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Consignment Without a UCC Filing? What

MARCH 2019 THE PUBLICATION FOR CREDIT & FINANCE PROFESSIONALS $9.00 Secured Lenders Know Can Hurt Them

A trade creditor can mitigate the risk of deal- consignee contains the terms of the con- ing with a financially distressed customer signment arrangement, that, if the agree- by entering into a consignment agreement ment is properly drafted, should protect the with its customer. A creditor that “dots its consignor’s interest in its consigned goods. i’s and crosses its t’s” and satisfies all of the The consignee holds the consigned goods requirements for consignment contained in for sale or converts the goods to a finished Article 9 of the Uniform Commercial Code product for sale, and only takes title to the Bruce Nathan, Esq., is a partner in the New York office of the law firm (“UCC”) obtains a first and prior interest in consigned goods when it uses or sells the of Lowenstein Sandler LLP, practices its consigned goods. On the other hand, goods. The consignor frequently issues in the firm’s Bankruptcy, Financial a creditor that fails to satisfy the UCC’s an invoice containing the payment terms Reorganization & Creditors’ Rights requirements for consignment risks losing to the consignee after the consignee’s Group, and is a recognized expert its superior interest in its consigned goods reported sale or use of the goods. If the on trade creditors’ rights and the and being relegated to holding a low prior- consignee cannot sell or use the goods, representation of creditors in bankruptcy ity general unsecured claim. the consignee can return the goods to the and other legal matters. He is a member of NACM, a former member of the board consignor as long as this right is granted of directors of the American Bankruptcy That said, certain creditors that fail to follow under the consignment agreement. Institute and a former co-chair of ABI’s UCC Article 9’s consignment requirements Unsecured Trade Creditors Committee. can invoke a recent decision of the United UCC Article 9 governs many consignment Bruce is also the co-chair of the Avoiding States Bankruptcy Court in Delaware in transactions. UCC Section 9-102(a)(20) Powers Advisory Committee working the Sports Authority Chapter 11 case, TSA defines a consignment as a transaction with ABI’s commission to study the reform Stores, Inc. v. Performance Apparel Corp. in which a person delivers goods to a of Chapter 11. He can be reached via email at [email protected]. (In re TSAWD Holdings, Inc.), as support merchant for purposes of sale, and (a) the for enforcing their consignment rights. The merchant deals in goods of that kind under Michael Papandrea, Esq., is an bankruptcy court held that a creditor who a name other than the name of the person associate in Lowenstein Sandler’s had allowed its UCC financing statement making delivery, is not an auctioneer and is Bankruptcy, Financial Reorganization & Creditors’ Rights Department to lapse still retained a superior interest in not generally known by its creditors to be focused on providing practical solutions its consigned goods that prevailed over substantially engaged in selling the goods for debtors, creditors’ committees, the blanket security interest of Sports of others; (b) the goods must have a value of individual creditors, and other interested Authority’s secured lenders. The court at least $1,000.00 at the time of delivery; (c) parties involved in bankruptcy and relied on the secured lenders’ actual knowl- the goods are not consumer goods immedi- creditors’ rights matters. Prior to joining edge of the consignment arrangement ately before delivery; and (d) the transaction the firm, Mike clerked for multiple when the lenders had made their loans to does not create a security interest. bankruptcy judges in the District of New Jersey and Eastern District of Sports Authority. Pennsylvania. He can be reached According to UCC Section 1-201(37), a secu- at [email protected]. What Is a Consignment? rity interest includes a consignment subject In a consignment transaction, the seller, to UCC Article 9. UCC Section 9-319(a) also known as the consignor, retains title to the states that a consignee acquires all of the goods that were delivered to a prospective consignor’s rights in the consigned goods purchaser, the consignee. The consignment when the consignor’s interest is not per- agreement between the consignor and fected. A consignor can perfect its interest

