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The limits of consignment rights when consigned goods are manufactured into finished product.

A vendor may choose to sell its goods on a consignment basis. In a consignment transaction, the vendor, as consignor, delivers goods to the buyer, as consignee. The consignee then either holds the goods for sale or uses the goods to manufacture a finished product. As a general rule, the consignor retains title to its consigned goods, and does not record a sale of the goods until the consignee has either sold or used the goods.

A consignor that complies with all of the requirements of Article 9 of the Uniform Commercial Code and "dots all of its i's and crosses all of its t's" has enhanced rights in the consigned goods. But what happens to the consignor's interest when the consignee uses the consigned goods to manufacture a finished product? Does the consignor have any interest in the finished goods, the accounts receivable arising from their sale, and other proceeds? The answer in a nutshell may be affected by the terms of the consignment agreement.

The United States Bankruptcy Court for the Western District of Pennsylvania, in In re Excalibur Machine Co., Inc. ("Excalibur Machine"), recently addressed this issue. A supplier and a manufacturer entered into a consignment agreement where the supplier consigned raw stainless steel plate to the manufacturer. The manufacturer agreed to store the consigned goods in a segregated area on the manufacturer's premises and purchase the goods, as needed, to produce finished goods.

The supplier argued that its interest in the consigned goods continued in the finished product. The court disagreed, relying on the consignment agreement. The consignment agreement granted the supplier enhanced consignment rights and a security interest in the consigned goods that were stored at the manufacturer's premises and the proceeds of any sale of these goods to third parties. The agreement did not extend the supplier's interest to any finished goods that the manufacturer had produced using the consigned raw steel, any accounts receivable and other proceeds arising from the sale of these goods, or for that matter, even in any products of the consigned goods.

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Bottom Line: The supplier should have negotiated for the grant of security interest in the manufacturer's finished goods and their proceeds, in addition to the consigned goods.

Overview of Consignment Arrangements

In a consignment, the consignor retains title to the goods delivered to the consignee. Title usually passes to the consignee upon the consignee's use or sale of the goods. As a general rule, the consignor issues an invoice to the consignee confirming the sale of the goods after the consignee's reported sale or use of the goods.

The consignment terms are frequently governed by a written consignment agreement between the consignor and consignee. A consignment 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 Uniform Commercial Code (UCC). UCC Article 9 deals with 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 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 perfected 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 pre-existing 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 Excalibur Machine Case

On December 3, 2004, Samuel Son & Co., Inc. ("Samuel Son") as consignor, and Excalibur Machine Co., Inc. and affiliated companies (collectively "Excalibur Machine"), as consignee, entered into a Consignment Security Agreement. Samuel Son consigned raw stainless steel plate (the "Consigned Goods") to Excalibur Machine under the Consignment Security Agreement. The Consignment Security Agreement further governed Samuel Son's and Excalibur Machine's rights and obligations as follows:

* Samuel Son retained title to the Consigned Goods and Excalibur Machine was required to identify the goods as Samuel Son's property;

* Excalibur Machine had to segregate the Consigned Goods at its premises in Linesville, Pennsylvania and could not commingle the Consigned Goods with Excalibur Machine's other property;

* Excalibur Machine could not remove the Consigned Goods from its premises without Samuel Son's prior written consent;

* Excalibur Machine could either use the Consigned Goods for the production of finished product or sell the Consigned Goods for cash at a price not less than the minimum purchase price specified by Samuel Son;

* Excalibur Machine was required to report to and invoice Samuel Son for all Consigned Goods that were either used or sold and Excalibur Machine agreed to pay all invoices owing to Samuel Son within 30 days of the date of invoice; and

* Excalibur Machine granted Samuel Son a security interest in the Consigned Goods and all proceeds of the sale of these goods to third parties. The security interest did not extend to finished goods or even to products derived from the Consigned Goods. This is the critical provision the Excalibur Machine court relied upon in denying Samuel Son any interest in the finished goods produced from the Consigned Goods.

Samuel Son filed a UCC financing statement with the state of Pennsylvania. The UCC financing statement covered the Consigned Goods and their proceeds.

Samuel Son delivered the Consigned Goods to Excalibur Machine's premises. Excalibur Machine segregated the Consigned Goods in an outdoor storage area. Excalibur Machine did not pay for, and had no obligation to pay for, the Consigned Goods while they were stored in the segregated area.

When Excalibur Machine needed the steel plate in its manufacturing process, Excalibur Machine moved the necessary Consigned Goods from the segregated area into its building for processing. Excalibur Machine then notified Samuel Son of Excalibur Machine's use of the Consigned Goods and Samuel Son invoiced Excalibur Machine for these goods. Samuel Son would then provide additional Consigned Goods to Excalibur Machine to replenish Excalibur Machine's available inventory of raw stainless steel plate.

