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Recent Court decisions on consignments and other security arrangements: the benefits of aggressive creditor action and the pitfalls of failing to document properly!

In certain industries, vendors frequently enter into consignment arrangements to facilitate their sale of goods. In the typical consignment, the vendor/consignor delivers goods to the buyer/consignee, retains title to the goods and does not record a sale until the consignee reports that it sold or used the consigned goods or, if the consignment agreement provides, kept the goods on hand for a fixed period of time.

A consignor has enhanced rights to the goods delivered to the consignee so long as the consignor satisfies all the requirements for a protected consignment interest. However, rights can be easily lost if a consignment creditor fails to take aggressive action to collect and protect its claim in response to its customer's bankruptcy filing and also if the creditor fails to dot its "i's" and cross its "t's" in the documentation that creates and secures payment of its consignment claim.

The United States Bankruptcy Court for the District of Delaware, in In re Whitehall Jewelers, Inc., recently dealt with whether a Chapter 11 debtor could sell consignment goods free and dear of the interests of consignment creditors. The Bankruptcy Court refused to approve the sale without first ruling on whether the consigned goods delivered to Whitehall were property of Whitehall's bankruptcy estate. That required Whitehall to first commence separate lawsuits against each of the 124 consignment creditors to determine ownership of the consigned goods. The court's decision shifted the balance of power in the case in favor of the consignment creditors, thereby enabling them to reach a favorable resolution of their consignment claims.

In another case, the United States District Court for the Eastern District of Virginia, in In re the Holladay House, Inc., upheld the Bankruptcy Court's ruling that a consignment creditor had a prior perfected interest in only the inventory delivered under its consignment agreement with the debtor, and not also in all of the debtor's

other non-consigned inventory as the creditor had intended to obtain under its consignment and security agreement with the debtor. While the debtor had granted the creditor a security interest in all debtor's inventory in the consignment and security agreement, the creditor's UCC financing statement limited the creditor's perfected security interest to its consigned goods. The court's ruling illustrates the importance to a secured creditor of conforming the collateral description in its security agreement and Uniform Commercial Code (UCC) financing statement. Otherwise, the secured creditor will not be able to recover all the collateral it had bargained for. A real downer!

Consignments

In a consignment, the consignor retains rifle to the goods delivered to the consignee. Title usually passes to the consignee upon the consignee's use or sale of the goods. The consignor issues an invoice after the consignee's reported sale or use of the goods, and the consignee can return unsold or unused goods to the consignor.

The terms of the consignment 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 the consignor's interest in the consigned goods. Consignments are also governed by each state's 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 least $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.

The consignor should file a UCC financing statement describing the goods in the correct jurisdiction in order to maintain a protected interest in the goods. Otherwise, the consignee's creditors can obtain judicial liens and security interests in the goods with priority over the consignor's unperfected consignment interest. According to UCC Section 9-317(a), a judicial lien creditor, including a bankruptcy trustee or debtor-in-possession, has priority over an unperfected consignor. UCC Article 9 allows a consignor to file a UCC financing statement 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 consigned goods. The consignor uses the same UCC form that a secured creditor uses in perfecting a security interest in personal property collateral.

The consignor must jump through additional hoops to obtain priority over the rights of the consignee's secured lender, or other creditor, with a prior blanket security interest in the consignee's inventory. According to UCC Section 9-103(d), a consignor has a purchase money security interest in its consigned goods. As such, the consignor would have priority over creditors holding prior floating liens in the consignee's inventory, including the consigned goods, if the consignor satisfies all of the purchase money security interest requirements contained in UCC Section 9-324. These requirements include (a) filing a UCC financing statement describing the goods prior to the consignee's receipt of the goods; (b) sending 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 such notice by the holders of conflicting inventory security interests within five years before the consignee's receipt of the goods.

The Whitehall Jewelers Case

The debtors, Whitehall Jewelers Holdings Inc. and affiliated entities, were a nationwide specialty retailer of fine jewelry. Whitehall operated 373 retail stores in 39 states, offering a selection of goods that included diamonds, gold, precious and semi-precious jewelry and watches.

Whitehall acquired most of its inventory pursuant to consignment arrangements (usually confirmed in written consignment agreements) with its vendors. The consignment agreements characterized the vendors' arrangements with Whitehall as consignments; confirmed that each vendor owned and had full title to the consigned goods and Whitehall had no right, title or interest in the goods until their resale; and adopted UCC Article 9 as the governing law.

The consignment vendors delivered their consigned goods to Whitehall for resale to Whitehall's customers. Whitehall did not segregate the consigned goods from Whitehall's non-consignment inventory, or otherwise identify the goods, as consigned goods, to its customers.

On or about June 25, 2007, Whitehall changed its name from "Whitehall Jewellers" to "Whitehall Jewelers." UCC Article 9 required Whitehall's consignment vendors to amend their UCC financing statements to reflect the name change within four months of the change as a condition for retaining their perfected interest in the consigned goods. Certain consignment creditors claimed that after its name change, Whitehall had continued to conduct business with them under its old name of "Whitehall Jewellers," instead of its new name of "Whitehall Jewelers." They were thereby induced to rely on their existing UCC financing statements instead of filing UCC amendments to reflect Whitehall's correct name.