1 BUSINESS CREDIT MARCH 2019 in its consigned goods by filing a UCC inventory to retain prior rights in the con- security interest in Sports Authority’s inven- financing statement, describing the goods signed goods. tory and other assets that also served as in the correct jurisdiction. And under Article collateral securing payment of the revolver. 9, a consignor could file a UCC on its own, A consignor that seeks to prove that it The term loan security interest was cre- without the consignee’s signature, as long has a true consignment and enhanced ated by Sports Authority’s execution of a as the consignee executes or authenticates priority status in its consigned goods, security agreement that included Sports a consignment agreement that describes without the need to satisfy UCC Article 9’s Authority’s inventory as collateral, and was the consigned goods. The consignor uses requirements, must satisfy the high bur- perfected by the filing of UCC-1 financing the same UCC financing statement form den of demonstrating that the consignee statements in the necessary jurisdictions. that a secured creditor uses in perfecting is generally known by its creditors to be On Dec. 15, 2015, Wilmington Savings a security interest in personal property substantially engaged in selling the goods Fund Society (“WSFS”) replaced BOA as collateral. A consignor that fails to properly of others. The applicability of this exception the term lenders’ agent. WSFS asserted file a UCC financing statement risks losing was at issue in the Sports Authority case. a secured claim against Sports Authority its prior rights in the consigned goods to More to the point, the Sports Authority for the remaining balance of the term loan those creditors of the consignee that obtain court addressed whether the consignor in the principal amount of approximately judicial liens and security interests in the is excused from complying with Article $276.7 million when Sports Authority had goods. Since a bankruptcy trustee and 9 where the secured lenders had actual filed its Chapter 11 case. debtor-in-possession are considered judi- knowledge of the consignment arrange- cial lien creditors, they would similarly enjoy ment when they had made their loans to On the Petition Date, approximately 11-12% priority over an unperfected consignor. Sports Authority. of Sports Authority’s total inventory was subject to various consignment arrange- A consignor must do more than merely file The Facts of the Sports ments. Early in the Chapter 11 case, the a UCC financing statement to obtain a pri- Authority Case consignors had disputed Sports Authority’s ority in its consigned goods over the rights On March 2, 2016, (the “Petition Date”) right to pledge or sell their consigned of the consignee’s creditor that obtained a Sports Authority, a national retailer of goods. The bankruptcy court approved perfected blanket security interest in the sporting goods and active apparel, filed Sports Authority’s sale of consigned consignee’s inventory prior to the consign- its Chapter 11 cases in the United States goods in the ordinary course of business ment arrangement. UCC Section 9-103(d) Bankruptcy Court in Delaware. Sports as long as Sports Authority had complied states that a consignor has a purchase Authority had developed a program for ven- with its pre-petition consignment agree- money security interest in its consigned dors to sell goods on consignment terms to ments. The order preserved WSFS’ right goods. As such, a consignor has priority Sports Authority by entering into “pay by to recoup payments that Sports Authority over a creditor with prior blanket security scan” agreements with Sports Authority. had made to the consignors from the sale interest in the consignee’s inventory if Performance Apparel Corporation (“PAC”) of consigned goods in the event the court the consignor satisfies all of the following was one of the first vendors to sell goods later ruled that WSFS had prior rights in the requirements for a valid purchase money on consignment to Sports Authority. PAC consigned goods. By the end of July 2016, security interest contained in UCC Section had filed a UCC-1 financing statement with Sports Authority had returned or sold all of 9-324: (a) perfection of the consignment respect to its consigned goods on Aug. 28, the goods it had received on consignment interest prior to the consignee’s possession 2009, and gave notice of the consignment from PAC, which had an “extended cost” of the goods; (b) delivery of a notice to the arrangement to Bank of America (“BOA”), of $1,586,446 as of the Petition Date, and holders of conflicting security interests the agent for Sports Authority’s term paid the proceeds to PAC according to the in the consignee’s inventory stating that loan lenders. However, PAC had failed to terms of PAC’s consignment agreement the consignor has, or expects to, acquire file a continuation statement (which was with Sports Authority. a consignment interest in the goods and required to continue the perfection of its describing the goods; and (c) receipt of the consignment interest), causing PAC’s On March 15, 2016, Sports Authority com- notice by the holders of conflicting security UCC-1 filing to lapse in 2014 and leaving menced an adversary proceeding against interests in the goods. PAC with an unperfected interest in its PAC. Sports Authority sought a declaratory consigned goods. judgment regarding the priority of PAC’s UCC Article 9 is not the governing law for all interest in its consigned goods. WSFS consignment transactions. Consignments Prior to the Petition Date, Sports Authority intervened as a plaintiff in the adversary that do not satisfy the requirements of had borrowed approximately $1.1 billion proceeding and sought (1) a declaration that UCC Section 9-102(a)(20) are “true con- from various lenders. The loans included a WSFS’ (and the term lenders’) perfected signments” governed by state law. True $650 million asset-based revolving credit security interest in PAC’s consigned goods consignments do not require a consignor facility and a $300 million term loan. BOA had priority over PAC’s unperfected con- to file a UCC financing statement and pro- was the administrative agent under both signment interest in the goods and (2) judg- vide notice of its consignment interest to loans. The term loan, which was at issue ment against PAC to recover all proceeds secured creditors with a prior perfected in the Sports Authority case, was secured PAC had received from Sports Authority’s blanket security interest in the consignee’s by, among other assets, a second priority prior sale of PAC’s consigned goods.