Once Excalibur Machine moved the Consigned Goods into its building, the goods were processed into a finished product. Excalibur Machine then sold the finished product to its customers. Samuel Son's interest in and rights to the finished goods and their proceeds was at issue in the Excalibur Machine case.

Excalibur Machine's Chapter 11 Filing

On January 31, 2009, Excalibur Machine filed Chapter 11 with United States Bankruptcy Court for the Western District of Pennsylvania. On February 11, 2009, Samuel Son moved in the bankruptcy court to prohibit Excalibur Machine's use of the cash proceeds from, and for adequate protection of Samuel Son's interest in, Excalibur Machine's finished goods, accounts receivable and other proceeds. Samuel Son argued that its security interest in the Consigned Goods continued in the finished goods that Excalibur Machine had produced with the Consigned Goods. As such, Samuel Son also claimed a security interest in Excalibur's accounts receivable arising from the sale of these finished goods and all proceeds from the collection of such accounts.

Excalibur Machine opposed Samuel Son's motion, arguing that Samuel Son's consignment and security interest extended only to the Consigned Goods that were segregated in Excalibur Machine's yard. Once Excalibur Machine used the goods to produce finished product, and Samuel Son invoiced Excalibur Machine for the goods, Samuel Son no longer owned the goods and lacked any interest in the finished product and the accounts receivable arising from their sale.

The Court's Decision in Favor of Excalibur Machine

The court had to decide whether the Consignment Security Agreement extended Samuel Son's security interest in the Consigned Goods to the finished goods that Excalibur Machine had produced using the Consigned Goods and the accounts receivable arising from the sale of these goods. The court ruled that the Consignment Security Agreement limited Samuel Son's consignment and security interest to only the Consigned Goods and the proceeds of their sale, and not to the finished goods and their accounts receivable and other proceeds.

The court relied on the Consignment Security Agreement which granted Samuel Son a security and consignment interest in only the Consigned Goods and the proceeds of their sale to third parties. The agreement did not extend Samuel Son's security interest to the finished goods that Excalibur Machine had manufactured using the Consigned Goods.

The court also noted that while the Consignment Security Agreement permitted Excalibur Machine to sell Consigned Goods to third parties, Samuel Son and Excalibur Machine did not intend that Excalibur Machine would be making such sales. Samuel Son was permitted to maintain an inventory of raw steel plate in a segregated storage area at Excalibur Machine's premises and have these goods available for purchase by Excalibur Machine on an "as needed" basis. When Excalibur Machine needed steel plate to manufacture into finished goods, Excalibur Machine purchased the goods out of consignment by moving them into its building. At that point, title to the goods transferred from Samuel Son to Excalibur Machine. Excalibur Machine was then required to give notice to Samuel Son of Excalibur Machine's movement of the goods and Samuel Son was supposed to issue an invoice to Excalibur Machine for the purchase price of the goods, which was payable on 30-day terms.

Once Excalibur Machine purchased the Consigned Goods and incorporated them into its finished product, Excalibur Machine treated the goods as its own property. Excalibur Machine was obligated to pay for the goods in accordance with the terms of the invoices that Samuel Sons had issued confirming its sale of the goods. Excalibur Machine had no obligation to account to Samuel Son for the processed steel and its proceeds, or return any of the finished goods and any proceeds to Samuel Son.

Conclusion

As the Excalibur Machine case makes clear, consignment rights do not necessarily continue when the consignee uses the consigned goods in the manufacture of finished products. UCC Section 9-336 states that if a creditor's collateral becomes part commingled goods, the creditor's security interest may continue in the product. It is interesting that the Excalibur Machine court never addressed this provision. Instead, the court relied on a consignment agreement that did not extend Samuel Son's security interest to the Excalibur Machine's finished goods, or to even the products derived from Excalibur Machine's use of the consigned goods.

The moral of this story is that a consignor who wishes to obtain a perfected security interest in the finished product that incorporates its consigned goods should make sure its consignment arrangement includes a grant of a security interest in its favor in the finished goods and all accounts receivable and other proceeds (in addition to the consigned goods) and use a UCC financing statement that includes finished goods, accounts receivable and other proceeds (in addition to consigned goods) in the description of collateral. Once again, "dotting your i's and crossing your t's" saves the day.

Bruce Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler 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:Case overview
Geographic Code:1USA
Date:Jul 1, 2009
Words:2177
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