Whitehall's Chapter 11 Filing

On June 23, 2008, Whitehall filed its Chapter 11 petition. Whitehall had approximately $63 million of consigned goods, received from approximately 124 vendors, in Whitehall's stores when it filed Chapter 11. The consigned goods comprised most of Whitehall's inventory and the consignment creditors were Whitehall's largest creditors.

Whitehall owed approximately $71.5 million to LaSalle Bank and other lenders. The lenders' claims were secured by first priority liens and security interests in substantially all of Whitehall's assets, including Whitehall's inventory. Whitehall also owed approximately $40 million to another lender whose affiliates owned a majority of Whitehall's stock. The claim was secured by a second lien and security interest in Whitehall's assets, including inventory.

Whitehall's Proposed Asset Sate

The same day as its Chapter 11 filing, Whitehall moved for court approval of the sale of substantially all of its assets, including the consignment goods, free and clear of all liens, security and consignment interests and other encumbrances. The proposed purchasers were a group of liquidators that intended to conduct going-out-of-business sales at Whitehall's stores. The proposed purchase price was approximately 50% of the cost value of the goods.

Whitehall argued that the Bankruptcy Court had the power, under Bankruptcy Code Section 363(f), to approve the sale of the consigned goods free and clear of all consignment interests because Whitehall had challenged all of its consignment vendors' interests in their goods. Section 363(f)(4) permits a debtor to sell assets free and clear of liens, security interests, encumbrances and other interests by proving such liens and other interests are subject to bona fide dispute.

Whitehall disputed its vendors' consignment interests and claimed they were unsecured creditors on several alternative grounds. Certain vendors had failed to file UCC financing statements to perfect their consignment interests. Other vendors had filed UCC financing statements that were defective, thereby rendering their consignment interests unperfected. Certain defective UCC financing statements incorrectly identified "Whitehall Jewellers" as the debtor, despite Whitehall's prior name change to "whitehall Jewelers." Other vendors had failed to satisfy UCC Article 9's requirements for a purchase money security interest that would have otherwise granted them priority over Whitehall's secured lenders with a floating lien in all of Whitehall's inventory. Whitehall also argued that the consignment arrangements were "sales or returns" under UCC Section 2-326 and were therefore subject to the claims of Whitehall's creditors.

Certain vendors objected to the sale of their goods free of their consignment interests. They claimed that Whitehall could not satisfy Section 363 (f), which is a prerequisite for court approval of the sale of their consigned goods free and clear of their interests, because they, not Whitehall, owned the goods.

The Whitehall Court's Decision

The Bankruptcy Court refused to approve the sale until it determined the ownership of the consigned goods. Bankruptcy Code Section 363(b) allows a debtor to sell only property of the debtor's estate. Property of the estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case."

The court rejected Whitehall's argument that it owned the consigned goods by virtue of its possession of and obligation to insure the consigned goods, its identical treatment of consigned goods and other inventory and its ability to sell, and pass title to, the consigned goods without the permission of the consignment vendors. Whitehall's consignment agreements stated that its consignment vendors owned the consigned goods. In addition, Whitehall disclaimed ownership of the consigned goods in its filings with the Securities and Exchange Commission.

The court also ruled that it could not determine whether the consigned goods were property of Whitehall's bankruptcy estate in the context of a contested matter, such as Whitehall's Section 363 sale motion. The court could only invalidate a lien or other interest, such as a consignment interest, following the commencement of an adversary proceeding, a full blown lawsuit, pursuant to Bankruptcy Rule 7001 (2), and not by a motion. The court, therefore, required Whitehall to first commence adversary proceedings against each of its 124 consignment vendors prior to any determination of Whitehall's and its vendors' interests in the consigned goods.

Impact of the Whitehall Court's Refusal to Approve an Immediate Sale of the Consignment Goods

The Whitehall court's refusal to approve Whitehall's immediate sale of the consigned goods allowed the consignment creditors to delay the sale process. The court also directed Whitehall to segregate all proceeds in an amount equal to the cost of such goods, of consigned goods sold post-petition, into a separate escrow account and prohibited any sale of consigned goods at prices below cost. Whitehall faced the prospect of a substantial delay of the sale process and limitations on the sale and disposition of the proceeds of its consigned goods while it litigated 124 separate lawsuits over the issue of whether the consigned goods were property of its bankruptcy estate. This ended up shifting the balance of power in the case in favor of the consignment vendors.

The vendors exploited their advantage to negotiate a global settlement of their claims on favorable terms to them. As part of the settlement, Whitehall agreed to return the consigned goods to vendors participating in the settlement and pay these vendors from the escrow account for the post-petition sale of their consigned goods. A win-win for consignment vendors!

The moral of the Whitehall case is that expeditious and aggressive action by Whitehall's consignment vendors in objecting to the immediate sale of their goods resulted in the favorable treatment of their claims.