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On May 18, 2018, the parties filed cross-mo- consignment arrangement when it had secured interest in consigned goods to tions for summary judgment regarding their made its loan to the debtor, then the con- an unperfected consignor. The facts in respective interests in the consigned goods signor’s interest is no secret to the lender, Sports Authority were easy—the term loan and their proceeds. WSFS argued that it and it would not offend the purpose of the agreement referenced PAC’s consignment (and the term lenders) had a blanket per- UCC Article 9 to afford the unperfected interest as a permitted lien and PAC had an fected security interest in Sports Authority’s consignor priority over the secured lender’s existing UCC filing referencing its consigned inventory, including the consigned goods, perfected blanket security interest in the goods when the term loan was extended pursuant to the term loan credit agreement consignee’s inventory. to Sports Authority. Will a court consider a and security agreement and its filed UCC-1 lender to have actual knowledge if it learns financing statements in the relevant juris- The bankruptcy court concluded that of a consignment arrangement while con- dictions. WSFS asserted that PAC’s con- the term lenders had actual knowledge ducting diligence regarding the consignee’s signment interest was not perfected on the of PAC’s consignment arrangement business prior to making its loan? Petition Date because PAC’s previously filed when they had made their loan to Sports UCC-1 financing statement had lapsed due Authority. The court relied on the fact that Or, will the impact of this Sports Authority to PAC’s failure to file a UCC continuation PAC was listed as a Permitted Lien in a decision be somewhat limited? It is worth statement. As a result, WSFS’ (and the term schedule to the term loan agreement. The noting that the same bankruptcy judge lenders’) prior perfected security interest court also relied on the testimony of WSFS’ who issued this Sports Authority decision had priority over PAC’s unperfected interest witness that BOA and all of the term lend- recently rejected another unperfected in the consigned goods pursuant to Section ers had known that PAC had a perfected consignor’s argument that it did not have 9-322(a) of the UCC. interest in the consigned goods when they to file a UCC financing statement to have had made the term loan. As a result, the priority over the blanket security interest PAC argued that the lapse of its UCC filing court held that PAC’s arrangement with of Sports Authority’s secured lenders in was not dispositive because its consign- Sports Authority was a true consignment a ruling issued in a companion litigation, ment arrangement was a true consignment and was not governed by UCC Article 9. TSA Stores, Inc. v. M J Soffe, LLC (“Soffe”). and, therefore, was not subject to UCC PAC did not have to continue its UCC filing, In the Soffe decision, the court concluded Article 9’s filing requirements. PAC relied and, therefore, despite losing its perfected there was insufficient evidence in the on the term lenders’ actual knowledge of status under the UCC, PAC’s consignment record to demonstrate that the lenders PAC’s consignment arrangement prior to interest was superior to WSFS’ (and the had actual knowledge of that consign- making the term loan. term lenders’) blanket security interest in ment arrangement. the consigned goods. The Court’s Granting Frankly, a consignor’s best bet is to avoid of Summary Judgment Conclusion going through the very costly route of liti- in PAC’s Favor The Delaware bankruptcy court’s recent gating to obtain answers to these questions. The bankruptcy court held that PAC’s decision in the Sports Authority case is A consignor would be wise to follow the interest in its consigned goods was a win for unperfected consignors to the applicable requirements for perfection and superior to WSFS’ and the term lenders’ extent they can prove the debtor’s secured priority under UCC Article 9 to avoid the blanket security interest in the goods, creditors knew about the debtor’s existing cost and uncertainty inherent in litigating despite PAC’s failure to continue its UCC consignment arrangements when the whether its consignment arrangement is financing statement and thereby continue secured creditors had entered into loan governed by UCC Article 9’s requirements. the perfection of its consigment interest agreements with the respective consign- under UCC Article 9. The court relied on ees. That said, proving actual knowledge This is not the end of the story. WSFS has UCC § 9-102(a)(20), that a consignment may not always be as simple as it was in filed an appeal from the bankruptcy court is not subject to Article 9’s priority rules if this Sports Authority case where PAC’s con- order granting relief in favor of PAC. Stay a consignor can prove that the consign- signment interest was explicitly acknowl- tuned for further developments! ee’s creditors generally knew that the edged in the term loan credit agreement. consignee was substantially engaged in Nonetheless, the court’s decision suggests *This is reprinted from Business Credit selling consigned goods. The court also that an unperfected consignor can prevail magazine, a publication of the National agreed with the holdings of other courts over a secured lender with actual knowl- Association of Credit Management. This that Article 9’s priority rules do not apply if edge of the consignment interest at the article may not be forwarded electronically a secured creditor had actual knowledge time the term loan was made. or reproduced in any way without written that its borrower held goods on con- permission from the Editor of Business signment when the security interest was Only time will tell how broad of an impact Credit magazine. granted. As the court explained, the UCC’s this Sports Authority decision will have. The filing requirements are designed to protect courts will have to grapple with the issue creditors from “hidden liens”—such as the of what constitutes actual knowledge of “secret liens” of unperfected consignors. If an existing consignment arrangement that a secured lender knows about a particular would subordinate a lender’s prior perfected

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