Risk Mitigation in Supply Chain Contracts: Consigned Goods

COVID-19 Update

Date: May 20, 2020

Key Notes:

  • As the economic impacts of COVID-19 increase the likelihood of bankruptcy filings, those who consign goods must ensure they are protected against others’ claims against the consigned goods.
  • If a transaction meets the Uniform Commercial Code’s definition of a consignment, to protect its interests in the consigned goods, the consignor must file a UCC financing statement and potentially other notices prior to the goods being delivered to the merchant.
  • If a consignor follows UCC notice requirements and perfects its security interest in the consigned goods, its claim will have priority over those of other unsecured lien creditors, including a bankruptcy trustee, and can even have priority over claims from those with a prior security interest in the same inventory.

While the COVID-19 global pandemic has certainly affected the economy, its full financial impact remains to be seen. However, with retail establishments and other businesses shuttered, bankruptcies are sure to follow. If your business consigns goods to merchants, there are simple steps you can take to ensure your rights in the goods are superior to those of a potential bankruptcy trustee, debtor, debtor-in-possession or other creditor. If your consignment transaction is governed by the Uniform Commercial Code (UCC), the risks of failing to comply with consignment rules can be severe. However, by perfecting your security interest in the consigned goods, you can elevate your status from general unsecured creditor to the equivalent of a secured creditor based on your consignment interest should your customer file for bankruptcy.

Why do I need to perfect my security interest in consigned goods?

If you consign goods to a customer and the consignment arrangement is governed by the UCC, there are certain steps you must take to perfect a security interest in the goods. If you do, your interest in the consigned goods will defeat the unsecured claims of a judicial lien creditor, which includes a potential bankruptcy trustee. However, if you don’t perfect your security interest and the UCC governs the transaction, a potential bankruptcy trustee can set aside your interest and treat your claim to the consigned goods as a general unsecured claim. This is true even though you, as the consignor, have title to the consigned goods and your customer has no obligation to pay for the consigned goods if they are not ultimately sold.

A consignment under the UCC is not simply a transaction in which one delivers goods to a merchant for the purpose of sale – there are additional requirements. First, the goods must not be consumer goods immediately before delivery. Second, each delivery must have an aggregate value in excess of $1,000 at the time of delivery. Third, the consignment itself must not create a security interest, meaning that the transaction does not secure some other obligation, other than returning the consigned goods. Finally, the merchant (i.e., customer) to whom the goods are consigned must not be an auctioneer, must deal in goods of that kind under a name other than that of the person making the delivery and must not generally be known by its creditors to be substantially engaged in selling others’ goods. In a typical UCC consignment arrangement, the consignor is the manufacturer of the product (for example, apparel) and the consignee is the retailer (for example, clothing store) who ultimately sells that product to the product’s end user.

If your transaction does not meet the UCC’s definition of a consignment but still meets the requirements of a consignment under common law, then your interest in the consigned goods as their owner may still possibly prevail over the claims and interests of your customer’s creditors or bankruptcy trustee. Generally, common law consignments do not require perfection, filings or notices, but they tend to be more difficult to prove.

If I made a UCC-governed consignment transaction, what should I do to protect myself?

If you made a consignment transaction governed by the UCC, you must perfect your security interest. According to the UCC, your security interest in the consigned goods is a purchase-money security interest (PMSI) in inventory, which you must perfect by filing a UCC financing statement describing the consigned goods in detail in the proper location (if your customer is a business, in the state where it is organized). If you perfect your PMSI by filing a financing statement, the “first to file” rule protects you from claims by your customer’s subsequent secured creditors (and proper notice to existing creditors can even protect you against their claims to the consigned goods, as discussed below). Without a perfected PMSI, the UCC provides that while the consigned goods are in your customer’s possession, the customer is deemed to have “rights and title to the goods identical to those the consignor had” when determining the rights of its creditors and purchasers of value for consigned goods. Your financing statement is valid for five years and must be renewed prior to the deadline by filing a continuation statement.

What if there is already a perfected security interest in my customer’s inventory that would cover my consigned goods?

After filing your UCC financing statement, you can do a UCC search to determine whether another creditor has filed a financing statement covering your customer’s inventory and after-acquired property. If so, your PMSI can still take priority over the previously filed security interest, but only if you meet certain requirements. First, you must have perfected your PMSI (i.e., properly filed the UCC financing statement) before your customer takes possession of the consigned goods. Second, you must send an authenticated notice to the other creditor stating that you have or expect to acquire a PMSI in the merchant’s inventory and you must describe the consigned goods. The creditor must receive the notice before your customer takes possession of the consigned goods. The notice is good for five years.

What if I made a UCC-governed consignment transaction with a customer who is now in financial distress, but I didn’t perfect my PMSI?

If you made a UCC-governed consignment transaction but didn’t file a financing statement, and you now suspect that your customer is in financial distress, it may still be worthwhile to file one. If you file a UCC financing statement, you can perfect your PMSI in goods delivered within the 20 days prior to filing. By doing so, you ensure that your claim to those goods delivered in the prior 20 days would prevail over a lien creditor’s lien arising during that 20-day period, or even a claim by a bankruptcy trustee, who would also have lien-creditor status. However, filing a financing statement for goods already delivered can raise preference concerns under Bankruptcy Code Section 547.

What else can I do to protect myself if a customer has financial difficulties?

Review and analyze the consignment agreement to understand your rights and your customer’s responsibilities, particularly the requirement for the customer to segregate the consigned goods. Tracing issues and mixed inventory can hamper your claims with respect to the consigned goods. You can help ensure that the consigned goods are segregated by reminding your customer about its segregation responsibilities and/or inspecting to verify the segregation of your consigned goods if your agreement allows you to do so. If possible, you can also take steps in advance to uniquely identify the products with packaging, labels or other means.

FOR MORE INFORMATION

For more information, please contact:

Kip T. Bollin
216.566.5786
Kip.Bollin@ThompsonHine.com

David S. Forsh
212.908.3913
David.Forsh@ThompsonHine.com

Sean A. Gordon
404.407.3678
216.566.5626
Sean.Gordon@ThompsonHine.com

Kyle Hutnick
216.566.5652
Kyle.Hutnick@ThompsonHine.com

Laura Watson Schultz
216.566.5824
Laura.Schultz@ThompsonHine.com

Louis F. Solimine
513.352.6784
Louis.Solimine@ThompsonHine.com

Additional Resources

We have assembled a firmwide multidisciplinary task force to address clients’ business and legal concerns and needs related to the COVID-19 pandemic. Please see our COVID-19 Task Force page for additional information and resources.

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