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Consignment the right way: file a UCC financing statement.

Frequently vendors enter into consignment arrangements with their customers. In a typical consignment, a vendor does not book a sale until the customer reports that it had sold or used the consigned goods.

In many instances, vendors intend the consignment arrangement to be a security device to increase the likelihood of payment from a financially distressed customer. However, all too frequently, consignment vendors belatedly discover that they had failed to satisfy all of the requirements for obtaining a special protected interest in their consigned goods, and end up being relegated to the status of general unsecured creditors in their customer's bankruptcy case. A common error is the consignor's failure to file a UCC financing statement describing the goods in the required jurisdiction.

That is just what happened in In re Morgansen's, a bankruptcy case pending in the United States Bankruptcy Court for the Eastern District of New York. The bankruptcy trustee had moved for bankruptcy court approval of an auction sale of the debtor's assets, including the sale of consigned goods, over the objection of consignment vendors. The consignors claimed the trustee had no right to sell the consigned goods because the consignors owned them.

The bankruptcy court approved the trustee's auction sale of the consigned goods. The court held the consignors did not have any protected consignment interest in the goods because they had failed to file UCC financing statements describing their goods. The trustee could sell the consigned goods because they were property of the debtor's bankruptcy estate, and the con signors ended up being relegated to the status of pre-petition unsecured creditors.

See what happens when a consignment vendor fails to file a UCC financing statement as part of its consignment arrangement with a financially troubled customer--the consignor loses to the customer's bankruptcy trustee!

What Is a Consignment?

In a consignment transaction, the seller is the consignor, and the prospective purchaser is the consignee. The consignor retains title to the goods following delivery to the consignee. The consignee may hold the goods for sale, or use the goods, such as converting the goods to a finished product for sale. The consignee obtains title to the consigned goods upon the consignee's use or sale of the goods. The consignor usually issues an invoice, containing the payment terms, to the consignee after the consignee's reported sale or use of the goods. If the consignee cannot sell or use the goods, the consignee can often return them to the consignor.

The terms of a consignment arrangement are frequently governed by a written agreement between the consignor and consignee. The agreement should contain all of the necessary terms and conditions to protect a consigner's interest in consigned goods. Consignments are also governed by each state's Uniform Commercial Code ("UCC").

UCC Article 9 governs most consignment transactions. UCC Section 9-102(a)(20) defines a consignment as a transaction in which a person delivers goods to a merchant for purposes of sale, and (a) the merchant deals in goods of that kind under a name other than the name of the person making delivery, is not an auctioneer and is not generally known by its creditors to be substantially engaged in selling the goods of others; (b) the goods must have a value of at Mast $1,000.00 at the time of delivery; (c) the goods are not consumer goods immediately before delivery; and (d) the transaction does not create a security interest.

UCC Section 1-201(37) defines a security interest to include consignments subject to Article 9. Section 9-319(a) states that in determining the rights of creditors of, and purchasers for value of goods from, a consignee, the consignee is deemed to acquire all of the consignor's rights in the consigned goods if the consignor's interest in the goods is not perfected. That means the consignor should file a UCC financing statement describing the goods in the correct jurisdiction ha order to maintain a protected interest in the goods. Otherwise, creditors of the consignee can obtain judicial liens and security interests in the goods, and according to UCC Section 9-317(a), a judicial lien creditor (including, a bankruptcy trustee or debtor-in-possession) has priority over an unperfected consignment.

A "sale or return" that is not a consignment under Section 9-102(a)(20) may also be covered by UCC Article 9. A seller's reservation of title to goods sold and delivered to a buyer is limited to the grant of a security interest in the goods under UCC Section 1 201(37). Again that means a consignor should file a lice financing statement to perfect its interest in its goods.

UCC Section 2-326(2) further states that goods are held on a sale or return basis where they were delivered primarily for resale and the buyer can return them despite their conformity to the contract. Goods held on a sale or return basis are subject to the claims of the buyer's creditors while ha the buyer's possession, unless the consignor perfects its interest by filing a UCC.

Bottom line: for most consignment arrangements, a consignor must comply with Article 9's requirements for obtaining a perfected interest in its goods and protecting its interest from competing secured creditors and lien creditors, including the consignee's bankruptcy trustee. That includes a proper consignment agreement between the consignor and consignee and filing a UCC-1 financing statement describing the consigned goods in the jurisdiction where the consignee is located. And under Article 9, the consignor could file a UCC on its own, without the consignee's signature, as long as there is a consignment agreement executed or otherwise authenticated by the consignee that describes the con signed goods. The consignor uses the same UCC form that a secured creditor uses in perfecting a security interest in personal property collateral. The UCC form also allows the consignor to identify the existence of a consignment transaction.

And the consignor must do more to obtain a priority interest in the consigned goods over the rights of the consignee's secured creditor with a prior floating security interest in the consignee's inventory. UCC Section 9-103(d) states that a consignor has a purchase money security interest in its consigned goods. As such, the consignor would have priority over a prior floating security interest in the consignee's inventory if the consignor satisfies all of the following requirements for a valid purchase money security interest contained in UCC Section 9-324: (a) perfection of the consignment interest prior to the consignee's possession of the goods; (b) dispatch of an authenticated notification to the holders of conflicting security interests in the consignee's inventory that states that the consignor has, or expects to, acquire a consignment interest in the goods and describes the goods; and (c) receipt of the notice by the holders of conflicting security interests in the goods within five years before the consignees receipt of possession of the goods. Otherwise, the consignee would be behind the prior perfected floating lien secured creditor.

