A purchase money security interest is a type of credit agreement between two parties that allows the seller of goods to be protected against credit default by the buyer. It does so by allowing the seller to have a legal right to essentially repossess any future goods it will sell to the buyer if future payments are not promptly made. This is especially useful when the buyer holds the goods as inventory. Having a purchase money security interest allows the seller to have rights to the inventory ahead of any other creditors who might have claims on the buyer's assets.
Credit arrangements are the way that a great amount of business is conducted in the modern world. This is especially true in terms of dealings between two businesses, when one company provides goods to another company, which then holds the goods as inventory until it can sell them. If the buyer has financial problems, the initial seller of the goods could feel the repercussions of those problems. For this reason, a purchase money security interest is used to protect the seller from the buyer's credit default.
As an example, imagine a situation whereby a company has an existing agreement to sell goods to a distributor, who then resells the goods to the public. Unfortunately, the distributor has been consistently late on recent payments, causing some consternation on the part of the selling company. The distributor contacts the seller and promises that it will be able to recover, and the seller decides it doesn't want to give up on a profitable relationship. Instead, it agrees to a purchase money security interest with the distributor.
The purchase money security interest allows the selling company to be protected against any further credit problems by the distributor. Part of the arrangement requires the seller to contact any other lenders with security claims on the distributor's operations. In this case, the seller lets these other lenders know that the seller's own claims on the inventory it sells to the distributor supersede all other claims.
If the distributor makes future payments on time, the credit relationship may continue. By contrast, if the distributor continues to struggle making payments, the seller can then repossess the goods that the distributor has been holding as inventory. In addition, if the items were sold and the distributor still defaults, the seller can make a claim on the profits from the goods that were sold. It is important to note that the purchase money security interest covers only future goods sold and not any outstanding debts that were incurred prior to the agreement.