The Holladay House Case

The debtor, Holladay House, was a furniture retailer. In September, 2007, Holladay entered into a consignment and security agreement with D.M. Reid Associates under which D.M. Reid had consigned furniture to Holladay for sale to Holladay's customers as part of a 90-day sales promotional event. The consignment and security agreement memorialized Holladay's consignment arrangement with D.M. Reid and granted D.M. Reid a security interest in all of Holladay's consigned and non-consigned inventory to secure payment of all of Holladay's obligations to D.M. Reid. D.M. Reid timely filed a UCC financing statement with the State Corporation Commission for the Commonwealth of Virginia, the UCC filing office. Unfortunately, D.M. Reid did not adequately describe its collateral in its financing statement.

D.M. Reid's collateral, as described in the consignment and security agreement, included all of Holladay's inventory, in addition to the consigned goods from D.M. Reid, and all products and proceeds. However, D.M. Reid's UCC financing statement contained the following narrower description of collateral:

"All inventory, furniture and furnishings of every kind, accessories, goods, merchandise, finished inventory, delivered to consignee at any time by consignor pursuant to a consignment agreement between the consignee and consignor, whether now existing or hereafter arising, wherever located and all proceeds thereof."

On December 21, 2007, Holladay filed Chapter 11. D.M. Reid claimed that Holladay owed $172,437.88 to D.M. Reid when Holladay filed Chapter 11. On January 30, 2008, Holladay moved for court approval of the use of cash collateral. D.M. Reid objected to Holladay's cash collateral motion, asserting that Holladay could not adequately protect the security interest that D.M. Reid had asserted in all of Holladay's inventory.

The Bankruptcy Court overruled D.M. Reid's objection to Holladay's cash collateral motion. The court held that D.M. Reid did not have a perfected security interest in all of Holladay's inventory, but instead had a perfected interest in only D.M. Reid's consigned goods, because of the narrower description of D.M. Reid's collateral (covering only consigned goods) in its UCC financing statement. D.M. Reid then appealed from the Bankruptcy Court's decision.

The District Court's Decision

The United States District Court for the Eastern District of Virginia also held that D.M. Reid had a perfected security interest in only the consigned goods that D.M. Reid had delivered to Holladay under the consignment and security agreement, and not in any other inventory of Holladay House as provided in the consignment and security agreement.

A creditor obtains a security interest in a debtor's assets by the debtor's execution of a security agreement that describes the collateral. However, the creditor must then perfect its security interest in its collateral in order to prevail over all of the debtor's lien creditors, such as a bankruptcy trustee. Most security interests are perfected by filing a properly completed UCC financing statement with the appropriate UCC filing office. The financing statement must include the name of the debtor, the name of the secured party and a proper description of the secured creditor's collateral. This requirement is designed to give notice to third parties of the existence of the creditor's security interest in the debtor's assets. If the description of the collateral in the financing statement is narrower than the description in the security agreement, or the UCC's collateral description contains significant disparities or omissions when compared to the description in the security agreement, the creditor's perfected security interest is limited to the narrower or incomplete collateral description contained in the financing statement.

The description of collateral (consigned goods) that D.M. Reid had included in its UCC financing statement was narrower than the description of its collateral, all of Holladay's consigned and non-consigned inventory, contained in the consignment and security agreement. As a result, the financing statement did not put third parties on notice of the need to inquire about D.M. Reid's security interest in Holladay's non-consigned inventory. That limited D.M. Reid's perfected security interest to only its consigned goods. The court also noted that D.M. Reid's filing of the consignment and security agreement with the UCC filing office was not sufficient to perfect D.M. Reid's security interest in all of Holladay's inventory. D.M. Reid's UCC financing statement did not refer to the consignment and security agreement and incorporate its terms, including its reference to Holladay's consigned and non-consigned inventory as collateral security for payment of Holladay's obligations to D.M. Reid. Once again, as a result of this omission, a reasonable searcher could rely only on the more limited collateral description, consigned goods, contained in D.M. Reid's financing statement.

Bottom line, D.M. Reid was done in by an incomplete collateral description in its financing statement.

Conclusion

The Whitehall decision illustrates the benefits to consignment vendors that aggressively protect their consignment interests (in that case, by opposing Whitehall's sale of their consigned goods). The court's refusal to approve the sale, without first determining ownership of the consigned goods, posed a sufficient enough risk to the sales process to induce Whitehall to settle with its consignment vendors on favorable terms to the vendors.

The Holladay decision further points out the need for secured creditors to properly document their security arrangements, including properly describing their collateral in their UCC financing statements. D.M. Reid's failure to include in its UCC financing statement the broader description of its collateral (all of Holladay's inventory) that was contained in the consignment and security agreement limited D.M. Reid's perfected security interest to only D.M. Reid's consigned goods as described in its financing statement.

Bottom line folks: aggressive creditor action, coupled with proper drafting, maximizes trade creditor recovery!

Bruce Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandier PC. He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI's Unsecured Trade Creditors Committee. He can be reached via email at bnathan@lowenstein.com.
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Author:Nathan, Bruce
Publication:Business Credit
Article Type:Column
Geographic Code:1USA
Date:Jan 1, 2009
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