Mingling: Good for cocktail parties, not so good for security interests

So, you’re a lender who has a perfected security interest in a large pile of limestone aggregate at a cement plant. Another lender has a perfected security interest in a pile of clay at that same plant. The aggregate and clay are crushed, and then ground and blended with other ingredients, before being heated in a kiln to produce a substance called “clinker”. The clinker is ground and blended with other ingredients to produce fine cement powder, which is stored onsite in a large silo.^[1]

All well and good. But your original collateral is technically gone, having been mixed with other ingredients (in which you don’t have a security interest) to create the inventory of cement. The question to be asked is, does each lender’s security interest in its own collateral continue in the product produced? And if it does, what if one of the lenders isn’t paid and there are competing claims to the cement stored as a finished product in the silo? The Personal Property Security Act in each common law province in Canada contains at least some answers to those questions. First, that legislation provides in general that perfected security interests in goods that become commingled and lose their separate identity do continue in the resulting product. Also, each Act has rules for determining the priority of security interests in separate goods that are then commingled to become part of what the Act refers to as a “product or mass” in which the identity of the separate goods is lost. Although there are some provincial variations, the approach taken by the priority rule in the British Columbia Personal Property Security Act is typical. It provides that the separate security interests in the goods (e.g. limestone and clay) that are commingled to produce the product (e.g. cement) share in that product based on the ratio of the obligation secured by each security interest to the sum of all obligations secured by all security interests.

But uncertainty and unfairness can arise out of applying that rule. There may be disputes as to the obligations owed to each of the two lenders, or as to the value of the product. Or there could be a third lender with a security interest in the product itself, but not in its constituent parts. The result of applying the statutory rules might not give each lender the result that it expects.

So what’s a lender to do? As in any situation in which it is known in advance that there may be competing security interests, whether in discrete and identifiable goods, in commingled goods, or in goods which may become an accession to other goods, the preferred approach is to enter into an inter-lender agreement before funds are advanced, to clearly set out the priorities between the competing security interests. An inter-lender agreement can also deal with other issues, like sharing information about the collateral and the debtor, or determining the terms under which each lender may demand payment, accelerate debt and realize on its security interests. For example, under an inter-lender agreement one lender could be authorized to take the lead in enforcing the collective security against the commingled goods or other assets and the other could agree to cooperate with that enforcement provided certain conditions are satisfied.

So while mingling can be a good thing in some social situations, it can lead to uncertainty in lending situations. A well-drafted inter-lender agreement can help to resolve the uncertainty, leading to a (with apologies) more concrete result for all of the affected lenders.