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CREDITCOLUMN Bruce S. Nathan, Esq. BAILMENT OR CONSIGNMENT: IT MAKES A DIFFERENCE!

n a tolling arrangement, a vendor legal requirements for obtaining a purchase The consignment terms are frequently usually supplies raw materials to a money type priority interest in the goods. governed by a written agreement commodity processor for conver- This issue recently arose in In re between the consignor and consignee. sioIn into finished product. The processor Citation Corporation, a Chapter 11 case The agreement should contain all of the then delivers the finished or partially fin- pending in the United States Bankruptcy necessary terms and conditions to pro- ished product to the supplier, or the sup- Court for the Northern District of tect a consigner’s interest in the con- plier’s designee, and charges the supplier a Alabama. The debtor/processor and a steel signed goods. Consignments are also fee for the processor’s services. supplier had entered into a “Consignment governed by each state’s Uniform In many tolling arrangements, both the Agreement” for the processor’s forging of Commercial Code (“UCC”). material supplier and the processor the supplier’s steel into airplane crank- UCC Article 9 governs most consign- assume—and their contracts frequently shafts. The processor’s blanket inventory ment transactions. UCC Section 9- provide—that the supplier retains owner- secured lender claimed a prior right to the 102(a)(20) defines a consignment as a ship of the raw materials delivered to the supplier’s steel located at the processor’s transaction in which a person delivers processor, and the finished or semi-fin- forging facility when the processor had goods to a merchant for purposes of sale, ished product of such new materials, in the filed Chapter 11. and (a) the merchant deals in goods of that processor’s possession. However, these The Bankruptcy Court held that the kind under a name other than the name of expectations might be shattered where the transaction was a bailment, rather than a the person making delivery, is not an auc- processor has financial problems and ends consignment. As such, the supplier was tioneer and is not generally known by its up filing for bankruptcy. the owner of the steel and prevailed over creditors to be substantially engaged in Now, might the poor supplier find itself the lender. selling the goods of others; (b) the goods competing with the insolvent processor’s must have a value of at least $1,000 at the bankruptcy estate and blanket secured CONSIGNMENT VS. BAILMENT time of delivery; (c) the goods are not con- inventory lender over who has a prior right sumer goods immediately before delivery; to the supplier’s raw material and finished Consignment and (d) the transaction does not create a goods in the processor’s possession? The In a consignment, the consignor security interest. answer to this question depends on retains title to the goods that were deliv- The consignor should file a UCC whether the tolling arrangement is a con- ered to the consignee. Title passes to the financing statement describing the goods signment or bailment. The supplier would consignee upon the consignee’s use or in the correct jurisdiction in order to lose if the transaction is characterized as a sale of the goods. The consignor usually maintain a protected interest in the goods. consignment unless the supplier had filed a issues an invoice after the consignee’s Otherwise, the consignee’s creditors can UCC-1 financing statement describing the reported sale or use of the goods, and the obtain judicial liens and security interests goods and otherwise complied with the consignee can return used or unused in the goods, and according to UCC goods to the consignor. Section 9-317(a), a judicial lien creditor (including a bankruptcy trustee or debtor- tus. Courts have found a transaction to be risk of loss once Citation was in possession in-possession) has priority over an unper- a bailment based on the existence of the of the Avco Steel. Citation never used the fected consignor. And under Article 9, the following factors: Avco Steel for any other purpose other than consignor could file a UCC on its own, 1. The bailor supplying the goods producing crankshaft forgings for Avco, without the consignee’s signature, as long retained the option to seek their return based upon a production schedule deter- as there is a consignment agreement exe- prior to processing and to the return or dis- mined by Avco, all in accordance with the cuted or otherwise authenticated by the position of the finished product according Consignment Agreement. The consignee that describes the consigned to the bailor’s instructions; Consignment Agreement also did not pro- goods. The consignor uses the same UCC 