with respect to the specific piece of equipment. In the event of an insolvency, these steps will allow the business to “leap frog” the pre-existing interests of the lender and recover the equipment – even though it may only be partially completed – for the benefit of the business. As the old adage goes: some recovery is better than no recovery at all. The business can (hopefully) find a new vendor to finish production of the equipment.

Alternatively, the business can consider demanding a performance or payment bond from the vendor (in which the business is identified as the beneficiary), but such bonds are expensive and rarely used.

In addition, the business and vendor may look for creative ways so identify and then immediately transfer ownership of distinct parts of the equipment at various times in the production process. A completed sale under Article 2 of the Uniform Commercial Code gives the business yet another defense to any claims made by a lender or a bankruptcy trustee in the same equipment.

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Law Firm of Conway, Olejniczak & Jerry, S.C.

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