Consignment Vendor’s Failure To Comply With The UCC May Be Viewed As A Secret Lien And Goods May Be Lost

Scott E. Blakeley, Esq.

A sophisticated credit professional more than ever works closely with the sale’s department to make the sale. One way a credit professional may make a sale to an otherwise financially shaky account that would not qualify for credit terms, is a sale on open account is a sale on consignment. Consignment sales minimize the risk of non-payment. A consignment transaction is not a true sale until the customer (consignee) actually sells the goods; until then, title remains with the owner, usually the manufacturer (consignor).

For the manufacturer or owner who puts up merchandise for sale, the process of selling inventory on consignment does introduce risk wherever there is the possibility of a competing creditor’s claim. Inventory, or proceeds from the sale of that inventory, may become a target of other creditors unless the manufacturer has complied with the Uniform Commercial Code’s (UCC) requirements for perfecting a security interest in the inventory. As the case of In re Truck Accessories Distributing, Inc. discussed belows shows, where a vendor selling on consignment fails to comply with the UCC, the vendor risks losing its inventory, or the proceeds from the sale of the inventory, to a competing creditor.

Consignment Sales

The technical definition of a consignment sale is one in which a consignee has taken possession of merchandise from the goods’ owner. The owner is the consignor. The consignee has the obligation to pay the consignor from the proceeds of the sale of the merchandise. The consignee receives a commission or some other recompense for making the sale. If the consignee does not sell the goods after all, he may return them to the consignor without obligation. Title to goods on consignment remains with the consignor until the sale takes place.

Complying With The UCC

Article 9 of the UCC’s perfection requirements provides the means whereby a manufacturer, or consignor, can establish a valid security interest in his own inventory, even when that inventory has been delivered to a consignee. Compliance with the perfection requirements of the UCC not only protects ownership of inventory; in the event of a dispute over the goods, the consignor will prevail over a competing creditor.

Perfecting a security interest in inventory takes several steps that begins with the consignor. An agreement is executed describing the relationship of the parties involved (i.e., the owner is consignor and the seller is consignee); a description of the inventory; and agreement that title to the merchandise only passes to third-party buyers. Then the consignor completes a UCC-1 financing statement which again describes the inventory and makes clear that the inventory is delivered on consignment. The consignor then files the statement with the filing office (usually the Secretary of State).

The consignor seeking to establish a security interest in its inventory must take additional steps if the consignee has a pre-existing, inventory-secured creditor. For the consignor’s security interest in its inventory to prime the lien of a pre-existing secured creditor, the consignor should first make sure that its UCC-1 and consignment agreement has already been recorded at the time the consignee receives possession of the inventory.

Secondly, the consignor must give written notice to any pre-existing, inventory-secured creditor. It is the consignor’s responsibility to check the filing office to determine that the consignee-debtor and its secured creditor have filed financing statements covering inventory and after-acquired property The consignor’s written notice to the inventory-secured creditor should state that the consignor is delivering inventory on consignment to the consignor-debtor. The notice should describe the merchandise.

A consignor must give notice to any creditor asserting a security interest in the debtor’s inventory in order to avoid any appearance that inventory coming to the consignor-debtor is free from ownership claims. This notice also distinguishes the Anew@ merchandise on consignment from other inventory that is subject to the after-acquired property clause contained in the creditor’s security agreement. The consignor that takes these steps is entitled to the identifiable cash proceeds from the sale of its merchandise, or to the return of the merchandise itself.

To have priority in the accounts receivable generated by the sale of consigned goods, the consignor must also comply with the UCC notice filing requirements as to accounts receivable.

If there is a pre-existing creditor, and the consignor has failed to give notice in the manner just described before he consignee received possession of the inventory, then the consignor has failed to perfect its interest in the consigned merchandise. Its priority in receipt of payment is thereby governed by the “first to file” rule. This means that a pre-existing, inventory secured creditor’s lien would take priority over a consignor’s security interest.