2. The bailor retained title to the raw vide for Citation’s purchase of Avco Steel or form that a secured creditor uses in per- materials it had supplied and finished for Citation’s sale of the Avco Steel to a fecting a security interest in personal prop- product produced from it and the bailee third party. erty collateral. The UCC form also allows held the goods for the bailor’s benefit; After forging the Avco Steel, Citation the consignor to confirm the existence of a 3. The processor/bailee retained the risk returned the forgings to either Avco or consignment transaction. of loss for the raw materials and finished Avco’s designee for further work. The The consignee must do more to obtain product in its possession; Consignment Agreement further directed priority over the rights of the consignee’s 4. The supplier’s raw materials were seg- both Citation and Avco to monitor their secured lender, or other creditor, with a regated from the processor’s other property; transactions to ensure that all the Avco Steel prior blanket security interest in the con- 5. The processor did not include the that Avco had delivered to Citation was signee’s inventory. According to UCC supplier’s raw materials as part of the manufactured into crankshaft forgings and Section 9-103(d) a consignor has a pur- processor’s inventory; and then redelivered to Avco or Avco’s designee. chase money security interest in its con- 6. The supplier did not show an account signed goods. As such, the consignor would receivable owing by the processor. Citation’s Loan Agreements with Its have priority over creditors holding prior The bailor/supplier’s failure to satisfy Secured Lender inventory security interests in the goods if any of these requirements could result in Prior to Citation’s and Avco’s entry into the consignor satisfies all of the require- the loss of bailment status and characteri- the Consignment Agreement, Citation and ments contained in UCC Section 9-324 for zation of the transaction as a consignment. its secured lender, J.P. Morgan, had entered a purchase money security interest. These To further confuse matters, consignments into a lending arrangement. Citation had requirements include (a) filing a UCC-1 share a number of these criteria. This has granted J.P. Morgan a security interest in financing statement describing the goods resulted in the courts struggling to distin- Citation’s accounts and inventory to secure prior to the consignee’s receipt of the guish between a bailment and consignment payment of the loans pursuant to various goods; (b) sending an authenticated notifi- and reaching inconsistent decisions. As a agreements entered into between them. J.P. cation to the holders of conflicting security result, transactions that suppliers had Morgan also filed a UCC financing state- interests in the consignee’s inventory that assumed to be bailments ended up being ment describing its collateral, thereby per- states that the consignor has, or expects to treated as sales or consignments. In these fecting its security interest. acquire, a consignment interest in the circumstances, the bailor/supplier had to goods and describes the goods; and (c) satisfy all of the UCC Article 9 require- Citation’s Chapter 11 Filing receipt of such notice by the holders of ments for obtaining a perfected security or Citation operated under the conflicting inventory security interests consignment interest in the goods and pri- Consignment Agreement until September within five years before the consignee’s ority over the bailee/processor’s blanket 18, 2004 when Citation filed Chapter 11. At receipt of the goods. inventory secured lender. Any bailor/sup- that time, Citation had 306,000 pounds of plier that had failed to satisfy these require- Avco Steel at Citation’s Navasota, Texas Bailment ments was relegated to the status of a low forging facility. A bailment is a delivery of goods by the priority general unsecured creditor. On November 18, 2004, Avco filed a owner, the bailor, to another party, the motion for relief from the automatic stay bailee, for some express purpose. After ful- THE FACTS OF THE CITATION CASE to obtain possession of the Avco Steel at filling this purpose, the bailee is obligated Citation’s facility. Avco, J.P. Morgan, to return the goods to the bailor or dispose The Parties’ Arrangement Citation and its unsecured creditors’ com- of the goods according to the bailor’s On December 11, 2002, Citation entered mittee agreed to (1) Avco’s taking posses- instructions. As such, a bailment is an into a Consignment Agreement with sion of the Avco Steel; (2) valuing the Avco entrustment under UCC Article 2-403(3). Lycoming Engines, a division of Avco Steel at $306,000; and (3) reserving the The bailor has a right to the goods with Corporation (“Avco”). Under