In Re Morgansen's Ltd.

The debtor, Morgansen's Ltd., was engaged in the business of selling various expensive merchandise, such as jewelry, art, collectibles and furniture, from a shop in the Hamptons, in Long Island, New York, to retail customers, other dealers and interior decorators. The debtor also conducted auction sales of its inventory from time to time.

The debtor had a cyclical business. Its shop was open 5 to 7 days per week during the summer, but only 2 to 3 days per week for the balance of the year. The debtor acquired about 70 percent of its goods by consignment; the balance by direct purchase. The debtor commingled the consignment and other goods and placed most goods on display in the shop.

The debtor entered into a written agreement with each consignment vendor. The contracts were clearly denominated a consignment agreement, with the first line reading "CONSIGNMENT AGREEMENT BETWEEN MORGANSEN'S LTD ("MORGANSEN'S") AND [NAME OF CONSIGN OR] FOR AND ON BEHALF OF (CONSIGNOR)". Other language in the consignment agreement read as follows:
   Thank you for consigning your property
   to Morgansen's. The terms and conditions
   of the consignment are as follows:
   CONSIGNMENT; You 'Consignor' hereby
   consign to Morgansen's the property
   ... which Morgansen's as the exclusive
   agent for Consignor, will offer for sale
   at, but not limited to public auction.


The contract also granted the debtor complete discretion over the timing and location of any sale and the manner or conducting any sale. Unfortunately, none of the consignors had flied UCC financing statements describing the consigned goods.

Most of the debtor's customers did not know whether the debtor had purchased its merchandise for resale on the debtor's own account or had acquired the merchandise through consignment arrangements. Customers purchased goods from the debtor and then resold them to third parties.

On February 20, 2003, the debtor filed Chapter 11. It conducted business for just 6 months; its case was converted to a Chapter 7 liquidation on August 26, 2003; and a Chapter 7 trustee was appointed to liquidate the debtor's assets. The trustee moved for bankruptcy court approval of an auction sale of the debtor's assets at its premises. The sale was to include "all goods subject to consignment arrangements.

Several consignors objected to the Trustee's sale of their consigned goods. They argued the trustee had no right to sell the consigned goods, which they claimed they had owned, and the goods should be set aside from the auction.

The court overruled the consignors' objections and approved the trustee's auction sale of the debtor's assets, including all consigned merchandise. The court found that the consignors had no perfected or other protected interest in the consigned goods because the consignors had failed to file UCC financing statements identifying their goods, as required by UCC Article 9.

The arrangements between the debtor and its consignors were consignments, as defined by UCC Section 9-102(a), thereby requiring the filing of UCC financing statements, describing the consigned goods in the jurisdiction where the debtor was located--New York State. First, the debtor was a merchant who dealt in goods delivered to it for the purpose of sale, and operated under a trade name other than the names of its consignors. Also, the debtor was not an auctioneer, despite the fact that it had conducted several auctions each year at its premises and had an exterior sign indicating it was an auctioneer. The debtor did not act exclusively as an auctioneer, having engaged in many non-auction transactions with its customers.

There was also no proof that the debtor was generally known by its creditors to be substantially engaged in selling the goods of others, which would have precluded the existence of any consignment arrangement. The personal knowledge of some consignors that the debtor was marketing their consigned goods had no bearing on what other creditors generally knew or should have known about the exact nature of the debtor's business activities. The debtor's unsecured creditors included utilities and other third-party suppliers of goods and services that were not aware of the debtor's business.

The court also found that the consignors had delivered goods to the debtor on a "sale or return" basis. Therefore, under UCC Section 2-326(2), the consigned goods were property of the consignee's/debtor's bankruptcy estate and were subject to the claims of the debtor's creditors. The consignment agreements authorized the debtor to sell the consigned goods by private or auction sales. The debtor's only obligation under the agreements was to pay the net proceeds of the sales, "after deducting commissions, to the consignors.

The consignors could have protected their consignment interest in the goods by filing UCC financing statements. Their failure to do so allowed the trustee to avoid their consignments, and sell the consigned goods for the benefit of the debtor's creditors, and relegated the consignors to the status of pre-petition unsecured creditors of the debtor.

Conclusion

A consignor seeking to protect its interest in goods consigned to a financially distressed debtor needs a consignment agreement that contains all of the necessary "bells and whistles" to protect the consignor's interest in the consigned goods. And, most important, the consignor should file a UCC financing statement, describing the consigned goods, in the state where the debtor is located in order to protect the consignor's interest in the goods from the risk of the consignee's bankruptcy filing and the consignee's bankruptcy trustee's avoidance of the consignment.

Bruce S. Nathan, Esq. is a partner in the law firm of Lowenstein Sandler PC in New York, NY. He is also a member of NACM and the American Bankruptcy Institute. He can be reached via e-mail at bnathan@lowenstein.com.
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Title Annotation:Credit Column; Uniform Commercial Code
Author:Nathan, Bruce S.
Publication:Business Credit
Geographic Code:1USA
Date:Apr 1, 2004
Words:2099
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