Debtor Known To Sell On Consignment

An exception to the consignor’s need to comply with the UCC Article 9 notice requirement, and an issue in Truck Accessories Distributing, is where the debtor is generally known by its creditors to be engaged in consignment sales. However, in a priority fight with a competing creditor or trustee over the same collateral, it is a heavy burden for a consignor to convince a court that the debtor’s creditors indeed knew that the debtor was engaged in selling the goods of others on consignment.

Informal Consignment Arrangement Between Vendor and Debtor

In Truck Accessories Distributing, the debtor distributed truck accessories. The vendor contending a consignment arrangement (the consignment vendor) with the debtor manufactured truck accessories, which the debtor resold. The consignment arrangement between the parties provided that: (1) the debtor would keep the consignment vendor’s product in a separate building from other inventory; (2) the consignment vendor would bear the cost of shipping; (3) the debtor would remit to the consignment vendor sale proceeds from its product on a weekly basis; and (4) the debtor would assess the consignment vendor a 5% warehousing fee and 5% handling fee. If the consignment vendor’s goods were not sold, the debtor received nothing. The debtor incurred no risk other than its costs of doing business. The consignment vendor did not comply with the terms of the UCC and file a financing statement with the filing office, the secretary of state, notifying the world of the consignment arrangement.

Prior to entering into the consignment arrangement, the debtor had obtained a bank loan. The bank was granted a security interest in the debtor’s assets, including existing and after-acquired inventory. The debtor ran into financial difficulty and was forced to file Chapter 7 liquidation. The bank sought relief from the automatic so as to foreclose on the debtor’s inventory, including the consignment vendor’s inventory. The consignment vendor opposed the relief from stay request as to its inventory, contending that it still owned the inventory, not the debtor, and thus had greater rights to this inventory than the bank.

The trial court ruled that the bank had a superior right to the consignment vendor’s vendor, and denied the claims of the consignor.

Risk Of Loss On Consignment Vendor

The court observed that when non-consigning creditors know of a debtor’s consignment arrangements with a vendor they can take precautions to protect their open account sales. That is the reasoning behind excusing a consignment vendor from complying with the UCC’s notice provisions. From the non-consigning creditors view, consignment arrangements were undisclosed — the infamous “secret liens” that the drafters of the UCC loathe. Such undisclosed arrangements take proceeds from the debtor’s sales that otherwise would be used to pay unsecured creditors.

“The basis for this hostility to consignment arrangements from the bankruptcy courts is fairly obvious. Regardless of the legal theory of the consignment, in practical operation it looks like a sales transaction in which the unpaid seller retains a secret lien in his goods. From a creditor’s point of view, the consigned goods appear to be part of the regular inventory of the consignee which, therefore, ought to be subject to their claims.”

The court stated that the consignment vendor became an unsecured creditor upon the sale of its inventory and had no priority claim unless it had complied with the perfection requirements of Article 9 of the UCC. The court determined that by virtue of security agreement and financing statement, the bank had a security interest in the consignment vendor’s inventory.

Comply Or Risk Losing Your Goods

The Truck Accessories Distributing ruling reminds vendors considering consignment sales that such sales are more than mere “sale or return” transactions. When a party delivers merchandise to a customer to sell, but with the right to receive back the unsold merchandise, the transaction is nothing more than a sale, thus making the selling party (who believed it was a consignment creditor) merely a general unsecured creditor. Since adoption of the UCC, consignment sales have changed. Failure to comply with the notice provisions of the UCC puts the consignor’s inventory at risk to existing and subsequent inventory lenders, unsecured creditors’ committees and a bankruptcy trustee, e.g., while the non-perfected consignment vendor waits for its inventory to be sold, creditors may rush in and levy this inventory to satisfy their claims.

The intent of the UCC is to compel a consignment vendor to comply with the filing statutes. Unrecorded consignment agreements are viewed as “secret liens” and are disfavored as they do not give general creditors the opportunity to protect themselves. Creditors of a debtor in a “sale or return” transaction naturally conclude that goods held by a debtor belong to the debtor. Consignment sales that do not create a hidden lien are to be left alone.

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