the parties’ right to contest Avco’s ownership, priority over the bailee in possession of the Consignment Agreement, Avco supplied of and prior rights to, the Avco Steel. goods and creditors of the bailee with a steel (the “Avco Steel”) to Citation for security interest or lien in such goods. A Citation to forge into airplane crankshafts. The Competing Positions of J.P. Morgan bailment is not a sale or consignment, and Avco did not file a UCC-1 financing state- and Avco is therefore not subject to the Article 9 ment describing the Avco Steel. J.P. Morgan asserted that Citation and UCC filling requirements and other rules. Citation had no obligation to pay for the Avco had intended to create a consignment Raw material suppliers in tolling Avco Steel. Title to the Avco Steel remained arrangement. J.P. Morgan relied on the fact arrangements have claimed bailment sta- with Avco at all times and Citation bore the that the agreement was called a “Consignment Agreement” and the term 2. At all times, Avco had the right to plan for a consignment. That means making “consign” had appeared on 68 separate take back the Avco Steel or direct its dis- sure the agreement protects the supplier’s instances in the agreement. As a result, J.P. position; rights in its goods delivered to the processor Morgan claimed a prior right to the Avco 3. Avco retained title to the Avco Steel; and in any finished product produced from Steel and sought recovery of $306,000 from 4. The Consignment Agreement did not such goods. The supplier should also file a Avco. Avco’s failure to file a UCC-1 financ- allow or authorize Citation’s sale of the UCC financing statement that describes the ing statement describing the Avco Steel and Avco Steel; supplier’s raw materials and the finished otherwise comply with the UCC Article 9 5. Citation bore the risk of loss for all product in the processor’s possession and requirements for obtaining priority over Avco Steel in Citation’s possession; take all of the other necessary steps under J.P Morgan resulted in J.P. Morgan having 6. Citation used the Avco Steel solely for UCC Article 9 to obtain priority over the a prior perfected security interest in the Avco purposes, forging into aircraft crank- processor’s blanket security inventory lender. Avco Steel. shafts and redelivery to Avco or its designee; The supplier should also seek the agreement Avco argued that the Consignment 7. Citation provided monthly reports to of the processor’s secured inventory lender Agreement was, in fact, a bailment. As Avco reflecting the forging of Avco Steel to waive or subordinate the lender’s interest such, Avco claimed ownership of, and a into airplane crankshafts. in the goods. Otherwise, the supplier is at prior right to, the Avco Steel in Citation’s The Court further found that the main risk of losing any rights to its goods if the possession without the necessity for filing a characteristic of a consignment—a transfer transaction is subsequently treated as a sale UCC-1 financial statement describing the of goods for sale—did not exist in the or consignment. Avco Steel and otherwise complying with transactions between Citation and Avco. Better safe than sorry! I UCC Article 9’s requirements for obtaining Neither Citation nor Avco had intended priority over J.P. Morgan’s security interest Avco’s sale of the Avco Steel to Citation. Bruce S. Nathan is a Partner in the New York City in Citation’s inventory. As a result, Avco was the owner of the office of the law firm of Lowenstein Sandler PC. He is a member of NACM and is on the Board of Avco Steel in Citation’s possession when Directors of the American Bankruptcy Institute THE COURT’S DECISION Citation had filed Chapter 11. Citation did and is a Co-Chair of ABI’s Unsecured Trade UPHOLDING BAILMENT not have any rights in the Avco Steel to Creditors Committee. He can be reached via which J.P. Morgan’s security interest could e-mail at [email protected]. The Bankruptcy Court ruled that the have attached. A win for the supplier Avco! Consignment Agreement was a bailment CONCLUSION This is reprinted from Business Credit rather than a consignment. The Court magazine, a publication of the National relied on the following facts: Association of Credit Management. This article 1. Avco had delivered and Citation had Suppliers operating under tolling agree- may not be forwarded electronically or repro- accepted the Avco Steel for the specific ments should not celebrate just yet and duced in any way without written permission purpose of forging into airplane crank- assume that their arrangement is a bailment from the Editor of Business Credit magazine. shafts, pursuant to the terms of the rather than a consignment. The best practice Consignment Agreement; for a supplier is to hope for a bailment but